Momentum vs. Fundamental vs. Expectations

These are three very important characteristics we need to consider when designing our portfolios for 2021.

The momentum is definitely positive and will be a wind at our back. This is primarily driven by the Federal Reserve monetary policies which are echoed by central banks of other countries around the world. In November and December, the Fed provided us with the same post meeting statement. Inflation has been running below 2% for some time and to achieve and average 2% inflation, they will be accommodative until the inflation rate runs above 2% for a period of time. They are also planning on purchasing U.S. Treasury and other bonds (corporates, municipals and mortgage backed securities) for the foreseeable future.

The fundamentals are stable and getting stronger. Economic data is ok and getting stronger but is still being stifled by the COVID-19 virus. Other parts of the world that have moved past the virus growth stage are beginning to return to their economic pace of 2019. This is encouraging because the U.S. should be close behind them. Many corporate balance sheets are in very good condition and margins are beginning to rebound, improving profitability. However, many states are still in shutdown mode, elevating the unemployment numbers and hurting economic activity, especially in the travel & leisure and dining sectors. The markets are expecting these issues to improve in 2021.

Expectations have been building with forecasts of 6.5% GDP growth in 2021 and 4.5% in 2022. S&P 500 earnings are forecast to hit $166/share for 2021, slightly better than in 2019. The 4th quarter 2019, as reported, operating earnings of the S&P 500 were $39.18/share with a P/E of 20.56x. The 12/31/20 EPS are projected to be $36.05/share slightly below the 9/30/20 number of $37.90/share, with a P/E ratio of 30.45x. As you can see the growth of the price of the S&P 500 is far exceeding the earnings. I am talking about the operating earnings here because that is what the analysts like to focus on. If we use, as reported or net earnings, we see a P/E multiple of 39.54x for 12/31/2020. The historical average, fair value P/E multiple for the markets has been 16x – 18x P/E. We are almost double that now.

The 4th Quarter of 2020 saw the NASDAQ composite (+15.4%), the Russell 2000 (+30.99%) and S&P 500 Mid Cap (+24.27%) lead the way, indicating that the markets are confident the 2020 recession is over and a recovery in 2021 has begun. Most recently, the 10-year U.S. Treasury yield has risen from 0.66% to 1.13% confirming these expectations. A weaker U.S. dollar, rising gold and other metals prices is also confirmation of these beliefs. You can feel the money chasing this trade. The 2–10-year U.S. Treasury yield curve spread has also widened in the 4th quarter from 54 B.P. to 99 B.P. A steeper yield curve will help bank earnings in 2021. The price of oil has also risen substantially in confirmation of a pickup in worldwide economic growth.

I did mention, in previous writings, that once the election was over the market had a good chance of continuing its strength, no matter who won. The ending of the uncertainty, as well as, hopes for a fiscal stimulus from either party, and continued low interest rates, would be the key factors. I do think the probabilities for increased taxes, rising interest rates, due to a weaker U.S. dollar, which will cause import prices to rise and increased government regulations, will be headwinds for the markets.

With all of the good news priced into these markets, as evidenced by the huge premium in valuations, it is difficult to see what can propel or sustain these markets at such levels. I am starting to see some rotation out of growth stocks into value names as investors decide to capture some profits and derisk their portfolios a bit. The markets are priced out to 2022 earnings levels and a lot can happen to disrupt expectations. I am not looking for any major pullbacks, unless something drastic happens, a black swan event. I do think we will see several 5-10% pullbacks at different times throughout the year. These will create good buying opportunities.

John E. Thur, CFA

If you want to read more information on how last years markets will impact this years markets, check out our 2020 Year End Insight from The Investment Committee.