2021 Stock Market Outlook
The S&P 500 has rallied 70% since bottoming out in March 2020, making it easy for investors to predict limited upside potential for equities in 2021. While current stock valuations remain elevated, promising news of effective vaccines, an enormous fiscal stimulus, and low interest rates make owning stocks in 2021 attractive.
The new bull market that emerged in March 2020 should continue to climb – reaching record highs – as the expansion phase continues. Our base estimate for the S&P 500 in 2021 is a price target of 4,100, or 9.68% return. We estimate that earnings per share in the S&P 500 will increase by 26%, from $135 in 2020 to $170 in 2021.
We project 26% earnings-per-share growth, because businesses are learning how to navigate the pandemic profitably. Companies are achieving profits by efficiently managing costs and the supply chain. Earnings will also see a boost in 2021 when companies begin deploying their cash hoards on potential share buybacks and new employees, as well as mergers and acquisitions. In fact, non-financial corporations’ cash holdings increased to a record $2.1 trillion in 2020, according to Moody’s Investor Service.
High Returns Follow Substantial Declines
History tells us that major market rallies follow poor economic environments. The bear market of 2020 lasted only six months, with the S&P 500 recovering 34% of its losses. Previous bear markets featuring declines of 30% or more continued to experience gains two years after the market had bottomed, as shown in Figure 1 below. This implies that 2021’s returns still have room to grow should earnings and economic growth be boosted by accommodative monetary/fiscal policies and effective vaccines.
Figure 1: S&P 500 Positive Two-Year Return After A 30% Decline In Stocks
Stocks vs. Bonds
Estimated mid-to-upper single-digit stock returns should outperform cash and bonds by a significant margin in 2021. The S&P 500 earnings yield of 4.51% will continue to exceed the nominal 10-year US treasury bond yield of 0.95% by 3.56%, as shown in Figure 2 below. According to Goldman Sachs, stocks have outperformed bonds 89% of the time in the following five years when earnings yields exceed bond yields by levels similar to today.
Figure 2: S&P 500 Forward Earnings Yield & Nominal 10-Year Treasury Bond Yield
Stimulus and Vaccines to the Rescue
We believe the economy will push forward with supported stimulus even though COVID-19 cases continue to rise and vaccine rollout has been slow. We raised our 2021 US GDP growth estimate from 4% to 5% after Joe Biden announced a $1.9 trillion stimulus package. Adding to the growth is an effective vaccine that should support the reopening of the economy in mid-to-late 2021.
If the aforementioned plays out, we believe the bottom half of the K-shaped economic recovery will be lifted. The K-shaped recovery represents economists’ views of the current economy. The upper stem of the K symbolizes thriving conditions (high wage work from home jobs, online retail), while the bottom stem implies worsening conditions (brick and mortar, travel, low wage service jobs), as shown in Figure 3 below.
Figure 3: K-Shaped Recovery
US Market Movers
2021 will favor fundamental, bottom-up stock selection. Earnings growth should drastically rise in 2021, but will not lift all companies. Therefore, we see viable short selling opportunities for overvalued equities.
Technology, consumer discretionary, healthcare, e-commerce, communication services, and industrial automation are positioned to do well in 2021. Technology stocks look promising due to strong earnings projections and an environment where people continue to live digitally. Companies with strong online business models are outpacing competition.
Cyclical stocks, which include restaurants, hotels, airlines, clothing retailers, and automobile manufacturers, among others, should outperform with an improving economy.
Automation stocks are at the forefront of a new renaissance on how we produce, deliver, and consume goods, as well as how we travel. The healthcare industry is also seeing changes through telemedicine and effective home monitoring devices.
Large and mid-cap stocks with consistent profits and low debt will be favored over small caps. Small cap stocks, however, contain high cyclical exposure, and will benefit when the pandemic nears its end.
Risks to Our Outlook
- A double-dip recession caused by a resurgence of the COVID-19 virus due to new variants and/or an extremely slow vaccination rollout poses a risk to our outlook. A double-dip recession can also result from too short of a recession. Recessions typically last one year, and the 2020 recession lasted only six months. The previous six-month recession, occurring in the 1980s, was followed by a weak expansion, which collapsed about a year later.
- US stocks are expensive in terms of valuation. As of 1/15/21, WSJ reported the trailing 12 months P/E ratio of the S&P 500 to be 40.98, as shown in Figure 4. According to Goldman Sachs, past elevated valuations have hindered equity returns over the following five years.
Figure 4: P/E Ratio of the Russell 2000, Nasdaq 100, and the S&P 500
- Tensions with China, Russia, North Korea, and Iran, including potential cyberattacks aimed at stealing intellectual, consumer, and corporate data.
- Government and consumers coming down on technology companies for private data sharing, as well as unfair mergers and acquisitions.
- The first-day IPO gains of 40% or more throughout 2020 have not been seen since the dot-com bubble.
Finally, we do not believe the risks listed in this outlook will reverse the economic expansion. They may, however, cause bouts of market volatility going forward. We are overweight equities, because fiscal stimulus, low interest rates, effective vaccines, and strong earnings growth potential should drive this market higher.
Matthew Kiss, MBA