The 2020 gains in the popular indices are remarkable, yet surprisingly disparate. The Dow Jones Industrial Average is up 5.8% year-to-date. The S&P 500 has done somewhat better with a 14.4% gain. A sharp end of the year advance in small capitalization stocks drove the Russell 2000 to a year-to-date gain of 17.5%; however, it is the technology-laden Nasdaq Composite that is this year’s hard-to-beat champion with a 40.4% year-to-date gain. The Nasdaq’s performance has been extraordinary in 2020 and we would note that some bull market cycles do not experience a 40%+ gain and over the last 90 years the average gain in the S&P 500, prior to a 10% correction, has been 58%. Perhaps more significant is the fact that this 40.4% gain is nearly seven times the advance in the Dow Jones Industrial Average for the same time period. Since the March 2020 lows, the Dow Jones Industrial Average and S&P 500 have rebounded 62% and 65%, respectively. After recording fresh new highs this week, the Nasdaq Composite and the Russell 2000 have rallied 84% and 95.5%, respectively off those lows. It has been a spectacular year for investors, particularly since it also included the worst recession since the Great Depression and a bear market in earnings.

Investors have written off 2020 earnings and instead focused on the projected rebound in 2021 earnings. But even so, the stock market is not cheap. It is pretty clear that third quarter earnings estimates were better than expected but with third quarter earnings season practically complete, estimates are now stabilizing. In the week ended Friday, IBES consensus estimates rose $0.12 for 2020, $0.33 for 2021 and $0.43 for 2022. S&P Dow Jones consensus estimates were relatively unchanged and increased $0.05 for 2020 and $0.01 for 2021. Overall, the consensus estimates for 2021 are currently $169.18 for IBES and $166.20 for S&P Dow Jones. If one applies a 20 multiple to the IBES $169.18 forecast, it equates to an SPX target of 3384 for yearend 2021. The stock market is currently 8.5% above this target. While it is possible that earnings could outperform 2021 estimates, it seems the market has already factored positive earnings surprises in to current prices. More specifically, at SPX 3695, the 2021 year-end forecasted PE ratio for the S&P 500 is 22.2 X. The trailing operating PE ratio is 30.6 X which is higher than the June 1999 peak multiple of 29.3 X and the December 2001 peak multiple of 29.6 X.

Liquidity Wins
While we are worried about rich fundamentals, it is clear that the stock market is being driven by liquidity and as we have often noted it is not wise to “fight the Fed.” However, the market is priced for perfection, could be vulnerable to unexpected shocks and caution is warranted. As noted in previous weeks, some of our long-term indicators suggest that the market is apt to underperform over the next twelve-month period. However, this “underperformance” does not mean 2021 is destined to be a boring market. The new year could be an unusually volatile time including at least one big advance and a large decline. If so, investors should stay alert. It is wise to have stocks in one’s portfolio that can weather the volatility ahead and/or are good long-term holdings for good and bad times.

Assessing Debt and Ownership
Given our concerns about a liquidity driven market we are focused on factors that help define an equity bubble such as leverage, debt, and equity over-ownership. The Federal Reserve released financial data last week for the third quarter and it held few surprises.

Federal Debt Levels are Worrisome
Total outstanding US debt was a record $59 trillion in September, up from $53.9 trillion at the end of 2019. US debt represented 280% of nominal GDP in the third quarter, is up from 248% at the end of 2019 and is greater than the previous record of 273% of GDP recorded in 1933. See page 3.

Federal government debt grew at an annualized rate of 11.4% in the first quarter, 59% in the second quarter and 9.1% in the third quarter. It was a record $22.5 trillion in September and jumped from 87% of GDP in June to 106.3% in September. This compares to the record 110.3% of GDP recorded in 1944. Rising government debt is not a surprise given the fiscal stimulus provided during the shutdown; however, they are concerning when put into an historical perspective. See page 4.

