There is no doubt that the current equity market is displaying significant positive momentum. This is made clear by the fact that the Russell 2000 index has been core to price leadership in 2021. In fact, the iShares Russell 2000 Value ETF (IWN – $152.31), the iShares Russell 2000 ETF (IWM – $225.83) and the iShares Russell Growth ETF (IWO – $329.01) are all beating other indices with gains of 17.2%, 16.7%, and 16.5%, respectively. This compares to the 6.3% year-to-date gain in the SPY. See page 14.

Similar but Different from 2000

Several technical indicators are confirming the advance. The NYSE cumulative advance decline line is corroborating the advance with a record high as of February 12. Our favorite 25-day up/down volume oscillator is neutral this week but recorded five consecutive trading days in overbought territory last week. In this indicator, five to ten consecutive days in overbought territory is a sign that persistent buying pressure is supporting the move. See page 10. Even more impressive has been the 10-day average of daily NYSE new highs which hit 514 this week, exceeding both the 10-day average of 492 made on January 20, 2021, and the previous record of 489 made January 22, 2000. See page 11. This last point should also come as a warning flag to investors since the strong market breadth seen in January 2000 preceded the bull market peak made in March 2000 by less than two months. However, the 2000 market was driven by both momentum and more importantly a mania for stocks. Today’s market appears to be a bit different. First, the equity advance is much broader today than the narrow bull market of 2000. Second, valuations were far more stretched in March 2000 than they are at present. Third, the mania for stocks seen in 1999 and early 2000 is not apparent, at least not yet.

Too Dangerous to Short

Normal sentiment indicators are surprisingly benign. The ISE Call/Put Volume ratio remains neutral. AAII bullish sentiment for February 11 jumped 8.1 points to 45.5% and bearish sentiment declined 9.3 points to 26.3% which puts it below its historical average of 30.5% for the first time this year; nevertheless, the 8-week bull/bear spread remains solidly neutral. On the other hand, February’s Bank of America survey of 225 global institutional, mutual and hedge fund managers did reveal a surprising level of bullishness. Cash levels in these investment portfolios dropped to 3.8%, the lowest level since May 2013. (This 2013 benchmark is significant since it coordinates with a Treasury bond sell-off triggered by Federal Reserve Chairman Ben Bernanke when he indicated his intention to taper bond purchases.) A net 91% of money managers indicated that they expect a stronger economy. This is the highest percentage reading in the history of the survey. One concerning fact is that only 13% of participants indicated they were worried about an equity market bubble. About 53% of all managers felt equity markets were in a late-stage bull market while 27% believe the bull market is still in its early stages. Equally notable, a net 25% of the investors surveyed said they were taking “higher-than-normal” risks at the present time. This was the highest percentage ever recorded. The most crowded trades were long technology and bitcoin and short the US dollar. Although this survey gives us concern, we believe it would be extremely dangerous to short this market at this time.

Consensus 2022 Hits $200

One reason it could be unwise to short the current market is that consensus S&P earnings for 2020 and 2021 continue to move upward. For this year and next, S&P Dow Jones consensus earnings estimates rose $0.08 and $0.22, respectively, and Refinitiv IBES consensus estimates rose $0.61 and $0.66, respectively. Full year 2021 earnings forecasts for S&P Dow Jones and IBES are now $170.77 and $173.70, respectively. But it is most important to note that the IBES consensus estimate for 2022 has exceeded $200 for the first time and is currently estimated at $200.41. Applying a 20 PE multiple to this estimate equates to a target for the SPX of 4000. In short, one could argue that the market is not wildly overvalued – just discounting future earnings.

What Could Upset the Apple Cart?

However, this last statement – just discounting future earnings — is dangerous since no investor can actually predict the economy, stock market or earnings two years in advance. With this in mind, it is prudent to think about what could go wrong with the two factors that underpin the bullishness of professional investors today — strong fiscal stimulus and easy monetary policy. In short, what could upset the apple cart?

The Democratic majority in Congress and the White House makes fiscal stimulus relatively predictable for 2021. But what about monetary policy? As we previously noted, low interest rates, high liquidity, and a benign Fed are the perfect recipe for speculators. Therefore, it is not surprising that a net 25% of the investors surveyed by Bank of America, the highest percentage ever recorded, said they were taking “higher-than-normal” risks today. However, keep in mind that as interest rates rise the risk/reward ratio for speculators will also change and at some point, potential risk will outweigh potential rewards. In a word, the risk for 2021 could be inflation.

