The big surprise of 2021: a booming economy and a lukewarm stock market

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An abnormally bad year brought abnormally large gains to the stock market in 2020. A return to normalcy could, however, lead to disappointment.

The

Dow Jones Industrial Average

rose 5.8% in 2020 to 30,179, after rising 0.4% in the past week. The

S&P 500

is up 15% this year to 3,709, up 1.3% for a week – though

Tesla

(ticker: TSLA), which is up 731% in 2020, won’t join the index until Monday. The

Nasdaq Composite

is up 42% in 2020 to 12,756, after a weekly gain of 3.1%. Even the

Russell 2000

has taken action, with an increase of 18% in 2020.

These gains came despite the large amount of bad news that hung during the year: the coronavirus that halted the economy and killed more than 300,000 people; the non-stop attention to politics, turning every tap on the stock market into a referendum on the elections; and the death of George Floyd and the protests that followed. It is a reminder that the market has no emotions, does not respond to signals from individuals, and appreciates what can happen about what happened.

Next year promises to be less traumatic. Last week, people in the US began getting vaccinated against the coronavirus, with some expecting that 100 million Americans would have received the shots by the end of the first quarter. The return of everyday life to something more like normal should be an incredible boost to the economy, one that is finally helping the US escape the slow growth it was trapped in under both Barack Obama and Donald Trump, when the US gross domestic product growth struggled to reach 3% in any given year.

In fact, the biggest mistake investors make is looking at the past decade and extrapolating to the future. The latest recession was sparked by a financial crisis that left banks with wounded balance sheets, diminished risk appetite and stagnant growth, thanks to the lack of major fiscal stimulus and a Federal Reserve worried too much about inflation that never came.

This time, trillions of dollars in fiscal stimulus were immediately distributed – and more is likely to come. The Fed also seems to realize the mistake it made after the 2008 financial crisis and has pledged not to tighten monetary policy until 2023.

Most importantly, the current recession is not due to taking too many risks, but rather a virus that has brought it to a standstill. That means the recovery should be faster and stronger than the recovery that began in 2009, said Christopher Harvey, US equity strategist at

Wells Fargo

Effects. “It’s not J, K, XYZ, or whatever letter you want to throw at the recovery,” he says. “It’s a V-shaped recovery.”

That is certainly not the consensus. Economists predict that the U.S. economy will grow by 4% in 2021, faster than what was common from 2010 to 2019, but not enough to reverse the damage done by the coronavirus recession until 2022 or 2023. Chances are that economic growth will. much faster than that, says Michael Darda, chief economist at MKM Partners, who estimates GDP will grow 4.5% to 6.5% next year, while inflation will average 2.5% to 3.5% .

“The second half of the year should be very strong as the roll-out of vaccines and more intensive therapies accelerate the reopening of the efforts,” he says. “The billions of cash accumulation in the household sector will ‘decline’ as households spend on many services (leisure and hospitality, etc.) that they could not spend in 2020.”

But as we have heard so many times in 2020, the economy is not the market. It’s not that growth isn’t good for stocks – it absolutely is. A booming economy means earnings from the S&P 500 could grow 15% to 20% next year, Darda says. But strong growth could also cause Treasury yields to rise, and that would put pressure on market valuations, especially those of high-end growth stocks in the technology, communications services and consumer discretionary sectors. Investors use government bond yields as a risk-free rate, and the higher they rise, the more valuations for growth stocks can fall. “The market will be flat with single digits up / down as multiples contracts with higher discount rates,” Darda says.

Wells Fargo’s Harvey agrees. He predicts that by 2021, investors will be rotating from high-flying big tech to cheaper, economically sensitive stocks. But technology is a huge portion – 28% – of the S&P 500.

Apple

(AAPL) alone makes up nearly 7% of the index, and

Microsoft

(MSFT), more than 5%. If these stocks were to enter water or – panting! – even fall, the index would struggle to make much progress.

“If they don’t work, it will have a big weight on the index,” said Harvey, who has a target of 3850 on the S&P 500 by the end of 2021.

His advice: buy stocks with a high “Covid beta” – the stocks most sensitive to the rise and fall of the market, based on good or bad news about the coronavirus – because they will benefit the most if life returns to normal. They contain

Darden Restaurants

(DRI), which is up 3.1% over the past week despite the outlook for

MGM Resorts International

(MGM), and

Whirlpool

(WHR).

Of course, there will be reasons to doubt that the rotation is real. Last week, the Nasdaq beat the Dow by more than two percentage points. Just remember that’s normal too.

Read more Trader: Dogs of the Dow Stock-Picking Strategy didn’t work this year. It could be in 2021.

Write to Ben Levisohn at [email protected]