Despite Ongoing Uncertainties about the Pandemic, the Economic Recovery and Global Events, the Stock Market is Poised to Move Higher in 2021.
The financial markets turned in a stellar performance in 2020, the year of COVID-19, when real GDP probably fell about 3.7%. Both stocks and bonds had a great year. The S&P 500 was up 16.3% on price, 18.5% with dividends. The Bloomberg Barclays U.S. Aggregate index, the broadest measure of U.S. fixed income securities performance, delivered a 7.5% total return.
The S&P 500’s stellar performance equaled the sum of returns of its 11 industry sectors, which varied widely. On the plus side, the main drivers were technology (up 42%), Consumer Discretionary (up 32%), Communication Services (up 22%) and Materials (up 18%). On the negative, Energy lost 37.3%. Other slower growth, income-oriented sectors – like financials, real estate and utilities – also posted losses.
Digging a little deeper: The five stocks with the largest market capitalizations – Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL) and Facebook (FB) – had a combined price return of 52.8% in 2020. These stocks accounted for about 56% of the S&P 500’s gains (according to my calculations). By the end of the year, these five mega-cap stocks had a combined market capitalization of $7.5 trillion, equal to 23% of the S&P 500’s total market capitalization, up from 18% at the end of 2019.
Excluding the five mega-caps, the remaining 77% of the S&P 500 delivered a price return of 8.9%, which is solid. This represented about seven percentage points of the S&P 500’s total 2020 price return of 16.3%.
I still think of the big five stocks as technology companies, but S&P classifies them differently today. Apple and Microsoft are components of the S&P 500 Information Technology sector; but Alphabet and Facebook are now included in the S&P 500 Communications Services sector (in the Interactive Media and Services subsector). Amazon is a member of the Internet and Direct Marketing Retail subsector of the S&P 500 Consumer Discretionary sector.
With the help of these mega-caps, it is not surprising that the second and third best performing S&P industry sectors were Consumer Discretionary (up 32.1%) and Communications Services (up 22.2%). Excluding Amazon, I estimate that the rest of the S&P 500 Consumer Discretionary sector gained 9.5%. Excluding Google and Facebook, the rest of the S&P 500 Communications Services sector delivered a 16% return.
Another important trend was the strong 20Q4 performance of many stocks and sectors that had underperformed the market earlier in the year. By my calculations, 18 of the top 25 performing S&P 500 stocks in 20Q4 (with an average 62% return) underperformed the Index for the full year. There was very strong 20Q4 performance in sectors that had struggled from the direct and second order effects of the pandemic, including oil & gas, oilfield services, hotels, airlines, (healthcare, hotel, office and retail) REITs, money center banks and certain industrials.
Performance of the Dow Jones U.S. Total Market Index vs. Certain Industry Sectors
for the 2020 fourth quarter and full year
|DJ US Aerospace and Defense||28.5%||-19.2%|
|DJ US Airlines||28.3%||-31.1%|
|DJ US Banks||33.3%||-16.5%|
|DJ US Full Line Insurance||35.7%||-23.8%|
|DJ US Gambling||19.0%||-11.5%|
|DJ US Hotel/Lodging REITs||35.6%||-33.2%|
|DJ US Hotels||34.9%||-4.9%|
|DJ US Marine Transportation||43.3%||-42.1%|
|DJ US Oil & Gas Producers||25.9%||-37.0%|
|DJ US Oilfield Equipment and Services||48.4%||-41.1%|
|DJ US Recreational Services||30.8%||-38.7%|
|DJ US Retail REITs||19.9%||-31.6%|
|Dow Jones U.S. Total Market Index||11.7%||16.3%|
Source: Stockcharts.com and Lark Research calculations
Within my coverage universe, several companies whose stock prices had fallen 50% or more at the onset of the pandemic enjoyed double-digit stock price gains in the 2020 fourth quarter, outpacing the broader market. Most of them are components of the industry sectors included in Table 1 above.
While I was happy to see these stocks rally, my initial reaction was that their 20Q4 advance was too far and too fast. A large part of the year-end rally was obviously due to optimism about a quicker end to the pandemic with the recently announced vaccine rollouts. Yet, there are still considerable uncertainties about the timing and sustainability of the rebound and also the structural changes that may result from different (spending) habits for consumers and businesses that may affect the strength of the rebound.
