Valuation Check – What could possibly go wrong?
Despite the upheaval we have all felt during 2020, the stock market has made what appears to be a miraculous recovery, with the S&P 500 rising from a closing low of 2,237 on March 23rd to 3,668 as of December 10th. Indeed, the S&P500 is now up over 12% for the year, remarkable given that virus panic had driven prices down by more than 30%. As we have shared for several months, the market appears to be looking past the pandemic to “normalized earnings”, which assume that things get back to a pre-pandemic normalcy. At this point it appears that the “V” shape of the recovery is over, and it is time for stocks to start delivering on those normal earnings to confirm expectations. Valuations by several measures appear to be high and a little caution is warranted. Here is a list of concerns that could still trip up the market.
Valuation: One concern is simply the amount of optimism that exists in the market. Valuations by multiple measures are high. For example, the “Buffet Ratio”, a measure of total US stock valuation compared to the overall economy (measured by nominal GDP), is at an all time high, passing levels last seen in 2000 just before the technology stock meltdown.
A Blue Wave: During our election analysis we shared that ‘gridlock’ was the likely to be the winner of the election, and that was also the market’s favorite result since it meant few changes could be made. However, with the upcoming special election in Georgia there is still potential for democrats to take the senate and enact dramatic tax and other changes, a result that could upset current market expectations.
A Viral Comeback: Perhaps it goes without saying, but the market has reacted strongly to the positive news of a Covid-19 vaccine. A setback in safety or efficacy for the vaccine could result in a market reassessment of the pace of the recovery.
Rising Interest Rates: Current stock market valuations are driven at least partially by incredibly low interest rates. The Federal Reserve is keeping rates low to stimulate the economy, a strategy that has worked well so far this year, and the Fed has no plans to raise rates any time soon. If inflation were to start to rise however, that could upset the plan and force the Federal Reserve to raise rates sooner.
Middle East War: I’m old enough to know that no list of ‘worries’ is complete without an honorable mention to the middle east, a constant source of surprises of geopolitical turmoil for decades. It makes this list due to the recent assassination of a leading Iranian nuclear scientist by unknown attackers (though Iran clearly blames Israel). Thus far Iran has not retaliated but it is entirely likely that there will be at least some tit-for-tat response.
So, there it is, perhaps not a comprehensive list of worries, but a solid list, nonetheless. It is not my intention to be overly negative. Rather, I want to take a moment to remember risks and stay grounded amid what has been an incredible rally. We are very proud of how the portfolios have weathered the storm of 2020 and remain committed to the long-term strategy for our clients. If you have any questions or would like to discuss your portfolio, please give us a call.