A year ago, in my outlook for 2020, I suggested that "the path was paved to 5,000 on the S&P 500." A few months later, that idea was looking particularly far-fetched. However, after a brutal first quarter of 2020 and an economic contraction of astounding suddenness and magnitude, we've seen a remarkable rebound. Is the path still paved to that 5,000 milestone? I believe it is, and it may come sooner than I projected a year ago. In early 2020, equity markets hit a pothole — a giant economic pothole that caused hardship in so many ways. However, for many stocks it was also a springboard. On December 8, the S&P 500 Index closed above 3,700 for the first time in its history — one of its many record closes in 2020. For a number of reasons, I believe the S&P 500 is likely to eclipse 5,000 before the end of 2023.
A historic November
Two significant events occurred in November 2020. First, in the midst of a pandemic, we concluded an extremely divisive U.S. presidential election. Second, we received news that multiple COVID-19 vaccine trials were showing impressive efficacy results. These events are complex and important on many levels. But perhaps most significant for financial markets is that they have removed uncertainty, which is often one of the biggest headwinds to equity performance, in my view.
Although Democrats technically control both the House and Senate, I expect the chance of sweeping legislation is low. While we may see some corporate and personal tax increases, the magnitude is likely to be modest. And given the challenging economic conditions we currently face, this is unlikely to be the first order of business for the new administration and Congress. Instead, I expect more targeted stimulus packages that focus on those hobbled by the pandemic as well as infrastructure-related investments.
I believe the vaccine news, however, brings a much stronger gravitational pull to the market. With an end to the pandemic in sight, investors are likely anticipating a sustained and robust economic recovery over the next few years. This potentially benefits cyclically sensitive stocks in sectors such as industrials, financials, and consumer discretionary. Moreover, what's not widely contemplated is that buoyant economic conditions should also propel sales growth for many companies in the technology and communications sectors. Accelerating revenue growth often underpins higher stock prices. This backdrop — reduced political uncertainty combined with a post-pandemic recovery — could be a springboard that has the potential to perhaps unlock animal spirits and drive equities even higher, in my view. And this time, it may benefit the majority equities, not just growth-oriented ones.
The vaccine news brings a much stronger gravitational pull to the market.
Limitations may extend the rebound
I believe there will be limits to how fast the economy can rebound in 2021 and into 2022, which could mean we'll see a prolonged recovery. This is also positive, in my opinion. For example, we are already seeing capacity constraints in shipping, trucking, and rails as freight volumes increase. In addition, after nine months of stalled capital expenditures, corporate boards may begin to allocate capital more ambitiously.
We are also likely to see increased merger-and-acquisition activity as companies that were hesitant to make large strategic moves in the midst of the pandemic will now revisit them. This includes private equity firms, which have upwards of $5 trillion to invest on the heels of record capital raises. Increased M&A activity can have a two-pronged effect: It lifts valuations across broad segments of the market and results in quicker valuation rebounds when stocks pull back as they're viewed as "targets."
Stockpiles of cash and low-yielding bonds
Also supporting our bullish outlook is the record amount that is invested in cash proxies — a trend that was exacerbated by the COVID-19 pandemic. Market participants who are now holding super-low-yielding fixed-income investments may be looking to move those assets to equities as the economic outlook brightens. Investors have come to recognize that the bulk of the S&P 500 is made up of high-quality growing companies, which has made them resilient in times of economic turbulence, with 2020 being a textbook example, in our view.
While absolute equity valuations may be on the high side relative to history, in our view, stocks remain extremely cheap when compared with bonds. This was the case a year ago, and it became more pronounced in 2020, due to the sharp decline in 10-year Treasury yields. The S&P 500 dividend yield is 1.52%, well above that of long duration government bonds. And the spread between the S&P 500 earnings yield and the 10-year Treasury remains near all-time wide levels. Over time, this spread has been near zero as the growth in S&P 500 dividends offsets the volatility inherent in equities, whereas bond coupons are static and bond prices are less volatile. In fact, over the past 20 years, 10-year U.S. corporate bond returns have outpaced those of the S&P 500 Index.
We believe that international and emerging-market equities also look attractive versus fixed-income investments. Globally, we're seeing $17 trillion in debt with negative yields as well as historically low yields on sovereign bonds in many developed and emerging markets. We believe that these extraordinarily low rates, now combined with a weakening U.S. dollar versus other currencies, are bullish for non-U.S. equities.
Extraordinarily low interest rates, now combined with a weakening U.S. dollar, are bullish for non-U.S. equities.
Capitalize on the volatility
The months ahead will also bring volatility to equity markets. As the economy rebounds, it could put upward pressure on prices, leading to possible inflation. Already, commodity prices are universally higher, and in many cases, sharply so. Also, in 2021, we expect central banks are likely to move away from their hyper-accommodative monetary policies, and there will be very high government deficits that need to be financed. The key risk is that a sharp rebound in economic activity from COVID-19-depressed levels lifts interest rates from the ultra-low levels we've seen in 2020. However, I would argue that even if the yield on the 10-year Treasury doubles from current levels, stocks would continue to look attractive versus bonds. Rising rates will likely cause volatility in the equity market, but we view this as a buying opportunity as we don't think higher inflation will be sustained.