Twenty-twenty (2020) was a year of head-scratching drama. The year started off great with low unemployment, an economy humming along, and the stock market hitting all-time highs in mid-February. Then things began to fall apart. The pandemic gripped the world’s attention; the market sold off roughly 34% in just a little over a month; and spring and summer followed with the realization that the pandemic wasn’t going anywhere anytime soon. Throughout the summer, riots took place in cities across the country; then autumn brought us hopes for a vaccine but also a particularly contentious presidential election. If asked to predict market returns in a year like that, what would you have said? Up 18.4? That’s what the S&P 500 returned last year. That 18.4% return is 12.7% higher than the February 2020 peak and a whopping 70.2% above the March low. In previous emails, I’ve pointed out that these returns were not consistent across all sectors of the market; some sectors like technology were up almost 44% for the year, while others like energy were down significantly. But it’s difficult for most to imagine that the market could have achieved any returns in a year like 2020.
Now we find ourselves in a new year. More people in the U.S have received at least one dose of a Covid vaccine than have been infected by the virus. Many health experts forecast that by the end of June, everyone in the US that wants to take the vaccine will be able to get it. Many financial analysts expect to see renewed economic activity in those sectors of the economy hardest hit – travel, tourism, hospitality, energy and the like. And the market hit new highs in January.
These new market highs in the middle of a pandemic, plus the crazy trading of a failing, mall-based videogame store – GameStop – is leading people to talk about bubbles and irrational exuberance. Is the market reaching lofty valuations and should we expect a major downturn? This chart suggests to many people that the valuations we’re seeing now (a Price/Earnings ratio of 21+%) looks a lot like the valuations we experienced just prior to the dot-com bust of 2001/2002.
Will the early 2020s become a repeat of the early 2000s? I don’t think so, for several reasons.
First, interest rates are very different now compared with 2000. Currently, the Federal Funds rate is close to 0% and the 10-year Treasury yield is just over 1%. In 2000, the Federal Funds rate was 6.25% and a 10-year Treasury that was also in that 6+% range. In 2000, if equity investors began to feel uneasy about market valuations, it would have been a relatively easy decision to sell stocks and buy Treasury bonds with a risk-free return of over 6% per year. Investors cannot do that now – there is little incentive to move out of stocks for a risk-free rate of return of 1% or less.
Second, the mathematical equation that investors use to calculate the value of future profits includes that risk-free interest rate. In that equation, as interest rates decline (like now), the value of a given a stream of future profits goes up.
Lastly, in 2001, corporate earnings dropped dramatically (down 31% compared with 2000) and the market followed along. In 2020, earnings were down significantly but most analysts are forecasting that 2021 earning will be almost 22% higher than 2020. This is almost the opposite of what happened in the early 2000s.
If corporate profits increase this year by 22%, will the market be 22% higher by year-end compared with now? I doubt it. I expect the market moves we saw in the 4th quarter of 2020 were in anticipation of better 2021 earnings. But at the same time, I don’t expect a 2001/2002 downturn just because we’ve reached similar valuations. And while I don’t think a major downturn is in our immediate future, I wouldn’t rule out one of those garden-variety downturns that are fairly common in equity markets. Remember, a market pullback (down 5-10%) occurs on average three times per year, and a market correction (down 10-20%) occurs on average once per year.
If you have questions or would like to chat, please let me know.
Cheers!
