The market powers into the second quarter, but investors should be vigilant

Published Mon, Apr 5 20218:34 AM EDTUpdated Mon, Apr 5 202110:01 AM EDT

At some point as a market cycle unfolds, the big risk shifts from overthinking the situation to underappreciating the hazards. It's not clear we're there yet: Both the impressive market action and torrent of positive economic news continue to reward the "keep it simple" approach so far in 2021, with higher stock prices, outperformance by cyclical beneficiaries and index pullbacks that are brief and shallow, if a bit more frequent. If two bedrock rules for staying with market trends are "Don't fight the Fed" and "Don't fight the tape," then investors should be comforted by the lack of provocation by either right now. A revving economy and easy Fed policy The economy is revving hard right now. The ISM manufacturing index last week reported a 37-year high of 64.7, auto sales are back to a record annual rate, home price growth is the best in 15 years and 916,000 net new jobs in March took the unemployment rate down to 6% — with Goldman Sachs talking about a move under 4% next year. And with it all, Federal Reserve officials will continue to insist none of it will prompt a shift away from maximum-easy policy until full employment is here and not projected — and even then, not unless inflation is running above 2% for a while. This "sweet spot" interlude, when good news does not elicit a policy offset, will not last forever. And the market will probably undergo a few exaggerated scares about it ending before it does. But it isn't over yet. The push above the 4,000 mark by the S & P 500 last week extends a remarkably orderly uptrend since late October, the index benefiting from broad upside participation, salutary day-to-day ebb and flow among equity styles and sectors, swelling flows into stock funds and lavishly accommodating credit markets. A repeat of 2013 and 2017? While it's too rash to say for sure that 2021 will be a rerun of two of the most persistently strong years since the 2008 financial crisis, the rhythm of the tape so far resembles the "immaculate rotation" cadence of 2013 and 2017, two prior post-election years when volatility fell and stocks powered higher after bond yields jumped from historic lows. It's fair to point out that equity valuations near 21-year highs and 10-year Treasury yields at 1.7% are less-effective rationalizations for stocks' stark expensiveness than they were at 0.5% last year. But earnings expectations have climbed in lockstep with the S & P 500 for 10 months now, with the forward price-earnings ratio steady near 22 since June. The S & P 500 was up 5.8% on the first quarter. Tidily enough, FactSet says first-quarter profit forecasts rose 6% over the three months, and estimates for all of 2021 are up 5%. Along the way, there has been a rolling sequence of corrections in the most extended, speculative precincts of the market. Over the past 10 weeks, the market has absorbed the GameStop "meme stock" positioning shock of late January; the stiff 30%-plus comeuppance in the "preprofit" hypergrowth tech stocks exemplified by the ARK Invest portfolios ; the sloppy liquidations related to Archegos' margin calls; the cooling of the SPAC craze – even sharp corrections in small-cap and semiconductor stocks. These have served to release some pressure from the most egregiously valued stocks while stoking enough uncertainty to moderate investor sentiment and keep risk appetites from getting (or at least from staying) at perilous extremes. All while limiting S & P 500 pullbacks to fleeting dips of less than 5%. This is the behavior of a healthy, well-supported equity complex for sure — though it also could be considered the luckiest, best-case outcome, too. Does the increasing frequency of these concentrated shakeouts suggest a growing vulnerability of the broader market? Cracking the 4,000 threshold Investors are generally fully invested, with cash and short-interest levels near record lows, real-time trading liquidity lacking and fewer unexploited areas of the market than there were before the ripping revival of distressed, value and cyclical stocks since last fall. There isn't much technical significance to the 4,000 level on the S & P 500, though perhaps it's worth recalling that the index at least hesitated for several weeks (and up to a year and a half in the instance of the 2,000 threshold) when recent 1,000-point levels were hit. Around the 4,100 level, if reached relatively soon, the index would again bump against the upper bound of its well-established uptrend path, something that could certainly coincide with the waning of April's favorable seasonal tailwinds to provide a more interesting tactical test for the rally. At that level, too, the index would exceed 20 times calendar-year 2022 forecast S & P earnings, a nice round (and pretty stout) multiple of earnings for a year that won't start for another eight months. The extreme compressed nature of the past year's crash-and-surge phase and the rapid spread of boom-time expectations means it can't hurt to be alert for the shift toward a market that is less generous per unit of good news than this one has been. The forces of mean-reversion are no longer quite as friendly to stocks as they've been. Forward S & P returns after the ISM manufacturing reading above the 60 level have been subpar, for instance. When the huge ISM beat was reported Thursday, industrial stocks lagged. Cyclical/infrastructure favorites Caterpillar and Deere look at once expensive, overbought and tired. While the searing growth-vs.-value swings have eased a bit, there has been a subtle outperformance in recent weeks by quality and defensive stocks such as staples, utilities and dividend-growth names, a trend to watch for a potential change to a more subdued market character. And the past couple of earnings-reporting seasons have seen a pronounced "sell the news" response to stupendously strong results relative to forecasts. For all of 2020 the popular lament was, "Why are stocks so strong with the economy suffering so badly?" Would a year of real-economic prosperity in 2021 that fails to drive quite as much equity appreciation be all that surprising or unjust? This itself doesn't relieve the bulls of the doubt. And bull markets have a way of giving investors more than they might seem to "deserve" in the moment. Yet with economic optimism about the U.S. economy nearly universal, stock prices up 80% in 53 weeks, investors heavily committed to equities and a pattern of rolling subsector stampedes and shakeouts underway, a "trust but verify" treatment of the rally might make sense.

Traders on the floor of the New York Stock Exchange.

Source: NYSE

At some point as a market cycle unfolds, the big risk shifts from overthinking the situation to underappreciating the hazards.

It's not clear we're there yet: Both the impressive market action and torrent of positive economic news continue to reward the "keep it simple" approach so far in 2021, with higher stock prices, outperformance by cyclical beneficiaries and index pullbacks that are brief and shallow, if a bit more frequent.

If two bedrock rules for staying with market trends are "Don't fight the Fed" and "Don't fight the tape," then investors should be comforted by the lack of provocation by either right now.