Text size

Shipping in downtown Brooklyn, N.Y. A booming U.S. economy will be a continued tailwind for revenue.

Spencer Platt/Getty Images

The

Dow Jones Industrial Average

celebrated its 125th birthday this past week, but investors didn’t throw any over-the-top celebrations in honor of the milestone—or tantrums, for that matter. Major stock indexes bounced around from day to day, drifting modestly higher to extend a relatively directionless streak for the market to a second week.

The Dow finished the week 321.61 points higher, at 34,529.45, up 0.94%. The

S&P 500 index

gained 1.16%, to 4204.11, while the

Nasdaq Composite

rose 2.06%, to 13,748.74.

The path of least resistance for the market remains higher, and while investors can point to plenty of storm clouds on the horizon, they appear to be problems for another day.

“If you just look at traditional valuation metrics, they’re extended relative to history, and it’s easy to get somewhere between cautious and bearish,” says David Donabedian, chief investment officer at CIBC Private Wealth Management. “But we continue to have negative real yields across the yield curve, massive [quantitative easing], and a belief that as good as earnings estimates look for this year and next, they may still be too low.”

The S&P 500 has climbed 39% over the past 12 months, while the index’s forward earnings are up about 40%, according to

Credit Suisse

strategist Jonathan Golub. It may be an expensive market at about 22 times forward earnings, but it isn’t just multiple expansion fueling the rally.

A booming U.S. economy will be a continued tailwind for revenue—just look at retailers’ results from this past week—while much of companies’ pandemic-era cost cutting remains in place, boosting profit margins in the recovery. In fact, S&P 500 components’ forward net profit margins stand at a record-high 12.8%, according to Yardeni Research. For all the talk of cost inflation, supply-chain pressures, and rising commodity prices, companies seem to be doing just fine at passing those along to their customers and keeping their margins intact.

That’s a tough scenario to bet against, Donabedian says: strong demand, earnings that are likely to continue to trend higher, and a central bank that’s still trying to prime the pump.

What about those storm clouds? It’s no secret that the biggest threats to that lofty market multiple are higher interest rates and bond yields. The inflation outlook and Federal Reserve policy, which are intertwined, will exert an even greater influence on the market in the second half of 2021.

The Wall Street consensus is for the 10-year Treasury note to yield 2% or more by the end of the year, up from around 1.6%. Potential tax increases in the U.S., setbacks in the global fight against Covid-19, and other negative wild cards abound.

“We’re sitting at peak good news already being discounted but peak bad news not being priced in yet, and we’re entering a slower part of the year when people go on vacation and trading volumes decline,” says Robert Phipps, director at Per Stirling Capital Management. “It wouldn’t surprise me if the market chops sideways for a while.”

The solution may be to focus on the stocks and sectors that can benefit from the big-picture tailwinds while remaining relatively insulated from the headwinds.

That leads investors to the more cyclical and value-oriented areas of the market. Those are the businesses most tied to the growing economy, with cheaper valuations that are less sensitive to rising discount rates. That’s not a new strategy—the

Russell 1000 Value index

has beaten its Growth equivalent by about 12 percentage points since the start of 2021. But there’s potential for the trade to keep working.

“Historically, the

Russell 1000 Growth

trades at a 5.6x multiple point premium to Value,” Golub writes. “It currently trades at 10.3x over.” Each point of the valuation gap that narrows would mean 4% or 5% outperformance for value over growth.

Valuations aside, many cyclical and value stocks coming off a nightmarish 2020 are in a position to show faster earnings growth in 2021 than the relatively pandemic-insulated software and technology sectors, which face tougher comparisons.

The market won’t always be as placid as the past two weeks. Consider overweighting industrials, banks, materials, and energy, and wait for a better entry point for the expensive long-term growth names.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com

Read More