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U.S. stocks have defied almost all expectations in this crisis-riven year, first plunging into a bear market in February and March, as the coronavirus pandemic spread and the economy shut down, and then rebounding with lightning-fast speed to reach new highs by late summer. Following a selloff in tech stocks earlier this month, the
index closed on Friday at 3341, about 240 points short of its record, and up 3.4% for the year.
Don’t expect this sort of drama to continue through year end, at least so far as the S&P and its fellow market measures—the
Dow Jones Industrial Average
—are concerned. Wall Street’s stock market strategists see only a modest move higher in the S&P 500 through December 2020, although there could be plenty of action below the surface, given potential economic and political shifts, a possible rotation from growth stocks to value, and the challenges inherent in investing in a zero-interest-rate world.
Among the half-dozen Wall Street strategists whom Barron’s recently canvassed, none sees the S&P 500 ending the year very far from current levels. The strategists’ average year-end S&P 500 target is 3492, less than 5% above Friday’s close.
The group expects the picture to brighten in 2021, however. The four strategists with published 2021 targets see the S&P settling at 3800 or 3850 next year. Based on the midpoint of that range, the benchmark index could gain about 15% from here.
The strategists’ average S&P 500 earnings forecast is $128 for 2020. But they expect earnings to shoot up by 26% next year, to $161, even with last year. “We’re at a point where, albeit slowly, we seem to be emerging on the other side of Covid-19,” says Savita Subramanian, head of U.S. Equity & Quantitative Strategy at
Bank of America Securities.
The near-term outlook has darkened for corporate profits, although they could rebound in 2021.
Wall Street strategists’ average earnings forecast for the S&P 500 this year, down from actual earnings of $161 in 2019
This has been the year of Big Tech. Near-zero interest rates and a hunger for growth have pushed many investors into the same five giant tech stocks—
(MSFT)—and lifted valuations to increasingly lofty levels, even after the Nasdaq’s recent setback.
The five are expected to grow their revenue by an average of 15% in 2020, despite the deepest global recession since the Great Depression. The other 495 companies in the S&P 500 could see their sales decline by 5% this year. Similarly, the Big Five boast Ebitda (earnings before interest, taxes, depreciation, and amortization) margins of 29%, versus 17% for the S&P 495. All of the tech titans have net cash, implying little balance-sheet risk.
What’s Next: More Gains for Stocks
Here are Wall Street strategists’ predictions for 2020 and 2021.
*Goldman Sachs estimates. YE=Year end. N/A=Not Available.
The Federal Reserve gets much of the credit for keeping the tech sector, the broad market, and the economy aloft in 2020. After starting to lower interest rates in mid-2019, the Fed went all-in in March as the coronavirus swept the U.S., dropping its federal-funds rate target to a range of 0.00% to 0.25%. All six strategists see no change in the fed-funds rate for this year and next.
Ultralow interest rates have boosted the valuations of companies expected to earn the bulk of their profits in the future—sometimes years down the road. When discounted back to the present, far-off cash flows are worth more today than in a higher-rate world. That calculation has helped lift stock indexes to records even as earnings have tumbled.
“The investment community is paying more for duration today than they ever have in history,” says David Kostin,
’ chief U.S. equity strategist. “Given that we anticipate rates to stay low, this valuation-at-the- lower-bound question becomes the dominant issue that will be driving the market and prospective returns.”
The price-to-forward earnings ratio of the Russell 1000 Growth index recently hit 31 times, while its Value equivalent trades for 19 times. Growth investing trounced value for much of the past decade, and growth stocks’ lead widened this year as the market rebounded. Some strategists see a change in leadership for the remainder of 2020, if not beyond.
“If we get a vaccine this year, or more signs that we’ve contained this crisis adequately, we can resume a greater semblance of normal activities,” Subramanian says. “That would cause a renewed interest in some of the more economically sensitive cyclicals, coming off of very low levels of investor positioning.”
Note: YTD % change for foreign markets in local currency; *Change in percentage points
Paying up for a narrow group of tech-related companies’ future earnings growth is easier to justify when profits are tumbling elsewhere, as has been the case for most of this year. But as the U.S. and other economies emerge from a coronavirus trough, the “old economy” should rebound. Investors looking for bargains in value sectors must differentiate, however, between companies whose earnings are sitting at cyclical lows because of reversible drops in demand and those being disrupted permanently.
Industries such as semiconductors, construction, and auto manufacturing won’t be affected fundamentally by the pandemic in the long term. But accelerated shifts away from business travel or bricks-and-mortar retail might never reverse.
For many industrials, materials, and financials companies, a rebound in global economic activity could mean a return to prerecession levels of sales and earnings in a relatively short order. Cheaper valuations relative to growth sectors could further support outperformance by cyclical and more value-oriented stocks. A Covid-19 vaccine or further improvements in treatments could accelerate the economic reopening.
Yielding to Reality
U.S. Treasuries don’t provide much income these days. Preferred shares could be a better place to look.
- 1% Strategists’ 2020 year-end forecast for the 10-year Treasury yield
- 5.4% The yield on the iShares Preferred & Income Securities exchange-traded fund
“We recommend positioning for a continued recovery in the economy,” says Mike Wilson,
chief U.S. equity strategist and chief investment officer. “Look for the companies that can generate the greatest operating leverage on the other side of this pandemic.”
Companies whose profits are most sensitive to changes in revenue had the most to lose on the way down, but have the greatest room to recover. That includes apparel maker
Citizens Financial Group
(CFG), whose strong positions in their industries could leave them better-positioned relative to peers. Other stocks on Morgan Stanley’s Fresh Money Buy List include
(LIN), a leader in industrial gases.
