Market Update February 2021 – Will the Momentum Continue? 

CAPITAL MARKETS

The new year is off and running.  Yes, the S&P 500 Index was down slightly in January (although economic “stalwarts” such as GameStop stole the headlines with a 1625% gain, before losing 80% in the first week of February), but February opened with a reversal to new highs.  The sharp rebound since March 2020 has investors continuing to ask if the market has gotten ahead of itself, certainly a legitimate question.

Often, the impetus for this type of question is a comparison to a historical period that might look to have had similar market activity and/or fundamentals.  One might compare today to the “dot.com” NASDAQ Composite Index in 1999, thinking there is comparable market activity or conditions.  But, at the risk of breaking the cardinal rule to never say “it’s different this time”, there are several meaningful differences between these two periods.

1999 saw a speculative market enamored with the prospects of a coming cultural shift towards widespread use of the internet for commerce.  Suddenly, just about any business that had developed a website was rewarded with the prospect of exponential growth through an immediate opportunity to reach new potential customers.  Essentially, these companies offered promise based on the hope that they could create and grow a customer base, eventually becoming profitable.

Unlike 1999’s roster of unprofitable, high flying stocks, the market leaders that have driven 2020’s initial recovery phase have been established, proven businesses with a track record of profitability.  And while these businesses were initially hit hard in 2020, their recovery has required bringing existing customers back and rebuilding prior profitability. 

Rather than 1999’s playbook of a euphoria driving prices higher based on hope for profitability, 2020/2021’s market gains are supported by proven businesses looking to recoup prior profitability as the economy moves further into recovery.

Add to this the benefit of unprecedented actions by the monetary and fiscal authorities (liquidity) to support an economic recovery (earnings improvement) and you have a recipe for higher asset prices.  Or said differently, with capital available, investors will continue to invest into assets perceived to offer higher values in the future. 

What could derail this scenario?  Possibly a reversal by monetary policy officials to begin backing off current policies?  Or political actions that fall short of expectations?  But, with the Federal Reserve’s recent affirmation to maintain certain policies for the foreseeable future and a new administration that has verbally supported more fiscal stimulus, a change in the trend of economic support seems unlikely.  That leaves an “unexpected disruption” (a reversal of currently improving health conditions?) as one potential barrier to further economic recovery, or possibly a market disturbance (a likely culprit would be meaningfully higher interest rates) as the primary risks for 2021.

But for now, the recovery from March 2020 persists.  Support from improving economic conditions continues to grow.  Availability of capital continues to support further investment and higher prices.  What may be next?  With health conditions trending in the right direction and as improving optimism for further distribution of vaccinations continues to grow, maybe soon we can change its name from “recovery” to “expansion”.

CHART OF INTEREST – Will the Momentum Continue? 

When markets rise rapidly, investors typically break into two groups: the “momentum will continue” group versus the “too much, too fast” group.  And following 2020’s event-driven hit to the global economy, a disruption unlike anything we have seen during this era, it’s an especially difficult environment for assessing the future.  If the cause was unprecedented, will the rules apply to the response?

Predicting the stock market rarely ends well, but investors can make educated decisions about likely outcomes.  If the value of a stock is directly related to the stability and growth of earnings, then price should follow expectations for future earnings growth. And this also applies to the broader market.

This chart looks at the S&P 500 Index, its expected earnings and the price-to-earnings (P/E) ratio, which standardizes the relationship between price and earnings and provides a simple gauge for quickly assessing if the market is historically cheap or expensive.  (For earnings and P/E ratio, we use Bloomberg Estimates Earnings Per Share for the next four quarters)

The story this chart tells is not surprising.  Entering 2020, earnings expectations were modest at best, the market was moving slightly upward, and its P/E ratio was stable at a reasonable level around 19.  (P/E ratios are often higher during low interest rate periods.)  But the sudden shock of the pandemic took its toll.  With so much uncertainty, earnings expectations were lowered significantly and only represented best guesses.

But not surprisingly, when the S&P 500 Index found a bottom and responded to promises of stimulus from both fiscal and monetary authorities, the resulting rebound drove the P/E ratio higher.  The “why” can be seen in the second and third panel.  While the market moved on the hope of improvement, it was still too soon to predict when and how earnings would recover and raise estimates of the future. 

But now, as the trend in health conditions has significantly improved, companies and analysts are beginning to see more clarity in the future path and, as can be seen in the second panel, forward earnings estimates have jumped in January 2021, resulting in valuations, i.e. P/E Ratios, dropping in tandem.

Going forward these variables will tell a lot about the equity markets opportunity in 2021.  And while other factors are part of credible forecasts, the trend in the earnings recovery will be the primary driver of where the market goes in 2021.  (Spoiler alert: interest rates are riding in the passenger seat!)

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