If you ushered in the new year with an adult beverage or five, join the club. Investors everywhere have been partying like it was 1999.
Over the past few weeks, they have propelled global stock benchmarks to record heights, poured fortunes into bitcoin, and swarmed the initial public offerings of money-losing businesses such as Airbnb Inc. (ABNB) and DoorDash Inc. (DASH).
They have also bet huge amounts on Tesla Inc. (TSLA), helping to drive the automaker’s share price to the outer limits of plausibility – and beyond.
Investors have achieved this giddy state of bliss despite locked-down economies and surging COVID-19 infection counts in Canada, the United States and Europe.
All of which leads to the puzzle du jour: Will investors party even harder in 2021 as vaccines turn back the coronavirus? Or will they suffer a nasty hangover, reminiscent of the dot-com crash two decades ago, when reality refused to live up to impossibly high hopes?
At first glance, the case for exuberance looks persuasive. Vaccines have the potential to restore a semblance of economic normality by the end of summer. Central banks are vowing to maintain ultralow interest rates for years to come. Household wallets are stuffed with cash after several months of enforced thrift.
These are all good reasons to be positive about stocks.
But investors shouldn’t underestimate the case for caution. Valuations, in particular, loom as a reason for worry.
Judging by long-term price-to-earnings ratios, stocks are now at their most expensive levels since the dot-com bubble of the 1990s. Meanwhile, bond prices have rocketed so absurdly high that they all but guarantee a loss of purchasing power to anyone who sticks with them.
The tug of war between a brightening economic outlook and increasingly lofty valuations is pulling experts in opposite directions.
At J.P. Morgan Securities, chief U.S. equities strategist Dubravko Lakos-Bujas declares that U.S. stocks will surge 20 per cent in 2021. He says investors will enjoy “market nirvana,” thanks to vaccines, low interest rates and political gridlock that will prevent tax increases.
Over at Bank of America, chief investment strategist Michael Hartnett leans hard the other way. He is worried about the high degree of bullishness he detects among fund managers. He is particularly concerned about the speed with which those deep-pocketed institutions are dumping cash in favour of riskier assets, such as commodities and stocks
When bullishness is this pervasive, most of the good news is already embedded in market prices, and smart investors should start edging toward the door, Mr. Hartnett says.
The key question for him and others is whether the market’s near-universal glee is just a bit too upbeat. Consider a survey of 207 large institutional investors, conducted in late November and early December by Absolute Strategy Research in London. The poll showed that “composite optimism” among those powerful investors had surged to record highs.
“This is the most bullish result we have seen” in six years of conducting the survey, wrote David Bowers and Charles Cara of Absolute Strategy.
But is it good news? The two strategists argue the high level of “groupthink” among their respondents is reason for concern.
In contrast to previous editions of their survey, in which diverse opinions were common, the vast majority of respondents are now betting on exactly the same scenario, according to Mr. Bowers and Mr. Cara.
About 81 per cent of the people they surveyed were committed to “a single, dominant, deeply embedded narrative” about a vigorous economic recovery and stock-market rebound ahead.
“The investment community is going into 2021 singing from the same hymn sheet,” they say.
The danger is that reality may not be humming the same tune. With hopes so high and stock prices so elevated, any sour notes would be jarring.
What should ordinary investors do? Sticking to a balanced, long-term investment plan still makes sense. So does looking beyond today’s happy groupthink and monitoring potential risks. Here are some threats to the bullish consensus for 2021:
The pace of recovery
Exuberance about stocks reflects optimism about the economy as a whole. Right now, most forecasters see nothing but sunshine ahead.
At Capital Economics, Stephen Brown says the recovery in Canada will surprise people with its strength. He is forecasting a robust 5-per-cent expansion in gross domestic product in 2021 and an even more impressive 5.5-per-cent jump the following year.
Other prognosticators are equally upbeat. According to Bank of America economists, global GDP will jump 5.4 per cent in 2021 (the fastest pace since 1973) while U.S. GDP expands 4.6 per cent (the best mark since 1999).
But what if recoveries turn out to be more plodding than expected? It wouldn’t require a double-dip recession to undermine today’s exuberant market consensus. Slow growth would do the job, too.
Dean Baker, senior economist at the Center for Economic and Policy Research in Washington, D.C., suggests people prepare to be underwhelmed.
He argues that massive GDP rebounds typically require areas of big-ticket consumption – home buying, home construction and car buying – to first suffer a brutal slump. The slump sets the stage for the vigorous recovery to come. In the financial crisis of 2008, for example, car and home purchases collapsed in many countries. Their depressed state allowed economies to mount a sustained comeback as companies catered to pent-up demand.
The rebound this time around will be muted because key sectors haven’t suffered as much as they did a decade ago, Mr. Baker says. Low interest rates and high cash levels encouraged big-ticket purchases during the pandemic so purchases of cars and homes held up better than expected. Since these sectors escaped devastation, they now have only limited room to recover.
To be sure, other sectors, such as restaurants, hotels and airlines, did suffer grievous damage. However, they seem ill-suited to generate supercharged growth for the economy as a whole, because they involve smaller-ticket items rather than major purchases. Many also face natural limits when it comes to making up for lost consumption.
“We will see people return to restaurants, but do we think they will be eating meals out every night?” Mr. Baker asks.
