Over the past month, we’ve taken a different path than most equity strategists. Rather than getting excited about the reopening, we’re getting a bit more concerned about execution risk and what’s already priced in.

First, on the execution front, there’s growing evidence that supply remains a problem for many companies, just as demand is picking up. These issues have been particularly acute in certain materials and components, and now it’s becoming more apparent that we have a labor shortage as well. In addition to numerous surveys and company commentary, Friday’s disappointing employment report suggests labor availability may be a gating factor on the speed of the reopening. Furthermore, while these problems haven’t broadly affected margins yet, stocks are discounting machines, and they don’t always wait for an engraved invitation.

To prepare for this execution risk, we downgraded small caps and early cycle stocks like consumer discretionary, while upgrading consumer staples and recommending a move up the quality curve across all sectors. At the same time, we’ve maintained our reflationary bias, with overweights in financials, materials and industrials.

We started highlighting these concerns in mid-March and are now even more convinced that they are warranted. On valuation, the risk is elevated too. But with liquidity still flush and the S&P 500 making new highs every day, few seem worried. For many, the weak payroll number just means more accommodation from the Fed, or at least not any withdrawal.

From our vantage point, the equity risk premium is underpricing these costs and supply issues, as well as other risks that we’ve discussed over the past month. Most notable are the peak rate of change in economic and earnings data, as well as in policy and liquidity, extreme equity supply and investor leverage. To be fair, the market isn’t completely ignoring these risks either. Since mid-February, many stocks and indices have traded lower, some as much as 30% or 40%, and they aren’t really recovering. Longer duration stocks have been hit the hardest, as long-term interest rates moved higher than most expected this year.

Lower quality stocks have underperformed, too. Most recently, many popular large cap technology stocks sold off on terrific first quarter earnings results after an outsize run into the event. This was in line with our call for a rotation towards higher quality, but also a reminder that stocks often peak on good news. We think it will be important to see if these stocks can make new highs on the weak payroll report and lower yields. If they can’t, they are likely to come under further distribution.

To be clear, this peak rate of change and execution risk are normal as we exit the early stages of a recovery and enter what we call the mid-cycle transition. In past cycles, 1994, 2004 and 2011 were comparable years to where the economy is today. We think 2021 will be similar for investors: flattish returns for the year with a 10-20% correction along the way.

During such periods, the game is to be more selective with one’s investments and even more tactical with the rotations under the surface. The first quarter saw full-on cyclical rotation, with both reflation and reopening stocks leading. But that is starting to morph now, with reflation plays still working, while reopening stocks take a breather on this execution risk.

Finally, remember that we’re still only a year from the trough in the recession, and new bull markets tend to last for years. So whatever correction the market experiences this year, we are likely to make higher highs next year.

The goal as an investor is to navigate the mid-cycle transition, avoid the stocks with the biggest draw downs, and be in position to capture the next leg. The first stage of that transition seems to be well along. In short, taking down the most egregiously valued stocks as rates moved higher. Small caps, early cycle stocks like semiconductors, and lower quality stocks are now underperforming, too, along with some reopening plays that got too extended. It’s likely that the S&P 500 will eventually feel it, too, before the transition is complete.

The bottom line: dreaming about a reopening is likely much easier than doing it. Given that stocks are discounting mechanisms, we’ve often said that it’s better to travel than arrive from an investment perspective. As a result, we continue to think it’s time to be more selective, and a tad more defensive, until these risks are better reflected in earnings expectations, price, or both. Welcome to the mid-cycle transition.