To summarize, we have characterized the current economic situation as the transition from early to mid cycle, the time of the expansion where we are past the peak rate of change and therefore maximum monetary accommodation. With the NBER recently declaring the end to the COVID-19 recession as far back as May 2020, our timing of this mid cycle transition starting back in March seems spot on. Years associated with prior mid cycle transitions include1994,2004, and 2011. In all cases, US equity markets were characterized by the following features: Falling P/E, narrowing leadership, a skew towards quality and a 10-20% correction in the major indices.
This year has been no different, but looks incomplete in our view. More specifically, there has been an extreme narrowing in leadership and shift towards quality; and while we have seen a de-rating in equity valuations, it's been more modest than prior mid cycle transitions which has allowed the major averages absent of a 10%+ correction, at least so far. We think the primary missing ingredient for that correction is Fed's slower than normal withdrawal of monetary accommodation given how much progress has already been made. This delay in removing accommodation has kept long term interest rates much lower than the economic fundamentals would suggest. Given the very high quality nature of the S&P 500 and Nasdaq 100, these indices have remained very resilient even as the average stock has fared quite poorly since March. For example 44% of the Russell 2000 small cap index has experienced a 20%+ drawdown this year.
This is a liquidity fuelled rally. As long as central banks are willing to continue to engage in quantitative easing and governments are running large deficits, asset prices will enjoy a tailwind more often than not.Click HERE to subscribe to Fuller Treacy Money Back to top