By Haddon Libby
If past performance is any indicator of future results (which it isn’t), the S&P 500 earned on average 5.3% annually over the last 20 years. As a reminder, that period included the bursting of a dot com bubble, the Great Recession, and the current Pandemic. Someone invested for last 10 years, or only 3 years, would have earned more than 11%.
At present, many stocks are priced like it’s 1999 (the dot com bubble) while others look like 2009 (Great Recession) – two outcomes that are far better than many imagined back in March.
To understand where the market may go in 2021, we need to think about some of the reasons for current market valuations despite a raging pandemic.
First and foremost, the market sees the end to the pandemic coming toward the end of next year. While certain parts of the economy will be emerging from a deep Depression, other parts will be coming out of a period of historic growth due to changing consumer and business behaviors.
Due to the weakness amongst small businesses and various industry sectors most heavily impacted by the shutdowns, the Federal Reserve intends on keeping interest rates low for years to come. By holding rates below the actual rate of inflation, the Federal Reserve has created an economic environment with negative real interest rates. Negative interest rates are thought to be stimulative toward the economy as well as and very supportive toward those in debt. These positive outcomes occur at the expense of those on fixed incomes while creating the risk of deflation for the economy. The challenge caused by deflation is that lower prices come along with a shrinking economic pie.
For now, negative real rates mean that assets like real estate to benefit from lower debt costs which causes the underlying asset to be more affordable and thereby worth more. The same principle applies to stock valuations and other stores of value, including Bitcoin.
Extraordinary fiscal measures that help many businesses get through pandemic shutdowns will also serve to create zombie companies that are unable to compete against better financed rivals.
Meanwhile, companies benefitting from changes in consumer and business patterns have seen valuations soar. Break-out hit of the pandemic, Zoom, has seen its stock valuation soar to 60 times annual sales. Where most companies are valued between 10 and 30 years of earnings, logic-defying valuations for Zoom or Tesla, suggest levels of irrational exuberance reminiscent of the dot com bubble of twenty years ago. In comparison, most of the market is valued at far more rational levels so long as Federal Reserve interventionist policies continue.
If the Federal Reserve were to tighten the money supply or increase interest rates, current valuations would need to adjust downward. As the odds of this happening scenario happening are quite low, most believe that interest rates will remain historically low while Federal Reserve liquidity programs will be sufficient to maintain current yield levels on investment grade corporate debt.
For 2021, it is reasonable to assume that Technology stocks will continue to outperform many other business sectors. The challenge here relates to valuations as some stocks appear richly valued.
Healthcare is another sector that should perform well in 2021 as long deferred treatments replace emergency procedures related to the pandemic. Relative to the market, many healthcare stocks appear undervalued and with strong cash flows and reliable dividend streams.
Industrial’s is an area where performance may be less consistent. Under the weight of the costs of the pandemic, governments globally will be pressured to reduce defense spending hurting many stocks in this sector while most airlines are relying on government assistance for solvency. A change in consumer patterns means delivery services should continue growth.
For more on 2021 expectations, drop me a note at Hlibby@WinslowDrake.com and we will get you on the e-mailing list.