Since the bear market bottom on March 23, 2020, global equity markets have surged higher. Over the past year, all equity classes have rallied, with the U.S. outperforming international markets, emerging outperforming developed markets, and smaller capitalization stocks outperforming large-cap stocks. These patterns are not unusual as the beginning of bull markets have often favored high-beta (more market sensitive) stocks, like small caps. While the gains have been eye-popping (in some cases over 100%), investors should not expect a repeat in the second year of the bull market.
Historically, the strongest returns have occurred in the first year of a bull market. The second year has typically produced positive — but lower — gains, accompanied by higher volatility. The average return for the S&P 500 Index in the first 12 months of the past 11 bull markets was 42%. The first year of the 2020 bull market was up a record 75%, just edging the first year of the 2009 bull market, which was up 69%. The average return for the S&P 500 Index during the second year of previous bull markets is a respectable 12.7%, with all 10 prior instances positive. The average drawdown (the peak-to-trough decline of an investment over a given time period) in year two was -9.8%.1
S&P 500 Index performance in years one and two of bull markets
Sources: Wells Fargo Investment Institute, Bloomberg. Data includes the 10 bull markets from 1957-2020. The timelines considered for drawdowns are months 13-24 of previous bull markets from 1957-2009.An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
Early phases of the economic expansion can be the most bullish period for highly cyclical stocks (i.e. small caps and emerging markets). An environment with ample fiscal stimulus and a highly accommodative Federal Reserve tends to favor economically sensitive asset classes and sectors. In fact, historically, the second year of bull markets has seen leadership from Financials (as the yield curve steepens) and Industrials (as manufacturing sentiment improves).
Another trend often seen in the second year of bull markets is price-to-earnings (P/E) multiple compression. In 2020, many companies reduced expenses, creating significant operating leverage that should boost earnings in 2021. We anticipate S&P 500 Index earnings per share will grow by more than 30% this year with cyclical sectors such as Industrials, Consumer Discretionary, Materials, and Financials leading the way. While 2020 equity market returns were driven mainly by P/E multiple expansion, we expect 2021 performance to be driven by robust earnings growth. With earnings growth expected to outpace price growth, we look for multiples to recede.
A barbell market capitalization approach – Small caps are highly cyclical and have historically performed well in the early stages of new bull cycles. The first year of this cycle has been no different, with small caps leading the way. While the first year is typically a time of price recovery, the second year is mainly about an earnings recovery. This is key for small caps, with history (the last three bull markets) showing when the percentage of Russell 2000 Index non-earners has peaked, small-caps outperformed large caps (as measured by the S&P 500 Index) over the following one-, two-, and three-year periods. Even so, large caps remain a favored asset class as they are higher in quality, less volatile, and have tremendous earnings power. This was evident during the recent correction in the Russell 2000 Index when the S&P 500 Index significantly outperformed, offering stability and remaining near its record high. We maintain our favorable guidance on U.S. large- and small-cap equities.
Emerging over developed – We expect a broader trade recovery, a weakening U.S. dollar, higher commodity prices, and the COVID-19 vaccine to be tailwinds for emerging market equities over the next 12 months. Earnings expectations have risen dramatically over the past 6 months, and forecasted 2021 growth ranks second behind small caps. Emerging market equities have outperformed developed market equities in the early innings of past recoveries and we expect this dynamic to play out in this recovery as well. We believe recent weakness in China and U.S. dollar strength has provided an opportunity to add exposure to an area that is often underrepresented in portfolios.
Lean into cyclical sectors – Over the past 6 months, our sector guidance has shifted to areas that have tended to thrive in the early stages of economic recoveries. This includes upgrading Financials, Industrials, and Materials to favorable and Energy to neutral. We’ve also downgraded defensive sectors, such as Consumer Staples, Health Care, and Utilities. As noted above, cyclical sectors have historically maintained leadership in the second year of bull markets. We expect similar results this year and recommend investors put new money to work in our recent upgrades first (i.e. Financials, Industrials, and Materials) followed by Communication Services, Consumer Discretionary, and Information Technology.