What’s Next for the Stock Market

Using data from the past fifty years, the correlation between the S&P 500 price and the corporate earnings of those 500 companies is over 85%.  It is a compelling picture and can provide some explanation for why the stock market has roared back following the widespread shut down last spring.  Investors are looking forward to next year (aren’t we all?) and are less concerned about this year.  

What Are Investors Expecting?  

If earnings are so important, then what are investors expecting? Wall Street analysts are expecting a recovery in earnings in 2021 and current forecasts are for companies, collectively, to exceed 2019 profits.  This may seem surprising given the economic stress that the country, and the world, has been under.  But while we have all had to quarantine to varying degrees, and while some people have tragically lost livelihoods and are still struggling, the majority of the population continues to work. 

In addition to a bounce in earnings, the amount of cash sitting in bank accounts is at record levels.  Many companies used their lines of credit and stopped non-essential spending and the average person did too.  Cash has accumulated.  At some point all of this cash needs to go somewhere because no one is making a meaningful yield in savings accounts or money markets right now.

Some companies are using their cash hoard to make acquisitions.  With rates so low, it doesn’t make sense for many companies to pay down debt.  Another use of cash for some companies has been to announce special dividends and we expect that increase in 2021.  And it is not just companies, many households are anxious to spend too.  Many people want to start traveling and going to restaurants again.  All of this combined has led economists to expect huge growth next year as we start to return to a post-Covid life.

Considering past recessions, the stock market responds to inflection points and we are in the midst of one.  In the graph above, it is clear to see profits bottom in the second quarter of this year and then climb back over the next few quarters. Strong growth is expected to continue into 2022.

It isn’t just the S&P 500 that has bounced back.  In the chart above, the performance of different indices over the past year reflects the Covid-related drop in March.  This was quickly followed by a recovery, driven by the announcement of the Government stimulus package.  An early business winner of the Covid crisis was large US Growth-oriented stocks and it shows in their market performance.  This category is dominated by technology companies that benefitted from the quarantine shutdown as economic activity shifted online.

The chart below illustrates the performance of those same indices starting from the market bottom in March.  It is clear to see the market leaders and laggards. But starting in November, the stock strength started to shift for the first time in a long time, with smaller-cap companies starting to outperforming other asset classes.  Last month, Value-oriented companies also began to outpace Growth.

Coming out of a recession means that we are at the start of a new business cycle.  Historically, the beginning of a business cycle has been a good time to invest in the stock market.  With interest rates so low and dividend payouts increasing, there is attractive cash flow coming from stocks too.  The massive amounts of cash sitting in bank accounts has to go somewhere and with yields so low, bonds don’t look as attractive as in the past.

Many investors are asking, is it too late to get into the market or should I wait until a pullback?  And if I invest now, what investment product do I choose?

Preparing for 2021

One of the biggest mistakes investors make is to try to time when to get in and out of the market.  After the 2008 Global Financial Crisis, too many people, both professional and individual investors, tried to time the market and got it wrong.  Rather than guessing where the market is headed in the short term, an investor needs to determine what their near-term cash needs are and think long-term.  The longer time period an investor has, the less impact near-term volatility has on performance.  Look past the day-to-day fluctuations and follow the earnings.  

Personally, I have faith in the innovation and incredible hard work of the workforce and entrepreneurs that power our economy.  The stock market represents many of the most successful companies in their industries globally.  Not all corporate leaders get it right, but there will be a competitor to replace them if they are wrong for too long. 

If you buy a broad representation of stocks, as represented by an index like the S&P 500 or Russell 3000 or a Total US Stock Market Index, you reduce your exposure to single-stock, or single-style, risk.  To pick stocks successfully over time is more than a full-time job.  Investment professionals are often wrong, even with smart, talented analysts and extensive resources.  Stick with a low cost, broad market index and spend your time taking care of your health and planning your next vacation in a post-Covid world.

At Archer Bay Capital, we help clients better understand the markets and the economy in order to make better financial decisions now and in the future.  Contact us to discuss stocks, bonds, and our forecast for economic growth, or to schedule a consultation today.