After going sideways in January, U.S. stocks have returned to their recent winning ways in February. The S&P 500 Index is now up about 3.6% year-to-date, an auspicious start to 2021. And this performance comes after a tumultuous 2020, in which stocks lost roughly a third of their value in 34 days last winter as the pandemic landed in the U.S., only to recover that and more by the end of the year.
Three Underlying Supports for Equities in 2021
While equity investors do face elevated prices in today’s market, they also have three important factors working in their favor: strong earnings, supportive monetary policy from the Federal Reserve and a broadening economic recovery as the pandemic wanes.
First, the most important sustenance for stocks—earnings—have continued to be very strong. In the current reporting period, companies are mostly reporting better-than-expected numbers and in many cases are raising their financial forecasts for 2021. While there are still some very weak parts of the economy, such as travel and leisure and bricks-and-mortar retail, the overall takeaway from the current earnings season is that companies have adapted well to the challenges the pandemic has posed and are performing well.
Second, the Fed continues to play an important role in supporting equity prices. By pledging to keep short-term interest rates low for an extended period to support the economic recovery, Fed Chairman Powell has taken unexpected Fed rate increases off the list of potential risks for equity investors. Long-term rates have continued to tick up, however, a healthy sign that investors are anticipating a robust economic recovery. The U.S. ten-year Treasury note yield now stands at 1.28%, the highest level in nearly a year after spending most of 2020 in sub-1% territory.
Third, the U.S. economy, bolstered by a potential $1.9 trillion stimulus package from Congress and increasing vaccination rates, is likely to rebound strongly in 2021. A recent Wall Street Journal survey of economists found that, on average, they are expecting the U.S. economy to grow 4.3% this year. As vaccinations increase as we move toward summer, we expect a constructive narrative to form about how life is returning to many hard-hit parts of the economy.
With all of these tailwinds, what could possibly go wrong?
Signs of Froth
With so many indicators pointing upward, perhaps the biggest thing for equity investors to worry about today is investor overconfidence. Discussions about stocks (and options and cryptocurrencies) are becoming increasingly popular, especially in online forums such as Reddit’s WallStreetBets. Individual investors, stuck at home for months, are now contributing a greater percentage of trading volume than they have for years. Margin debt is at its highest level in years and many stocks are now trading at valuations that have finance gurus scratching their heads.
While investor optimism would seem to be a good thing, it is in fact a harbinger of lower returns going forward. Stocks jump the most from moments of extreme pessimism, such as in March when the virus was poised to crush our way of life, or in 2008-2009, when the financial system teetered on the verge of collapse. Now, we are arguably in the opposite position. In our view, the biggest risk to stocks’ performance in 2021 is that today’s prices already reflect the strong and very welcome economic recovery we will see this year.
We hope everyone is staying safe and well.
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