With that in mind, I will turn to a brief review of current expectations for the economy in 2021 before continuing with my thoughts primarily on the outlook for the stock market.
Economic Outlook. The Philadelphia Federal Reserve’s Survey of Professional Forecasters is a compendium of the forecasts of economists from 47 organizations, including Wall Street firms, industry associations, corporations, universities and independent research firms. The Survey is published quarterly and conveys the views of these forecasters on real GDP, the unemployment rate, the monthly change in payroll employment and headline and core CPI and PCE inflation.
In the latest Survey, which was published in mid-November, economists predicted that real GDP would contract by 3.5% in 2020, but grow by 4.0% in 2021. The forecasts anticipate slower GDP growth for 20Q4 and 20Q1 than in the previous survey, presumably due to the second wave of the pandemic, but modestly faster growth in 2021.
Since the Survey was released last November, the combination of the announced rollout of the coronavirus vaccines and the passage of an additional $900 billion COVID-19-related relief package by Congress has caused many economists to raise their estimates for 2021 GDP growth. In mid-December, FOMC participants raised their outlook for 2021 GDP growth to 4.2% from 4.0%. In Barron’s 2021 Outlook issue, dated December 21, 2020, the average 2021 real GDP growth estimate of 10 Wall Street strategists was 4.6%. On Jan. 13, the Conference Board predicted that real GDP would rise 4.1% in its base case forecast for 2021, with a range of 0.8% in its downside scenario to 6.4% in its upside scenario, depending primarily on different possible courses of the pandemic.
These 2021 forecasts are all above the average rate of real GDP growth of 2.4% from 2011 to 2019. Many economists consider the U.S. economy’s long-term potential annual rate of growth to be 2.0%-2.5%. Consequently, the consensus 2021 growth rate of 4.0%-4.5% is temporarily above the long-term trend, due to the expected recovery from lows of the pandemic. Most economists therefore assume that GDP growth will moderate steadily downward to the long-term 2.0%-2.5% trend level in 2021 to 2024.
These aggregate GDP forecasts do not tell us anything about the sources and composition of that growth. In the table below, I give projections for real GDP and its major components for 20Q4 (which is incorporated into my estimate for all of 2020) and for 2021. While my projections are rough guesses (in contrast to the professional economists most of whom probably build their models from the ground up using a variety of data sets), I believe that they do show what areas of the economy have been hurt the most by the pandemic and consequently the most likely major contributors to a near-term economic rebound.
The hardest hit component during the pandemic has been personal consumption expenditures on services, but expenditures on goods, both durable and nondurable, are up. Households have been forced to cut back spending on restaurants and other discretionary activities and they have so far transferred that savings to purchases of goods. Sales of durable goods were quite strong for most of 2020, but they have declined slightly in the final months of the year.
After a big dip in 20Q2, gross private domestic investment rebounded sharply in 20Q3. Residential investment has bounced back sharply, offsetting most of the decline in nonresidential investment and reductions in inventories. Net exports have been more of a drag on the economy this year, as exports have fallen faster than imports. Government spending has so far held up, but budgets have been pressured due to falling tax revenues and increased spending in response to the pandemic. In recent months, the public sector has been trimming its payrolls.
My projection for 20Q4 represents a departure from the consensus view. The consensus estimate, as measured by the Philly Fed forecasters, anticipates a 4.0% increase in 20Q4 real GDP, due to a continuation of the economic recovery. I, however, worry that the second wave of the pandemic has slowed the economy, as evidenced by the loss of 140,000 jobs in the December payrolls survey and declining retail sales and durable goods orders in November and December. Consequently, I anticipate that 20Q4 GDP will come in light, up only 0.4%. As a result, my full year forecasts anticipates a decline in real GDP of 3.7%, slightly worse than the consensus view of -3.5%
My projection of 4.3% GDP growth in 2021 GDP growth is in line with consensus. My forecast anticipates a turnaround in personal services spending, especially for leisure-related activities. It also anticipates improvement in gross private domestic investment, both residential and nonresidential; a small decline in net exports, with faster growth in exports; but decreased government spending, as the states seek to reel in their budget deficits. If Congress passes Joe Biden’s proposed $1.9 trillion COVID-19 relief program, there is upside to my forecast.
