Investors want to get a handle on the question, ‘Will the Stock Market Go Up in 2021?’ after stock prices rose in excess of 18% in 2020. The gains in the past year resulted solely from an expansion of the price-to-earnings valuation metric as earnings fell during the pandemic. Investors are now worried about the longevity of the bull market. So, will the stock market go up in 2021?
The COVID-19 pandemic determined the course of the stock market in 2020.
Economic activity in the U. S. and around the world slumped sharply in the first and second quarters of 2020 from the lockdown measures implemented to ‘control the spread’.
The unemployment rate spiked to 14.8% in April from 4.4% in March.
The U. S. gross domestic product (GDP) plunged by a record 31.4% annualized rate in the second quarter.
The Federal Reserve and Congress acted to ease the economic pain from the pandemic. The Fed cut interest rates to near-zero. Congress approved several rounds of stimulus, including the $2.2 trillion CARES Act.
These actions enabled the U. S. economy to regain its footing partially. The GDP expanded at a 33.4% annualized rate during the third quarter, its highest expansion rate ever. The unemployment rate gradually declined to 6.7% by year-end.
The S&P 500 member companies saw their profits decline year-over-year through all quarters of 2020. The 32% decline in second-quarter profits was the steepest. With fourth-quarter results currently being reported, analysts expect S&P 500 earnings in 2020 to be lower than the 2019 tally by 12.3%.
Stock price volatility stayed high through 2020. The S&P 500 declined nearly 20% in the first quarter and rebounded by the same magnitude in the second.
The S&P 500 broke even for the year in the third quarter. It continued its ascent in the fourth quarter to end the year 18% higher.
Although small-cap stocks lagged large-caps for most of 2020, the former rose sharply after U. S. FDA approved two COVID-19 vaccines in the latter part of 2020.
Small-cap stocks, as measured by the Russell 2000 index, ended the year 19% higher.
Will the Stock Market Go Up in 2021? – The Positives
Investors and analysts are banking on vaccines to close the chapter on the pandemic. This closure can assist economic recovery and help extend the longevity of the bull market.
The World Bank expects the global economy to grow by 4% in 2021 after contracting 4.3% in 2020.
In mid-December, the Federal Open Market Committee forecasted the U. S. GDP to expand by 4.2% in 2021 after shrinking 2.4% in 2020.
A growing economy should help boost corporate earnings as well. FactSet shows analysts currently estimate S&P 500 companies to earn $169.59 a share in 2021, up from $138.18 in 2020. In other words, analysts expect S&P 500 aggregate EPS to grow by 22.7% in 2021.
Meanwhile, governments and central banks are doing all they can to support the recovery via fiscal stimulus measures and ultra-low interest rates.
Will the Stock Market Go Up in 2021? – Key Risks
The above scenario paints a favorable outlook for stocks in 2021, including strong earnings growth, low-interest rates, and ample policy support.
So what can go wrong in 2021? It is the unfolding of this economic recovery.
Near-zero interest rates and accommodative monetary policies have supported the rally in stock prices in 2020. They justify low yields on all assets, including stocks, and therefore correspondingly higher stock prices.
While near-zero interest rates are real currently, investors appear to be assuming they are here to stay forever. Investor sentiment and stock valuation reflect some excesses.
Investor Sentiment: First-day returns on initial public offerings and trading of call options on single stocks by retail investors show unbridled optimism among investors. Margin balances in investment accounts have recently set new highs. The euphoria is reminiscent of the late-1990s technology-stock bubble.
Learn more: Which sectors are likely to fare well this year?
Stock Valuation: The S&P 500 closed at 3,756 on December 31, 2020. With analysts estimating S&P 500 companies to earn $169.59 a share in 2021, the S&P 500 closed 2020 at a forward P/E ratio of 22.1.
The forward P/E ratio has averaged 17.6 and 15.7 over the past five years and ten years, respectively. The forward P/E has been higher than the current value, only 4% of the time since 1985. As such, the forward P/E valuation metric appears high from a historical perspective.
History has often shown valuation extremes by themselves are not sufficient to trigger a decline in stock prices. Other conditions are required.
What conditions can cause stock prices to decline in 2021? Rising inflation, higher interest rates, higher corporate tax rates, stricter corporate regulations, and vaccine-resistant virus strains are among the conditions that can shorten the bull market.
Investors currently expect inflation to stay at bay in 2021. Although bond-market bulls are few and far between, investors expect interest rates to remain low in 2021 in the wake of assurances from the Fed on interest remaining near zero through 2023.
If the economy keeps improving, longer-term interest rates should rise from these record low levels. The difference between short- and long-term bond yields should widen as well. These changes in interest rates can call the near-zero interest rate thesis into question.
Investors currently believe a relatively centrist Biden administration will not increase corporate tax rates or pass regulations that could shave shareholders’ cut of corporate profits. Stocks are likely to succumb to unfavorable developments here as they would raise valuation metrics while reducing the capital available for future growth.
Lastly, vaccine-resistant virus strains are a wild card. While the evolution of such virus strains can play a role in keeping interest rates lower for a longer duration, they can undermine confidence if new vaccines against evolving virus strains are elusive.
So, what does all this mean? Will the stock market go up in 2021?
Will the Stock Market Go Up in 2021? – The Bottom Line
In this section, we look at two scenarios, one optimistic and the other pessimistic to bracket the range of reasonable outcomes.
The S&P 500 closed 2020 at 3,756, giving the index a trailing P/E ratio of 27.2, based on analysts’ 2020 EPS estimate of $138.18.
Historically, the trailing P/E ratio has ranged between 12.0 and 24.0 from 2011 through 2019.
The S&P 500 would close 2021 at 4,613 if S&P 500 members earn $169.59 a share as expected in 2021, and the trailing P/E ratio remains unchanged at 27.2. Such a close would imply a 2021 year-end forward P/E ratio of 23.8, assuming analysts’ 2022 S&P 500 EPS forecast stays at $193.73.
In this scenario, the S&P 500’s return in 2021 would be in line with the 22% EPS growth in 2021. This outcome requires the P/E ratio to continue exceeding historical norms. This scenario can materialize if interest rates continue to stay near-zero and there is no threat of corporate tax rates going up.
How low can stocks reasonably drop if rising interest rates and the threat of higher corporate tax rates compel analysts to lower their 2022 S&P 500 EPS forecast?
In this scenario, we assume analysts lower their 2022 S&P 500 EPS forecast to the long-term average of 10% from 16% currently expected. The lower growth rate pegs 2022 EPS at $186.55.
We also assume the forward P/E ratio returns to its 5-year average of 17.6. Under these conditions, the S&P 500 would end 2021 at 3,283, nearly 13% below where it started the year.
In sum, AlphaProfit believes the negatives are likely to be pushed beyond 2021. In other words, economic growth will neither be too strong in 2021 nor get curtailed by higher taxes or stringent regulations.
AlphaProfit answers the question Will the Stock Market Go Up in 2021? with a Yes. The S&P 500 will likely go up in 2021. The advance will, however, lag the EPS growth recorded by the member companies in 2021.
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