The Biden administration has been quickly reversing the energy policies of the Trump administration and oil prices have been rising accordingly. This coupled with the freezing temperatures in Texas which are disrupting energy transportation while increasing demand for heating needs, have boosted the WTI future above $60 this week. This is a 35% YOY increase. It is likely to move higher and thereby be the driver of higher inflation in 2021. See page 3.

At the end of 2020, all inflation benchmarks were stable and hovering around 1.4%. This 1.4% level is good for both consumers and businesses as well as for Federal Reserve policy. However, history has shown that a sharp rise in crude oil pricing will not only negatively impact the CPI but will be the catalyst for higher long-term interest rates. This is already happening. The 10-year Treasury note yield is currently at 1.2% which is higher than any time since the pandemic struck in March 2020. See page 4.

On a not-seasonally-adjusted basis, January’s CPI rose 0.4% month-over-month and 1.4% year-over-year. Yet, January’s benign 1.4% inflation rate was contained by a seasonal 2.5% YOY decline in apparel and a 1.3% decline in transportation. The decline in transportation inflation is expected to be a temporary phenomenon. Fuel prices peaked in December 2019 at $61.06 and fell to $18.84 at the end of April 2020. In short, the easy year-over-year comparisons for fuel prices are behind us. See page 5. Charts of the crude oil future and the 10-year Treasury note yield index show the correlation between the two, but more importantly, the 10-year yield chart shows that there is resistance at the 1.4% yield level. If 1.4% is exceeded, it could indicate much higher levels for interest rates. Not only would inflation put pressure on interest rates and the Fed in terms of its easy monetary policy, but it could also force the FOMC to adjust its long-term outlook. A change in monetary policy is the opposite of what the consensus is expecting in 2021 and it could shock the equity market. In sum, do not fight the Fed, but beware of what could change the Fed’s outlook.

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Last week we outlined eight factors that typically identify a stock market bubble and discussed where we believe the current market stands in regard to each. One important and obvious characteristic of an equity bubble is that prices disconnect from valuation. Yet as we noted last week, while current valuation levels are rich, they are not at the inane levels often recorded at a bubble peak. We quote: “In short, fundamentals may be stretched today, but interest rates are low which means a 20 PE for 2021 is within our model’s fair value range. It will not be a surprise if valuations get even more stretched in coming months. All in all, equities are disconnecting from fundamentals, but this may continue for a time.” (US Strategy Weekly “And if it is a Bubble” January 27, 2021)

What is currently in the market’s favor is that this year’s consensus earnings estimate for the S&P 500 Composite is on the rise. According to Refinitiv IBES, to date, of the 203 companies in the S&P that reported fourth quarter earnings, 84% have beaten expectations. This is well above the long-term average of 60.5%. The blended earnings estimate for the fourth quarter now shows a decline of 1.2% YOY versus the decline of 10.3% YOY expected on January 1. Excluding the energy sector, IBES estimates fourth quarter earnings should actually rise 2.4% YOY, which would end three consecutive quarters of negative earnings comparisons for the S&P. In addition, energy sector earnings are expected to rebound sharply in 2021 and this should give an added boost to 2021 results.

At the end of last week IBES estimated 2020 consensus earnings were $138.71 and due to differences in accounting standards, S&P Dow Jones estimated earnings of $121.37. With only two more days of fourth quarter earnings results, IBES raised its 2020 estimate to $139.21. All told, fourth quarter earnings have been a pleasant surprise for investors.

Fourth quarter results are also a positive catalyst for 2021 earnings forecasts. At the end of last week, IBES estimated 2021 S&P earnings to be $171.55, but after two more days of earnings results, their estimate increased to $172.05 this week. S&P Dow Jones forecasted $169.39 for S&P 500 2021 earnings in their regular report at the end of last week. What is important about these various increases in earnings is that if one applies a 20 PE multiple to the current IBES estimate of $172.05 it equates to a price target of SPX 3441. Although this is 10% below current prices, the good news is that this does not represent an extreme overvaluation given the current low level of inflation and interest rates. Thus, any correction should find support around the SPX 3400 level. Conversely, stock market bubbles tend to end with ridiculously high PE multiples. In sum, if equities are forming a bubble market, it may continue for a time.

