There is an old saying — “if you’re watching the train, then you’re not on it.” Hence, like a high-speed locomotive, stocks continue to rumble forward as we are now close to concluding the second month of the year with record highs recently established among most major equity indexes. Clearly, investors have been looking past various short-term uncertainties as optimism for the second half of the year is rising alongside upgraded expectations of improving economic and corporate earnings growth.
We find this to be a most interesting time, as we are now only days away from beginning the one-year anniversary of the dramatic COVID-19-induced selloff (February 19–March 23, 2020), which resulted in history’s fastest 35% decline in the S&P 500® index, as well as a more than tripling of high-yield and investment-grade credit spreads. As we process those brutal five weeks in our minds almost a full year later and do so now with the benefit of knowing all that has transpired since, perhaps it is not all that surprising to realize the S&P 500 has now booked better than an 80% total return since last March, and bond credit spreads have round tripped back to pre-virus levels.
There is certainly rationale for these moves, in our opinion, given the list of catalysts we have identified over the past year, most of which are continuing to play out. These include widespread vaccine distribution, the pace of economic and corporate earnings recoveries, pending fiscal stimulus, and ongoing accommodative monetary policy. However, stock price gains of this speed and magnitude are clearly breathtaking from a historical standpoint and can leave little room for error in terms of avoiding some degree of downside risk in the short term. While there is longer-term validity in terms of making sense of these recently ascending stock prices, nonetheless, 80% is still 80%.
We believe the risk of a meaningful pullback in stocks continues to increase. We define meaningful as being in the 5%–10% range between now and perhaps late spring when the favorable effects of second-half economic and earnings growth as well as improving virus trends driven by wider vaccine dissemination become more apparent. Perhaps investors will be content to wait out these next few months at increasingly higher price levels as these anticipated catalysts come to fruition. Then again, after experiencing a near double, perhaps not.
The markets are also in the process of absorbing higher long-term interest rates. Since the start of the year, the 10-year Treasury yield has seen a noticeable increase from 0.93% to 1.32% as of the close on February 16. When looking at the 10-year rate since last summer, the move is even more distinct from its early August closing record low of just 0.52%. While the reasoning behind this rise can be viewed somewhat favorably (strong anticipated economic growth in 2H21 and the implementation of higher-than-expected fiscal stimulus between now and that point), these higher rates could still create some short-term angst for investors given the higher price-earnings multiples now inherent in stock valuations. (The S&P 500 is trading at about 22x CY21 forward operating earnings estimates, according to Factset Earnings Insight.)
We believe long-term investors should not be surprised in the event stocks experience a pull back or even a full-fledged correction of 10% or more. Based on the current market environment, should we see this type of downside activity, we believe it would likely represent buying opportunities as longer-term catalysts likely display increasing strength during 2H21. Here we would focus on the following:
- Vaccine distribution is beginning to ramp up. Following a slow start in the aftermath of Pfizer’s and Moderna’s two-dose vaccine approvals toward the end of last year, we are now seeing the numbers of those vaccinated increasing at more rapid rates. In the U.S. as of February 16, more than 54 million people had received at least one vaccine dose with administration averaging more than 1.6 million shots daily. According to the calculation site Worldometer, we are also finally beginning to see a decline in active COVID-19 cases — those patients who have contracted the virus but have yet to recover — as reported for the first time since September. These numbers could see further improvement in the months ahead as Johnson & Johnson awaits FDA approval on its one-dose vaccine, potentially coming as early as the end of this month.
- High-dollar fiscal stimulus could soon be passed by Congress. Through budget reconciliation, it now appears President Biden’s $1.9 trillion fiscal stimulus package could pass the Senate with a simple majority, perhaps by the end of February. Leaving some room for negotiations within the Democratic Party, it is likely the legislation will pass with ultimate economic relief north of $1.5 trillion, considerably higher than originally anticipated. The composition of this stimulus, which is expected to include direct payments to individuals and families, assistance to state governments and small businesses, as well as more investment channeled into the national vaccine rollout, should help bridge the gap between current economic conditions and a strong second half acceleration.
- Monetary policy from the Federal Reserve looks to remain extremely accommodative. In his “State of the U.S. Labor Market” address on February 10, Fed Chairman Jay Powell was not shy to reiterate the committee’s short-term concerns about the economy, as reflected by slowing monthly job growth over the past several months. In this commentary, Chairman Powell further reiterated the Fed’s intentions to maintain the Fed Funds rate at a lower bound of zero and monthly open-market bond purchases of $120 billion. We view this ongoing monetary policy by the Fed as advantageous to the markets, particularly as the economy looks to improve in 2H21.
- We are expecting a strong acceleration in U.S. gross domestic product (GDP) growth in 2H21. Following what could be a somewhat rocky 1Q, we expect U.S. GDP growth to pick up considerably, potentially to annualized levels exceeding 6% during 2H21 and eclipsing aggregate pre-virus levels last seen in 2019. Should this prove to be the case, we believe it will likely be an important tailwind for the markets, as we could begin to hear the term “economic recovery” replaced once again by “economic expansion.”
- Corporate earnings growth forecasts are also rising. As the final wave of earnings reports for 4Q20 now head into the history books, it appears the year will not conclude nearly as bad as most had feared several months ago, and this is also being complemented by rising forecasts for CY21. As gathered by Factset Earnings Insight, CY20 operating earnings for S&P 500 underlying companies are now expected to finish the year only about 11% lower than 2019, less than half the rate of decline forecast last summer. Moreover, aggregate earnings forecasts for CY21 have now reached expectations of better than 23% growth, which if achieved would be close to 10% higher than pre-COVID-19 2019 earnings. When we combine stronger economic growth, fiscal stimulus, continued Fed open-market activity, and a rising vaccination pace, we see a high probability the market will be quite receptive to these potentially higher levels of earnings.
- Change of leadership toward value stocks is likely. As we have stated in previous commentaries, after a decade of lagging performance by value stocks relative to their growth counterparts, we believe the year ahead could see a meaningful reversal in that trend. Catalysts for value stocks in 2H21 would include a general rising tide of economic growth, a steepening yield curve beneficial for large financial stocks, and changes in consumer behavior induced by wider vaccine distribution (also more favorable for much of the value universe).
Where does this leave us in terms of the high-speed market train investors still find themselves on? Perhaps this can be best answered from the differing perspectives of those on it and those who may feel they missed it. If we do see a market pullback or correction, passengers should probably realize they have come very far very fast and avoid temptation to disembark. Those who may have sold following last year’s decline and have not returned in the months since may perhaps recognize a second chance could be at hand and consider reboarding. While there could be some bumps on the tracks immediately ahead, it appears as though the next couple of years could potentially still be quite a nice ride.
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