Earnings of the S&P 500 Index companies continue to deliver positive surprises as the results of the second quarter of 2021 are revealed. Market agents are really focused on the direction of future earnings. What will earnings look like in 2022?
How do we know, given the many moving parts that must factor into an earnings forecast? We don’t know for sure what the direction of interest rates will be, but we do know that they are likely to remain very low or at the present levels. We also know that inflation indicators are mixed and that arguments can be made for a rising inflation trajectory that will ultimately lead to higher or much higher interest rates, even as counterarguments can be made that this inflation flare will prove to be transitory. The outcome of that discussion will become evident in 2022, we hope.
The condition of labor markets is not completely clear, and the dynamics involved are complex. We know that excess deaths in the United States approached one million people as of May 2021 (“Estimation of excess mortality due to COVID-19,” http://www.healthdata.org/special-analysis/estimation-excess-mortality-due-covid-19-and-scalars-reported-covid-19-deaths), and we also know that the number of cases of long haul COVID disability in the labor force and the general population continues to rise. We don’t know how large the impact of long haul COVID will be, and we don’t know how many people will face long-term partial or full disability, but we do know that the number continues to grow and is now estimated in the millions of people.
So how do you come up with earnings estimates for 2021 and 2022? You take the first two quarters of the year; you take last year; and you take the 2019 pre-COVID trend and try to construct the economic models that would give you an earnings estimate. That’s what we try to do at Cumberland.
If you buy into the possibility of the S&P 500 delivering earnings in excess of $200, you would look at the present price of the S&P, you would say, gee, that’s a high multiple; but when you compare that price with the present level of interest rates, you would say that the market is not excessively valued because the equity risk premium (ERP) is attractive. The ERP invites the investor to own more stocks vs. bonds, not the other way around. And the outlook for earnings on cash or the interest rate earned on cash equivalents remains very, very low.
In our view, as long as this condition persists, the stock market could head higher; so it’s not unreasonable for us to see the S&P 500 Index above 5000 next year (2022), maybe sooner — or maybe it takes a little while longer. At the same time, the dividend yield coming from the S&P 500 still exceeds the interest earnings yield on cash equivalents, and that reality is likely to persist for at least another year or two or three. The combination says to us that, on balance, you have to be somewhat fully invested or nearly fully invested in the US stock market if you are a US-dollar-based American-oriented investor.
At the present time, Cumberland Advisors continues its cash reserve somewhere around 11%–15%, depending on the account and its U.S. Equity ETF portfolio deployment. We are not fully invested, but we are approximately 85–90% invested, and those investments are deployed in sectors that are specifically chosen because of the way the world looks to us. The remaining cash could be deployed at any time.
We are overweight the entire array of the healthcare sector, and we’ve been talking about that position for months. We see the COVID pandemic transforming the healthcare sector from a more sleepy, slow-growing, dividend-yield-defensive sector to a worldwide growth sector in an entire new generation of applications. COVID, as it evolves, is the catalyst for adaptations and growth in the healthcare field. The sector’s market weight in the S&P 500 is approximately 14%. Cumberland portfolios in our U.S. Equity ETF structure assign the healthcare sector a weight of 27% or 28%. That’s about as high as we are willing to go in a large sector.
The other sector that is persistent is defense. We’ve held those positions for a long time, and we expect to continue to do so. Why? The geopolitical alignment of the world, with China taking initiatives countering US geopolitical dominance, says that defense and security is a big issue and will be a big issue for the rest of the decade.
There was a time when you would have looked at the defense industry and said, it is a target of congressional attack; it is a target for reining in expenditures; but we don’t believe that’s the case today. The world is a very dangerous place, and the dangerous elements in the world, sad to say, are expanding. That’s true not just of China and the South China Sea and Taiwan, it's a reality all over the world.
Pandemics, unfortunately, have a history of spurring geopolitical instabilities, changes in governments, outbreaks and revolutions among citizens, and turmoil. That’s what pandemics do. That’s what they have done throughout history, and that’s what this pandemic is doing now.
In view of all this, Cumberland’s portfolios have an overweight position in the defense sector in the broad sense of the word. It's not just missiles. It can be drones. It can be in cybersecurity and in all the other technical areas that are now critically important. We read about cybersecurity breaches every single day in our news flow. The US stock market and the companies in the S&P 500 Index include those which are America’s frontline in both the healthcare sector and the security/defense/technology sector.
Notice I haven’t talked about consumer technology. I’m not emphasizing the consumption side in this note. There’s a distinction between the application of technology in cybersecurity and defense and the application of technology, including artificial intelligence, in targeting you as a consumer, the better to manipulate your thinking and independence.
Today, you can buy something. The record of your purchase is immediately utilized to infer a lot about you; and, as you know, you can within seconds receive solicitations for products and services that AI algorithms calculate will induce you to spend money on something else. Powerful technology and rapid responses pushing out information entice consumers to succumb to strategically selected temptations. That doesn’t mean you have to be duped. It does mean you have to have your antennae up. And you have to be on the lookout for deception, because the practitioners who are after your money and your information or who aim to shape your thought are very cunning. We distinguish between the technology sector in the consumer side and technology applications on the defense and security side, because they are two different elements driven by different factors and not to be lumped together.
Our outlook for the market continues to be bullish — we see higher stock prices and higher earnings, a trajectory that will probably be in place for the rest of this decade. Notwithstanding a longer term upward market direction, we do expect bouts of volatility and sudden downdrafts. Headline risk is multidimensional, whether, COVID, China, Wildfires & Drought or otherwise.
That said, our view of the COVID pandemic is that it isn’t over. Its evolution may continue another two, three, four, or even five years. That’s what history tells us about prior pandemics. There’s no reason to believe human behavior has improved in the last 700 years since the bubonic plague, or Black Death, in Europe killed a third of the population of the world.
We remain nearly mostly fully invested, with a cash reserve to deploy opportunistically and we look for higher markets in the coming years.
David R. Kotok
Chairman of the Board & Chief Investment Officer
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.
