S&P 500 KEY POINTS:
- The S&P 500 has risen more than 20% in 2021 without suffering a single drop of at least 5%
- Slowing growth, deteriorating market breadth, high valuations and seasonal weakness pose headwinds heading into the fall
- However, the prospect of an increase in corporate taxes may be the most important risk to consider for the equity market in the short term
The S&P 500 has soared since the end of March 2020 and is up more than 20% in 2021 alone. Last week, the index notched its 55th record closing high of the year, after rising for the seventh consecutive month in August. The non-stop rally, which has gone all year without a drop of at least 5%, has been fueled by unprecedented fiscal and monetary support in response to the coronavirus pandemic. Retail investors, who have teamed up in social media forums and bought on every dip based on the belief that stocks only go up, have also had a pivotal role in this bull market, which seems overbought by many metrics (e.g., the 14 week RSI indicator is flashing an extreme overbought reading, while the index trades at a ~43% premium to its 200-week moving average).
While it is very difficult to time a correction, traders should start exercising more restraint and caution amid deteriorating market-breadth (thin sector leadership), frothy valuations and some seasonal weakness (as a side note to address the last point, equities have lost 1% on average in September since 1928).
Covid-19, a softer recovery, high inflation and exorbitant multiples all pose risks to stocks, but the elephant in the room that should no longer be ignored is the prospect of higher corporate taxes as Democrats prepare to begin crafting their $3.5 trillion human infrastructure plan upon return from summer recess. While the final package may be smaller than currently envisioned, in order to bring all wings of the party on board, the legislation will have to contain a tax hike to fund an expanded social safety net.
West Virginia Senator Joe Manchin, a moderate Democrat in the 50-50 split upper chamber whose vote is indispensable to moving the White House agenda forward, has urged his party to hit the pause button on the initiative. However, his opposition to the massive bill may just be a strategy to dial back on government spending and force his most liberal colleagues to compromise.
With images of the botched Afghanistan exit and Biden’s approval ratings plummeting, Democrats have no room for error and are keenly aware that they must deliver, as failing to legislate could cost them their narrow majority in the 2022 midterm elections. Manchin knows this, which is why I suspect that, after pressure campaigns and some arm-twisting, he will fall in line to advance a scaled back version of the proposal. Again, this means one thing: tax reform is likely to emerge from the budget reconciliation process, most likely one that raises the corporate tax from 21% to 25%, although key pieces remain unresolved.
As complacent investors wake up to the possibility of a tax levy increase and its detrimental effect on earnings, volatility could pick up in the fall and pave the way for a meaningful pullback in the S&P 500. In this scenario, shares of long-duration growth-oriented companies, whose revenues and earnings are expected to grow at a faster pace than their peers, could be hit the hardest, along with companies in the healthcare and telecommunication sector. However, any correction is likely to be transitory, as above-trend economic expansion for this year and next should create a constructive backdrop for profits. For reference, even with the expected slowdown in the economy, EPS for the S&P 500 for 2022 are expected to increase by roughly 9%, slightly above the historic rate of 6% annually.
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—Written by Diego Colman, DailyFX Market Strategist