Several economists and market strategists have been trumpeting a big boost in consumer spending in 2021 from stimulus relief and pent-up demand. When the drag of the pandemic recedes, probably during the second half of the year, buoyant consumers may celebrate by spending part of their savings, reclaimed income and stimulus checks on restaurant meals, gambling, movies, sporting events and vacations. People will go back to the office and children to day care. Center cities, empty during the pandemic, will become crowded again.
Yet, structural changes to the economy could alter the shape of or limit the recovery. There may, for example, be a permanent shift in the away-from-home eating habits of Americans. According to Commerce Dept. advance estimates, spending in food services and drinking places was down 19.5% in 2020 to $617 billion; while spending in food and beverage stores was up 11.5% to $853 billion. Prior to the pandemic, away-from-home food and beverage spending regularly exceeded at-home spending by a modest amount. Still, the WSJ reported recently that some food and household products companies are expanding their manufacturing capacity in anticipation that the 2020 changes in spending patterns will be long lasting.
There are also questions about changes in the (white collar) workplace. Many companies may allow more of their employees to work more from home more often, which could reduce the demand for office space. After the sharp rise in online sales and the failures of more retailers, there may also be a further decrease in demand for retail space.
Since online video has replaced in-person meetings, there are also questions about the future of business travel. In its “World in 2021” issue, the Economist predicts that business travel could decline by 33%. A permanent reduction in business travel could affect the recovery outlook for airlines, hotels, restaurants, rental car companies and similar enterprises.
Personal travel should recover faster, but the pace and magnitude of recovery is still uncertain. Domestic travel to visit relatives should bounce back sooner, due to pent-up demand; but vacation travel may be slower to recover. Domestic vacation demand, especially to popular destinations like Florida, will likely come back more quickly than international vacation travel, due to testing requirements and other restrictions still in place in many countries.
Airlines expect some pick-up in demand in 2021, off the 2020 lows, probably in the second half of the year. Other sectors, like cruise ships and hotels expect a slower pace of recovery, with sales not returning to pre-pandemic levels until 2022 or 2023.
The recovery will generally see both a rise in the absolute level of consumer and business spending and a shift in the mix, especially from goods back to services. Structural shifts may change industry dynamics, with those sectors that have suffered the most during the pandemic struggling to return to pre-COVID levels of activity and the beneficiaries of the pandemic, like technology, extending their revenue gains (but probably at a declining percentage rate).
With vaccine rollouts, restrictions on movements and gatherings should begin to end by mid-year. For companies that are on the ropes, the timing of the recovery may determine their ability to survive; but most public companies have taken steps – drawing on credit lines or issuing new debt in the public markets – to ensure their liquidity.
The Federal Government and the Federal Reserve. Actions taken by the Federal Reserve since the start of the pandemic have brought interest rates nearly to zero and kept markets and businesses afloat. These actions have helped shape the dynamics of industries and companies. They have also helped limit the downside and duration of the downturn in economic activity, but raised certain long-term risks for the Fed itself and the financial system.
Prior to the pandemic, the Fed was on a course to normalize interest rates and reduce the size of its balance sheet; but it was forced to reverse course in mid-2019 in response to weakening global economic activity. When the pandemic washed on to U.S. shores, the FOMC brought its target Fed Funds range down in two quick steps: by 50 basis points (bp) to 1.00%-1.25% on March 3 and then by 100 bp to 0%-0.25%. Rates on all other types of debt, including bank loans, corporate bonds, mortgages and municipal securities, fell commensurately.
The Fed also began buying U.S. Treasurys and Agency mortgage-backed securities at an unprecedented rate. From mid-March to mid-April, it bought $1.4 trillion of U.S. Treasurys and $250 billion of Agency and mortgage-backed securities. Since mid-April (through Jan. 13), it has purchased $814 billion of Treasurys and $417 billion of Agency MBS. That brings its total purchases since the start of the pandemic to $2.9 trillion and its total holdings of U.S. government securities to $6.7 trillion.
