A Stock Market Outlook for the Second Quarter

The S&P 500 gained more than 6% in the first quarter of 2021. Energy and financial services were some of the best performing sectors, rebounding strongly after a difficult 2020.The technology sector trailed the overall market for the quarter. The bond market fell during the quarter with optimism about economic growth and worries about inflation as the catalysts for rising bond yields.

The quarter ended with the unveiling of President Joe Biden’s infrastructure plan, fallout from the meltdown of the Archegos Capital hedge fund and continued debate about inflation expectations.

Some of the concerns dominating headlines to start the second quarter are likely to fade while others may have greater impact. The booming market for initial public offerings, popularity of “meme” stocks, rising margin balances and rich valuations for unproven companies are among the most consequential concerns for investors.

Here’s what you need to know going into the second quarter.

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Looking Back and Projecting Forward

The segments of the economy that have struggled the most during the pandemic are likely to be the primary beneficiaries from a post-pandemic recovery, offering a potential continuation of the market rally in those segments that began in late 2020. Pent-up demand should boost the economic segments hurt most by social distancing, including travel, restaurants and brick-and-mortar retail.

Bank stocks should also benefit from the end of the pandemic and a steeper yield curve. Some investors point to rising interest rates as a potential risk for technology stocks. However, technology leaders with strong cash flows may not be hurt too badly by rising interest rates caused by stronger economic growth. The so-called FAANG stocks — Facebook (ticker: FB), Amazon.com ( AMZN), Apple ( AAPL), Netflix ( NFLX) and Alphabet ( GOOG, GOOGL) — may be vulnerable to a market correction but are unlikely to collapse.

The greater risk may lie with more speculative smaller companies that have unproven business models and uncertain cash flows. For companies going public in 2020, initial public offerings and special-purpose acquisition companies, or SPACs, saw much activity. According to Bloomberg, last year’s dollar value of IPOs was the highest since 2007 and above the peak of the dot-com boom. Of last year’s IPOs, 80% had negative earnings, about the same percentage as was the case in 2000. A significant percentage of IPOs were of SPACs, otherwise known as blank-check companies. Many SPACs have yet to complete a deal and are trading below their offering price.

Watch out for highly leveraged positions. According to Alpine Macro, margin debt is at record levels as a percent of gross domestic product. The demise of Archegos Capital shows the dangers of holding highly leveraged, concentrated positions and a reminder that some forms of borrowing can be hidden from the view of regulators and counterparties. Defaults by Archegos caused billions of dollars in losses for half a dozen banks, including Credit Suisse, UBS and Morgan Stanley. Lenders and regulators did not have a full picture of what was happening with Archegos, as the family office used total return swaps to accumulate large positions in a few stocks. The Archegos debacle illustrates a regulatory gap not quite closed by the Dodd-Frank Act.

Small companies have experienced rapid growth, but historical data shows that paying a high multiple of price-to-sales produces inferior returns over long periods. More than 400 U.S. companies with a market cap of more than $250 million began the year trading at a valuation greater than 10 times sales. Small companies with the combination of high valuations and profits that are not expected to materialize until far in the future may be the most vulnerable to rising interest rates.

[SEE: 6 Investments to Offset Potential Inflation.]

Government Debt

Concerns about mounting government debt, inflation and rising interest rates dominate the headlines but may influence markets more in future years than in 2021.

Despite the substantial rise in government debt, debt servicing costs as a percentage of GDP are far below the levels of 20 years ago. Worries about the impact of the $1.9 trillion American Rescue Plan may be misplaced, as much of the spending is temporary in nature and will not have a lasting impact on GDP growth, the output gap or inflation.

Most of the Biden COVID-19 relief plan is aid that keeps spending from falling off more than would otherwise be the case, rather than pure stimulus. Only about $500 billion of the American Rescue Plan should be thought of as pure stimulus, such the $1,400 stimulus checks and tax credits paid regardless of earned income.

Biden’s infrastructure plan would have a longer-lasting impact on economic growth, interest rates and inflation. But the implications of the tax and spending elements of the plan will be uncertain until the hotly debated plan is brought to a vote later this year.

Inflation and Interest Rates

Inflation should rise because of year-over-year comparisons to pandemic-depressed levels as the economy reopens. Pent-up demand may also lead to temporary supply and demand imbalances. Airline flights are an example of an activity in which flight demand may return before airlines can restore their operations to pre-pandemic levels.

The Federal Reserve has made it clear that it will look through a temporary spurt of higher inflation caused by transitory factors such as low base effects and temporary supply bottlenecks. Over the longer term, it is likely that inflation will remain under control until the economy gets closer to full employment.

Optimism about the economic recovery is the primary driver behind rising rates. Although 10-year Treasury yields rose dramatically during the first quarter, yields remain below pre-pandemic levels. Higher interest rates represent good news for savers but are less favorable news for more speculative growth stocks. Bond yields could still rise from here, but the higher risk collision between mounting government debt and the bond market is likely to be delayed until the Fed tapers purchases of Treasury securities.

[See: 6 of the Best Streaming Stocks to Buy]

Takeaway

Although some of tomorrow’s big winners will be found among the large group of speculative and highly priced companies, many will fail. Selectivity is important in the more speculative segments of the market, looking beyond themes and memes to identify companies with a viable path to profitability.

Disclosures

Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.

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A Stock Market Outlook for the Second Quarter originally appeared on usnews.com

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