Exactly a year ago, a new bull market was born. Propelled by unprecedented stimulus, stocks crept out of their deep pandemic route and started sprinting.
History indicates that after a sharp decline in the bear market, strong bull markets usually follow with gains entering the second year. However, investors should expect a lower return over the next 12 months with a harder road to get there.
It was on March 23, 2020 when the S&P 500 bottomed out after the Covid crisis drove the stock benchmark 30% in 22 days, the largest drop in such a short time. There have been five other bear market sell-offs at 30% or more since World War II, and the market has risen every year with an average return of nearly 17%, according to data from LPL Financial.
Still, the first year’s comeback rally is usually hard to top. Only in the aftermath of the 1987 crash, according to data, stocks increased more sharply in the second year than in the first year. In addition, the second year of a new bull market is prone to relapse with an average 10% downturn, LPL said.
The S&P 500 is up about 80% from the March low, marking the best start to a new bull market ever, LPL data showed. These historic beginnings could open the door to sophomore slump and more volatility on the horizon.
“Starting the second year of the current bull market could be just as exciting for investors, but it is easy to question whether the strength will last,” said Lindsey Bell, chief investment strategist at Ally Invest. “Think of the sports-free agent who disappoints after scoring the nine-figure contract, or the sequel that just doesn’t live up to the original.”
4% profit from here?
Wall Street’s consensus year-end target for the S&P 500 stands at 4,099, representing a 4% gain from Monday’s end of 3,940.59, according to the CNBC Market Strategist Survey rounding up the predictions of 15 top strategists.
The bull market was officially announced as the S&P 500 wiped out its pandemic losses and hit a record high on August 18, after which the start of a bull cycle was traced back to the market afterwards.
Still, the 2020 “black swan” event makes the current bull market one of a kind. Unlike the past few crises where the malfunctioning of the financial markets was the culprit, this time the downturn was triggered by a pandemic. And unlike the slow and steady recovery in previous cycles, this recovery was extraordinarily fast, thanks to trillions of dollars in help from Congress and the Federal Reserve.
“This is the first bull market we’ve all experienced, where it’s essentially manufactured by the government and by the Fed,” said Tom Essaye, founder of Sevens Report. “The massive stock gains didn’t come organically. They were essentially decreed by the government taking on massive amounts of debt and deficits to stimulate economic activity. That changes the outlook for the future.”
While history is on the market side, many believe the new bull’s lasting strength depends on its ability to sustain the rally without massive amounts of stimulus. Another round of stimulus checks started hitting Americans’ bank accounts this month. Once the stimulus boost fades, Wall Street bets that corporate earnings will do the heavy lifting and deliver on the lofty promises of stock prices.
What are the risks?
At its current level, the S&P 500 is trading more than 21 times forecasts for next year’s earnings, a level not seen since 2000, according to FactSet.
“You are essentially transitioning from a government-infused rally to what we hope would be an organic-economically-infused rally in which the economy reopens and in turn feeds itself,” Essaye said.
Meanwhile, inflation expectations are on the rise amid the historic economic reopening and massive stimulus measures, making it harder to justify the high valuations of stocks. The concern manifested itself in the year-to-date underperformance of the tech-heavy Nasdaq Composite as higher inflation and interest rates erode future earnings from growth-oriented companies.
Another potential threat, as this rising market ages, could be higher tax rates as President Joe Biden proposed higher rights to fund a major infrastructure program. Goldman, US stock strategist David Kostin, warned investors that Biden’s tax plans could cut S&P 500 earnings per share by 9%.
Biden has indicated his willingness to raise the corporate tax rate to 28% in a partial rollback of President Donald Trump’s 2017 tax reform. Meanwhile, Biden also endorsed raising the top marginal tax rate to 39.6% and taxing capital gains and dividends at the higher ordinary income tax rate.
Wells Fargo believes corporate tax rates will rise but fall short of Biden’s 28% proposal, and that any damage from higher taxes will be mitigated by higher corporate profits.
“We believe record economic growth and fiscal spending will support higher profits, potentially offsetting the impediment to a higher tax regime,” said Ken Johnson, investment strategies analyst at Wells Fargo.
– With help from CNBC’s Nate Rattner