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Should Markets Really Be This Optimistic?

Markets in Review

After a strong finish last year, the S&P 500 Index gyrated most of the first quarter this year but ended up 5.77%, with the majority of those gains occurring in March. The Dow Jones Industrial Average had a similar rocky start to the year but still ended Q1 up 7.76%. In stark contrast to last year’s performance and the broader market in general, the tech-heavy NASDAQ trailed with a disappointing 2.78% gain.

The big action this quarter occurred primarily in smaller capitalization companies, and especially in value and dividend-based stocks. This was a continuation of the trend we noted at the end of last year. For almost a decade, small-capitalization companies, and especially those with a value bias, have underperformed large-capitalization companies. This is common in late-stage bull markets where investors are attracted to the biggest companies with the largest remaining growth potential.

Figure 1: Price Performance through 3/31/2021

Source: Bloomberg

However, with the availability of vaccines and a light at the end of the tunnel, many companies that had underperformed for years only to be decimated during the COVID bear market are finally showing their true upside potential. This rotation into smaller companies with a value bias is typical during the early stages of any new business cycle, but even more so due to the violent market action last year.

The Russell 2000 Index, which includes 2000 of the smallest companies in the market, was up 12.44% in Q1. Furthermore, value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, dominated the beginning of this year. The broad Russell 3000 Value Index returned 11.31% for the quarter, but the Russell 2000 Value Index that is focused on smaller capitalization companies that also have a value bias returned an impressive 20.71% during the same time period.

U.S. fixed income assets overall were down -3.37% for Q1 as yields, which move in the opposite direction of bond prices, continued to grind higher from their August lows. Looking at just the 10-year U.S. Treasury Bond, the yield increased from approximately 0.92% at the end of last year to 1.74% at the end of March (a stunning 90% increase in yield over just three months).

In general, rising yields and improving economic growth prospects drove the reopening rotation theme this quarter that resulted in a move away from both big technology companies and safe haven investments into companies with the greatest potential for upside.

Should the Markets Really be this Optimistic?

It seems the tide has turned with investors expecting numerous rounds of “COVID Stimulus” and trillions of proposed fiscal infrastructure spending to lift economic activity to levels not seen in decades. As mentioned above, smaller companies and value-based stocks tend to perform best in a rebounding economy. Many of the traditional value sectors (e.g. energy, financials, industrials, and materials) that have been underperforming for years recorded strong performance in Q1. Investors hope government support will jump start and maintain a strong economic recovery for years to come.

As we look out over the balance of 2021 and the next few years, economic growth assumptions seem reasonable, although there may be significant bumps in the road along the way. COVID stimulus, thus far, was used to support short-term objectives of maintaining consumer spending and bailing out badly damaged sectors and businesses that suffered a near death blow from virus-induced disruptions. Even with more than 10 million unemployed and cities boarded up, negative headlines have not slowed the market’s march higher.

Valuations have reached unimaginable levels, with the S&P 500 Index trading at 44 times trailing earnings. Historically, a trailing price-to-earnings ratio of 20 times earnings used to be considered pricey. It seems that investors have come to expect full Fed support to keep markets moving in a positive direction and have perceived little risk that gains could falter.

Speculative investor behavior underscores the idea that investing looks easy as they have gotten used to what seems like a never-ending series of new market highs. Yet the storyboard has changed dramatically with the Fed likely to be supportive, but on the sidelines until they need to start to withdraw accommodation, as interest rates and inflation rise.

Factors that Could Impact the Economic Cycle

Near-term inflation is not as big a concern as many pundits think, with entrenched deflation still present throughout the global economic ecosystem. The crazy run in technology and momentum stocks has subsided for now and will probably yield less return as investors get back to the basics of a company’s fundamentals determining stock prices.

A significant risk factor to economic recovery and the bull market is proposed tax increases. While the intended purpose of tax increases is to fund infrastructure spending, tax policy is largely being driven by the politics of wealth redistribution. The problem with tax increases is that they can offset the positive economic growth effects of infrastructure spending. It’s like priming a pump with water, which gets the water flowing strong, and then pouring sand into the pump, effectively clogging it up, stalling water flow or, in this case, economic growth. 

The Fed and government have spent tens of trillions to keep the economy afloat during and after the 2008 Financial Crisis. Following the COVID crisis they will be forced to spend tens of trillions more to keep the economy alive. Rampant spending will drive the U.S. budget deficit dangerously close to 30 trillion dollars within the next couple of years.

Rising interest rates pose another huge risk factor to the economy and markets as the cost to finance the ballooning debt starts to increase. If rates do rise to 3.0% or higher on the 10-year Treasury note, the cost to fund that deficit will drive a virtual increase in the level of debt that may well become unsustainable.

In the near term, the reflation trade, value stocks, and the sectors closely aligned with economic recovery should be a great place to invest. Many value stocks are still trading at reasonable prices with trailing price-to-earnings ratios less than half of their large-cap growth counterparts.

With the largest growth companies trading at extreme valuation levels, it pays to keep an eye on changing risk factors. The high-flying tech trade reminds us of the bubble right before prices started to fall hard, bringing value back in line with reality. These major price adjustment events usually catch investors by surprise and can torpedo retirement plans.

Looking Ahead

While investing may continue to look easy for a while longer, we have learned the hard way that investing is never easy. The most important path to investing success is to preserve your capital by taking small losses during volatile periods and in bear market cycles. Avoiding the types of portfolio crushing large losses that happened in the past, and will absolutely happen again in the future, allows investors to be well-positioned for the next bull market growth.

Limiting future losses may be more important this time around because losses may be larger than historical norms suggest. We have had unprecedented monetary policy and government support of markets for more than a decade and rationalizing the excesses may be very painful.

However, we think the proposed infrastructure plan could set the stage for another new long cycle bull market that could provide stunning returns once the bear market dust clears. For the moment, it looks like smooth sailing ahead with market expectations still anchored by the euphoria of more government support.


Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.

Photo by Anna Nekrashevich from Pexels


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  1. Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.

  2. The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.

  3. The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.

  4. The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ.

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  6. The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.

  7. The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.

  8. The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.

  9. The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.

  10. The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.

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Unless otherwise indicated all performance is sourced from Bloomberg.


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