Last week was full of surprises, though by looking at the market’s performance you wouldn’t know it. Between the attack on the Capitol, the now 50-50 split in the Senate, and the first (net) loss in jobs since April, one might have expected a pullback in stocks. Yet last week, the major indices continued to move higher. And that performance is testament to the determination of investors to look forward, as they should. The question investors are now asking is: how much more appreciation can we reasonably expect? The answer is: quite a lot, if you are in the right parts of the market. But aren’t stocks overvalued after the S&P climbed 18% in 2020 and is now trading at 22.3 times 12-month forward earnings? We believe some are, but we are also finding valuations very attractive in others.
The markets ignored the uprising in Washington, apparently confident in the resiliency of our country’s democratic institutions. It helped that the attack was relatively quickly quelled and Congress returned to the Floor to conclude the formal acceptance of the votes of the Electoral College, naming Joe Biden as President-Elect. During the fray, though, it was also revealed that both Georgia Senate seats had gone to the Democrats, pushing the Senate to a 50-50 split and giving VP-Elect Harris the tiebreaking vote (should one be needed). Investors appear to recognize that such a split will likely increase stimulus and infrastructure spending, while allowing for only modest increases in taxes and regulation.
Friday’s jobs report, however, revealed the adverse impact of COVID’s resurgence on economic activity and this was narrowly focused in the leisure and hospitality sector, where net jobs fell by nearly 500,000 in December. The data also showed that activity in other sectors actually picked up last month, led by retail trade, construction, and manufacturing. So, while net jobs fell by 140,000—much worse than the expected gain of 50,000—there were positive signs of the increased activity in those December trends. And investors recognize that the drop in leisure and hospitality is temporary, even if “temporary” is longer than initially expected and painful for those trying to work in those sectors. The new stimulus package should help cushion the blow for those households and preserve spending power. And remember that savings rates remain abnormally high since households are essentially being forced to save by the virus. This points to a stronger rebound in economic activity when the virus is eventually contained. And it is that future on which investors are focused. The arrival of highly efficacious vaccines last quarter enabled people to envision a return to normality. That vision has been driving stock prices over the last several months and will likely continue to do so even as the economy stumbles through winter.
Yet stocks appear expensive at a price (for the S&P 500) of 22.3 times 2021 expected earnings. Is this really a good time to put more money to work? Shouldn’t investors perhaps consider shifting to bonds or even cash? Looking a little more closely at those valuations tells us that equities remain the place to be and bonds remain less attractive than in the past with lower yields and the risk of price declines. Not all stocks are expensive and the S&P 500 is heavily skewed by just a handful of companies.
Sources: Factset, Bloomberg, and Advisors Capital Management. SPY, the S&P 500 ETF, is used as a proxy for the price appreciation of the S&P 500 Index.
The S&P 500 Index is heavily weighted towards just six stocks and those six have gained the most from the change in behavior induced by the pandemic. This group, the so-called MFAANG stocks, Microsoft, Facebook, Apple, Amazon, Netflix, and Google (Alphabet), collectively rose 61% in 2020, while the rest of the market rose just over 2%. Moreover, they are far more expensive, relative to earnings, than the rest of the market (and even more so if Tesla were included on this short list). When we exclude those six and assess the forward price-to-earnings ratios of the stocks for the remaining 494 companies in the S&P 500, we find those companies are trading at only 17 times this year’s earnings, while MFAANG as a group is trading at 41 times. And if we look at areas of the market most primed to benefit from the reopening coming later this year, we find appealing consumer, financial, energy, and industrial company stocks trading well below that adjusted market average. And in the growth segment, where appreciation even outside of MFAANG stocks has been substantial, we are still finding value and appreciation potential. Bargains remain.
So be prepared for elevated volatility as COVID disrupts our lives and businesses, and don’t let it dissuade you from your investment objectives. By investing in individual stocks, rather than ETFs or mutual funds, investors can avoid owning those overvalued stocks and find both attractive valuations and the potential for further appreciation.