- 2021 starting off as expected
- Benchmarks are not the stock market
- Returns are broadening out
2021 starting off as expected
We continue to expect economic growth to surge forward in lockstep with global re-openings. In such an environment, one would anticipate yields to rise and equities to outperform bonds. That is exactly what has happened with market returns so far this year to the end of February. It all seems very reasonable. Perhaps it’s surprising then that more and more people are asking the question, “Has the stock market peaked?”
Three common arguments we hear for a market peak are:
- The market has had a spectacular move off last year’s lows and has climbed upwards in a virtually straight line. We are overdue for a correction.
- There is a lot of unusual activity out there grabbing the headlines, such as the GameStop saga and the meteoric rise of Bitcoin. This type of activity can be a signal of market tops.
- Index valuations are not cheap relative to history. In particular, the S&P 500, perhaps the most watched index in the world, is trading at 22.4x next year’s earnings. We have not seen these valuation levels since the dot com bubble.
These are valid arguments. However, before we can address them we first have to clarify what the term “market” means. If we were to ask one hundred people to explain what the stock market is, a significant portion would likely respond with the name of an index or a benchmark, such as the S&P 500. It’s a fair answer but, of course, it’s not correct for a couple of reasons.
Benchmarks are not the stock market
First, benchmarks are only subsets of the market. For instance, there are over 200 stocks in Canada’s major index, the S&P/TSX Composite, and that’s less than one tenth of the public companies listed in Canada.
Second, the most common benchmarks are capitalization weighted which means larger companies have the highest weightings. Most benchmarks represent a specific slice of the market (large cap, small cap, ESG, Energy stocks, etc.) and their performance is skewed towards the largest companies within that slice, rather than being a representation of all the stocks in the index.
Periodically, one stock (or a small subset of stocks) becomes so large relative to the other stocks in the index that they drive the return of that index. Of course, Nortel is the example for Canadians. At its peak during the dot com bubble, Nortel was over 1/3 of the TSE 300 (S&P/TSX Composites predecessor index). It drove benchmark returns and exploded to sky-high multiples.
Further down in the benchmark were outstanding companies trading at much more reasonable valuations. The S&P/TSX peaked in mid 2000. It took over two years for the index to hit its bottom. In the meantime, many non-tech names had risen significantly in value. The index showed a market performing poorly, while the reality of the average stock was quite different. We show some examples below:
Source: Capital IQ
That brings us back to the question of whether the stock market has peaked. We actually agree with all three of the arguments above that are often used to point out a peak is near. However, we do not think these are necessarily a harbinger of bad days ahead. We will get a correction at some point – they’re normal and don’t concern us. If your time horizon is measured in years and not days, then it shouldn’t concern you either. Corrections are impossible to predict consistently and most investors are worse off in the end by trying to do so.
Returns are broadening out
There is froth in market segments and this can pull a market down. The U.S. housing market was in a bubble over a decade ago, and it pulled the whole world economy down with it as well as global stock markets. We do not see anything as systematically important at this time.
If Bitcoin, for instance, were to fall 50% tomorrow then the stock market might fall in sympathy. But there likely wouldn’t be any long-term impact to prices, and it would not pull the economy into a recession. In fact, given the stimulus out there, it’s hard to imagine a situation outside of a resurgent virus that could derail the economic expansion we will see over the next couple of years.
Most major benchmarks do not look overvalued, especially considering how low bond yields are. We feel that yields would still need to rise quite a bit more to be a real concern, although a fast move in yields could roil investors.
Benchmarks like the Nasdaq 100 and the S&P 500 do look expensive, primarily because a small group of tech stocks have driven them for years and now have high weightings in the index. Although this is not a Nortel situation, it is similar to the early 2000’s in that we see lots of undervalued opportunities in the stock market even though some benchmarks do look expensive.
So far this year, we have seen a change in leadership from the tech sector to more cyclical stocks. It is typical of early days of economic expansion, and it’s a reminder that there’s more to the stock market than just a handful of large stocks. Accordingly, we remain overweight stocks in our client portfolios.