Last fall, Gradient Investments published a Market Reflection titled, Stock Market Checklist, which discussed key factors in determining whether the rally in the stock market could continue from the COVID induced lows of March 2020. Factors we believed would determine the future direction of the stock market included:
- Status of COVID with regards to vaccines and therapies
- Stimulus packages
- Overall levels of economic activity
All these factors have been inline to better than expectations, which helped propel the market to new highs going into year-end and has continued thru the first quarter of 2021, as well.
We feel our checklist needs an update as some of the unknowns of last year have become evident and the market begins to look at more traditional factors to determine the future direction of the stock market. These items include:
- Economic activity – pace of recovery
- Corporate earnings – health and the acceleration of growth
Economic activity has picked up in the back half of 2020 and continues to accelerate. A couple of tools used to measure economic activity are unemployment rates and Gross Domestic Product (GDP) growth rates. A vast improvement in unemployment rates has ensued from the depths of the shutdown. Unemployment rates spiked to 14.8% in April 2020, to the latest reported rate of 6.0% at the end of March 2021. Annual GDP growth has seen a similar snapback which can be seen in the chart below, with GDP expected to go from negative 3.5% in 2020 (red circle) to Goldman Sachs forecasted GDP growth of +8% in 2021 (light blue circle), which are levels not seen since the 1950s (green circle).
A good indicator to understand the health and prospects of companies is to analyze their earnings history and projections. Earnings shed a light on how successful a company is operating its business and reflects their profitability. A quick way an investor can judge the overall health of corporate America is to look at the earnings of the S&P 500 and its growth rate. In general, the more consistent and faster the growth of earnings the better companies are performing, which in turn should drive stock prices higher. The opposite is true as well.
In the chart below, the expected growth rate of the S&P 500 earnings for the first quarter of 2021 is 24.5% (green circle), which would be one of the highest quarterly growth rates since 2018. In recent years, actual reported earnings (dark blue bars) have beaten estimated earnings (light grey bars) 11 out of 12 times, so if recent history holds, the actual earnings in the first quarter should be even higher than the forecasted 24.5%.
The big growth rate in the first quarter will also continue the recent trend of improving growth rates of the last year which can be seen directionally with the red arrow. Increasing growth rates help explain why the stock market has rallied over the last year.
As time passes from the initial shock of the COVID shut down and the economy continues to reopen, we feel investors will refocus on economic activity and the health of individual companies to evaluate investment options. This contrasts with recent metrics, such as the pace of vaccine rollouts, which should be a welcome change for investors.