Household debt is the second largest sector after the federal government, and it grew 5.6% in the third quarter due to an escalation in mortgages. The household’s total debt was nearly $16.2 trillion in September and represented 76.5% of GDP. However, this percentage is well below the 98.2% of GDP seen at the end of 2008 prior to the financial crisis in mortgages. In general, household debt has been fairly contained in 2020. The financial sector is also in good shape and its $17.3 trillion in debt represents 81.9% of GDP and is well below the 2008 peak of 123.7%. A healthy banking system is important for the overall economy and so is a financially stable household sector. Corporate debt actually declined in the third quarter after double digit growth in the first two quarters of the year. See pages 5 and 6. All in all, there were few surprises in this year’s debt accumulation, most of which has been due to fiscal spending. Our main concern for federal deficits would be sharply higher interest rates which would compound federal deficits going forward.

Stock Ownership Helps Net Worth but Needs Monitoring
The Federal Reserve also released household net worth and equity ownership data last week. After increasing a solid 12% in 2019, household net worth increased 4.4% in the first three quarters of 2020 to $123.5 trillion. In 2019, the increase in household net worth was due primarily to a 27.5% increase in equity holdings. In 2020 the increases in household net worth were a combination of a 16.6% increase in cash, due in large part to fiscal stimulus, and a 5.5% increase in tangible assets, primarily real estate. Equity holdings only increased 3.3% in the nine months ended September. This may be surprising to some, but remember, in the first nine months of the year the SPX gained 4.1% and the DJIA lost 2.7%. In short, it was a dull first three quarters. But we expect stock market gains will boost household net worth in the fourth quarter.

We are closely watching the relationship between equity and real estate ownership within the household sector. It is normal for residential real estate, or a home, to be a family’s main asset and thus represent the main pillar of net worth. But in the third quarter, the household sector showed equity holdings of $35.6 trillion, an amount that easily exceeded real estate holdings of $31.2 trillion. Since 1952, there have only been four other quarters in which equity ownership was greater than real estate ownership. These were the fourth quarter of 2019, the third quarter of 2018, the first quarter of 2000 and the fourth quarter of 1999. Each of these previous quarters were followed by sharp stock market corrections. More important, the two back-to-back quarters of high equity ownership in late 1999 and early 2000 represented the end of the 1997-2000 stock market bubble. See page 8. This is a worrisome precedent. We are also watching for extreme levels of equity ownership relative to total assets which could represent a saturation of demand. This can be measured as equities as a percentage of total assets and/or as a percentage of financial assets. In the third quarter, equities were 25.4% of total assets versus the 2000 peak of 26.4%. Equities were 22.6% of financial assets versus the March 2000 peak of 24.2%. Given the rally seen in equities in recent months, these percentages are apt to increase in the fourth quarter. In short, it is possible that equities are approaching an over-ownership situation. See page 9. In sum, the current advance has excellent momentum, but be alert to any and all pitfalls.

Click to download

We focus on three issues this week. The first is that technical indicators have finally and whole-heartedly confirmed the current advance. The second is that even though third quarter earnings estimates are beating expectations, it has little relevance to a market that has been focused on 2021 forecasts since March. Based on 2021 earnings estimates, equities are priced for perfection and this is certainly a cause for concern. And third, recent data releases are defining a pattern of economic deceleration. This is also worrisome. This combination of deteriorating economics/fundamentals and strengthening price action can only be explained by the fact that liquidity is driving the equity market.

Several indicators that we monitor suggest the market is likely to underperform over the next twelve to eighteen months. But bear in mind that this does not mean 2021 is destined to be a boring market. It is more likely that 2021 could contain several bull and bear market cycles that result in little gain in the end. Investors should prepare for an unusual environment and adjust portfolios so that they can weather extreme volatility.

Economic data for November was generally disappointing. The unemployment rate declined in November to 6.7% from 6.9%, but this was due in large part to the decline in the civilian labor force. The addition of 245,000 new jobs was less than expectations and perhaps the biggest letdown was the decline in the employment population ratio from 57.4 to 57.3. The participation rate also fell from 61.7 to 61.5. In short, the percentage of the population that is employed and working is declining. See page 3.

Jobs are key to the economy. They are the most critical component of household income, personal consumption, corporate revenues, and earnings. Therefore, the steady shift of workers from temporary layoff to being permanently unemployed is disturbing. See page 4. In our opinion, the absence of CDC guidelines that would allow businesses to safely open coupled with the lack of urgency seen in Congress to pass fiscal stimulus that would support small businesses is unconscionable.

