2020 was a year beset by a public health crisis, civil unrest, political dysfunction, and uncertainty across just about every facet of life. Yet the S&P 500 still posted a stout +18.4% return for the year, following a powerful +31.5% surge in 2019.1 Never mind the fact that there was a global pandemic, more political uncertainty than usual, and a steep and scary bear market all wedged in between.
The S&P 500 Priced-In the Downturn – and the Odds of a Powerful Recovery – In Record Time
Source: Federal Reserve Bank of St. Louis2
Long-time equity investors recognize this pattern, whereby the stock market seems to defy all expectations and looks totally disconnected from reality. Some onlookers may think something is wrong, or out of whack. But history tells us this type of ‘disconnect’ happens all the time. The stock market has no emotional connection to what is happening in the moment – it is always looking ahead to what’s next, in my view. In 2021, it sees accelerating earnings, solid GDP growth, and a wall of liquidity.
So, what will the bull market look like in 2021? I’ve been thinking about the post-World War II bull market, the “v-shaped” recovery off the financial crisis bottom of 2009, and the late-cycle risk binge we saw in 1999.
The World War II comparison is interesting. In that time, the nation was of course gripped by uncertainty, division, and broad worry about the future. The government also ran record deficits in order to finance the war, with the Fed and Treasury setting government bond yields to establish an upward sloping yield curve.
Record Debt as a Percentage of GDP: WWII and Today
Source: Federal Reserve Bank of St. Louis4
The stock market struggled in the early months of entering the war, but after a 1942 military success in the Pacific, the “v-shaped” bounce took hold – even as the bulk of the war and all the casualties it caused were yet to occur. I see quite a few similarities to 2020, and can imagine investors being perplexed in 1942 at how the market could rise during such a devastating time.
The early-cycle recovery in 2010 also bears some resemblance to what we’ve seen late in 2020 and early 2021 – a capital rotation into small, value, and cyclical categories. Interestingly, the bounce off the bottom in 2020 favored mainly high growth, high valuation Technology and Consumer Discretionary categories, which is where I see some resemblance to 1999.
The ‘risk binge’ we saw tied to the dot com craze in 1999 pushed a lot of investors very far out onto the risk curve, paying exorbitant premiums for the possibility of supercharged future cash flows. Most of those cash flows never arrived. Technology companies are different today, in my view – the earnings growth is there. But that does not mean investors are paying fair prices. I think 2020 delivered an ultra-compressed cycle in Technology, where years of future profits were priced-into stocks in a matter of months. To the extent inflation later in the year pushes longer-term interest rates higher, I also think we could see a reality check for the Technology sector.
Bottom Line for Investors
The stock market is fully valued, trading near 23x forward earnings. The peak in 2000 saw a P/E of 26x. Many investors may wonder how much more upside is possible, just one year into the bull market.
But there is a significant difference between today and the late 1990’s: interest rates. I have written before that as long as investors expect interest rates to remain low, they will likely be more willing to pay higher premiums to own equities. In 2021, I think investors will favor equities with more attractive valuations, and will look for companies with the ability to accelerate earnings (i.e., companies with low 2020 comparisons). Finally, to the extent that inflation later in the year could push longer-term interest rates higher, I think we could see some selling pressure in high valuation categories, like Tech. More on that in a future column.