Adjusting our Earnings Estimates for 2020 and 2021

The S&P earnings results for the fourth quarter, and for 2020 generally, are much as we expected. So, with the annual earnings season nearly complete, we are adjusting our 2020 earnings estimate to match the S&P Dow Jones estimate of $121.87. This reflects a decline of 22.8% year-over-year versus our expectation of a decline of 20% to 25% in 2020. We are also raising our 2021 estimate from $166.60 to $168.60, representing a 39% increase this year. See page 19. But more importantly, we would not be surprised if this earnings estimate proves to be too conservative over time, particularly as the drag from the energy sector abates and the productivity improvements seen in 2020 help to drive the bottom lines for many companies in 2021.

Economic Reports

Real GDP grew in the fourth quarter at a seasonally adjusted annualized rate of 4%, which means that economic activity in the full year of 2020, contracted 3.5%. This 2020 contraction followed gains of 2.3% in 2017, 3.0% in 2018 and 2.2% in 2019. To our surprise, despite the 2020 recession, GDP grew at an average pace of 1.94% during Trump’s four years in office which was precisely the midpoint between the 1.89% rate for Obama’s eight years and 1.99% for GW Bush’s eight years. See page 3.

Economic growth in the fourth quarter was driven primarily by personal consumption of services and gross private investment. This shift in economic activity toward the service sector was a welcomed change since most of 2020’s economic activity was supported by personal consumption of durable goods, particularly housing and autos. The gains in gross domestic investment in the fourth quarter were primarily in residential structures. In fact, residential fixed investment hit a record $983.5 billion in the quarter which was an 18.3% gain year-over-year. This represented the strongest year-over-year rise in residential investment since the third quarter of 2013. See page 4. And as a percentage of real GDP, residential activity rose to 4.58%, the highest since the third quarter of 2007. This is strong but just slightly below its long-term average of 4.6% of GDP. See page 5. In sum, housing continued to be a major driver of economic activity at the end of 2020. But this may not continue in 2021. Ironically, as residential investment rose in the fourth quarter, homeownership levels declined rather markedly. See page 6. Total homeownership in the US fell from 67.4% of all households to 65.8%. The greatest decline was seen in the South where the homeownership rate fell from 70.8% at the end of September to 67.7% at the end of December. The Northeast was the only region in the US to experience a gain and rose from 62.0% to 62.6% in the fourth quarter. In terms of age groups, the 35 to 44 years old segment underwent the biggest decline in homeownership from 63.9% to 61.0%. Given the anecdotal evidence of households fleeing the Northeast and California to Texas, Florida and the Carolinas, this data seems illogical. However, the fourth quarter could be a transition phase as households move from states where restrictions have closed most institutions and establishments to states where schools and businesses have been open. Or it could be more ominous. The contraction of jobs in 2020 may have forced households to sell homes and move to apartments. Time will tell. However, we do believe economic growth in 2021 could disappoint investors if the federal government does not focus on stimulating job growth.

In December, personal income grew 4.1% YOY and real disposable income rose 3.2% YOY. However, a more revealing statistic is real personal income, which excluding current transfer payments fell 0.5% YOY in December. It also declined 0.45% in November. In short, government assistance, not economic activity, is propping up incomes and the economy. See page 9. And while personal income rose 4.1% in December, personal consumption declined 2.1%. Moreover, consumption has been negative in every consecutive month since March. This reveals the weak underbelly of the US economy and it is unlikely to change until the job market improves. See page 10.

Technical Indicators Little has changed in the technical arena. Our volume oscillator remains in neutral territory, the 10-day new high list has dropped from the record 492 hit on January 20^th (breaking the previous record of 489 recorded in January 2000) to a more normal 259. Sentiment indicators are also surprisingly benign despite the headlines of individual traders driving volatile meme stocks. However, it is worth noting that at the end of the year stock market capitalization relative to nominal GDP was 2.1 and higher than the prior record of 1.82 set in March 2000. A similar Wilshire 5000 ratio was 1.83, exceeding its peak of 1.43 set in March 2000. These high ratios are signs that equity valuations may be outperforming the economy. See page 4. Expect 2021 to be a wild roller coaster ride and invest accordingly.   

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