While these purchases have helped lower interest rates and ensure financial market liquidity. They have also served to fund indirectly the Federal government’s deficit of $3.13 trillion in fiscal 2020 and its expected deficit of $2.3 trillion in fiscal 2021. (The $2.3 trillion deficit estimate for 2021 does not include Mr. Biden’s $1.9 trillion add-on pandemic relief program.)
Finally, the Fed has provided credit directly to certain credit markets and also to businesses and their employees who were most at risk due to the collapse of economic activity. This was accomplished through multiple temporary facilities, many of which were resurrected from the 2008 financial crisis. These include the Municipal Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, the Money Market Mutual Fund Liquidity Facility, the Primary and Secondary Market Corporate Credit Facilities. the Term Asset-Backed Securities Loan Facility, Central Bank Liquidity Swaps and the Temporary Foreign and International Monetary Authorities Repo Facility.
Two especially notable new facilities are the Paycheck Protection Program Liquidity Facility, which provides non-recourse loans to lenders that originate SBA-guaranteed Paycheck Protection Loans to small businesses, and the Main Street Lending Program, which supports lending to small- and medium business enterprises and non-profit organizations.
In December, the Federal Open Market Committee, which oversees the Fed’s open market operations, made two adjustments to better adapt its programs to recent and expected future developments in the economy and financial markets. The first was a shift in its policy toward inflation; the second was a change in its approach to asset (i.e. Treasury securities) purchases.
The FOMC has long had an inflation target of 2% and would typically respond to inflation that was running meaningfully higher or lower than that target. Under its new policy, adopted in response to the pandemic, the FOMC will keep its fed funds target range at 0%-0.25% until the labor market reaches full employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time. In essence, the FOMC is willing to let inflation run hot until the economy returns to full employment.
The FOMC has also altered its policy stance on asset purchases. It will continue to increase its holdings of Treasury securities by at least $80 billion per month and agency MBS by $40 billion per month, but now those purchase guidelines will remain in place until substantial additional progress has been made toward its maximum employment and price stability goals. This expands the purpose of these asset purchases beyond their original intent of promoting smooth market functioning and maintaining accommodative financial conditions.
Although there is much to consider and discuss about the Fed’s actions and revised policy guidelines, I am going to focus here on the impact that its unprecedented and exceptionally accommodative monetary policies have had on the financial markets, especially on stocks. There is little question that these policies have promoted higher valuations in the stock market (as evidenced by near historically high price-to-earnings multiples), in the fixed income markets (as evidenced by historically low yields) and in the real estate markets (as evidenced by high and rising property prices and declining capitalization rates).
Many people fear – perhaps correctly – that these ever higher prices are indicative of bubbles in asset prices (that presumably will be popped some day). Clearly the formation of these potential bubbles have been a long-time coming.
With the Fed essentially doubling down on its policies and focusing ever more intently on its goal of maximum employment, it looks like stocks can continue go higher over time, perhaps for several more years, perhaps even longer.
Although it looks like the asset bubbles are getting bigger, there is no law that says they eventually have to pop. They might get whittled away by inflation. Indeed, in one “thread the needle” strategy, the Fed would allow inflation to reduce the size of the asset bubbles (and the debt burdens that are accompanying them).
So where can the market go from here? In Barron’s market outlook issue (dated December 21), the 10 Wall Street strategists set an average year-end 2021 price target of 4036.50 for the S&P 500. The 10 estimates ranged from a low of 3800 to a high of 4400, representing projected 2021 returns ranging from 1.2% to 17.1%. The average estimate equates to a predicted advance of 7.5%.
The sectors favored by most of the strategists are financials and healthcare. Two other sectors with mostly favorable ratings were industrials and consumer discretionary. Out-of-favor sectors include utilities, consumer staples and real estate, all of which underperformed the market in 2020. The strategists were either neutral (with overweight ratings more or less offset by underweight ratings) or silent on technology and energy, which were the best and worst performing sectors, respectively, in 2020. They were also mostly neutral on materials and communication services.
