Kiplinger's Investing Outlook

Midyear Investing Outlook: Where to Invest Now

After a powerful start, stocks will grind higher in the second half of 2021. But watch out for curveballs.

For most of 2021, it has been easy to hit the proverbial investment ball out of the park. So far this year, the S&P 500 stock index has logged a record high 26 times. Including dividends, the broad market benchmark returned 13.3% through the first week of May—well above the 10.3% average annual return for large-company stocks, going back to 1926. The bull bobbled the ball shortly thereafter, knocked off course by a surge in inflation more powerful than we’ve seen in years. But having just entered its second year, this market likely has more gains ahead, driven by soaring economic growth as the U.S. reopens and corporate profits that are crushing analysts’ expectations.

Still, as we go deeper into 2021, investors should expect fewer grand slams and more singles and doubles. That means staying nimble and on the alert for curveballs, whether in the form of higher inflation, rising interest rates or COVID setbacks. Instead of relying on the momentum of an unstoppable U.S. market, investors should be open to new strategies and should be comfortable on a global playing field.

Wall Street’s handicappers are all over the place in this mercurial market, with portfolio strategists pegging year-end targets for the S&P 500 that range from 3800 (down 10% from its early May close of 4233) to 4600 (up 9%). Investors should probably expect something more toward the middle of that range (closer to 4300), with the S&P 500 delivering low-single-digit percentage gains from here to year-end. That would put gains for the full year at close to 15%, plus roughly another 1.4 percentage points from dividends. (Prices, returns and other data are as of May 7.)

Broad-market benchmarks might not be the best measure of success at year-end as different asset classes and investing styles rotate into favor. For now, we prefer stocks to bonds, bargain-priced “value” shares over those that are fast-growing, and economy-sensitive “cyclical” sectors such as financials, industrials and materials to more-defensive sectors such as consumer staples and health care. We think small-company stocks, despite a strong showing already, deserve space in your portfolio, as do international holdings, especially from developed markets. “It sounds like an oversimplification, but the winners of 2020 are turning into the relative losers of 2021. What did well in the pandemic trade is doing less well now,” says Andrew Pease, global head of investment strategy for Russell Investments.

A sophomore slump?

Bull markets typically post banner years as they bounce off bear-market bottoms, as did this one, jumping nearly 75%. Gains in year two, which began in late March for this market, are typically less generous but are still consequential, averaging 17%. But note that sophomore years often weather significant pullbacks, too, averaging 10%.

“In the first quarter, we saw stocks go up in a straight line—all sectors, value and growth, all market caps. Obviously, I don’t think we’re going to see that same velocity of movement or straight line higher,” says Gargi Chaudhuri, head of iShares Investment Strategy, Americas, at investment giant BlackRock. Bouts of volatility shouldn’t be surprising, says Chaudhuri. “But if we do see them, we expect pullbacks to be opportunities to reenter the market,” she says.

We would not bet against the market’s economic underpinnings, which are stunning and historic. “We’re experiencing something that most of us have never experienced in our lifetimes—an economic melt-up,” says Jonathan Golub, chief U.S. equity strategist for Credit Suisse. A consensus of forecasts from economists calls for growth in U.S. gross domestic product that would be the highest in nearly four decades. Expect some hiccups along the way when reports on employment, inflation or what have you catch traders off-guard. But Kiplinger expects a growth rate of 6.6% in GDP for the year. That compares with a 3.5% contraction in GDP in 2020 and growth of 2.2% in pre-pandemic 2019. Growth should peak in the second quarter, at a 9.1% annual rate.

Normally, peaking economic growth would be a warning signal for stocks, warranting a shift to more defensive strategies. In the current climate, an expected deceleration in growth still leaves the economy far above the trend line. The economy is poised for strong growth over “the next few years,” says Leuthold Group chief investment strategist Jim Paulsen, “driven by the impact of massive monetary and fiscal policies, post-COVID pent-up demand, a surge in re-openings and re-employment, rising confidence, and the like­lihood for a significant inventory-rebuilding cycle.”

