A bungled vaccine rollout, another coronavirus wave and an insurrection failed to derail animal spirits verging on delirium in financial markets as 2021 began.
That, of course, is to be expected because financial markets are focused only on the long term. This narrative runs through a series of Wall Street predictions that U.S. equities could levitate another 15% or 20% this year. Some seasoned market observers like GMO’s Jeremy Grantham warned that America was experiencing a bubble of “epic proportions.”
Others found themselves vexed at the yawning disconnect between the real economy and U.S. equities. After all, more than 10 million Americans are on unemployment, and millions of small businesses are hanging on for dear life.
Incongruous though it may appear, good things are bound to come out of this pandemic. Biomedical technologies are likely to enjoy quantum advances. Economists at Vanguard compare the exponential rate of innovation today in biomedicine to the huge leap forward that information technology saw in the 1990s. Others believe the mRNA breakthrough behind several vaccines could soon be applied to treating cancer.
Part of the euphoria is rooted in the expectation of a strong economic rebound as the pandemic fades in the second half of the year. Many economists see GDP in the U.S. rising between 4.5% and 5.5% for the year.
For the comparison’s sake, GDP has only hit 3.0% once in the last two decades—and that was in 2006. Jim Paulsen, chief market strategist at the Leuthold Group, thinks current estimates are wrong and boldly predicts GDP will jump 6%, which would make this the best year since 1984.
As we enter 2021, it is clear many Americans have saved a boatload of money and can’t wait to return to normalcy. Nicholas Christakis, a doctor and sociologist at Yale and the recent author of the book Apollo’s Arrow, chronicles the pandemic’s path across the planet and hints that by the end of the year we may witness a wave of licentious orgies and hedonistic hijinks from people flush with cash and fed up with cabin fever.
That’s the new Roaring Twenties scenario pervading stock market psychology. Some bulls even see the Democratic control of both houses of Congress as a positive sign that further stimulus is on the way. While Democrats’ twin Senate victories in Georgia prompted many advisors to prepare their clients for higher taxes, the stock market celebrated the prospect of higher interest rates by sending bank stocks surging.
A Dose Of Reality
How much of this optimism is just fantasy remains to be revealed. Robert Doll, Nuveen’s chief equity strategist, sees 2021 as a year when earnings, which he expects to climb 21%, will have to play catch-up. Doll sees the S&P 500 advancing only 7%.
Two sober realists at MFS, Rob Almeida and Erik Weisman, need even more convincing. In their view, asset markets entered 2021 priced to perfection.
Just assume that kinks in the vaccine rollout are finessed and that signs of productivity gains from work-from-home digitization are transmitted throughout the Main Street economy. “Put aside the fact that a large percentage of the population wants to wait and see on the vaccine. The glass isn’t just half full—it’s overflowing,” maintains Weisman, MFS’s chief economist.
Almeida looks at this from another perspective. Go back 15 months to the fall of 2019 when no one had ever heard of Covid-19. Corporate profit margins were already falling, GDP growth was subpar, and companies were overly reliant on financial engineering to beat their earnings estimates.
Almeida argues there are still a lot of large, public U.S. businesses with 7% operating profit margins masquerading as entities with 11% margins. Some companies looking for growth are entering new industries. Apple, for example, is going into the automobile business. Bold, outside-the-box moves like that rarely expand margins.
Both Almeida and Weisman don’t doubt GDP could easily rise 5% or 6% this year. “That’s a one-off. I don’t disagree, but what is the durability?” Almeida asks. “The market is looking out six to nine months. We’re looking at the long term.”
Liz Ann Sonders, chief market strategist at Charles Schwab, voices concern that temporary layoffs could become permanent. Even before the pandemic, one of the biggest fears among labor economists was that artificial intelligence and robotics would result in the elimination of more than 20 million jobs over the next two decades. By all accounts, Covid-19 has accelerated the journey to a digital future.
If the U.S. manages to sustain a growth rate of 2.5% during the 2020s, most people would view that as an improvement over the previous two decades. But does it justify a Shiller CAPE (cyclically adjusted PE ratio) of 33 or 34? Many advisors and asset managers question that price level and are looking elsewhere. Rajiv Jain, CEO and CIO of GQG Partners, says “valuation sensitivity should be far greater today” than at any time in recent memory.
Contrarian Views
Few years have witnessed such a wide dispersion among different investment sectors within the S&P 500 as 2020 did, according to DoubleLine CEO and CIO Jeffrey Gundlach. Information technology was up 43.9% while energy fell 33.7%. Like many observers, he believes technology’s long run of market supremacy is coming to an end.
Another related area of dispute is what happens to inflation. Even with all the fiscal and monetary stimulus, many observers still think inflation is permanently dead. The inflation consensus is 2%, “but I’ll bet it’s higher,” says Richard Bernstein, CEO and CIO of the asset management firm bearing his name.
It’s a major issue for vulnerable long-duration assets, like technology companies and venture capital-backed businesses, not to mention long-term bonds. “Tech investors should be worried about a bubble,” Bernstein warns.
Pensions and endowments are worried about inflation, yet they are “investing in venture capital,” he continues. “That makes no sense.”