A sustained rotation from growth to value is a recipe for relatively flat performance on the index level, says Goldman Sachs’ Kostin. The weight of tech stocks in the market relative to lagging sectors means it would be a lopsided rotation. And many investors, after taking profits, don’t immediately redeploy 100% of their cash.
The risks to the market are numerous, starting with the economic outlook. Since bottoming in April, many economic indicators have rebounded sharply, but the pace of Main Street’s recovery has lagged behind Wall Street’s. Unemployment remains above 8%, and consumer spending could drop if expanded unemployment benefits aren’t extended by Congress. Ailing state and local budgets could lead to cuts in services and layoffs, worsening the impact on certain groups.
The summer surge in Covid-19 cases in the U.S. is largely past, with nationwide cases and hospitalizations recently back down to June levels. But experts such as Dr. Anthony Fauci warn of the risk of another surge in the fall, when flu season begins and cold weather forces people into closer proximity indoors. If that is accompanied by new stay-at-home orders or restrictions on economic activity, the recovery could reverse.
A contentious election season also means heightened uncertainty, with polls showing former Vice President Joseph Biden well ahead of President Donald Trump in the race for the White House. The battle for party control of the Senate is equally contested.
These circumstances support a continued preference for growth companies with secular tailwinds, which don’t depend on a rising economic tide to increase their sales and earnings.
Investors looking to bet on a cyclical recovery might do better overseas. Valuations are cheaper in Europe, Japan, and emerging markets, where stock indexes tend to have more cyclical exposure than the S&P 500.
“If you’re concerned about volatility around the election, one way to stay in the market but reduce some risk is to shift some U.S. exposure to Europe and the emerging markets,” says Michael Fredericks, head of income investing for
Multi-Asset Strategies team.
Ultimately, the growth-versus-value decision depends on what the world will look like once Covid-19 is in the rearview mirror. If that means a return to a slow-growth, low-interest-rate, and low-inflation world, growth will remain the place to be. “Our view is that technology stocks and growth stocks have a lot left because longer-term economic growth is not going to be extremely strong,” says Saira Malik, Nuveen’s head of global equities.
Malik recommends focusing on megatrends continuing through or accelerated by the Covid-19 pandemic. She points to
(WORK) as a key beneficiary of remote working and companies’ drive to increase productivity, and says that Slack can continue compounding growth over the long term. Other technology-driven trends such as telemedicine could outlast any near-term cyclical bounce.
“For cyclicals and value stocks to work, you want faster economic growth, signs of inflation, and higher interest rates,” says Malik. “There has been some talk of that lately, but we don’t see it as sustainable.”
In late August, Fed Chairman Jerome Powell revealed a rare shift in central-bank policy toward average inflation targeting. The Fed will now allow inflation to rise above the central bank’s 2% target for extended periods of time. This means the Fed might no longer raise rates proactively to stave off expected inflation just because unemployment is low. That sounds like a recipe for higher inflation over the coming economic cycle.
An aging population that prioritizes saving, technological innovation that brings down prices, global supply chains, and other forces have kept a lid on inflation over the past decade, despite low interest rates. Many strategists aren’t convinced that the next decade will be much different.
“We’ve learned that inflation isn’t purely a monetary phenomenon,” says Edward Yardeni, economist and president of Yardeni Research. “We’ll have to see it to believe it. But what we can take from it is that interest rates will remain at or close to zero for the foreseeable future.”
Whether that will help the economy is one issue, Yardeni says, but low rates should keep supporting the stock market as portfolio managers and individual investors either move money out of bonds and into stocks or allocate new money to stocks rather than to bonds. That also supports continued growth-stock leadership.
Morgan Stanley’s Wilson sees long-term inflation and interest rates rising as a result of unprecedented peacetime deficit spending by the federal government. Heavy spending looks to remain the case no matter which party is in power after the November election.
“The biggest surprise of this year is a generational shift in fiscal policy: We’re getting much more than we would have in a recession that wasn’t a pandemic,” he says. “That’s going to be with us for years, which means larger fiscal deficits will become more structural in nature than investors currently expect.”
If that means interest rates rise, the long-duration assets that outperformed in the past decade will become the laggards.
The strategists that Barron’s consulted generally see the yield on the 10-year U.S. Treasury note ticking up to about 1% by year end from a current 0.67%, as the price of the security falls. By the end of 2021, strategists’ estimates range from 0.75% to 1.45%. Income-seeking investors will need to look elsewhere.
“On the fixed-income side, the starting point from a yield perspective is pretty dismal,” Fredericks says.
Better-quality parts of the high-yield market still offer attractive returns, he notes. But moving too far down the quality spectrum could be problematic, given the uncertain outlook for industries more permanently affected by the pandemic.
Fredericks notes that preferred shares issued by high-quality financial companies offer solid yields and opportunities for capital appreciation. Big banks such as
Bank of America
(BAC) have preferreds, yielding 4.5% and 4.9%, respectively. The
iShares Preferred & Income Securities
(PFF) exchange-traded fund yields 5.4%.
Fredericks expects common stocks that pay dividends to be in greater demand next year, as interest rates stay low and a steadier economy gives investors confidence that companies will be able to maintain their payouts. “We think the puck is headed toward the scarcity of income being a big driver of flows and total returns,” he says.
That could be positive for traditional dividend-yielding sectors like utilities. And dividend-yielding cyclicals could deliver the best of both worlds.
Write to Nicholas Jasinski at email@example.com