In our view, the best way to assess the job market is to monitor the growth rate of “employment” over a 12-month period. A decelerating rate that approaches zero will predict a pending recession and a recession begins when this growth rate turns negative. But a pivot in the growth rate often defines a recovery. From this perspective, the job market was arbitrarily shut down so there was little warning for this unusual recession. However, the employment low was made in April with a negative 13.5% growth rate and has been improving ever since. But November’s growth rate was still poor at negative 6%. Meanwhile, the pace of those unemployed 27 weeks or longer continues to rise and currently resembles the pattern seen in early 2009! See page 5. These statistics suggest household consumption is apt to decline in the first quarter. If so, earnings could also disappoint.

The ISM indices are good benchmarks for assessing the strength of both the manufacturing and service sectors of the US economy. However, both ISM indices declined in November and both surveys pointed to weakness in new orders and general business activity. See page 6. The NFIB Small Business Optimism Index fell from 104.0 in October to 101.4 in November which was worse than expectations. The most revealing part of the survey was that the net share of respondents expecting the economy to improve dropped from 27% to 8%. This was a perfect example of how the current number of COVID-19 cases and the accompanying restrictions are hurting small businesses and dampening sentiment.

Autos and housing have been the core of the 2020 rebound, yet both weakened in November. Total vehicle unit sales fell from 16.74 million to 15.97 million units in November and all segments of the industry showed a decline. For the second month in a row the pending home sales index fell. October’s index fell to 128.9, down from the August peak of 132.9. See page 7.

Under normal circumstances, third quarter earnings results for the S&P 500 would make us bullish, but these are far from normal times. As of December 4, 496 companies in the S&P 500 Index had reported third quarter 2020 earnings. And of these, 84.5% reported earnings that were above analysts’ expectations and 12.3% reported earnings below expectations. In a typical quarter, 65% of companies beat and 20% miss estimates. Even more impressively, companies have reported earnings that are 19.7% above estimates. This is dramatically better than the 26-year average surprise factor of 3.5% and the last four quarter average of 8.7%. In addition, more than 78% of reporting companies exceeded revenue expectations and beat forecasts by 3.6%. This compares to the long-term average surprise factor of 1.5%. Not surprisingly, the estimated earnings growth rate for the S&P 500 in the third quarter is now negative 6.1% and much improved from the July 1 consensus forecast of a 25% decline. If the energy sector is excluded, the third quarter growth rate improves to negative 1.9%. Earnings growth forecasts improved for all sectors in the third quarter, but the greatest improvement was in consumer discretionary which flipped from an expectation of a 50% decline in year-over-year earnings growth to positive 0.8% currently. However, despite all this good news for the quarter, IBES consensus estimates for 2021 are relatively unchanged at $168.85. A PE multiple of 20 times next year’s earnings equates to an SPX target of 3377, or 9% below recent closing prices. See page 10.

At SPX 3702, the trailing operating PE is 30.6 X and remains higher than the June 1999 (29.3 X) and December 2001 (29.6 X) peaks. The 12-month forward PE ratio for the SPX is 22.3 X. Both benchmarks are well above their standard deviation lines and the SPX is now trading more than 13% above the top of our valuation model’s year end 2021 fair value range. See page 11. High valuation suggests the market is vulnerable to unexpected shocks and this suggests caution is warranted.

But in direct contrast to this the popular indices continue to set a series of record highs and our technical indicators are finally confirming the advance. In particular, the 25-day up/down volume oscillator is currently 5.02 (preliminary), above 3.0 and has been in overbought territory for six consecutive trading days and for nine of the last eleven trading days. The oscillator reached a reading of 5.52 late last week which was the strongest reading since February 2019. It is our contention that new price highs in the indices should be accompanied by long and often extreme overbought readings which represent solid buying pressure. After a lengthy delay, this oscillator has finally confirmed the new highs. See page 13. And most other breadth indicators followed suit. The 10-day average daily new high indicator is robust at 380 per day and the NYSE cumulative advance decline line made a simultaneous record on December 8 with the indices. See page 14. The AAII bullish sentiment index rose to 49.1% and the last 4 weekly readings are the highest since January 2020. But while the AAII bull/bear 8-week spread is quickly rising it still remains in neutral territory. See page 15.

