After 2020 Stock Market Outperformance, What Are the Odds for 2021?
With the S&P 500 climbing to a new all-time closing high of 3,735.36, what are the stock market valuation indicators tell us? Although 2020 has been an outlier year in many ways, the S&P 500 is up over 70% from its March 23rd pandemic lows, and year-to-date, the index has risen 15.4%. Notably, the YTD rise, if it were to hold through the end of the year, would rank 2020 as the 46th best performing annualized return for the S&P 500 over the last 95 years. Not a bad accomplishment for such a turbulent year. The 2020 return is nearly double the average annual return of the S&P 500 since the 500 stock index was adopted in 1957.
Economists view the stock market as forward-looking, a leading indicator foretelling future economic pace. So, after the 2020 outperformance, what might 2021 look like?
What are the Odds?
The bad news is that the vast majority of historical valuation measures show a significantly overvalued market. For example, the Bull-to-Bear ratio is 3.7, well above the 1.0 neutral territory. The Consumer Comfort Index is 59.5, near the highest level seen since the late 1990s (what happened in late 1999/early 2000 brought pain to the stock market). The S&P 500 Price/Earnings-to-Growth (PEG) ratio of 1.9 is at its highest level since 1985. Tobin’s Q (or “Q Ratio” compares an asset’s market value to replacement value) for non-financials. Currently, at an adjusted 3.3, it is at its highest level since 1952.
The forward P/E ratios for the S&P 500 (large-cap) and the S&P 400 (mid-cap) are at their highest levels since 2006, while the S&P 600 (small cap) forward P/E is near its highest level since 2006. The Shiller P/E is 33.8x, versus a 20-year average of 25.6x and approaching its 20-year high of 37.3. The S&P 500 P/S ratio of 2.68x is at its highest since 2000 and well above the 1.50x median. Finally, market capitalization to GDP, often termed The Buffett Indicator, shows an overvalued market. The market cap of the Wilshire 5000 to GDP is 1.83, well above the 0.8 median average and the highest level since 1970. Looking at both the S&P 500 to GDP and Dow to GDP ratios, these are both at 70-year highs.
How is the Economy?
While above-normal valuations often go hand in hand with above-average economic growth, that does not appear to be the case this time. According to the U.S. Bureau of Labor Statistics, GDP is projected to grow just 2.6% in both 2021 and 2022. While this is better than the 2.1% average from 2010 through 2019, it falls far short of the 3-4% annual GDP growth experienced over the previous 40 years. Unemployment numbers, while well down from the pandemic highs, seemed to have stalled in the mid-6% range, nearly double the pre-pandemic numbers. While a COVID vaccine should help the economy recover to a more normalized state, how fast and far such an impact will have is unknown.
On a more positive note: one should take into account the outsized influence of the FAANGM stocks on the P/E multiple. FAANGM stands for Facebook, Amazon, Apple, Netflix, Google, and Microsoft. These six stocks now account for nearly 25% of the S&P 500’s entire market capitalization. Since 2013, these six stocks are up 567.5%, compared to just 103.3% for the other 494 stocks. As mentioned previously, the S&P 500 forward P/E is 22.1x. The forward P/E for the FAANGM stocks is 40.1x. If you remove the FAANGM stocks, the adjusted forward P/E for the remaining 494 stocks falls to 19.3x, which is close to the modern era average CAPE P/E of 19.6x, suggesting, at least from an earnings perspective, the market is not as overvalued as it appears. In addition, according to Yardeni Research, the Fed’s Stock Market Valuation model shows the S&P 500 forward P/E at 21.7x, compared to a 114.9x P/E for bonds, implying, stocks remain the superior investment choice to fixed income.