When economic growth is scarce, investors pay dearly for fast-growing stocks. But when growth is abundant, bargain hunting for undervalued stocks tends to pay off. So far this year, stocks in the S&P 500 with a value tilt have returned an aggregate 18%, compared with 9% for their growth-focused counterparts. “Growth will have its day in the sun again, but not for the remainder of 2021,” says Golub. That doesn’t mean you should abandon growth stocks—in fact, you might be able to pick up bargains in some tech stocks).

The value in value

It’s a good time now to explore funds with a knack for value, such as Ariel Fund (symbol ARGFX), led by longtime value aficionado John Rogers. He likes carpet manufacturer Mohawk Industries (MHK, $230), the fund’s second-largest holding. “Mohawk has an extraordinary brand. As people buy new homes or remodel their homes, there’s going to be new carpeting,” he says. (For more from Rogers, see Value and Small Stocks Will Lead.) Dodge & Cox Stock (DODGX), a member of the Kiplinger 25 list of our favorite funds, is a value stalwart. Vanguard Value Index ETF (VTV, $141), a diversified exchange-traded fund with a large-company value tilt, charges just 0.04% in expenses.

Value-priced shares often overlap with cyclical stocks. Cyclicals—those in the consumer-discretionary, financial, industrial and materials sectors—can be nerve-rackingly volatile, says Leuthold’s Paulsen. “Unlike a steady-Eddy defensive stock or a persistent growth stock, cyclicals can surge higher and quickly give back most of that outperformance,” Paulsen says. Nonetheless, during periods of healthy economic growth, cyclicals will enhance your returns, he says. Many have jumped in price already. Among the most affordable “super cyclicals,” according to Credit Suisse, are delivery giant FedEx Corp. (FDX, $315) and equipment-rental company United Rentals (URI, $347), both with below-market price-earnings multiples.

Small-company stocks, which tend to do well early in the economic cycle, hit some turbulence this spring after a good run. The Russell 2000 index, a small-cap benchmark, is up 15% for the year to date, compared with 13% for the large-cap S&P 500. “It’s still early days,” says Leuthold chief in­vestment officer Doug Ramsey. The most recent cycle of small-cap outperformance was from 1999 until 2011, Ramsey says. “The next cycle may not be 12 years, but it might be four to six years,” he says. Given the nature of these fledgling stocks, investors should brace for volatility.

Combine promising prospects for both value and small-stock investing in one fund with American Century Small Cap Value (ASVIX), a Kip 25 member. Holdings include paper-goods firm Graphics Packaging and car- and truck-dealership company Penske Auto­motive. Small-cap index exchange-traded funds to explore include Vanguard Small-Cap Value (VBR, $177) and Vanguard Russell 2000 (VTWO, $91).

Though U.S. economic growth is peaking, the global economy is still accelerating. That provides opportunities for economy-sensitive stocks with a global presence, say strategists at Goldman Sachs, as well as for stocks zeroed in on Europe’s reopening—as long as Europe’s economy can sidestep virus-related speed bumps. Consider chipmaker Nvidia (NVDA, $592), which derives more than 90% of sales from outside the U.S.; auto parts maker BorgWarner (BWA, $54), with 77% of sales outside the U.S.; apparel firm Nike (NKE, $138), 59%; and banking giant Citigroup (C, $75), 54%. Funds we like for international exposure include Vanguard FTSE Europe (VGK, $68), an ETF with a low, 0.08% expense ratio and 74% of assets invested in developed European countries. Actively managed T. Rowe Price Overseas Stock (TROSX) is 42% invested in Europe.

Commensurate with the rebounding U.S. economy, corporate profits are through the roof. With the first-quarter scorecard nearly complete for companies in the S&P 500, earnings look to be up more than 50% from the first quarter of 2020, with nearly nine out of 10 companies reporting earnings that beat analysts’ expectations. Profits will pack an even bigger wallop when second-quarter results are reported, after which earnings growth will likely moderate. For the year, analysts expect profit growth of nearly 35%—more than double the percentage gain expected a year ago. Excluding energy companies, which are rising from the dead but still facing long-term challenges, the biggest profit increases are expected from industrial, consumer-discretionary, materials and financial firms.

