Many investors, ourselves included, find it difficult to understand why stocks have done so well lately in such a challenging economic environment and Covid-19 still an ongoing threat. We heard that question quite a bit at our annual national conference for LPL financial professionals held virtually in late August. That isn’t the only question we’ve been getting recently, so we’ve compiled our top 10 investor questions and answers.
Question #1: Can Stocks Keep Going Higher, Considering The Risks?
With the S&P 500 Index up more than 50% since the March lows and stocks pricing in an optimistic recovery in the economy and corporate profits, we believe stocks may be due for a pullback—and the drop that occurred September 3–4 may be the start of it. The S&P 500 is near our bull-case scenario of a fair-value target of more than 3,450 that we highlighted in our Midyear Outlook 2020 publication—and our base-case target of 3,300 is under review. We also expect a pickup in volatility ahead of the November election.
From a technical perspective, we may see a little more near-term upside in the 3,700 range, potentially helped by positive Covid-19 news, another fiscal stimulus package—we still expect another one of more than $1 trillion—and continued strength from stocks that have performed better in the pandemic, mostly technology stocks. On the downside, we would see technical support at around 3,200.
Question #2: How Will The Election Impact Stocks And The Economy?
Historically, stocks have generated positive returns under all political combinations in the White House, House of Representatives, and Senate, including Democratic and Republican sweeps. While this is a very important election, as they all are, as investors we want to keep any impact to the stock markets in perspective.
Strictly from a markets perspective, a potential Democratic sweep of the Senate and presidency possibly could bring higher corporate, individual, capital gains, and dividend tax rates that may be expected to translate into lower stock values, all else being equal. But it could also bring more fiscal spending, including an infrastructure package, and lower tariffs. A victory by President Donald Trump may help keep taxes low, but it also may lead to escalating tensions with China, more tariffs, and further decoupling of the trade relationship between the two countries, all of which could potentially lead to bouts of market volatility.
For more in-depth answers to this question, read our last two Weekly Market Commentaries in which we discuss the potential economic and market implications of wins by former Vice President Joe Biden and President Trump.
Question #3: How Can Current Stock Valuations Be Justified?
The S&P 500 price-to-earnings ratio (PE) based on estimated 2021 earnings is over 21, above the peak levels that historically have marked the end of bull markets (in the 18–19 range) and the long-term average of 15–16. We acknowledge stock valuations are high. However, we don’t think they are irrational given: 1) the massive stimulus from the federal government and the Federal Reserve (Fed); 2) depressed interest rates that reduce the attractiveness of bonds and enhance the value of future corporate profits; 3) corporate profits are on the upswing with many winners in this environment; and 4) potential vaccine availability within the next six to 12 months.
Question #4: What Tactical Asset Allocation Changes Have You Made Recently?
We’re frequently asked when the decade-long leadership in growth-style stocks might reverse. At this point, despite the big drop September 3–4, we’re sticking with our preference for growth style until it becomes clearer that the U.S. economic recovery is more durable, but we recognize growth stock valuations look stretched and value style will eventually have its day in the sun. The sharp sell-off in growth stocks recently was a reminder of what can happen when the rubber band gets stretched too far, though we believe fundamentals and technicals still support leaning toward the growth style.
We have warmed up to small caps as the new bull market has taken hold, and we selectively added some exposure in our tactical model portfolios in August. On the sector side, our last move was to upgrade materials to positive in August on U.S. dollar weakness and strong technical momentum; we downgraded financials to negative in a corresponding move.
Question #5: What Sectors Do You Like?
We continue to favor cyclical sectors in general, but with an emphasis on the sectors we think are best positioned for the economic challenges presented by the pandemic, namely communication services, health care, and technology.