2020 is over. It was an eventful year, to say the least. And that applies to the stock market as well. After hitting new highs in February, the market lost 30% and then recovered it in record fashion.
The S&P ended 2020 positive by 15% while in the middle of a pandemic; it will be tough for 2021 to follow that up. Whether 2021 turns out to be a good or bad year for the stock market is yet to be seen. But here are five things to watch for in the stock market in 2021.
Will There Be a Pullback?
The stock market took off in the second half of 2020. If you sat around waiting for a good time to put money in, you likely missed out. With such great gains in the final eight months of 2020, many investors think a pullback is due.
A pullback is when a stock or index drops in price after a large upward movement. Many consider a pullback to be a 5% or 10% drop. Pullbacks can some times be a great opportunity for investing.
Since 1920, the S&P 500 Index has — on average — recorded a 5% pullback three times a year, a 10% correction once every 16 months, and a 20% plunge every seven years.— Fidelity Investments
Ignoring the brief recession in 2020, when the market dove downwards headfirst, you can see there was a pullback in June, September, and October. The S&P 500 pulled back 7.6% in June, 10.6% in September, and 8.1% in October. These pullbacks are healthy for the market and give it time to breathe.
P/E and Earnings
The P/E ratio of the S&P 500 is entering scary territories. It is currently at 37. The only two times in history that it has been higher were during the Dot-Com Bubble and the Great Recession in the late 2000s.
Price to earnings since 1950 — from Macrotrends
This signals that stocks are overpriced, compared to historical prices. Part of these high prices is because there is nowhere else to invest. The stock market is attractive because of the return it can provide compared to savings accounts or bond yields.
Another explanation of the high P/E ratio is two-fold. Stocks always look to the future. So their high prices are baking in expectations for the future. The earnings are currently low because of the pandemic. The P/E ratio is a simple ratio so dividing by earnings (which are low) will lead to a higher ratio, like the one we have now.
As earnings recover, the ratio may regress. But there is a concern if companies do not meet expectations. Analyst slashed earnings and revenue estimates in 2020 because of the pandemic, which allowed most companies to beat estimates. But if companies are unable to beat estimates for 2021, their stock prices may take a big hit.
Debt Levels
The government’s debt as a percentage of GDP is at 127%. With the federal deficit at $27 trillion and GDP around $21 trillion, it’s not pretty. The United States’ excessive growth of debt has hit new heights during the pandemic. The debt as a percentage of GDP was only 107% at the beginning of 2020. While this is concerning, the real focus is on corporate debt.
Corporations have been taken on debt for years. This was helped by the near-zero interest rates the Federal Reserve implemented in response to the Great Recession. The thought is that lower interest rates allow companies to take on more debt and stimulate the economy.
US corporate debt is near record highs at $10.5 trillion. Too much debt can lead to defaults, having a domino effect. Similar to the Great Recession, defaults can lead to financial problems in the whole economy.
Cyclical Movements
If you put all your money into tech stocks at the beginning of 2020 you’d be sitting pretty now. XLK, the leading Technology ETF, was up 40% last year. Energy stocks, on the other hand, didn’t do so well, as the leading energy ETF, XLE, was down 37% for 2020.
The gains and losses in these sectors can largely be attributed to the pandemic and lockdowns. As people did not need to travel, oil became less valuable, causing many of the oil companies to have terrible years. On the other hand, as people were working remotely, increased technology became an integral part of their lives.
As life “returns to normal” it is expected money will flow back to these beaten-down stocks. Airlines, cruises, and oil companies will benefit from increased travel, and technology companies like Zoom may not be as essential.
Knowing where money is flowing can help you identify the trends in the economy and make sure you don’t miss out on solid returns.
Inflation
No one likes to see their money lose value. But that is likely to happen after the government passed almost $4 trillion in stimulus money in 2020. 35% of all American dollars ever printed by the U.S. government were printed in 2020.
You don’t need to have a Ph.D. in economics to understand that the more there is of something, the less value it has. With more money in circulation, it is reasonable to expect increased inflation in 2021. The Federal Reserve targets inflation at 2% each year and will use its tools to try and achieve that. But there is the chance inflation will be higher due to the increased money supply. If that is the case, your dollar will not buy as much as it did previously.
Some investors may look to gold or Bitcoin as a way to avoid inflation. While the government can print money any day, gold and Bitcoin are believed to have a finite supply. Both of these inflation-hedge investments were up big in 2020.