The S&P 500 just logged its seventh consecutive monthly gain, marking its longest winning streak since January 2018. Indeed, there has not been a 5% pullback since October, an unusually long stretch for the stock market. The S&P 500 index is up over 20% year-to-date through August 31, marking only the 11th year since 1928 when that has occurred. While this is an admittedly small sample size, in those other 20+% years, the market has moved higher 83% of the time with an average return of 4.0% through yearend.
More important, though, are the current fundamentals which remain primarily positive. The Fed remains in an accommodative mode while fiscal policy remains highly stimulative. Corporate year-over-year earnings growth peaked in the second quarter (S&P 500 earnings growth was 93%) but remains robust with over 20% growth expected for both the third and fourth quarter and 9% earnings growth anticipated for 2022. Corporate balance sheets have improved after the pandemic shock, boosting share buyback activity to record levels.
There are, of course, many market concerns as well. The Conference Board found U.S. consumer confidence in August at its lowest level since February. Business executives have become more worried about inflation as higher costs for labor and raw materials eat into their companies’ profits. According to a survey released Thursday by the Association of International Certified Professional Accountants, roughly 64% of executives said their companies were raising wages to attract and retain workers. Geopolitical concerns are also increasing.
While the inflation clouds are gathering, the yield on the 10-year Treasury note is below 1.3% generating negative real returns (after inflation). The Fed is still buying $120 billion of bonds each month and there remains about $9 trillion of sovereign debt overseas with negative nominal yields. Thus, to foreign investors, a 1.3% yield looks attractive helping to keep interest rates at a low level. Economic growth is slowing in the U.S. and in China, the world’s second largest economy. The massive increase in U.S. federal debt resulting from unprecedented spending will further slow growth over several years.
Low interest rates have been positive for equity valuations (many of which are at record levels) but rising inflation could lead to lower valuations setting up a tug-of-war between strong earnings and declining multiples.
One interesting aspect of stock returns this year has been the underperformance of quality stocks. Nevertheless, we believe that quality (balance sheet strength, strong free cash flow and high returns on invested capital) remains a critical element to long-term investment performance. When we purchase stocks, we are buying ownership in an operating company, and we want to own outstanding companies rather than mediocre ones. That will continue to be our research focus.