A year after the Covid pandemic forced the nation into a shutdown, the stock market has been overhauled in ways Wall Street never imagined.
Last March, stocks plunged as the world faced the frightening spread of a virus many had thought would never make its way to the United States. The S&P 500 lost more than 15% in a searing decline on March 11 and 12. The index plummeted more than 30% by March 23.
Perhaps even more surprising than the fall was the market rebound that followed, powered by the twin booster engines of monetary and fiscal policy, including a rollout of programs from the Federal Reserve. The S&P 500 is up nearly 80% from the low that March and just hit a fresh record on Thursday.
“The policy response was meaningful and significant, and as a result prevented what could have been a far worse outcome,” said Tobias Levkovich, chief U.S. equity strategist at Citi.
The virus was a great equalizer. Much of the country was learning to work and attend school from home. Meanwhile, restaurants, gyms and other places where people gathered were closed or changed dramatically.
But America adapted, and so did investors.
They ran up tech stocks that benefited from a homebound populace, including Netflix, Zoom, Amazon and Peloton.
When the economy began to reopen, money moved into recovery-themed stocks, including energy, industrials, materials and financials. These sectors now lead the market, displacing high-flying tech shares.
After years of a steadily growing economy, the pandemic resulted in a shocking decline in gross domestic product. A sharp rebound followed, aided by easy monetary policy and blasts of fiscal spending.
The $1.9 trillion stimulus package, signed into law by President Joe Biden on Thursday, will be rolling out amid an uneven recovery. The service sector had never before led the economy into recession; it is the last to come back. About 10 million people are still unemployed.
“Economic volatility is here to stay … and that is different than the last 30 years,” said Julian Emanuel, head of equities and derivatives strategy at BTIG.
“There’s no escaping that when you think about the combination of [GDP] being down 31% for one quarter and up 33% in the next quarter,” he said.
“Applying record stimulus, the equivalent of about 36.2% of GDP in the subsequent year … it’s just going to be an environment where the quarter-to-quarter swings are going to be much greater than they were,” Emanuel added.
During the past year, a new cohort of retail investors — many using no-fee online trading platforms —became an important part of the market.
Goldman Sachs expects households to be the biggest source of demand for stocks this year, with $350 billion to flow into the market, compared with $300 billion from corporations.
“It’s newer and younger investors who are embracing speculation like never before, as evidenced by call options volumes that are multiples of prior years’ record volumes,” said Emanuel of BTIG.
Investors are also using record amounts of margin debt to finance their investments.
For now, the most speculative activity is focused on meme stocks, Emanuel said.
GameStop is the poster child for this volatility, a stock that was given up for dead by many but embraced by a group of retail investors.
Instead of calling their brokers, these traders turned to to the internet. WallStreetBets, a forum on Reddit, became a powerful force in market activity.
“The question is will it end up like it did at the end of the rally in 1999 and 2000,” Emanuel said. “Could it end up in a very strong parabolic-like surge across the entire stock market?”
Citi’s Levkovich said investors tend to sell momentum as much as they buy momentum.
“The moves we’ve seen in stock prices, where they can double or triple in a day,” he said. “The incredible issuance of SPACs, the crypto stuff — a lot of these are signs of too much liquidity generating speculative behavior.”
Nonetheless, the market rewards have been huge. Tesla, for instance, is up 630% since March 23, while Etsy has risen more than 520%, Freeport-McMoRan 540% and L Brands is up 500%.
Stocks have also not really been challenged by bonds for investment dollars, even with the recent rise in yields.
“Why as a 20- or 30-year-old would you want to buy a fixed income investment if the expectation for inflation is 2% and the Fed is telling you, it’s not going to stop with liquidity until inflation is sustainably above 2%,” said Emanuel of BTIG. “Because real yields are so low, it continues to be a good time for equity investment.”
The benchmark 10-year Treasury yield has moved higher lately, as the promise of the latest fiscal stimulus package has boosted the outlook for growth.
Economists expect the economy could grow by 6% this year. The 10-year yield, which moves opposite price, was at about 1.53% on Thursday, well off its year low of 0.50% but below its recent high of 1.61%.
Market now in midcycle
Sam Stovall, chief investment strategist at CFRA Research, expects the market to move higher this year.
He also says it’s due for a bigger correction than the market sell-offs that took place from mid-February to last week. In that period, the S&P 500 at the time sold off close to 6%, while the Nasdaq fell more than 10%.
“When I look at all the historical facts that say stocks are overpriced, it gets me scared,” said Stovall. “The S&P market cap is 140% of nominal GDP and the S&P average is 62%.”
The market has also had only one sizeable correction since it took off in March.
Because real yields are so low, it continues to be a good time for equity investment.Julian Emanuelhead of equities and derivatives strategy at BTIG
“We are more than 20% above where we were the last time we had a meaningful decline, which ended on Sept. 23,” Stovall said.
The market has now moved to a midcycle period, “after a fast and furious ‘Recovery’ regime,” Bank of America found. Strategists at the firm said that should mean a period of continued gains.
In this type of market environment, “typically capex outpaces consumption, rates rise and ‘good inflation’ picks up,” Bank of America said, referring to capital expenditures.
This phase could come to an end when “good” inflation turns into “bad” inflation, with prices rising too much and hurting margins. Bank of America’s strategists say this period could also last longer than the average nine months.
Cyclicals and value should lead
Cyclicals and value stocks are expected to continue to outperform. Wall Street strategists have a median target of 4,100 on the S&P 500 for year-end.
Citi’s Levkovich said he does not expect the market to go much further than it already has this year. He expects the S&P 500 to trade between 3,600 and 4,000 — very close to where it is now — and end the year at 3,800, the lowest forecast in CNBC’s Strategist Survey.
On Thursday, the S&P 500 closed at 3,939.
“People are positioned very bullishly, and that prevents downside risk to the market,” Levkovich said. But the market can also not gain the way it did when tech and growth were the leaders.
When the technology and internet growth names were still the leaders, a handful of stocks were responsible for the bulk of the index gains. Some of those names, like Apple and Amazon, have suffered double-digit declines.
The energy and materials sectors have doubled in price since last March, while industrials and financials are up about 95%. Tech is up about 83%. Meanwhile, communications services, including internet names, are up about 72%.
“If you lose the leadership of the big dogs, it’s going to hold back the market, even if the other guys are going up,” Levkovich of Citi said. “They’re not as big as the huskies … the valuations are different if you lose some of the big tech names.”
Later in the year, the market could struggle with cyclicals and value stocks as leaders, Levkovich said.
“We might be in a position where later in the year we could see some of the expectations around value and cyclicals disappoint, and then I think you see the rotation back to growth,” he said.
Just as the course of the economy will be decided by the course of the virus and the success of the vaccines, the stock market will be driven by the same factors.
“Everybody thinks the world will be a lot better in the second half,” Levkovich said. “If there are any hiccups — let’s say it’s a Covid outbreak where we didn’t contain it enough — that would be a disappointment.”