There is one simple way to explain the discrepancy between the underlying fundamental and technical factors of the market and it is liquidity. Historically, there has been a strong correlation between easy monetary policy and stock market gains. M2 growth peaked at 19.6% in July but in late November it was still growing at a 6.6% pace. Demand deposits at commercial banks jumped in late November from $2.5 billion to $2.97 billion. In sum, remember the wise Wall Street adage “Don’t fight the Fed.”

Click to download

With a little more than two months left to the year, few would deny that 2020 has been an unusual year. The turning point was the historic, unpredictable, and relentless spread of the COVID-19 virus from China to most other countries around the world. It is not the virus, but its aftermath that will have major repercussions for people, companies, and economic trends for years to come. Yet in the face of this challenge, the S&P 500 and Nasdaq Composite Index reached new highs in September and the DJIA, SPX and Nasdaq Composite are currently 4.2%, 3.9% and 4.5%, respectively, from all-time highs.

Some believe the rally in equities reflects a disconnect between the stock market and reality. But as usual, investors face a mix of positive and negative factors. Today is no different, even when putting the political backdrop aside.

The current negatives are obvious. The spread of COVID-19 resulted in mandatory shutdowns of businesses around the world. In the US, some businesses learned to adapt, and this created a division between winners and losers. But the bottom line is that the shutdown put 22.2 million people out of work between February and April, and 10.7 million of those remained unemployed at the end of September. Another negative is a resurgence of the virus in Europe which is generating a new round of restrictions such as curfews and limits on gatherings. This resurgence places a European recovery in the second half of the year on hold. Together, these two events create a third negative which is an enormous pressure on corporate earnings and an increasing risk of small business bankruptcies. As a result, the S&P 500 index is close to peak valuations on a trailing earnings basis and even when based upon forecasted 2021 earnings valuation remains at nosebleed levels. Added to these problems is the fact that the government is challenging the power and influence of the biggest technology companies with concerted anti-trust action. This week the Justice Department sued Google (GOOG.O – $1555.93) for illegally using its market strength to fend off rivals with distribution agreements that gave its search engine prominent placement on phones and internet browsers. Anti-trust action may prove beneficial to consumers in the long run, but in the shorter run it could pressure the big cap technology stocks that represent a large percentage of the SPX’s market capitalization. In short, it could hurt market performance.

The artificial shutdown of most economies was quickly followed by a series of policy measures to keep economies afloat. In short, the positives must begin with the extraordinary stimulative fiscal and monetary policies put into place around the world. As we have noted in the past, the combination of fiscal and monetary ease announced by the US totaled $5.5 trillion ($2.55 trillion in three fiscal packages and a $2.99 trillion expansion in the Fed’s balance sheet). This $5.5 trillion represents 28% of nominal GDP ($19.53 trillion at the end of the second quarter), or 3.4 months of economic activity. This stimulus went directly to consumers and businesses and it provided a safety net for the broader economy. In addition, another fiscal stimulus package is on the horizon, it is simply a matter of time and politics.

Yet, the biggest positive for investors is how well the economy is doing, particularly the tremendous strength in housing and autos. As of September, the NAHB single-family housing environment survey has recorded three consecutive months of record readings. Homeownership rates are surging in all regions of the US and reached 67.9% in the third quarter. This represents the highest homeownership rate since the 69.2% seen in 2004. See page 3. Residential building permits recorded a 10-year high in September and existing home prices have been moving steadily upward all year. See page 4. September’s retail sales rose 5.2% YOY overall and 3.9% YOY excluding motor vehicles and parts. Autos have been the brightest part of retail sales rising 10.5% YOY in September. Plus, September’s retail sales data included many bright spots in the economy with the exception of clothing, electronics and food and beverage establishments. The best part of all these statistics is that it all bodes well for third quarter GDP. See page 5.

Benign inflation is another positive for the equity market since low inflation is favorable for monetary policy, PE multiples and consumers. In September, the CPI rose 1.4% YOY, PPI finished goods fell 1.2% YOY, final demand PPI rose 0.5% YOY, crude oil fell 26% YOY and the PCE deflator gained 1.4% YOY. The decline in energy prices and positive spread between CPI prices and PPI prices is a favorable one for corporate margins. See page 6.

