Solid November in the Midst of a Surprisingly Robust Year for Stocks…What’s Next?
“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
– Sir John Templeton
The data is impressive. The S&P 500 advanced 11% in November, thus marking a new record high and the strongest November for this benchmark since 1950. For the year, it is up close to 14%.1 This is a “wow.” Who would have thought that the U.S. large-cap stock market would exhibit resiliency and so much strength in a year marked by a pandemic that caused a swift recession, with spikes in unemployment and declines in GDP that were at Depression-era levels.
We are pleased that we stayed measured. Our general perspective was that investors hold their ground and remain invested in U.S. stocks at the peak of the short-lived economic abyss in March 2020. At that time, many were predicting doom and gloom for the year and suggesting investors should reduce equity exposure. In our research, we concluded that prudent and aggressive fiscal policy responses would enable the economy to weather a self-induced soft patch to invest in our health. We felt this economic challenge was more akin to a heartbreaking natural disaster that was ugly but temporary and that it would sow the seeds for pent-up demand and solid recovery in a relatively brief amount of time. And indeed, that is what occurred…a 30%-plus decline in GDP in Q2 was quickly followed by a 30%-plus surge in GDP in Q3 and an advance of more than 60% in stock prices off the spring bottom.2 While we have been a bit surprised by just how swift the S&P 500 has recouped the losses and moved to new highs, we are glad we got the trend right and helped to prevent folks from suffering whiplash that could have occurred if they trimmed or sold during the March lows.
This begs the question…is the November surge in the S&P 500 unwarranted and simply a “sandcastle in the sky”? After all, this impressive price advance occurred just as COVID-19 was spreading at record levels in the United States and Europe in a so-called “second-wave” fashion. To wit, in November, 44 states in the United States set records for the number of new daily cases and 25 states for new deaths. This is tragic data. So how in the world could we be sitting around the dining room table this Thanksgiving enjoying new record highs in the S&P 500 and the Dow Jones Industrial Average (crossed 30,000 for the first time), the technology laden Nasdaq, and the well-known small-cap benchmark, the Russell 2000, when COVID-19 cases are spiking again globally?
In our view, there are three clear, rationale drivers of this:
- The U.S. presidential election came to a close
- Three health care companies announced positive COVID-19 vaccine results in late stage trials, with likely introduction of these drugs soon
- Outstanding news on the earnings front with more than 80% of S&P 500 companies beating estimates by wide margins for their Q3 reporting periods.3
So, while it is a little disconcerting to us that the market looks a bit overbought at this juncture on a short-term basis, with more than 93% of stocks in the S&P trading above their 200 day moving average,4 we engender confidence and maintain a positive outlook for continued gains in U.S. stocks as we close out 2020 and anticipate the 2021 experience for several key reasons:
- The visible catalysts outlined above driving the recent rise in stock prices
- The encouraging signals garnered from the solid breadth in this advance, in regard to the large number of benchmarks and the wide list of economic/industrial sectors exhibiting strength
- Normal seasonality — on average, December is one the strongest calendar months for stocks. Coupled with the data that illustrates that periods of strong momentum, like we are seeing at present, tend to be followed by solid, 12-month stock market returns (see chart below), this bodes well for continued positive stock price trends in 2021.
In the context of the quote above about the stock market return cycle and where we stand on that continuum (pessimism vs. skepticism vs. optimism vs. euphoria), we’ll label this with just a bit of nuance and believe that we are in the measured optimism phase. We have moved through the days of uber-negativity and skepticism expressed back in March 2020 but believe that with low interest rates and continued drivers for strengthening fundamentals (economic and earnings growth), there is plenty of runway to go, and we look for continued positive equity returns in 2021.
As you know, up to this point, we have called for a S&P 500 price target of 3500 by mid-2021 and set this target far earlier in the year when it stood at 2235 and many were taking targets down. We mentioned we were biased to take this target up should we get additional positive news flow on vaccine development and data on trends in the economy, as well as see fears about the consequences of the election wane. Having digested the events on these fronts, we are raising our price target to 3800-4000 on the S&P 500 by calendar year end 2021…we see this as embracing a measured dose of optimism as this results in expected returns of 3%-8% for next year from current levels. We also look for rising volatility in Q1 2021 that could emanate from a temporary lull in economic growth as we deal with a brief surge in COVID-19, and we are still absent both additional fiscal stimulus and formal introduction of a vaccine. Please stay tuned for the full Crystal Ball Outlook we will present in January 2021 that will cover our thoughts for next year in much more detail.
