The economy is rebounding. Need proof? Check out the first quarter earnings reports corporate America is releasing, which show S&P 500 companies are on track for their highest rate of profit growth in more than a decade.
Earnings aren’t the only reason to feel optimistic. More than 55% of Americans have received at least one dose of a Covid-19 vaccine as of late April. The number of people filing for initial unemployment claims reached a new pandemic low of 553,000 in the third week of April, a fraction of the 3.5 million tally a year ago. Consumers are feeling more upbeat, with confidence edging past pre-lockdown levels, according to the weekly Ipsos-Forbes Advisor U.S. Consumer Confidence Tracker.
Unsurprisingly, stock prices have also jumped higher. The major U.S. benchmarks notched new, all-time highs in the past month. And the S&P 500, which historically has posted average annual gains of about 10%, is up more than 12% in just four months.
All this good news is inflating talk of a potential bubble in the stock market. Federal Reserve Chairman Jerome Powell even dared to say that parts of the markets “are a bit frothy” following the central bank’s most recent meeting, though he declined to specify which parts.
May historically is one of just three months when the S&P 500 declines, on average, though it does so just barely. As earnings season winds down, news from Washington on potential legislation related to taxes or infrastructure could move the market—as well as inflation and interest rates.
An Earnings Season for the History Books
The National Bureau of Economic Research has not yet called an end to the recession that began in 2020, but earnings season is telling us that the worst of the economic downturn is over. The first two weeks of May will see the final flurry of earnings reports, including from many retailers.
Among those companies in the S&P 500 that have already released results for the first quarter, 86% reported that their earnings per share were better than analysts expected. That’s the highest positive surprise since FactSet began collecting data in 2008.
The question heading into May is whether this trend can continue for the rest of the sectors that haven’t reported yet, according to Ryan Kelley, chief investment officer and portfolio manager of Hennessy Funds. The financial and technology companies that have already disclosed their earnings results have driven the historical levels of performance we’ve seen so far during earnings season, and Kelley will be watching for confirmation from other parts of the economy.
“We still have a significant amount to learn from earnings season,” says Kelley, adding that results so far have caused some readjustments to expectations for the entire year. “A real significant number of analysts and companies are raising guidance for 2021.”
Inflation Remains a Wild Card
As for economic data in the month ahead, investors remain focused on inflation—and after months of fretting, the first signs of a real uptick in inflation have arrived. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure Index (PCE), rose 2.3% in March from a year earlier, the biggest gain since 2018.
“Everyone’s been focused on the extent to which inflation is going to kick in,” notes Greg Bassuk, the chief executive officer of AXS Investments. Tracking this pricing data will be really important, especially because it could influence the outlook for corporate earnings. In turn, the prospect of higher inflation that cuts into corporate profits could hamper the extent to which stocks can continue to rally, he adds.
The stock market could cool off if the pandemic suddenly worsened or if inflation kept creeping higher, which would prompt the Fed to raise interest rates too soon, Kelley adds.
For now, that’s not an immediate concern, though Kelley says investors will try to anticipate any Fed moves before they happen. Traders currently predict low odds of a rate hike at the central bank’s meetings through the rest of the year. “We still think this market has more to run because there will be a good amount of time, a couple years even, before the Fed is raising rates significantly,” says Kelly.
An Uptick in Volatility
President Joe Biden caused a minor stir in the stock market last month when the details of his Made in America plan were released. Proposals include raising the corporate income tax rate from 21% to 28% and reinstating the top individual income tax rate for high earners to 39.6%, up from the 37% current level stemming from former President Donald Trump’s tax cuts.
Wall Street will monitor developments on possible tax hikes closely because of the potential impact on stock prices, Bassuk says. “We’ll want to see how aggressive that proposal will be, and whether or not it will make its way successfully through Congress,” he says.
Beyond earnings reports, economic data and the Fed, policy moves by the Biden administration could cause some volatility in the stock market in May and beyond, says Bassuk. “Looking ahead over a number of months, we just don’t see enough certainty in any of these areas.”
Moreover, dynamics in the bond market continue to cause some angst in stocks. The yield on the benchmark 10-year Treasury remains near its year-to-date high after big jumps in February and March. After decades of generally falling interest rates—and more than 30 years of rising bond prices—investors are trying to sort out what the era change means.
“When will we see signs of an uptick in rates—that seems to be what the market is most concerned about,” Kelley says.
Another interesting development? Volatility has carried over to other markets, like cryptocurrencies, in addition to the traditional assets of stocks and bonds, Bassuk notes. Market volatility in general is the subject of “every other conversation with clients,” he adds. “There’s this tug-of-war between stocks and bonds, and we think it’s going to be a big theme in May.”
The Great Rotation Continues
Finally, four months into 2021, a dominant theme has emerged—and it shows no signs of letting up: The so-called “great rotation.” Investors continue to favor value stocks in lieu of growth stocks, migrating from “tech high flyers and stay-at-home stocks” to the more defensive or cyclical types, Bassuk says.
And Kelley expects this trend to continue as investors come back to the sectors and stocks that “were completely forgotten” in the beginning of the stock market’s rally last year. “It’s a small thing that is a big part of what’s going on in the market right now,” he says.