S&P 500 Index in 2020
1
2
3
4
5
3,800
3,600
3,400
3,200
3,000
2,800
2,600
2,400
2,200
Jan.
Mar.
May
July
Sept.
Nov.
1
Late February
Stocks begin to slide as fast-spreading COVID-19 triggers economic worries.
2
March 15
Following Bank of Canada rate cut, U.S. Fed slashes interest rates to zero and launches $US700-billion bond-buying program.
Late March
Stocks bottom as governments signal massive fiscal stimulus to address plunging economies and soaring joblessness.
3
Late August
Stocks reach new highs as economy rebounds, investors focus on long-term potential despite continuing pandemic and lofty valuations.
4
December 31
S&P 500 ends 2020 at 3,756.07, a record high.
5
THE GLOBE AND MAIL, SOURCE: BLOOMBERG
S&P 500 Index in 2020
1
2
3
4
5
3,800
3,600
3,400
3,200
3,000
2,800
2,600
2,400
2,200
Jan.
Mar.
May
July
Sept.
Nov.
1
Late February
Stocks begin to slide as fast-spreading COVID-19 triggers economic worries.
2
March 15
Following Bank of Canada rate cut, U.S. Fed slashes interest rates to zero and launches $US700-billion bond-buying program.
Late March
Stocks bottom as governments signal massive fiscal stimulus to address plunging economies and soaring joblessness.
3
4
Late August
Stocks reach new highs as economy rebounds, investors focus on long-term potential despite continuing pandemic and lofty valuations.
5
December 31
S&P 500 ends 2020 at 3,756.07, a record high.
THE GLOBE AND MAIL, SOURCE: BLOOMBERG
S&P 500 Index in 2020
3,800
Late February
Stocks begin to slide as fast-spreading COVID-19 triggers economic worries.
December 31
S&P 500 ends 2020 at 3,756.07, a record high.
3,600
March 15
Following Bank of Canada rate cut, U.S. Fed slashes interest rates to zero and launches $US700-billion bond-buying program.
3,400
3,200
Late August
Stocks reach new highs as economy rebounds, investors focus on long-term potential despite continuing pandemic and lofty valuations.
3,000
2,800
2,600
2,400
Late March
Stocks bottom as governments signal massive fiscal stimulus to address plunging economies and soaring joblessness.
2,200
2,000
Jan.
Mar.
May
July
Sept.
Nov.
THE GLOBE AND MAIL, SOURCE: BLOOMBERG
Rising prices
A very different risk stems from the huge amounts of cash that governments have pumped into their economies to aid struggling companies and support household spending. Broad measures of money supply, known as M2, have soared in Canada and the United States.
When economies start to reopen, households and companies might deploy that extra cash. If so, the sudden surge of demand could overwhelm the productive limits of still fragile economies and cause inflation to jump.
For now, debt markets seem unperturbed by this possibility. Long-term borrowing costs remain ultralow and investors have yet to demand much in the way of added compensation for the possibility of higher inflation down the road.
Investors’ calm is not unreasonable: For a decade, inflation has come up persistently short of official forecasts. Many traders have decided any threat from rising prices is a distant bugaboo.
But the general complacency means any sustained surge in inflation would be disruptive if it did occur.
Some observers see reason for concern. They worry, in particular, about massive bond-buying programs by central banks. These programs are helping to put a lid on interest rates as governments ramp up their borrowing to fund pandemic relief measures. But a prolonged regimen of artificially low rates could breed inflation. It could also fuel stock market euphoria that has nothing to do with the real economy. (Sound familiar?)
In a recent note, Credit Suisse analysts write they “continue to view high inflation as the main macro issue” because of easy money policies, lavish levels of government spending and changing demographics. They predict that U.S. inflation, now around 1.6 per cent, will surge above 3 per cent by the end of 2022.
A surprise return of inflation, if it occurs, would confront policy makers with hard decisions about how far and how fast they should go in raising interest rates to bring inflation under control. Higher interest rates would raise bond yields and make fixed-income investments more attractive to investors. That, in turn, would challenge today’s lofty stock valuations.
For now, the Bank of Canada and the U.S. Federal Reserve vow to be patient in raising rates. Central bankers might change their minds, however, if a persistent inflationary swell develops and they see evidence their policies are breeding reckless speculation.
Plagues and politics
If the fight against the novel coronavirus turns out to be more difficult than expected, investors’ bullish expectations will come under siege. Stock markets wobbled in late December on news that British researchers had discovered a new variant of COVID-19. Looking ahead, it is not clear how fast new vaccines will roll out, how willing people will be to get the jab, or how long lockdowns will have to persist.
Politics add another level of uncertainty. Some specific areas to watch in 2021 include the unpredictable future of Canada’s minority government, Europe’s continuing political dysfunction and simmering U.S.-China trade tensions. On a broader level, many governments are debating how to rein in the power of tech giants and how soon and how vigorously to reel back pandemic-inspired spending sprees.
The new year’s political battles will get off to a fast start when voters in Georgia go to the polls on Jan. 5 in a run-off election to select two U.S. senators. The outcome will determine whether Republicans and Democrats control the upper house of Congress, a key factor in deciding whether president-elect Joe Biden will be able to implement his agenda.
The upshot from all this seems clear: Market participants should welcome a brightening outlook for the year ahead, but they shouldn’t assume that the current party mood will continue through 2021. Wise investors may want to put some coffee on. It’s time to sober up.
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Ian McGugan