Technology. After delivering a spectacular 42.2% return in 2020, the S&P Technology sector warrants attention in 2021. With the 2020 gains, the S&P 500 Technology sector has more than tripled over the past five years, posting a compounded average annual return of 26.0%, making it by far the best performing sector. By comparison, the S&P 500 has delivered a compounded average annual return of “only” 12.9%.
Earnings for the technology sector have increased at a slower pace than share prices. The consensus estimate anticipates 2020 operating EPS of 65.89, up 4.7% over 2019. If the consensus proves true, that will represent a five-year compounded average annual growth rate of 11.7%, much slower than the 26.0% average advance in the index’s value.
Thus, technology’s trailing 12-month price-to-operating earnings ratio has increased from about 21 on average from 2015-2017 and 17.1 in 2018 to 26.7 in 2019 and an estimated 35.8 in 2020. That is by far its highest since the 2008 financial crisis.
Technology valuation multiples based upon other earnings measures, such as diluted earnings before extraordinary items, normalized earnings and “as-reported” or GAAP earnings are also at post-2008 financial crisis highs, according to S&P Global Market Intelligence, but still nowhere near the stratospheric valuations of the dotcom boom.
A similar rise in technology sector valuation multiples can be seen in forward earnings. The current consensus estimate anticipates a 25% increase in technology operating earnings in 2021, which translates into a forward P/E of 27.7. Using one-year ahead historical operating earnings in the denominator, I calculate that technology’s forward P/E multiple has increased from an average of 17.4 from 2015-2018 to 24.5 in 2019 and now to 27.7 in 2020.
The current high valuation was probably the main reason that five of the ten Barron’s strategists gave no recommendation on Technology for 2021. Three recommended overweighting the sector and one an underweight position. The tenth strategist, Tobias Levkovich from Citi, split between underweighting software and overweighting hardware.
The Broader Market. Mr. Levkovich was among those on the low end of the forecast range for the S&P 500, because he suspects that a broadening of the rally will cause a rotation away from the five mega-caps, which will make it harder for the overall market to move higher in 2021. That certainly makes sense, if valuations on the mega-caps begin to revert to their long-term averages.
According to S&P DJ Indices, the S&P 500 was valued at 31.1 times projected operating earnings of 120.81 at the end of 2020. That is higher than the 2015-2019 average of 20.0 times and the 2010-2019 average of 17.8 times.
The sharp jump in the valuation multiple during 2020 is due to a combination of rising stock prices and falling earnings, as a result of the pandemic. The S&P 500 posted a price return of 16.3% in 2020, even though operating earnings declined by 23.1% to 120.81.
The same jump in valuation is evident when considering the S&P 500’s valuation on “as-reported” or GAAP earnings. On that basis, the Index was valued at just over 40 times earnings at year-end, compared with 23.3 times at the end of 2019, 22.8 times for 2015-2019 and 20.0 times for 2010-2019.
The gap between operating and as-reported earnings widened in 2020, as it typically does during a recession, because a large portion of the decline in earnings is attributable to charges, like asset impairments and unusual increases in loan loss provisions, that are considered non-recurring. As-reported earnings should be used when evaluating historical performance. Operating earnings can be useful in forecasting future earnings, if the items considered non-recurring, such as impairments or restructuring charges, indeed prove to be temporary.
Currently, the sum of all of the consensus forecasts for S&P 500 constituents (i.e. the “bottoms-up” estimates) anticipates 2021 operating earnings of 166.63, up 38% from estimated 2020 operating earnings, and as-reported earnings of 144.00, up 54%. Earnings are expected to rebound across many sectors and the gap between operating and as-reported earnings should narrow accordingly (back to recent historical, pre-COVID levels).
Thus, the forward valuation on the S&P 500 at the end of 2020 was 22.5 times operating earnings and 26.1 times as reported earnings. That is a lot closer to but still above the recent historical averages for both measures.
A few observations about the forecasts are worth noting: Companies’ earnings guidance and analysts’ estimates are often too optimistic at the start of the year. Those forecasts usually anticipate growth in revenues and earnings that relies upon strong second half performance. As the actual quarterly results roll in and company expectations become more realistic, those optimistic full year earnings forecasts are often eased downward to achievable levels.
