Our Outlook for the New Year
“It is better to be approximately right than precisely wrong.”
– John Maynard Keynes
No one is more appropriate to quote than John Maynard Keynes, developer of Keynesian Economics, when thinking about key economic events that marked last year. After all, it was Keynes who theorized that fiscal policy is the solution to save the economy and financial markets when threatened by unemployment and recession.
While we know that effective monetary policy undertaken by the Federal Reserve is also a very valuable tool, the United States employed aggressive fiscal policy in 2020, as we anticipated, and fortunately it seemed to work as theorized. We give a fist bump to Keynes on this front. In addition, we believe the above quote by Keynes is most appropriate, not just for these times but for all times, and particularly relevant for our 2021 Crystal Ball Outlook. His words help highlight that economic and financial market forecasting, while grounded in research, is more art than science. To that point, our goal is to evaluate the fundamental, valuation and technical data to get the general direction of the trend correct, not to nail down the exact financial targets. Yes, we publish specific targets for economic growth each year, as well as for projected price levels for various stock market indices. However, if we simply get the trend right (as well as the associated key factors we choose to monitor to determine if that projected trendline remains intact), we generally find that success in the markets follows suit.
In prep for this commentary, we reviewed the forecasts we made last year at this same time in conjunction with our 2020 Crystal Ball Outlook. In the 2020 Crystal Ball Outlook, we predicted a 75% probability of positive outcome with an upside target on the S&P 500 of 3500 (roughly a 10% total return for the year) and a 25% chance of mediocre- to worse-case outcomes and a downside target of 2600. The market actually closed the year at 3756 representing an 18% return for 2020, and it experienced a low of 2237 in the spring.1
Interestingly, our upside and downside targets came very close to being correct. This is true in a very volatile year marked by a global pandemic and a very venomous election. Despite the precarious environment in 2020, often noted to be unprecedented, the fact that our overall range was very close to reality shouldn’t be so surprising. A look at history tells us that the market advances in positive form approximately 75% of the time and only 25% of the time is it moderately down to significantly negative. In this context, our probabilities and our specific scenarios weren’t crazy or examples of winging it…they were in sync with studied historical outcomes. See the chart below that illustrates how rare it is for the market to generate negative returns through history. Even in those rare negative years, it’s even less likely to see significantly negative returns.
Source: J.P. Morgan
The bottom line is that you will likely experience moments when we do turn negative on the markets, but these will be relatively rare, perhaps on the order of 25% of the time over long periods. And such negative expectations will be accompanied by a highly probable sustained negative accent in the data and in anticipated policy decisions (mistakes). In that vein, despite the depressing headlines we saw last year, this was not the fact set in 2020…unprecedentedly powerful fiscal stimulus delivered in Keynesian fashion remedied a temporary soft patch, and the economic and earnings trend improved throughout the second half.
The supportive fiscal response to COVID-19 challenges, quickly followed by the stabilization in key economic and earnings data, are what kept us firmly locked in a hold your ground/remain invested view last year. This enabled us to get the overall trend correct. Our research on these fronts gave us the conviction to maintain our price target in the S&P 500 at the 3500 level throughout, and to recommend to clients that they remain invested in stocks rather than capitulate in the spring when many experts were taking price targets down and suggesting that selling positions was the better course of action. If investors capitulated to this fear, they would have missed the 70% rally off the low…the strongest and swiftest recovery following such a decline in the market on record.2 We are gratified that we maintained a positive message at a time that tested us.
What a Surprisingly Strong Year for Equities in 2020
The table below highlights the returns for the various indices in the last calendar year:
Equity returns were not only robust in the S&P 500 last year, but they were broad based as every major equity index posted positive results…large cap and small cap stocks in the United States, developed country international, emerging market international, more aggressive indices like the Nasdaq that are heavily technology laden, etc. Even gold performed well and actually bested the S&P 500. It is this broad-based strength that signals continued investor confidence for 2021 and is one of the reasons we remain positive for this new year. That said, if there was one fact that did surprise us last year, it was the speed with which we reached new highs in the market after the sharp 34% COVID-19-related correction in the spring.3 While we thought we would see 3500 or better in the S&P 500 within a reasonable time frame, we thought it might take up until mid-2021 to get back there. In fact, this swift move, that is historic in nature, does make us think that, perhaps, some of the positive results we would have expected to see in 2021 have already occurred in 2020. We still see further upside this year, but it is a bit more measured, because gains were so strong in late 2020. In other words, we see some of the benefits of vaccine deployment and a more sustained and comprehensive reopening as already being realized. 2021 should be profitable in our eyes for stock investors but not dazzling in nature.
