Where to Invest Now
Kiplinger's Personal Finance|July 2021
AFTER A POWERFUL START, STOCKS WILL GRIND HIGHER IN THE SECOND HALF OF 2021. BUT WATCH OUT FOR CURVEBALLS.
ANNE KATES SMITH

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% (see the chart, on page 30). 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 (see the chart, on page 31). “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 (see “Deals, Deals, Deals,” on page 64).

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,” on page 28.) 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.

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