Coming into 2020, many stock market strategists were cautious citing the approaching U.S. presidential election, a re-escalation of trade tensions, and elevated valuations as the primary concerns. Of all the concerns listed, a global pandemic that would shut down the entire economy was not being considered. That said, barring a last-minute selloff, 2020 stock returns are on pace to deliver solid double-digit gains.
While 2020 has been a challenging year for most of us, the stock market is singing a different tune and 2021 is setting up to be another strong market year given the arrival of approved COVID vaccines, expected earnings growth of 22%, and expected revenue growth of 8%.
With the stock market trading at 22x forward twelve-month earnings, which is a 40% premium to the 10-year historical average, stocks are seemingly priced for perfection and a lot must go right for stocks to deliver on heightened expectations.
As a result, it won’t take much to disrupt this rally and the short-term concerns that are at the top of my mind include: interest rates, taxes, and fiscal policy.
Interest Rates
Low interest rates have been the fuel for stock market growth and multiple expansion this year with the Federal Reserve pushing investors to take more risk. As a result, we are left with T.I.N.A – There Is No Alternative. Treasury bonds, corporate bonds, and cash are all yielding close to zero, so if you want a return greater than inflation, you must invest in either stocks or real estate.
That said, one potential consequence of the upbeat 2021 forecasts is that the expected surge in economic activity will result in inflation which will result in upward pressure on rates. Even if the Fed holds rates steady through 2021 (likely scenario), we could see the market pricing in a higher likelihood of rate hikes in the future which would have a negative impact on valuations. The last time the Fed increased interest rates was in 2018 and the market reacted with a negative year and a 4th quarter that experienced a peak to trough loss of over 19% - within 1% of bear market territory.
Georgia On My Mind
2021 will begin with a contentious election with major implications. On January 5th, Georgia will hold a special election for their two Senate seats which will ultimately determine the balance of power in the Senate.
As of right now, the split is 48 Democrats and 50 Republicans. The outcome of the Georgia elections will determine if the final tally is 48-52, 49-51, or 50-50.
The post-election rally was predicated in large part on the idea that there will be a split Congress (Democrats controlling the House and the GOP controlling the Senate), which would restrict the ability of a Biden administration to pass corporate and capital gains tax hikes and other policy proposals that would presumably include huge amounts of deficit spending.
If the Democratic challengers in the Georgia Senate races -- Raphael Warnock and Jon Ossoff -- defeat the Republican incumbents -- Sen. Kelly Loeffler and Sen. David Perdue -- the Senate composition would be 50-50 and Vice President Elect Kamala Harris would have the tie breaking vote.
The implication for the stock market with such an outcome would be that tax hikes are likely, and higher taxes would inevitably lead to downward earnings revisions for 2021, and, presumably, downward pressure on stocks.
Fiscal Policy
The stock market is completely disconnected with the challenges people are facing on Main Street. While the $900 billion fiscal package being discussed is a good start, we will likely need more. It is estimated by Moody’s Analytics that close to 12 million households fear they won’t be able to meet their mortgage payments, six million are likely to face eviction, and 37% percent of the unemployed said the pandemic prevented them from looking for a job. Also, it is estimated that if you consider those who had a job pre-pandemic but dropped out of the labor force after being let go, the unemployment rate would be close to 10%.
Without another major stimulus bill, we could easily see a prolonged recession.
Putting It All Together
This year has been good for the stock market, but the real world is still struggling.
The stock market has been making easy money off the March lows based on extraordinary policy support, the persistence of low interest rates, and the promise of recovery in 2021 that revolves around the COVID vaccines.
With historically high valuations, albeit with historically low interest rates, being the starting point for 2021, investors need to dial down their return expectations.
2021 is almost here and optimism has pulled stock market returns forward. With this in mind, there is a very plausible scenario where economic growth returns but is low enough to keep rates low and the Fed accommodative, we maintain a split congress, congress delivers a big enough fiscal package to help struggling families, and optimism and animal spirits remain high and push the stock market to higher levels. And the stock market still has T.I.N.A. on its side.
What Are We Doing?
- For clients who are funding portfolios with cash we are being cautious with the implementation and staging in over a period of 6-12 months.
- For clients who are fully invested we are remaining fully diversified with a bias towards quality. In addition, we are keeping at least six months of living expenses in cash and making sure all 2021 financial liabilities are met.
- We are making sure stocks are diversified across U.S. stocks and International stocks.
- We are underweight fixed income and overweight cash.
If you would like to speak about your portfolio in greater detail, please feel free to reach out to schedule a meeting.
In the meantime, we want to wish you and your family a happy holiday season!