Let’s Get Specific—Our Base Case Outlook and Likely Alternative Scenarios
The table below outlines our base case and various probable alternative scenarios should our assumptions in our base case deviate from expectations.
Please note that again this year, we place a 75% probability on positive results in U.S. stock market returns and only a 25% probability on moderately disappointing to negative results. Our base case calls for a final 2021 calendar year S&P 500 price level of 3900. When coupled with a 2% dividend yield, this would result in a total return of 6% to investors. We place a 55% probability on this outcome. We place a not insignificant 20% outcome on a more optimistic experience via a potential higher upside target of 4150 for the S&P 500 or a more handsome 13% return to investors. In fact, we will increase our base case to this higher expected result should distribution of the vaccine go well, and if we indeed see that the full U.S. economy, including the service sector, is on the crystal clear reopening path that more bullish investors hope for…we just find it too early to make such a rosy assumption in our base case scenario. Both our base case and the optimistic case that are being introduced in this commentary are built on the following additional key assumptions:
- Vaccine deployment and efficacy is safe and effective, thus allowing for consistent reopening of the economy throughout 2021; however, some bumps in the road of distribution will occur
- Real GDP growth of 4% for the year
- The Fed remains boldly accommodative and additional stimulus is deployed as required
- The S&P 500 achieves consensus earnings expectations of $196
- The 10-year Treasury yield drifts up in moderate fashion through the year and trades in a primary range of 1% – 2.5%
With this supportive backdrop, our base case scenario incorporates a P/E ratio of roughly 20 times earnings (below the current 21.5 times figure) on consensus earnings of $196. We believe the 3900 base case target is somewhat conservative on the multiple and assumes the P/E ratio moderates a bit from current levels. If the current P/E is roughly maintained and consensus earnings expectations are achieved, the S&P 500 could reach the 4150 level or better…hence the derivation of our optimistic 4150 target.
The disappointing case simply envisions vaccine deployment and reopening that is slower than the bulls expect, thus resulting in a slightly lower earnings figure of $190 and an associated slightly less impassioned P/E figure of 19 times. This disappointing potential level of 3600 at year-end would result in a -2% total return for the year…hardly a travesty. We assign a relatively low 15% probability to this scenario.
Our worst-case scenario price level of 3000 for the S&P 500 would cause some anguish for investors and cause them to absorb a 20% price decline and a total return including dividends of -18%. This would be somewhat on the order of a normal significant correction. We see this low probability outcome resulting in one of two ways. First, vaccine deployment and efficacy is a total disaster; or, second, on the flip side, the economy recovers even faster than expected. The latter case ironically could inspire the unexpected challenges of surging inflation and rates and cause the Fed to hike rates in “behind the curve” style. Either of these paths in the economy and markets could cause a solid correction. We assign a very low 10% probability to this.
The 2021 Wall Of Worry
If we are respectfully optimistic about 2021, and assign a 75% probability and sold returns, what headline risks do we think will be in the news this year to worry investors? And, what data will we be watching? Our wall of worry list includes the following:
The items in the table above shouldn’t be a surprise. Most appear on the left-hand side…amongst them, execution risks in deploying the vaccine; major bobbles in monetary and fiscal policy as we are still working through this period of post-holiday COVID-19 spread; reasonable transition experience in Washington, D.C., as the Biden administration pushes through it’s inaugural 30-day period. We believe these all can be managed in adequate fashion at this juncture, but not without some turbulence that will catch headlines and cause some volatility.
What we will be watching closely are the objective signals of the state of the economy and financial markets on the right hand side of the table…trends in the economy and earnings, the level and trend in interest rates and credit spreads that reveal whether the bond market is concerned about recession, etc. At present, the data is solid…GDP growth continues to recover, and earnings look to advance over 20% in 2021. All this while rates are low, making stocks look attractive from a valuation standpoint. While the pace of economic recovery is ebbing a bit during the current uptick in COVID-19 cases, it is still positive, and the vaccine calvary is on the go; until the latter gets to full speed, policy from the Fed and out of Washington continues to support. Only if the trend in these factors begins to falter, or if one of the wildcard items surfaces in significant fashion, will we change our constructive outlook.
We maintain our positive hold your ground view for 2021 and look for solid, measured returns for U.S. stocks.
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.
The Bloomberg Barclays U.S. Aggregate Index provides a measure of the performance of the U.S. dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the United States.
The Russell 2000 index is an index measuring the performance of approximately 2,000 smallest-cap American companies in the Russell 3000 Index.
The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index consists of 24 countries representing 10% of world market capitalization.
The MSCI All Country World Index (ACWI) is comprised of the stocks of about 3,000 companies from 23 developed countries and 26 emerging markets.
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