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Things were nice and orderly for a while there. We were led to believe that in 2021 a recovering global economy would lead to outperformance for economically sensitive market sectors such as industrials and materials, small caps, and companies emerging from value-oriented investing strategies. All this would happen at the expense of technology stock valuations and bond prices.

That’s more or less what we got this year, until March 15. The Russell 2000 index of U.S. small-cap stocks jumped 19.7 per cent, crude prices surged 34.8 per cent, copper rose 17.8 per cent and the technology-heavy Nasdaq 100 lagged far behind with a 1.7-per-cent appreciation.

A lot has changed, however, since the Ides of March: Small caps are off 8.5 per cent, drastically underperforming the technology-heavy Nasdaq 100′s return of minus 0.9 per cent. Oil is 6.8 per cent lower and copper is down 1.2 per cent since the middle of the month. Is the economic recovery already largely reflected in asset prices, as Citi U.S. equity strategist Tobias Levkovich believes? Or is this just a pause before the “reflation trade” – markets responding to the cyclical upswing – takes hold again?

There are two charts that can help investors answer this important question. It is interesting that a large divergence has opened up on our first accompanying chart, one that is likely to be resolved in the coming weeks.

Recovery & reflation: Mixed signals

from the market

U.S. 10-year bond yield

Russell 2000/Nasdaq 100 (right scale)

3.0%

0.24

2.5

0.22

2.0

0.20

0.18

1.5

0.16

1.0

0.14

0.5

0.12

0

0.10

2020

2021

April 2019

S&P 500 forward P/E ratio

U.S. 10-year TIPS (right scale, inverted)

28.5

-1.5

26.5

-1.0

24.5

-0.5

22.5

20.5

0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2017

2018

2019

2020

2021

THE GLOBE AND MAIL, SOURCE: BLOOMBERG;

SCOTT BARLOW

Recovery & reflation: Mixed signals

from the market

U.S. 10-year bond yield

Russell 2000/Nasdaq 100 (right scale)

3.0%

0.24

2.5

0.22

2.0

0.20

0.18

1.5

0.16

1.0

0.14

0.5

0.12

0

0.10

2020

2021

April 2019

S&P 500 forward P/E ratio

U.S. 10-year TIPS (right scale, inverted)

28.5

-1.5

26.5

-1.0

24.5

-0.5

22.5

20.5

0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2017

2018

2019

2020

2021

THE GLOBE AND MAIL, SOURCE: BLOOMBERG; SCOTT BARLOW

Recovery & reflation: Mixed signals from the market

U.S. 10-year bond yield

Russell 2000/Nasdaq 100 (right scale)

3.0%

0.24

2.5

0.22

2.0

0.20

0.18

1.5

0.16

1.0

0.14

0.5

0.12

0

0.10

2021

2020

April 2019

S&P 500 forward P/E ratio

U.S. 10-year TIPS (right scale, inverted)

28.5

-1.5

26.5

-1.0

24.5

-0.5

22.5

20.5

0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2017

2018

2019

2020

2021

THE GLOBE AND MAIL, SOURCE: BLOOMBERG; SCOTT BARLOW

The blue line on the chart measures the relative performance of U.S. small caps and technology stocks by simply dividing the level of the Russell 2000 by the Nasdaq 100. A rising line indicates that small caps are outperforming.

What we’re looking for here is the equity market’s view of the U.S. economic recovery. The more faith investors have in a resurgence in business activity, the more the Main Street-sensitive small-cap index should outperform the Nasdaq.

From Sept. 1, 2020, to March 15 of this year, the line on the chart steadily climbed, indicating economic optimism. The results closely tracked the U.S. 10-year bond yield, which was also rising to reflect the inflation pressures that accompany a recovery.

Since that point, yields have continued higher while small caps have underperformed. This makes little sense. Bond markets are projecting a quick recovery and inflation pressure while small-cap stocks indicate a rising degree of pessimism, at least temporarily.

I expect the divergence on the chart to close and the way it happens will be an important indicator for investors. A fall in yields (the purple line) to meet the blue line would suggest markets might be ahead of themselves in terms of pricing in the economic recovery. Conversely, a resumption of small-cap outperformance would suggest the postpandemic business recuperation is on track.

The second chart, comparing the forward price-to-earnings ratio of the S&P 500 with inflation-adjusted U.S. bond yields (using Treasury Inflation-Protected Securities, or TIPS, yields as a proxy), is also important for investors to follow. The premise here is that stocks become more expensive as real bond yields fall (bond returns are less competitive with equity earnings yield), and less expensive as bond yields rise.

Real bond yields have climbed 40 basis points, or 0.4 of a percentage point, since late January (note that the yield is plotted inversely on the chart to better show the trend) and S&P valuations, true to form, dropped from 27 times forecast earnings to 23 times.

The S&P 500′s P/E ratio is falling for the best possible reason – forward earnings estimates (the denominator in the price-to-earnings calculation) are climbing much faster than the index price (the numerator). The benchmark is up 5.5 per cent year to date while earnings estimates are higher by 24 per cent.

The current trend of higher inflation-adjusted bond yields, lower valuations and rising profit forecasts is positive for investors – at least for now. A sustained drop in inflation-adjusted yields would be a setback, suggesting flagging earnings growth.

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