What could knock this rally off its tracks?

David Joy – Chief Market Strategist, Ameriprise Financial
Weekly markets commentary — Jan. 11, 2021


It is somewhat remarkable that domestic equity prices surged to a 1.8 percent gain last week. Not even the shocking assault on the U.S. Capitol Building on Wednesday was enough to derail the powerful rally that has been underway since the election in November. Stocks have climbed 17 percent since then, having risen in seven of those ten weeks. Last week’s strength came in the wake of the Senate runoff elections in Georgia, which swung control of the Senate to the Democratic Party in a dramatic upset. While it may not always be necessarily true of individual voters, last week’s gains were clear evidence that the stock market votes with its pocketbook. 

The presumption is that the Democratic Party will be now be more likely to enact at least parts of President-elect Biden’s agenda, including more economic stimulus and spending on infrastructure. Democrats will now control the legislative agenda in the Senate. And although many bills will still require 60 votes to pass, the so-called reconciliation process allows for budgetary matters to be passed with a simple majority. Higher taxes, both corporate and on individual in certain brackets, are also part of the Biden agenda. 
But investors have chosen to focus on the potential economic impact of more spending, especially once the virus vaccine has been widely distributed and adopted. This is not just a U.S. phenomenon. There has been a torrent of monetary and fiscal stimulus worldwide in an effort to plug the economic gap created by the pandemic. The MSCI All Country World Ex-U.S. index is higher by 24 percent in the past ten weeks in dollar terms, including 3.7 percent last week.

Investors should pay attention to historically high valuations

The problem for investors is that stock prices have risen to levels that increasingly appear excessive. And while it is often said that valuation is a poor timing mechanism, it is also often a mistake to ignore evidence of excess. The S&P 500® index currently sits at record highs based on its price-to-earnings (P/E) and price-to-sales ratios. And although the trend is up, the index sits at the highest level relative to its 200-day moving average in over 15 years. On Friday it closed at a technically oversold level. Margin debt is at a record. Certain measures of sentiment are also elevated. Perhaps the starkest example of speculative excess is Bitcoin, which has more than doubled in price in just three weeks. 

The forward price to earnings ratio of the S&P 500 for calendar 2021 is currently 23X, based on the expectation that earnings will grow by roughly 22 percent this year. Not until 2022, based on expected earnings growth, does the P/E ratio decline to a more reasonable 20X. Even that level is at the high end of historical experience but can at least be justified on the basis of expectations that the Fed will still be holding the overnight rate at effectively zero and fiscal policy will be doing its part. Both of those conditions appear reasonable, based on what we know today, but current valuations also suggest that stock prices may already reflect a good deal of those expectations. 

The bull market likely hasn’t run its course, but stocks may be due for a ‘healthy correction’ 

None of this is to suggest that the current bull market has run its course. But it does make it more likely, and indeed more welcome for the longer-term investor, that stocks are due for a pull back, or what is often termed a “healthy correction.” It is difficult to know what might be the catalyst for such a pullback. 

But one thing to watch is the yield on the ten-year Treasury note. It has been said many times that part of the attraction of stocks is that, with bond yields so low there is no alternative. And low bond yields elevate the price investors are willing to pay for the future earnings stream of equities. However, last week the yield on the ten-year note surged higher by 21 basis points, rising above 1.00 percent for the first time since March and ending the week at 1.12 percent. How much further this move will run remains to be seen, but at some point, investors will take note, and equities might suddenly look very expensive. 

Sources: Factset, Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.

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A 10-year Treasury note is a debt obligation issued by the United States government that matures in 10 years. The 10-year yield is typically used as a proxy for mortgage rates, and other measures.

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