This year, however, the earnings projections seem most optimistic in the first half of the year. The comparisons against prior year results will easier in the first and second quarters, but the second wave of the pandemic is still raging and the rollout of the vaccines will take time. Some business surveys – such as the New York Fed’s January Business Leaders Survey, show that economic activity slowed in December and the slowing may be continuing in the new year.
Consequently, the downside risk to earnings forecasts is probably greatest in the 2021 first half. By comparison, third quarter projected earnings growth is modest, up 15% vs. prior year levels. Fourth quarter earnings growth targets are more optimistic at 20%-25%, but still less than the full year total of 40%-50%.
If the current estimate of $166.63 for 2021 S&P 500 operating proves correct, its valuation multiple – price-to-trailing 12 month earnings will decline from 31.1 to 22.5, which is modestly above the recent five-year average. That valuation could be justifiable on a fundamental basis, if the recovery in earnings back to long-term trends continues in 2022. Since the affects of the pandemic are anticipated to begin winding down at mid-year, the global economic recovery will most likely extend into 2022, perhaps to 2023 or even 2024.
Future Market Valuations. Market valuations have been moving higher in recent years, despite higher volatility in year-to-year operating earnings growth and a long-term earnings growth trend of between 6.0%-6.5% that remains essentially intact.
There are several causes of expanding market valuations: First, despite a couple of reversals when the Fed tried to normalize interest rates, rates have been declining on average since well before the 2008 financial crisis. In 2020, the U.S. Treasury yield curve shifted downward by 125 basis points on average, with longer-maturity yields (10 to 30 years) decreasing by about 85 basis points. These lower interest rates alone support an increase in the market’s P/E multiple of about a point (without leverage), according to my estimates.
Besides the Fed Funds target rate, the Federal Reserve’s securities purchase programs have and will continue to put more money into various segments of the financial markets, which will eventually find its way into the stock market. As noted above, many market watchers have commented on the development of asset bubbles stemming from Fed policies. I am not sure if we can classify the stock market’s current valuation as a bubble; but it is certainly higher than it was a decade ago. Although there are obvious long-term risks to the economy and financial markets that seem certain to increase over time, there is nothing to say that stock prices cannot go higher from here, especially if this extraordinary market intervention by the Fed lasts.
Without a clear catalyst to end this long bull market advance, which will enter its twelfth year in March, the market is likely to move higher over time. It probably will not go up in a straight steep line, however, and there should be corrections along the way. The pandemic might have qualified as a bull market busting catalyst, but with the vaccine on the horizon, broad-based evidence that key segments of the economy have already adjusted to the restrictions on gatherings and widespread forecasts of improved economic activity and corporate profits in 2021 and beyond, it seems more likely that it will pass having made a dent in the stock market’s upward momentum, but not putting an end to it. Even bears have to admit that the stock market’s rally off the April pandemic-driven lows has been impressive.
The 2020 rally in stock prices certainly has put valuations at a level that already anticipates a significant rebound in earnings across the economy and especially in sectors that have been hardest hit during the pandemic. Consequently, it could be vulnerable to a setback, perhaps from a delay in the timing of the anticipated end of COVID-19 restrictions.
The market will eventually suffer another correction, perhaps precipitated by events, perhaps not. The fundamentals suggest that the risk of a correction is higher in the first half of the year. At the moment, however, there is nothing that I see in the charts – daily, weekly or monthly – that suggests that the S&P 500 is on the verge of a downside reversal.
In Part 2 of this 2021 Outlook for the Economy and Financial Markets, I will offer a specific forecast for the stock market as well as an analysis of the 2020 performance of and current year outlooks for the major S&P 500 industry sectors.
 Many of the facts described in this section of the report were taken from an Open Vault Blog post dated Aug. 12, 2020 by the Federal Reserve Bank of St. Louis at https://www.stlouisfed.org/open-vault/2020/august/fed-response-covid19-pandemic
January 22, 2021
Stephen P. Percoco
16 W. Elizabeth Avenue, Suite 4
Linden, New Jersey 07036
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