2020 was an inscrutable year for stocks.  In a year of abject human and economic misery around the world, U.S. stocks turned in a shockingly good performance.  While the Dow Jones Industrial Average was only up 7.25% for the year, the S&P 500 Index was up 16%.  Virtually all of the gains notched in the market were the result of the surging technology sector as workers around the world outfitted their home offices and consumers used more online services than ever before.  Remove the contribution from the tech sector and many stock indexes would be flat to down for the year.

Equities around the world followed a similar pattern to their American brethren—first a major plunge as Covid began its initial spread in the first quarter, then a strong recovery as investors began to look ahead to vaccines and a global economic rebound in 2021.  The Dow Jones World Index (excl. U.S.) returned 9.3% for the year, a robust performance.

Equites’ performance in 2020 should remind investors that the stock market and the economy don’t necessarily march together.  In my 22 years of managing money, however, I can’t recall a period when the two were more at odds.

Economy Will Come Back to Life in 2021

While no-one can predict the specific path and timeline of the coming economic recovery, we believe progress is likely to be sluggish in the first half of 2021 as the vaccination programs work through their early challenges.  In the latter half of 2021, however, as the rate of inoculations increases, we expect to see a strong economic recovery, especially in the sectors most impacted by the pandemic, such as travel, leisure and restaurants.

Markets will also derive support from what is likely to be a strong fiscal response to the pandemic from the incoming Biden administration as well as continued support from the Federal Reserve, which has pledged to keep short term interest rates low until we are clear of the Covid crisis.

Two Headwinds

There are two notable headwinds for stocks as we begin 2021. First, as the incoming administration readies a $1.9 billion aid package for the economy, inflation may be starting to stir.  Across a range of commodities and manufactured products, supplies are beginning to tighten and prices are beginning to firm.  Bond yields have been inching up as investors, for the first time in a long time, begin to get a whiff of inflation. The yield on the 10-year Treasury note, currently 1.09%, is at its highest level since March.  Rates, should they continue to rise, will not only pressure returns from fixed income securities, but may also exert a gravitational pull on stocks’ high price-to-earnings (P/E) multiples.

Second, investor optimism is running hot.  Americans opened more than ten million new brokerage accounts in 2020 and many first-time investors began to trade actively.  When emotions run high, prices get skewed.  Burgeoning investor enthusiasm certainly helped stock prices in 2020, but once enthusiasm is widespread, it becomes a challenge for stocks’ future performance.  The signs of frothy markets are unmistakable: a hot IPO market, the proliferation of SPACs (Special Purpose Acquisition Companies), a roaring crypto-currency market and Wall Street analysts struggling to justify the current stock prices of the companies they cover.  

We will be watching closely for more indications of an overheating market.

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