December 31, 2020
Time for Growth at a Reasonable Price
While it might seem contradictory that the stock market could be hitting new all-time highs at the same time as Covid cases, hospitalizations and deaths are doing the same, we know that the stock market is a discounting machine, predicting the future of the economy and corporate profits, and on that basis it should really come as no surprise. For in this most difficult year for humanity, the tremendous response from central bankers, the federal government, as well as the scientific community has been nothing short of extraordinary, and it is that collective response that has provided hope for a much brighter 2021.
The combination of unprecedented monetary and fiscal stimulus, along with safe and effective vaccines delivered in record time, offer the prospect of robust economic and profit recovery as soon as the second half of 2021. Thus the S&P 500 capped a remarkable year for stocks, one marked by a sharp but brief bear market followed by an impressive recovery, with an additional 12% gain in the fourth quarter. For the year, the S&P 500 climbed 18% despite enduring a presidential impeachment, a pandemic, a global economic shutdown, racial protests, and a highly contentious election.
Momentum stocks, particularly those with exposure to the secular trends bolstered by the pandemic, thrived as the dominant theme this past year from a factor perspective and indeed, the Russell 1000 Dynamic Growth Index was up 54.6%, besting the Russell 1000 Defensive Growth Index by almost 30%. 2020’s strong growth returns were led by the FAANG+M type of stocks, resulting in an unprecedented concentration in the Russell 1000 Growth Index and a large relative price to earnings ratio for large growth to large value. The prospects of better economic growth should favor more cyclical issues in the period ahead, as the fourth quarter’s value and small cap relative returns may have suggested. Similarly, our process has been marginally reallocating away from some of the more fully valued secular growth stocks in favor of the more attractively priced cyclical growth stocks that, on our work, have equal or better earnings momentum. The preconditions and catalyst in place may be suggesting a rotation away from growth at any price towards growth at a reasonable price market environment. As a result, we expect a more favorable backdrop for active management in general and in particular, those active strategies that use a valuation discipline.
A late-fall resurgence of Covid cases, and the subsequent reinstatement of government restrictions, took some wind out of the economic recovery in the fourth quarter. In particular, the job market stalled as service economy layoffs returned. Consumer spending also appears to have moderated as the initial boost from stimulus checks and supplemental unemployment benefits from the original CARES Act expired, but also as consumers continued to have fewer out-of-the-home leisure options on which to spend. The Atlanta Federal Reserve Bank’s latest GDPNow estimate for fourth quarter real GDP growth on a seasonally-adjusted basis is +8.5%. Most Wall Street forecasters remain below that in the +4-6% range, a sharp deceleration from the third quarter’s historic rebound of +33.4%, which followed the equally historic -31.4% plunge in the second quarter.
Macroeconomic data has been more mixed as we end the year, with moderation in employment gains, service activity, and measures of personal consumption offset by strength in housing and auto sales, supported by historically low interest rates and related manufacturing activity. Inflation appears well-contained, which is not surprising considering the weakness in the labor market. As we look ahead to 2021, we would expect the pandemic to continue to restrain activity in the first quarter, and possibly the second quarter as well, until vaccines can be more widely distributed and administered. The second fiscal relief package that was recently passed and signed into law should help to bridge the economic gap to wider immunization. By the second half of the year, the combination of “herd immunity” freeing people to resume more normal activity, the lagged effects of highly accommodative monetary policy, along with pent-up demand and high consumer savings should all contribute to more robust economic growth. For 2021, we think real GDP growth of +5% is possible, a welcome rebound following 2020’s likely -4% decline.
We expect S&P 500 profits to exceed $38 per share for the fourth quarter, which is still down about 10% versus last year’s fourth quarter. For 2021, profit forecasts have trended higher with the consensus S&P 500 EPS estimate now standing at $167, a gain of 22% compared to 2020’s depressed $137, and above 2019’s peak of $163. While many of this past year’s uncertainties for the stock market – namely, the lethality of the virus, the timing and effectiveness of vaccines, and the outcome of the elections – seem to be falling by the wayside, presenting a more hopeful outlook, full absolute valuations and extremely bullish investor sentiment could keep the market in check. However, relative valuations still favor stocks in this low interest rate environment, and we believe the path of least resistance for the market remains higher, supported by the tremendous flood of liquidity from the Federal Reserve and other central banks around the world.
We continue to have strong conviction in the high-quality secular and cyclical growth stocks that comprise our Clients’ portfolios, many of which have seen their competitive positions strengthened as a result of this pandemic and are therefore poised to perform well as the economy fully reopens and returns to a more normal state. Additionally, many of our holdings are beneficiaries of secular trends, which this pandemic has further accelerated, such as work/shop/play-from-home. These stocks remain reasonably priced and are expected to deliver above-average profit growth in the year ahead.