The question is how much of the good news on earnings is already reflected in stock prices. BofA Securities notes that companies beating expectations on both revenues and earnings have been met with a yawn from the market, with their stocks outperforming the S&P 500 by just 0.40% on the day following the report, compared with a typical jump of 1.5%.

Rising risks

Although the bull market is still young, prudent investors will take note of the risks that are building. Business costs and consumer prices are rising, reflecting surging demand as the economy reopens combined with ongoing supply bottlenecks. In April, the consumer price index rose 4.2% compared with a year ago—the biggest increase since September 2008 and the catalyst for a 4% stock pullback over a couple of days. Lumber and copper prices are at all-time highs, prompting quips from some homeowners about selling their house for parts. Escalating prices are top-of-mind with corporate America, with mentions of “inflation” during corporate earnings calls skyrocketing 800% compared with a year ago, per BofA.

Wages will push higher in a tightening labor market and amid a political push from the Biden administration, says Ed Yardeni, of investment research firm Yardeni Research. “We are on the lookout for—but don’t expect—an inflationary wage-price spiral,” he says. For now, technology-led productivity growth will offset the inflationary consequences of fatter paychecks, Yardeni says.

Although the reality of higher in­flation is indisputable, there is debate about whether it will be transitory or mark the start of a new, longer-term regime of rising prices. “Inflation will likely run hot through the rest of this year,” says investment strategist Darrell Cronk, president of Wells Fargo Investment Institute. “In 2022, it’ll taper back to the upper 2% range, maybe the lower 3s—higher than we’ve seen for the past decade, but not problematic like the hyper-inflation days of the ’70s and ’80s.” Kiplinger expects an inflation rate of 4.4% at year-end, up from 1.4% in 2020 and 2.3% in 2019.

Traditional shields for protecting against the inroads of inflation on your portfolio include Treasury inflation-protected securities and real estate investment trusts. You can buy TIPS directly from Uncle Sam at www.TreasuryDirect.gov, or try Schwab U.S. TIPS ETF (SCHP, $62). With REITs, “the market is nuanced,” says Mark Luschini, chief investment strategist at Janney Montgomery Scott. He prefers REITs that operate in industrial sectors, such as distribution centers or cell towers, to traditional mall and office REITs. Vanguard Real Estate ETF (VNQ, $98) provides low-cost access to a diversified group of REITs. Top holdings include American Tower, which owns and operates a vast array of communications infrastructure, and Prologis, which owns supply-chain and industrial real estate, including warehouses, worldwide.

Companies with pricing power—those able to pass along higher costs to customers—are poised to outperform when inflation is on the rise. Stocks that BofA places in this camp include Comcast (CMCSA, $58), whose film and TV segments will benefit from a return to production; Marriott International (MAR, $147), which adjusts prices in its hotels daily; and Walt Disney (DIS, $185), which has already raised prices for its Disney+ service.

Commodities are “well worth considering as part of a long-term diversified portfolio,” says David Kelly, chief global strategist at J.P. Morgan Asset Management. IPath Bloomberg Commodity Index Total Return ETN (DJP, $27) is an exchange-traded note tracking energy, grains, metals, livestock, cotton and more. Invest in the stocks of a wide swath of raw materials producers and processors with Materials Select Sector SPDR Fund (XLB, $88).

Inflation often precedes another threat to financial markets: rising interest rates, which push bond prices lower (and yields higher, ultimately providing competition for stocks) and also put pressure on growth-oriented shares, whose future earnings become less attractive when interest rates are higher today. At the Berkshire Hathaway annual meeting in May, Warren Buffett said, “Interest rates basically are to the value of assets what gravity is to matter.” Treasury Secretary Janet Yellen briefly roiled markets when she suggested recently that interest rates might have to rise to keep the economy from overheating, before quickly walking back those remarks.

