2020 was of course dominated by the impact of the pandemic on the economy and specifically on the revenues and profits of each of the S&P 500 constituents. There was a sharp stock market sell-off in March-April, followed by a quick recovery. By mid-July, the S&P 500 had recovered all of its March-April losses. By the end of the September, it was up 4.1% YTD. With a quick resolution to the presidential election and the announcements of the vaccine rollouts, the Index rallied 11.7% in the fourth quarter, posting a 16.3% official return for the full year.
There were two trends of note that drove the S&P 500’s full-year 2020 performance: First, more than half of the gain was driven by five mega-cap stocks – Alphabet (GOOG.L), Amazon (AMZN), Apple (AAPL), Facebook (FB) and Microsoft (MSFT). Second, the fourth quarter rally was driven by optimism about a quicker end to the pandemic. This pushed up sharply the share prices of many of the companies whose businesses and stocks had suffered the most from the pandemic.
Since many high-flying stocks moved even higher and the profits of the pandemic sufferers have not even begun to recover, the fourth quarter rally brought valuations to near-record levels. Consequently, there has been more chatter in the media about a growing bubble in stock prices. Still, if the end of the pandemic is approaching, corporate profitability will recover in 2021, which should bring P/E ratios for the Index and its constituents down.
Profit trends may (or at least should) be a major driver of share price performance in 2021, but trajectories may differ across companies and industry sectors. For those companies that have seen their profits plunge during the pandemic, the key questions center around how quickly they are likely to improve. In some industries, there are questions about whether there will be permanent (or at least long-lasting) changes to customer demand. Even so, the end of the pandemic could unleash pent-up demand that may result in a temporary profit surge in 2021, but then questions will arise about how long that surge will last.
If there are longer-term structural demand shifts, profit recoveries for some companies may be slower, stretched over several years and conceivably capped below pre-pandemic levels. For companies whose businesses have benefited from the pandemic, such as consumer staples, those same questions about structural demand changes may determine whether they can continue to grow profits or whether they will experience profit declines, as customers return to their pre-pandemic behaviors.
Besides these issues, there are macro market drivers, such as the level of stimulus spending, the course of interest rates and Federal Reserve asset purchases. A consensus seems to be emerging that inflation will pick-up over time.
In the table above, I calculate the contribution of each industry sector to the S&P 500’s 2020 price return by applying market cap weights to the individual sector returns. (Please note: my estimates above are based upon the methodology that I used for calculating returns, which is different from that employed by S&P. My estimates are close, so I believe the analysis is relevant. For a full discussion of the differences between my approach and S&P’s see my full report.)
Information Technology contributed 9.7 percentage points to the S&P 500’s 16.9% return or about 57% of the Index’s total return, with help from the strong performances by Apple (AAPL) and Microsoft (MSFT). Other major contributors include Consumer Discretionary (3.5 pct. pts.), which was helped by Amazon (AMZN), and Communication Services (2.5 pct. pts.), which benefited from Alphabet (GOOG.L) and Facebook (FB).
According to my calculations, the five mega-cap stocks identified above earned an average market-weighted return of 55.2% in 2020 and contributed 9.6 percentage points to the S&P 500’s total return. By comparison, the remaining 495 stocks had an average return of 8.8% and contributed 7.3 percentage points to the Index’s return.
In the table below, I provide a sensitivity analysis of the overall return and year-end values of the Index under various combinations of returns for the five-mega caps and the rest of the S&P 500.
Given the exceptionally strong performance of the five mega-caps in 2020, there is much debate about how they will perform in 2021. Using the mean target prices of analysts, the implied average market-weighted price return for the five mega-caps is currently 21.3% (as of Feb. 6, 2021), which translates into a contribution of 4.73 percentage points to the 2021 return on the S&P 500. If, for example the average return on the rest of the S&P 500 is 10.0%, the total price return on the S&P 500 would be 12.5%. That would correspond to year-end value of 4225 for the Index.
After earning 55.2% in 2020, it would be quite amazing indeed if the five mega-caps are able to deliver a combined weighted-average return of 21% in 2021. For that reason, I expect a lower projected average return for the mega-caps, probably between 5% and 10%.
It would not be unusual for these stocks to undergo a correction in 2021 that would result in an even lower average return. On the other hand, while the valuations of these companies are high, none appear to be excessive, so another year of strong performance is possible.
It also seems reasonable that the average return on the remaining S&P 500 constituents could be at or above the 8.8% return posted in 2020, perhaps 10% or even as high as 12% in 2021. Combined with my estimated 5%-10% average return for the mega-caps, my projected 2021 return for the S&P 500 is between 8.9% and 11.6%, which translates into a price target of between 4090 and 4190.
(This post is a sample of my report “S&P 500 Sector Analysis and Outlook” which is part two of my 2021 Outlook for the Economy and Financial Markets. That report was published on Feb. 6, 2021. It contains a detailed analysis of each of the eleven sectors of the S&P 500. To obtain the report, please call or send me an email.)
February 23, 2021
Stephen P. Percoco
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