A New Year: More Normal, More Crazy, More Stimulus?

Ben Franklin said, “Early to bed and early to rise makes a man healthy, wealthy, and wise”. Here's hoping putting 2020 to bed makes our nation more healthy, wealthy, and wise. Wise investors understand the long-term upward bias of the stock market, but also know to expect the occasional large drop, usually precipitated by some unforeseen event such as the banking crisis of 2008 or COVID-19.

The markets reaction to this type of trauma often follows a classic three phase pattern. During the phase one drop, we see almost all stocks moving downward. During the phase two quiet period, we see most stocks bouncing around at lower levels for some time. Eventually as investors regain some composure and optimism, we enter the phase three recovery period where most stocks start a gradual upward climb. There was little last year that fit the description of usual, normal, or typical, and that included the stock market. Following the typical phase one drop, the market essentially skipped the phase two quiet period. Next, it accomplished a phase three recovery with break neck speed and kept moving onto new highs.

Everyone loves a great market recovery, so raising questions in the midst of all the exuberance can be a real mood killer. At the risk of being a party pooper, let's examine exactly what the “party in the market” was all about. Was it a celebration of great economic growth? While the final numbers are not yet in, most estimates project the economy (GDP) probably shrank about 4%. Was it to cheer companies making a lot of money? Analysts are all over the board on this one with the final numbers still in the works. Estimates generally range from a 15%-45% drop in profits. When gifts were passed out, were we excited to reopen our locked down businesses? At last count there are still over 18 million people collecting state and/or federal unemployment benefits. None of this is likely a surprise to us, and yet the party rages on. It's like a New Years Eve party where the past is dead, and everyone is toasting an assumed bright future based on ongoing stimulus checks and ultra low interest rates.

So just how bright does that future need to be to substantiate current market levels? To start, company earnings (profits) need to increase around 15% (using optimistic projections) just to dig us out of the hole created the pandemic last year. Over that same time period the stock market (the S&P 500) went up 17%. This means relative to 2019 investors are now paying 17% more for 15% less in corporate earnings. That's like ordering your favorite pie, being served a smaller slice, and getting a bigger check. Corporate profits (the pie) now must grow 32% just to get us back to already high pre-pandemic valuations. That's a stretch, and implies a high level of speculation was a big part of the market's extremely rapid phase three recovery. Speculation seems especially high in large cap growth stocks, a large part of the most popular indexes. I much prefer the small cap value area where speculation seems minimal and the risk/return trade-off seems more favorable. Focus on the basics like company profits. Avoid chasing performance driven by the latest fad, ideas which led to the internet bubble/bust of 2000.

Frank Rizzo, Certified Financial Planner

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic and market forecasts set forth in this material may not develop as predicted and there is no guarantee that strategies promoted will be successful. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly. The prices of small cap stocks are generally more volatile than large cap stocks.