The worry is that the Federal Reserve will overstep and choke off economic growth. But central bankers have been remarkably accommodative and have signaled they intend to stay that way for now. It will likely be next year before the central bank begins cutting back purchases in its massive bond-buying program, Fed watchers say. “Tapering asset purchases isn’t the same as tightening, but it might cause some stock market dips that investors can buy into,” says Pease, at Russell Investments. “The Fed won’t start thinking about raising rates until 2023, and then it’ll take a few hikes before policy goes from easy to tight.”

Still, the Fed controls short-term interest rates; long-term rates are driven by market expectations for economic growth and inflation. Already this year, yields on 10-year Treasury bonds have risen from 0.93% to 1.60%, pushing the Bloomberg Barclays Aggregate Bond index down 2.34% for the year to date. Kiplinger expects the 10-year note to reach 2.0% by year-end.

As part of a more defensive fixed-income stance, Wells Fargo recommends intermediate-term bonds and those that do well when the economy does—such as corporate bonds, which are likely to see fewer defaults. Consider our favorite, relatively low-risk high-yield fund, Vanguard High-Yield Corporate (VWEHX), a member of the Kip 25. For more on our bond-market outlook, see Bonds: Be Choosy for the Rest of 2021.

Stock investors can make the most of rising rates with shares of financial firms, many of which benefit as long-term rates rise relative to short-term yields. “Financials are up sharply, but we still feel there’s runway there,” says investment adviser Jason Snipe of Odyssey Capital Advisors. “Regionals are levered to the economy,” says Snipe. “As Main Street comes back, regionals will benefit from that activity.”

One way to bet on regional banks is via SPDR S&P Regional Banking ETF (KRE, $71).  Money center banks and investment banks are also worth a look, including JPMorgan Chase & Co., (JPM, $161), rated “buy” by investment research firm CFRA, and Morgan Stanley (MS, $88), rated “strong buy.”

A bigger tax bite

Proposals from the Biden administration to raise taxes on corporations and on wealthy individuals could pack a punch for stocks—but might not hit as hard as you’d expect. Biden has proposed raising the top corporate federal tax rate to 28%, up from 21%, to pay for proposed infrastructure spending. That would reduce aggregate earnings for S&P 500 companies by $15 a share next year, estimates Yardeni. The president has indicated, however, that he’s open to a top rate as low as 25%.

Under the administration’s American Families Plan, taxpayers making more than $1 million per year would pay 39.6% on long-term capital gains, nearly twice the top 20% rate today. With the 3.8% surtax on net investment income, the top tax rate on capital gains could hit 43.4%. Negotiations could lower the proposed 39.6% rate to something in the 25%-to-28% range, says Katie Nixon, chief investment officer of Northern Trust Wealth Management. And in the three months following hikes in the capital gains tax rate in 2013, 1987 and 1976, the S&P 500 gained 6.7%, 19.1% and 1.6%, respectively, according to investment firm LPL Financial. “For now, we’d side with an improving economy and accommodative Fed,” says LPL’s chief market strategist Ryan Detrick, who thinks the market “will take the coming higher taxes in stride.”

Investors still worried about a bigger tax bite might favor naturally tax-efficient investment vehicles in their taxable accounts, such as low-turnover index funds and ETFs, and growth-focused funds that don’t distribute a lot of dividend income. Take advantage of strategies such as tax-loss harvesting to offset gains. For bond investors, Kip 25 member Fidelity Intermediate Municipal Income (FLTMX) is a good choice.

Finally, in the perverse way of financial markets, the more bullish the mood, the more likely the bull is to stumble. “Sentiment is quite euphoric. It’s a warning sign,” says Russell Investments’ Pease. One measure of market speculation—margin debt, the money investors borrow from brokers to buy shares—was recently up 72% from levels a year ago, says Leuthold’s Ramsey, when a 50% jump has traditionally spelled trouble. He sees plenty of opportunity for tactical investors who bet on the right market sectors and investing styles, but he sounds a note of caution. “Don’t make the mistake of believing that because the economy is still in its relative infancy that so is the bull market,” he says. “There’s going to be a heck of a lot of volatility over the next several years.”

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