December 18, 2020
Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio & Technical Strategy.
Equity markets continue their advance to begin the new year, as investor focus remains on the potential for vaccines to allow a reopening as 2021 progresses along with higher odds of increased stimulus as a result of the Democratic sweep. The outcome is a net positive for potential economic growth this year, and consequently enhances the reflation trade already underway. The small caps are likely to extend their momentum, as increased fiscal stimulus and infrastructure spending benefit these US-centric companies. It also likely extends rotation within the S&P 500, as interest rates and the yield curve break out to new recovery highs. The most economically- sensitive areas were the largest gainers on the Georgia Senate runoff results. These areas- small caps, energy, financials, equal-weight consumer discretionary, materials, and industrials- are now up over 35%, 42%, 28%, 22%, 21%, and 18% respectively since the end of October.
Technical momentum remains strong in these areas, a trend that we believe can continue. However, performance has gotten stretched and markets do not often move in straight lines. We, therefore, believe it is important to maintain a healthy allocation to the areas operating best through the pandemic while also continuing to accumulate areas with the greatest leverage to the economic recovery- resulting in a balanced, but pro-cyclical approach to portfolio positioning.
Valuation remains lofty at 27.5x P/E, as investors discount low interest rates and the economic recovery. We are encouraged by the increased chances of higher fiscal stimulus, along with an accommodative Fed, to support economic growth in the year ahead; but the rise in interest rates needs to be monitored. Higher bond yields (albeit still at low levels) have some short term momentum, but we do not believe they will go significantly higher with central banks desiring low rates and US rates substantially higher than global peers. Also, the relationship between potential higher spending and higher taxes will be an important variable to valuation in the year ahead. We maintain our base case P/E multiple assumption of 23x (-16% compression) as we balance all of these factors.
As valuation multiples begin to normalize in 2021, earnings growth will be the necessary driver of market returns in our view. We have an above consensus view on earnings growth this year and use a S&P 500 EPS estimate of $175 (29% EPS growth)- resulting in a base case 2021 S&P 500 target of 4025. But while we are positive on equities over the next 12 months, we would not be surprised for the road to be bumpy along the way with key questions surrounding the ongoing virus surge, vaccine capacity and distribution, timing and size of stimulus, potential tax changes, and pace of the economic recovery.
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