And despite negative US headlines, there is good news regarding virus trends. On October 20th, The NEW YORK TIMES ran a story including charts that showed “new COVID cases” are trending higher in October, but due to the substantial increase in the number of tests taken and diagnosed since early September. Most importantly, US deaths per day have held steady since early September at around 700. See page 7. In general, this implies the spread of the virus and its deadliness is slowly fading. Moreover, therapies for the virus have advanced dramatically in the last six months and a vaccine is expected early in 2021. Overall, we believe all this good news outweighs the bad.

We have noticed that both consensus earnings estimates for 2020 have had unusually large increases in recent weeks. See page 10. IBES indicated that of the 66 companies that reported third quarter earnings to date, 86% beat expectations. Therefore, 2020 consensus forecasts are apt to move even higher. However, stock prices have ignored 2020 and for the last six months have been trading on 2021 earnings. Unfortunately, the 2021 outlook remains uncertain and this brings us to the biggest unknown of 2020 — the election.

With less than two weeks to go and with early voting taking place at a record pace, election results remain highly uncertain. The polls give former Vice President Biden a sizeable lead, but the race continues to narrow. Statista reports that 55% of Americans feel they are better off than they were four years ago and most Americans, particularly Democratic voters, feel this election matters more than previous years. This is an interesting, but inconclusive mix. See page 8. In terms of the election, the market’s 3-month performance is showing a gain in the SPX of 5.3% and a gain in the DJIA of 7.1% to date. In past election years gains have foretold of an incumbent victory. On the other hand, one cannot be sure that 2020 is a “typical” year. See page 9.

Last but far from least, the charts of the broad indices and technical indicators have turned increasingly bullish in the last two weeks. All the popular indices rallied from important support levels that equated to their 100-day or 200-day moving averages and in particular, the Russell 2000 index began to outperform large cap indices. The advance/decline line reached a record high on October 12 and the new high list continues to expand. Our 25-day up/down volume oscillator is yet to reach a fully overbought reading, but it did record its highest reading earlier this week since August 2020. These are all supporting the bullish case.

We continue to have a long-term bullish bias but would expect the market to be choppy and trendless prior to the election. If there is no clear winner on election night, the uncertainty is likely to create even more volatility. This implies investors should be somewhat cautious near term and focus on companies that will perform well despite the virus and despite an uncertain political backdrop.

Click to download

A new week brought new worries for the stock market. Moods were already downcast after the passing of Supreme Court icon Ruth Bader Ginsberg. Throughout her illustrious career Judge Ginsburg was a leader, a role model for working women and a staunch fighter for women’s rights. On Tuesday Prime Minister Boris Johnson told the British people to work from home if possible and ordered restaurants and bars to close early to counter a second wave of COVID-19. Johnson stopped short of imposing another full lockdown, as in March, but warned that more measures might be imposed if the virus were not contained. Newswire headlines announced US deaths from coronavirus surpassed 200,000 but failed to mention that the trend in new cases and deaths has decelerated dramatically. President Trump spoke (on video) to the 75th annual UN General Assembly and fueled fears of a geopolitical tiff by chiding China for unleashing COVID-19 on the world and stating that China needs to be held accountable for the destruction the plague has wrought by all members of the UN. The US Food and Drug Administration is expected to announce higher standards for an emergency authorization of any coronavirus vaccine, lowering the chances that a vaccine might be cleared before the November 3 election. And last but far from least, the first presidential debate scheduled for September 29th at 8:30 pm EST is merely one week away. This debate could become a pivotal factor for the stock market.

We believe last Friday’s Wall Street Journal’s article comparing Joe Biden’s and President Trump’s tax proposals may have been a contributing factor to the stock market’s recent decline. With Biden leading in the polls it is important for all investors to assess the impact a Democratic victory could have on the US economy. There are many factors to look at, but this week we will simplify it to tax policy.

President Donald J. Trump’s Tax Plan
President Trump’s tax policies are well known. He enacted tax breaks for individuals and corporations in 2017 and wants to extend these tax breaks past their current 2025 end date. Trump made it easier for corporations to bring home foreign profits and to deduct capital investment costs. Trump is currently proposing to cut the capital gain tax rate from the current 23.8% to 15% or 18.8%. And he wants to expand Opportunity Zones which offer capital gains tax breaks for investments in low income areas.

