With second quarter earnings season wrapping up this week, the results have been relatively strong. On average, S&P 500 companies have beaten consensus estimates by more than 15%. This is similar to the past 4 quarters and much higher than the average 4-6% beat rate if you average quarters over all time. It's also the typical pattern we see after a recession, when analysts’ forecasts are generally pessimistic and proved to be easy for companies to surpass as the economy recovers. The primary driver of the upside is operating leverage as revenues return to pre-recession levels before costs are layered back in. 

In fact, the operating leverage was even more extreme than normal due to the extraordinary government support passed by Congress through 3 forms of Covid-relief packages, which continue to drive up consumer spending power. Even for individuals who lost their jobs during the pandemic, unemployment benefits in the form of monthly payments are often better-paid than actual jobs. Normally a dramatic decline in employment, the likes of what Covid caused, would lead to significant declines in economic and sales growth. Instead, the stimulus packages allowed consumers to keep spending at a high rate. In fact, consumption never really declined that much and made new highs within just a few quarters of the recession trough. Meanwhile, companies cut costs and employment to the bone in anticipation of a major slowdown. The result has been predictable - an incredibly fast return to record profits and profitability that, however, look unsustainable now. These economic drivers in the form of government stimulus and monetary support are near peak: unemployment benefit is running out in September, no more stimulus checks, and Federal Reserve is expected to start bond tapering.  

Morgan Stanley this morning just increased their earnings forecast and now expect $205 per share for the S&P 500 in 2021. To provide some context: first, this is 28% above the all-time high prior to the pandemic. Second, it usually takes 3-4 years just to get back to the prior peak. This time it took just over a year. As a result, analysts at Morgan Stanley are not as bullish on earnings growth for 2022. They also expect the corporate tax rate to increase as an offset to the passage of the infrastructure bill. At the same time, the Federal Reserve is likely to reduce the size of its asset purchase program, which is likely to weigh on equity valuations.

The combination of lower than consensus earnings next year leads to the believe that there is very little upside to major U.S. equity indices over the next few quarters. In fact, Morgan Stanley's S&P 500 target price for end of 2021 is 4000, which is actually 10% below current levels. This is consistent with what we have been calling for, a market correction based on Tom DeMark's and Larry Williams' technicals, which are mainly predicated on i) we have been going up for so long and ii) on low volume, which is non-sustainable. 

However, on a positive note, such market correction would complete the mid-cycle transition we've been going through since mid-March and allow for the next leg of the economic expansion and bull market. Until then, as investing books teach us, as strategists are calling for on the news, and what we see in the price action of different sectors, investors should position themselves defensively within their equity portfolios, favoring quality names in the health care, consumer staples and utility sectors. We want to pair it with financials which remain a good way to maintain exposure to higher inflation and interest rates as the Fed tapers its asset purchases. Importantly, valuation for financials remains attractive and earnings forecasts were reduced during the second quarter, meaning there is less risk of a disappointment.

Bottom line, even though the recovery is well underway, the market has gotten ahead of itself in forward valuation, predicating on good earnings beat by companies but are driven largely by government stimulus, which is near peak soon. People talk about the Delta variant, even though we do acknowledge that it is affecting some reopening stocks, we think the overall market is already pricing in that the Delta variant will be manageable as vaccines and natural herd immunity allow for us to fend off further lockdowns.