January 2021 Market Commentary

Jack Brown, CFA

Despite a wrenching year of political, pandemic, and economic upheaval the stock market (S&P 500) returned +18.4% in 2020. This is nearly double its long-term 15-year average of +9.6%.  Indexes like the S&P 500 are size-weighted meaning much of the performance is driven by the largest names. This year the ten largest names returned 34% on average (excluding Tesla, which was added to the index in November and returned an eye-popping 743%). Consequently, the largest names did much better than the overall index.

The strong results of the largest names have led to some distortions in the index as well and may now pose some risk in 2021. Specifically, the 5 largest names in the S&P 500 currently account for an outsized 25%+ of the index’s weight.  Historically, the weighting of the top 5 names is considerably lower (approximately 14%) as indicated in the next chart:

Historical Weight of the Top 5 Names in the S&P 500 (1980 – 2020)

Source: Advisor Perspectives.

Valuation metrics tell a similar story. Consider the top 10 names in the index as of 1/15/21; these companies have an average price-to-earnings ratio of 28 times vs. 20 times for the overall index. Essentially a large portion of the market index is concentrated in a few names that may be overvalued or at least vulnerable to a downside risk if the growth thesis behind these names becomes challenged.

Source: YCharts. Note: We use the reciprocal of the weighted-average forward earnings/price method to calculate the price-to-earnings ratio of the Top 10 and S&P 500 average as this reduces the impact of skewness from companies like Tesla.

In 2021, we believe economic growth will be broad in the sense that the earnings of most sectors will do well as consumer behavior begins to resemble that of pre-2020. This would be unlike 2020 where some sectors did fine and others poorly, which impacted the stock performance of sectors. For example, consider two major sectors: technology and financials. As cooped up consumers embraced technology products, the technology sector in the S&P 500 returned an average of +44% return for 2020 vs. -2% for financial stocks.

In a year where we expect economic activity to broaden, it would surprise us to see a repeat of these results.  More likely, we expect the financial sector, for example, to at least ‘close-the-gap’ in terms of performance and possibly even surpass that of the technology sector as investors may be attracted to a combination of improving earnings for financials and relatively attractive valuations.

Economic Growth in 2021

While the first couple months of 2021 may show signs of weakness given the post-holiday spike in COVID-19 cases, we expect the remainder of the year to improve significantly. Notably we assume:

  • Vaccine distribution program accelerates by the end of March
  • December stimulus package is fully implemented early in the year
  • Political concerns do not significantly affect consumer or business confidence

Further, the massive buildup of money, as measured by the M2 money supply, will likely shrink throughout the year.  This means that the larger-than-normal treasure trove of cash (sitting in bank accounts and money market funds) that has been sitting on the sidelines since the summer will likely, in our view, be spent as vaccinated consumers feel confident enough to do things in 2021 that they have not done in 2020 – such as dining out and traveling.

As this cash hoard gets re-injected back into the economy, we expect a reasonable portion to be invested into the capital markets – in other words, a positive stream of asset flows into the markets.  Combine this with an assumed continuation of the Federal Reserve’s rather easy money policies (i.e. low overnight lending rates and other pro-liquidity programs), and it is reasonable to envision a positive outcome for stocks and bonds.

The net result of this base case we have outlined is that we have no reason to expect a weaker-than-normal stock market year despite coming off the heels of a better-than-normal year. In fact, we are more interested in putting cash to work at opportune times, such as an occasional pullback.

Since we do see some risk associated with the concentration of large stocks (i.e. the top 10 stocks accounting for 30% of the index) combined with a more level distribution of earnings growth, we expect to see investor dollars also be more evenly distributed among sectors and companies of various sizes.  Therefore, the caveat for 2021 is that it is a good year to be more selective, such as avoiding overvalued names and sectors in favor of more modestly valued areas.

We also expect continued buying pressure on fixed-income markets as investors chase yield.  Eventually rising economic growth and inflation expectations may, however, lead to a modest pick-up in long-term interest rates by the end of 2021.

Nevertheless, the management of risk remains as important as ever.  On this note, we leave room for the less-likely scenario where economic growth turns out to be worse than expected stemming from poor outcomes related to jobs, vaccines, political turmoil, or confidence. Further, interest rates could climb higher than expected and/or corporate credit quality could deteriorate as debt laden balance sheets come under broad scrutiny.  Should either of these unexpected scenarios occur (a weaker than expected economy or interest-rate/credit deterioration), we would also expect to see a negative impact on the stock market.

Conclusion

We expect a decent year for economic growth driven in part by a more confident consumer with a sizable amount of money to be injected back into the economy and markets – leading us to a positive base case for the overall market.

The market is concentrated in a smaller-than-usual group of stocks that have had a better-than-average year.  These stocks also have elevated valuations relative to the overall stock market.  This distortion combined with the potential for broad economic growth leads us to be a bit more cautious of some areas (i.e. overvalued stocks and sectors).

2021 appears to be an excellent opportunity for investors to consult their advisor to ensure portfolios are aligned with long-term strategic allocation goals.