Vice President Joseph Biden’s Tax Plan
The Wall Street Journal article noted that Vice President Biden’s spending plans exceed his proposed tax revenue, but Biden explains this as stimulus for the economy. The Biden plan would raise taxes on individuals and entrepreneurs making more than $400,000 a year and would raise the corporate tax rate to 28%, impose a new minimum tax on companies and raise taxes on the foreign income of US based multinationals. His plan also includes reinstating the individual mandate to purchase health insurance, which is the proposal included in Obama care that the Supreme Court ruled was a tax on citizens. Mr. Biden proposes to raise the top individual tax rate of 37% to 39.6%, expand the 12.4% Social Security payroll tax which currently exempts wages above $137,700, but would restart the tax again on wages above $400,000. The plan also repeals a 20% deduction for income from pass-through businesses and impose new limits on itemized deductions. Most importantly, Biden would raise the capital gains tax rate from 23.8% to 39.6%, but reportedly only on households with income greater than $1 million. Nevertheless, this is likely to weaken the stock market prior to the election since many investors are apt to take profits on long-held stocks to avoid the possibility of this tax hike in 2021.

Millennials should take heed of structural changes to capital gains rules that Biden is proposing that could significantly impact their inheritances. At present, heirs only pay income taxes on gains in equity value that materializes after the original owner’s death and only when they sell the stock. Biden’s proposal would tax all unrealized gains as capital gains at the time of death. This is unsettling. Unless an heir has considerable liquidity at the time of inheritance this structural change would require an heir to sell much of the portfolio in order to pay taxes, incurring more capital gains taxes and potentially losing a significant amount of the inheritance. The very wealthy may have lawyers and accountants that can find a way around this tax, but Middle America will bear the brunt of this change.

All in all, we find the Biden proposals to be dicey for equities. Raising the capital gains tax rate has historically lowered stock prices in the short run as investors rush to avoid the tax hike and it lowers demand for equities over the longer-term since it raises the bar for speculators. All in all, a Republican sweep suggests more tax cuts while a Democratic sweep would bring increases.

Keep Some Powder Dry
Nonetheless, economic data has been strong. Housing data shows existing home sales rose to 6.0 million units in August, a 10.5% YOY increase. The median existing single-family home price rose 12% from a year earlier, while the average existing single-family home price gained 9% from a year ago. See page 3. August’s new home sales will be reported soon, but July’s data showed a 36.3% gain in units sold from a year earlier with median and average prices rising in the high single digits. See page 4. Homeownership also jumped from 65.3% in March to 67.9% in June, with the largest regional gain seen in the South where ownership rose from 67.6% to 71.1%. Black homeownership rose 3% to 47% and Hispanic ownership rose 2.5% to a record 51.4% in the second quarter of the year. See page 5. As a result, homebuilder confidence reached record heights in August. See page 6. In August, retail sales also reached a record level on a seasonally adjusted annualized basis and this tends to be a good forecaster of overall GDP. See page 7.

However, fundamental valuations remain stretched even as the Refinitiv/IBES consensus earnings estimate for the S&P 500 index continues to rise. This week’s estimate of $166.62 combined with a 20 PE multiple suggests a fair value level of SPX 3332, but as we show on pages 8-10 this still puts the equity market at the high end of fair value. It is possible that earnings estimates will continue to surprise on the upside, but the political climate is too uncertain to know. It is equally possible that higher corporate taxes would make current forecasts too high for 2021. In short, we remain cautious in the near term.

Technically, we see several important support levels that are worth monitoring. In the Dow Jones Industrial Average and in the Russell 2000 the 100-day and 200-day moving averages are converging. This makes the DJ 26,290 and the RUT 1457 levels crucial to the longer-term outlook. By holding at or near these levels the chart patterns improve. But breaks below these levels are highly likely to generate more selling. Breadth data is also showing some strain. The 10-day average of daily new lows fell to 76 this week and is below the 100 benchmark that characterizes a bull market cycle. The 25-day up/down volume oscillator is at minus 1.29 this week and at its lowest point since April 8, 2020. Corrections within a longer bull market cycle rarely reach a fully oversold reading on minus 3.0 or less; rather, corrections tend to reverse as this level nears. Overall, the risks in the market may only be political, but they are taking a toll on stock prices. We await the presidential debate next week. 

Click to download