Measured Optimism and The Bull Versus the Bear Case
While we have set out specific price targets above for the S&P 500, we try not to get too attached to a static figure. The key is to get the trend right. We find that if you do that, success and a pleasant experience generally follow. Bottom line: We think the intermediate and longer-term trend remains up from here. That said, we are calling for single-digit returns next year, because some of the bull case has already been discounted and included in current S&P 500 prices from our perspective…some, but not all. Specifically, consensus returns that are somewhat bullish in nature at present embed 20% EPS growth in 2021 followed by an additional double-digit gain in 2022.
As we see it, underlying this base case and bullish view are such factors as introduction of a vaccine and evolving reopening of the economy as we move through 2021. Other key elements associated with this view would include margin expansion at S&P 500 companies that have significantly reduced costs during this pandemic, a healthy rebuilding of inventories at manufacturing companies, and, most important, falling excess capacity in our service sector. This sector accounts for more than 80% of our economy (think restaurants, airlines, hotels etc.). It is critical, therefore, that this significant component of our economy heal. In such a scenario, multiples can be sustained at the 20 times level on earnings approaching $200 by 2022, and hence, the 3800-4000 range. This is actually quite probable in our mind but not without risks.
The bear case is that COVID-19 spreads in such a way that we must shutdown more vigorously than anticipated and insufficient additional stimulus is provided in the interim to get us through this. In such a scenario, P/E multiples and earnings would suffer. This certainly is not our base case but something we will monitor.
In the short term, we will receive data in early December regarding the trend in such metrics as claims for unemployment insurance, payroll growth and consumer confidence. These had started to soften in late November and could continue to do so temporarily as news of a fall/winter surge and COVID-19 plays out prior to vaccine introduction. Perhaps enough so that it could cause a spike in volatility and a pullback of some sort from current levels. This is why we maintain our hold your ground view and express near-term caution yet longer-term measured optimism.
How to Position in this Transition Period
How do we suggest positioning an equity portfolio as we transition to reopening the U.S. economy? We believe balance remains the key! More than a few experts are suggesting a more permanent run to value stocks and no doubt they have bounced in November as news of the vaccine cavalry excited investors. Some are enamored with this thought when reviewing the data that demonstrated the wide gap in growth stock returns through November (+28%) versus value stocks (-2%).5 While we recognize potential opportunity from a rally that could continue in these value stocks, should the reopening scenario strengthen, we believe growth stocks will continue to do well also and that this should not be an either-or decision. A blend of growth and value is what we are employing in our internal equity strategies. It doesn’t make sense to us to abandon growth stocks that benefit from the very trends that are driving growth in our economy for some time to come—5G, advanced driving and electric vehicles, cloud, etc. At the same time, we recognize specific value opportunities that benefit from cyclical recovery and these same secular growth trends that are here to stay in the foreseeable future.
Interestingly, we do find more attractive opportunities in international equities than in years past and do believe that international exposure is as appropriate as ever; yet know that the international markets are much more tilted to value-oriented financial and energy sectors and much less exposed to technology. Therefore, having positions here automatically provides style diversification versus a pure U.S. portfolio.
We are encouraged by developments on the vaccine front and the longer-term benefits that a vaccine will provide to an economy that has shown strong evidence of recovering in Q3. This progress should help sustain the advance. Yet near-term risks remain until this actually occurs and the market has already discounted some of the good news. This calls us to increase our price target for calendar year end 2021, yet to maintain our hold your ground view for the near term. We continue to be cautiously optimistic and look for solid, single-digit returns in U.S. stocks in 2021.
3FactSet Earnings Insight
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 Dow Jones Industrial Average (DJIA) is an index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The Nasdaq Composite Index is the market capitalization-weighted index of over 3,300 common equities listed on the Nasdaq stock exchange. The Russell 2000 index is an index measuring the performance of approximately 2,000 smallest-cap American companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. stocks. It is a market-cap weighted index. Individuals cannot invest directly in an index. Index returns do not include fees or expenses. Investing in securities involves risk of loss, including loss of principal, that clients should be prepared to bear. Past performance is not indicative of future results.
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