Last weekend, I conducted an unscientific and low sample Twitter poll on the market perception of the Georgia special Senate elections. The results were surprising. Respondents were bullish on both a Republican and Democratic sweep.
As the results of the Georgia Senate race became clear, the analyst writing under the pseudonym Jesse Livermore tweeted that these results represent a “fiscal Goldilocks” scenario.
However, the analysis of the investment risk and opportunity is far more nuanced than just a simple bull and bear question.
The stock market isn’t the economy
It is trite to say that the stock market isn’t the economy and vice versa. This analysis from JPMorgan Asset Management tells the story. Technology, which includes Communication Services, comprises 6% of GDP, 2% of employment, and 38% of the S&P 500. Add in Amazon and Tesla, and their combined is nearly half of the index weight.
Here is why this disparity matters. When the market opened on Wednesday after the Georgia special elections, NASDAQ stocks fell even as the rest of the market rose on Wednesday. This was attributable to fears of greater antitrust and regulatory scrutiny of Big Tech companies. While there was an element of truth to that interpretation, there is more to the story of growth stock weakness.
As the election results trickled in Tuesday night and a Democratic sweep became apparent, the 10-year Treasury yield spiked to above 1% overnight and the yield curve steepened. These are credit market signals of greater economic growth in anticipation of more fiscal stimulus.
More growth should be bullish, right? Not for large-cap growth stocks. Growth stocks are duration plays, and they act like long bonds in response to changes in interest rates. When the yield curve steepened and bond yields rose, large-cap growth stocks underperformed.
When the yield curve steepened in anticipation of better economic growth, that should be bullish for cyclical stocks. But the cyclical weight in the S&P 500 is only about 20%, while large-cap growth is nearly 44.5%. As growth stocks face headwinds from rising 10-year yields, this index weight disparity makes it difficult to be overly bullish on the S&P 500.
An analysis of the relative returns of the top five sectors of the S&P 500 tells the story of the headwinds facing the index. Large-cap growth (Technology, Communication Services, Consumer Discretionary) relative performance is best described as flat to down. Healthcare relative performance may be trying to bottom, and financial stocks are starting to turn up. The top five sectors make up about 75% of the index weight, and it’s difficult to see how the S&P 500 can advance sustainably without the participation of a majority of its biggest sectors.
Notwithstanding the disparity in index weights, a rising 10-year Treasury yield is historically friendly to value stocks. Yields fall in anticipation of declining economic growth and rise in anticipation of better growth. In an environment where growth is scarce, investors will pile into growth stocks, and in an environment when growth is plentiful, investors favor value stocks. Inasmuch as value sectors represent about 30% of the S&P 500 weight, and growth sectors 45%, the style headwinds for the market are lessened should growth stocks become laggards.
Here comes the cyclical rebound
Regardless, there are plenty of signs that the economy is poised for a cyclical rebound.
Household finances are in good shape. Credit card debt (blue line) has fallen dramatically while checking deposits (red line) have soared. The consumer is ready to spend.
The prospect of even more fiscal stimulus is supportive of even more expansion. As the Democrats tend to be more focused on inequality, the distribution of stimulus money will be tilted towards lower-income Americans, who have a greater propensity to spend additional funds than to save them. Expect a wave of consumer spending to begin in the next six months as the combination of widespread vaccination and stimulus funds reach the wallets of American consumers.
In light of the large negative surprise in the December Jobs Report, it is worthwhile to consider what might happen next as the economy recovers. The headline loss of 140K jobs was led by weakness in the service sector, which was attributable to to huge declines of -372K in food and beverage jobs, -92K in amusement and recreation, and -63K in private education.
Australia is a case study of what pent-up consumer demand looks like in a post-COVID environment. To recap, Australia underwent a full lockdown until late September as a second wave hit. Case counts have since eased dramatically, even without a vaccine.
Like other countries, it is the service sector of the economy that collapsed. Take a look at what happened next. Travel demand has fully recovered.
AirBNB has also enjoyed a revival.
In light of the Australian experience, imagine what would happen to the US economy if a vaccine and more fiscal stimulus were overlaid on top of that?
What’s more, the recovery is global in scope. 82% of manufacturing PMIs are in expansion mode.
To sum up, the following sectoral balance analysis tells the story of an economy that’s ready to roll. Past recessions have been marked by over-levered household balance sheets (blue line) and corporate sectors that were deleveraging as the economy entered recession. This time, the corporate sector is in reasonably good shape, and weakness in the household sector has been offset by government stimulus. As soon as vaccines becomes widely available, the economy is ready to return to normal.
Too far, too fast?
However, equities may have risen too far, too fast. Willie Delwiche
observed that the markets entered 2021 with 96% of global markets above their 50-day moving averages. While these readings have been long-term bullish, the markets are poised for a short-term pause.
The current market recovery is reminiscent of recoveries from recessionary bottoms, such as 1982 and 2009. If the past is any guide, the market is due for a period of consolidation and choppiness.
A global cyclical recovery argues for a greater commitment to emerging markets instead of US large-cap growth stocks, which were the winners of the last cycle. An analysis of EM fund flows shows that investors have not fully embraced the EM as a cyclical recovery vehicle just yet. Fund flows are nowhere near a crescendo, which is constructive.
In conclusion, the Democrats’ trifecta win is bullish for the cyclical revival investment theme, but the S&P 500 may face headwinds because of the excess weighting of large-cap growth stocks in that index. Investors should overweight sectors and groups levered to the cyclical recovery, both within the US and abroad, such as EM. Tactically, the markets are poised to pause their rally in the near-term, and investors should take advantage of any weakness to add to their cyclical exposure.