For December, equity prices rallied to all-time highs as optimism prevailed across U.S. stock markets. The Dow Jones Industrial Average was up 3.3%, the S&P 500 was up 3.7% and the Russell 2000 was up 6.8%. The tech-laden Nasdaq also rose by 5.7%, boosting its year-to-date gain to a spectacular 43.6%.
As the country grappled with the accelerating resurgence of Covid-19 infections, several economic reports in December indicated a likely deceleration in the broad economy. According to the Labor Department, for the final week tracked of 2020, initial claims for state unemployment benefits slid to a seasonally adjusted 787,000 for the week ended December 26, compared with 806,000 in the prior week. The modest decline in weekly unemployment claims, which is the most timely data on the economy’s health, aligned with other recent weak economic reports, including a decline in consumer confidence to a four-month low in December, and drops in both consumer spending and income in November.
While corporate profits rebounded strongly in Q3 2020, that performance has been overtaken by the relentless pandemic, leaving GDP growth estimates for the fourth quarter around a 5% rate.
As we begin 2021, the broad economy carries very little momentum. Most economists expect modest growth or even a contraction in the first three months of 2021.
How can it be that central bankers and economists keep warning about significant dangers to the economy while investors continue to push up equity values into the stratosphere? It’s believed that because of comments made by central bank leaders, investors expect central banks to continue injecting large amounts of liquidity into financial markets. Historically, low yields amidst lots of cash and liquidity influence investors to put funds into riskier assets, such as equities. The result being a continued rise in equity prices.
Consistent with this theme, and after months of Washington gridlock, U.S. Congress passed a $900 billion pandemic relief package, delivering long-sought cash to businesses and individuals, as well as resources to support the rollout of vaccines. On December 27th, President Trump signed the stimulus bill into law, thereby releasing the emergency relief funds into the economy and averting a government shutdown.
Also, good news about vaccines and their imminent distribution has likely convinced many investors that a robust recovery is just around the corner. They reasonably assume that, once the vaccine is widely distributed in rich countries, herd immunity will quickly be achieved, setting the stage for consumers to return to economic activity in droves. Indeed, consumers in the United States are sitting on a large pile of cash that could be used once pent-up demand is unleashed.
The January 5th Senate runoff election in Georgia might be one of the biggest catalysts for market volatility early this year, since it will determine which party controls the Senate. The concern in financial markets has been that if the Democrats do control the Senate and House, they could raise taxes.
In the case of market volatility, beware of knee-jerk assumptions that tax increases necessarily mean down markets for stocks.
What does history say? Research by Denise Chisholm of Fidelity has shown, “Big increases are rare, only happening about 10% of the time over the past 70 years.” Her research analyzed the data in the calendar year of the tax changes, plus the year prior and year after. With the 13 previous instances of tax increases since 1950, the S&P 500, the stock index that tracks most of the major companies in the US, has shown higher average returns, and higher odds of an advance, in times when taxes are increasing.
Upon breaking down taxes into 3 basic baskets: corporate, personal, and capital gains, Chisholm noted that, “100% of the time corporate taxes were raised, equities advanced the year prior and the year during.” She points out, “This holds true even when you drill down into key sectors of the S&P 500.”
“Changes to the U.S. tax code don’t happen in a vacuum. There’s usually a lot of other action going on in Congress and the economy in general, because there is an economic need driving all the actions. There’s typically significant stimulus spending by the government. The stimulus is perhaps the critical factor that may be the reason for the higher-than-average returns—that is something investors really need to keep their eye on,” says Chisholm.
For 2021, there is little doubt that additional government stimulus will come forth both in the U.S. and other parts of the world.
In the U.S., on the tail of the senate run-off elections in Georgia, Q4 2020 earnings season gets unofficially underway on January 15th, with updates expected from banking giants JPMorgan Chase (JPM), Citigroup (C) and Wells Fargo (WFC), and with a host of other companies to report in the following weeks ahead. For Q4 2020, the consensus forecast for earnings for the S&P 500 is -12.2%. In notable contrast, for Q1 2021, the current forecast for earnings is +13.5%.
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