U.S. economic recovery mirrored in the stock market by Aleksei Kirilov & Valeriy Kirilov

U.S. economic recovery mirrored in the stock market

by Aleksei Kirilov & Valeriy Kirilov

stocks are a mirror

Recently, investors, analysts and representatives of the regulators have been discussing two topics incessantly: the pace of recovery of the U.S. economy, as well as the magnitude and duration of a possible surge in inflation. We analyzed these phenomena based on the indicators of the U.S. stock market, since the market assesses not only the current position of companies and industries, but also to a large extent their prospects for further development. Information from the Finviz1 service was used as the source data. For the study, the time period was chosen from the beginning of January 2020 to the end of May 2021. In this way, we were able to compare the characteristics of the stock market before the onset of the COVID-19 pandemic with the current values.

Table 1 shows data on the capitalization of U.S. stock market sectors, using their capitalization as of January 2, 2020 as 100%.

Figure 1 shows the change in capitalization of the stock market sectors as of 05/28/2021 in comparison with their capitalization as of 01/02/2020.

changes in capitalization

1 / https://finviz.com

Figure 1 - Capitalization of the stock market sectors as of 28.05.2021, the level as of 02.01.2020 is taken as 100%

Figure 2 - Growth in capitalization of stock market sectors from 03.23.2020 or 05.28.2021

In a previous article2, we have already examined how various industries behaved during the market decline in February - March 2020. It is interesting to compare how the capitalization of the market sectors changed during the recovery from the moment of the largest market decline on 03/23/2020 to the present. Figure 2 shows data on the growth of capitalization of the stock market sectors in comparison with the S&P 500 index from 03/23/2020 to 05/28/2021 (capitalization as of January 2, 2020 is taken as 100%).

In accordance with the value of capitalization growth after the crisis, all sectors can be conditionally divided into three groups, see Table 2.

differences between sectors

1 / Aleksei Kirilov, Valeriy Kirilov. Change in the sectoral structure of the American stock market due to COVID-19 as an additional risk factor. Intelligent Risk (PRMIA), November 2020, https://issuu.com/prmia/docs/intelligent_20risk-oct_202020-issuu

The largest growth was shown by the following sectors: Basic Materials, Communication Services, Consumer Cyclical and Technology. The stocks of companies in these sectors can be classified as “growth stocks” with the exception of the stocks in the Consumer Cyclical sector3. The large growth in these four sectors seems to be due to the fact that it was in these sectors that investors’ funds were originally directed. And investors did not lack liquidity, which was provided by the Fed as part of a huge quantitative easing program.

The shares of the Energy, Financial, Industrials and Real Estate sectors can be conditionally referred to as the so-called “value shares.” These sectors have started to grow rapidly since about November last year, as signs of economic recovery and consumer demand emerged. The capitalization of the Energy sector has not yet returned to its pre-crisis values. This is possibly due to the fact that the demand for oil in the economy has not yet reached pre-crisis levels, since it is the level of oil production and refining that largely determines the dynamics of this sector.

The lowest growth since March last year, only 24%, was shown by the capitalization of the Utilities sector. It can be assumed that the shares of this sector have been the least attractive to investors so far. Companies in this sector provide businesses and households with electricity, water, gas, i.e. everything necessary for normal functioning. Therefore, this sector can be used as an indicator to assess the degree of economic recovery. Of course, this is only a rough estimate in order of magnitude. As can be seen from the data shown below in Figure 3, approximately in the second half of April, the sector’s capitalization practically reached pre-crisis values. This may indicate that the restoration of the normal functioning of households and businesses is close to completion. And the results of this recovery can be seen in the data on GDP, industrial production, consumer demand, and other macroeconomic parameters for the second quarter of this year.

3 / In the Consumer Cyclical sector, shares of two companies are very heavy: Amazon and Tesla. At the beginning of 2020, the weight of these two shares was 29%, and on May 28, 2021, 39%. This probably partially explains the change in the capitalization of this sector. It should be noted that the capitalization of only five companies from the so-called FAANG group (Facebook, Apple, Amazon, Netflix, Google) at the end of May this year is 16.4% of the total market capitalization. Studying this phenomenon is beyond the scope of this article.

Figure 3 - Relative change in the capitalization of sectors with different rates of post-crisis growth

differences between sectors

As shown in another previous article4, disruptions in global supply chains have led to a sharp rise in commodity prices. Today, there is a shortage of many critical materials and goods in the world: grain, metals, lumber, computer chips, etc. In addition, inventories of materials and goods held by corporations are at very low levels. When this occurs, companies begin to purchase products for the future that are necessary for their business, that is, they try to maximize their inventories. This leads to further price increases which, in turn, are already beginning to affect the prices of services and consumer goods.

Perhaps this effect is one of the reasons for the significant growth in the capitalization of companies in the Basic Materials, Communication Services, Consumer Cyclical, and Technology sectors because, as we said earlier, the market assesses not only the current position of companies and industries, but also to a large extent their prospects for further development. Thus, in the growth of the capitalization of companies in these sectors, the market today implicitly anticipates an increase in inflation in the future.

The main U.S. macroeconomic parameters may return to pre-crisis values by about mid - late summer. However, the Fed’s leaders continue to declare that it is not going to wind down its quantitative easing program this year and, even more so, it is not going to raise the interest rate. The Fed and other major central banks have literally flooded the market with cheap money. The S&P 500 index at the end of May was 29% higher than the pre-crisis values, which is well ahead of the economic recovery and reflects the obvious overheating of the U.S. stock market.

4 / Aleksei Kirilov, Valeriy Kirilov. Impact of the pandemic on global supply chains. Intelligent Risk (PRMIA), April 2021, https://issuu.com/prmia/docs/intelligent_risk-april_2021_issuu

a soft landing?

Such a policy could potentially lead to a sharp rise in inflation by the beginning of autumn, forcing the Fed to greatly reduce its quantitative easing program. This would lead to a sharp decrease in liquidity in the U.S. stock market and a strong correction. To prevent such a development of events, individual representatives of the Fed already in June hinted about plans to reduce the quantitative easing program earlier. However, in order to ensure a more predictable behavior of the stock market, it is advisable for the Fed to officially announce already in July the terms and conditions of the gradual curtailment of the quantitative easing program.

authors

Aleksei Kirilov

Partner, Conflate LLC Conflate is a Russian management consulting company specialized in strategy, risk management, asset management and venture investment. As the partner of Conflate, Aleksei is responsible for asset management and venture investment. He specializes in the US stock and debt markets. Aleksei has more than 15 years of experience in financial services including development of financial strategy and financial KPI, liquidity management; controlling system, allocation of expense on business unit, financial modeling and debt finance. He has cross industries experience: banks, oil & gas manufacturing, real estate.

Aleksei has an MBA from Duke University (Fuqua School of Business), a financial degree from Russian Plekhanov Economic Academy and an engineering degree from Moscow Engineering Physics Institute.

Valeriy is the General Manager at Conflate LLC. He has 15+ years’ experience in risk management and management consulting (BDO, Technoserv, then at Conflate). Besides he previously worked in the nuclear power industry (safety of Nuclear Power Plants).

Valeriy has an MBA from London Metropolitan University as well as a financial degree from Moscow International Higher Business School MIRBIS and an engineering degree from Moscow Engineering Physics Institute. He holds the PRM and FRM certifications and the certificate of Federal Commission for Securities Market of series 1.0. Valeriy was a member of the Supervisory board of the Russian Risk Management Society in 2009 – 2010.

Valeriy Kirilov

General Manager at Conflate LLC