Value investors are hoping for the long drought for less expensive stocks to end. In a January webcast on value investing hosted by Ariel Investments, longtime equity manager Bill Miller of Miller Value Funds predicted “a consumption boom because people are pent-up and savings are so high.” Miller expects value to outperform growth “for at least a year” after the pandemic ends.
Some industries remain question marks. Another participant in the Ariel webcast, Artisan Partners’ Daniel O’Keefe, anticipates a boom in travel and leisure when the epidemic is over.
Business travel may have taken a permanent hit, but Bernstein isn’t so sure. The company that “makes the effort to see a customer will win the business, so [business travel] could partly rebound due to competition,” he says. Furthermore, the working-at-home trend could eventually be muted by “intra-company personnel competition.”
What unites many optimists and realists is the likelihood that the next decade will look very different from the last. Many leading strategists and portfolio managers contend that there is a bubble, but it is confined mainly to U.S. tech shares.
Shares of energy companies, retailers, banks, chemical concerns and companies in a host of other industries are hardly in bubble territory, Bernstein says. He’s not alone. Miller noted on the Ariel webcast that he is buying energy companies for the first time since the infamous 1986 oil bust.
A decade ago, Bernstein predicted U.S. investors were about to enjoy the greatest bull market of their lifetimes. For those who lived through the 1980s and 1990s, that seemed like a stretch. It doesn’t today.
Aside from Big Tech, which has gone sideways for six months now, it’s not that obvious where the traps are outside of businesses like retailing and hospitality, which have been directly harmed by the pandemic. The Leuthold Group’s Paulsen warns that defensive investments like utilities, gold and consumer staples could suffer a bout of serious underperformance. His research shows that when GDP is 4%, these sectors lag the S&P 500 by 12%.
When growth accelerates to 6%, the performance drag is closer to 23%. “Investors who thought they were responsible, cautious, defensive and avoiding the popular stocks could be subject to unexpected pain in 2021 due to a solid year of U.S. economic growth not experienced in decades,” Paulsen warns.
Jain doesn’t disagree, but he thinks the phenomenon Paulsen outlines accurately describes what transpired in the last nine months of 2020. Since March of last year, the S&P 500 had climbed more than 60% as of early January, and both utilities and consumer staples lagged the index by a lot more than 23%. Bernstein notes that if the economy is stronger than people think, consumer staples businesses may find it difficult to pass on input costs.
Over the last five or six years, the earnings of many health-care companies have climbed at almost the same rate as technology concerns, but the former group has seen virtually no multiple expansion, Jain says. Usually, Big Pharma is a whipping boy for politicians of all stripes, but the pandemic has quieted many of the critics. “People are willing to pay for drugs that are truly innovating but not for companies that are price gouging,” Jain maintains.
Most observers are anticipating a rotation out of Big Tech, the FAANG stocks, plus Microsoft. Sonders writes in her 2021 outlook, “The rotations will continue to come in fits and starts—largely driven by shorter-term virus-related news about economic activity.” Since Pfizer reported its Phase III vaccine trial results, technology stocks “have taken a back seat to the more cyclical sectors, which could have [farther] to go once the current hit to the economy passes.”
Schwab had favored large caps since March 2017, but Sonders reports the firm is now market-cap neutral. “Assuming the U.S. economy moves into a higher gear in 2021, small caps should be relative beneficiaries given their higher level of cyclical exposure,” she writes.
Going Global
Virtually all the professional investors interviewed for this article agreed that better bargains exist beyond U.S. borders. Almeida at MFS acknowledges American stocks deserve a premium because they are composed of more asset-light businesses with high-value intellectual property—but investors have been rewarding them for more than a decade.
Many American investors may barely have noticed, but emerging markets have been on a roll for the last two years. The MSCI Emerging Markets Index climbed 18.4% in 2019 and 18.3% in 2020. While Bernstein has been a long-time skeptic of emerging markets, he now considers the asset class worth looking at.
At the depths of the financial crisis in 2008, “nobody was saying emerging markets would emerge unscathed,” recalls Research Affiliates founder Rob Arnott. Back then, the consensus was they needed developed markets to sell their goods and commodities to. In fact, they came back from the crisis faster than other markets, advancing 78.5% in 2009.
Arnott thinks a replay of that scenario is possible. Right now, the worries center on their inadequate health-care systems. “Emerging markets may suffer more human damage but less economic damage,” he maintains. “They are far more accustomed to crises like [the pandemic] because they happen much more often” in less developed countries.
Another bruised equity market that Arnott likes is the United Kingdom, which has been afflicted by both a nasty Covid surge and fears of a messy Brexit. U.K. stocks, he notes, sport a Shiller PE ratio of 14, which is even lower than the 15 multiple on emerging markets.
Perhaps the biggest surprise awaiting advisors and their clients is that the 11-year bull market run has left American investors “geographically myopic,” Bernstein argues. New innovation and disruption ETFs are proliferating on a weekly basis.
All ARK Invest’s Cathie Wood has to do is announce a space ETF, and the entire sector goes wild.
“Returns outside the U.S. could be substantially better than inside,” Bernstein continues. “I’m not saying the U.S. will have a lost decade, however.”
What he is saying is that American investors are overly concentrated—too many are sitting on one side of the boat. The U.S. dollar has been softening for most of the last year, and the trade deficit is bulging. If non-U.S. investing stages a comeback and money continues flowing out of America, a lot of people could find themselves on the wrong side of the boat.