Faithful readers (hi mom!) will recall that it was about a year ago that I wrote about the potential impact of a new virus that was starting to spread worldwide. The virus turned out to be much worse than initially expected (in particular, my comment “as I write this, fears over the virus appear to be receding” has not aged well). Yet, a year later, the stock market is seemingly making new highs every couple of days. What is going on?
Stock Market Does Not Equal Economy
As we’ve stated before, the stock market and the economy do not necessarily move in lockstep. Since bottoming late last March, the stock market has moved up fairly steadily. This has been a combination of solid performance by companies who benefited from the pandemic (think Alphabet, FedEx, and Amazon, for example) and anticipation of returning to normal life after COVID. There has been a lot of talk about pent-up demand unleashed once the virus is controlled.
However, that does make people wonder how much of a recovery is already reflected in the stock market. If it is already pricing in a full recovery, what happens to the market as the economy does recover?
There are arguments for a continued strong performance by the stock market:
- Corporate Buybacks. Activity is up sharply so far this year. Many companies halted buybacks with the pandemic’s onset but are comfortable enough now to restart their programs. These could offer support to stock prices.
- Government Stimulus. Our government recently passed a second stimulus bill, and there are already talks of a third (and larger) bill. These should help those most affected by the pandemic and act as a bridge until the economy can fully reopen.
- Pent-up Demand. As mentioned before, there is a widespread belief that a lot of pent-up demand will show up once the economy reopens. Travel and dining, in particular, are candidates for sharp increases. More activity equals better earnings for companies, which also supports stock prices.
On the other hand, there are certainly some reasons to be concerned:
- High Valuation. Probably the biggest concern is valuation. By many measures, the stock market is very expensive right now. A recent publication from J.P. Morgan listed seven valuation metrics in the 92nd percentile or higher versus their historical ranges at year-end. While that doesn’t mean the stock market will fall any time soon, it does raise questions about what kind of returns investors can expect in the future.
- Investor Complacency. Investors also seem complacent overall. Two metrics support this. First, the put-call ratio has dropped precipitously, indicating fewer investors are hedging their stock market bets. Second, the outstanding margin is at record levels, suggesting many investors are borrowing to leverage their stock market exposure. That works great when the market goes up but can be brutal in a sell-off.
- Reduced Insider Buys. Finally, corporate insiders are not buying nearly as much stock as they were last year. The ratio of insider sells to buys is 16 to 1 so far this year. That tells us that insiders, who in theory know their companies very well, are not enthusiastic about their stocks right now.
What’s An Investor To Do?
If you’ve read my columns before, you know what’s coming next: stick to your plan. I know you probably get tired of reading it, but it’s the best advice I can offer. I am convinced that it is impossible to predict the short-term markets consistently, so I recommend not trying.
If you are one of those investors using margin to goose your returns, you may want to take some chips off the table. As Bart Mancuso noted in The Hunt for Red October, “The hard part about playing chicken is knowin’ when to flinch.” I think you are better off flinching sooner rather than later in this case, not because the market is necessarily going down but because if it does, leverage magnifies losses.
After a surprisingly strong 2020, the stock market has continued to perform well so far in 2021. No one knows what the rest of the year holds, so make sure that your portfolio reflects your long-term goals. Don’t increase your risk or maintain above-average risk in an attempt to squeeze out more returns or time the top of the market. You may get lucky once or twice, but you will fail over the long term.
David Crossman is a Senior Portfolio Manager with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email David at email@example.com.