Investors seem way too overconfident for their own good. By some measures, sentiment is as high as it was right before the tech bubble blew up in 2000. Yikes.
Meanwhile, potential surprises abound. Any of the five I
list below could hit stocks hard in 2021.
You don’t have to go back to 2000 to find precedent for investors being dinged by surprises that tank stocks. Coming into 2020, most of us felt pretty sure we would have another year of nice gains in the stock market. The economy was doing OK, and there didn’t seem to be any major risks on the horizon.
Then, boom! Covid-19 struck. The S&P 500 SPX,
How could we all have gotten it so wrong? We were victims of the investor’s worst enemy: Complacency. You’d think we’d have learned a lesson. But, no. Now complacency is arguably even more widespread, and it could wind up hurting us again.
Sentiment is at a two-decade high
I’ve been bullish on stocks — especially cyclicals and the ones worst hit by Covid-19 — since March in my stock letter, Brush up on Stocks (see link below), and in this column here, here, here and here.
To help make market calls like these, I regularly track a dozen sentiment indicators. As a contrarian, I try to do the opposite of the crowd. Now, all my sentiment indicators are at, or near, extreme highs. I’m happy people have joined me and pushed my stocks up. But at this point, we have too much of a good thing. And I’m not the only one who thinks so.
Consider the analysis of Leuthold chief investment
officer Doug Ramsey. To gauge sentiment, he goes beyond the 12 measures I
track. He likes to follow the “dumb money” vs. “smart money” in the stock options
market. Ramsey compares options positions held by retail investors in
individual stocks (the dumb money in his view), to options positions in the
S&P 500 Index held by institutional investors.
Right now, retail investors are very bullish and
institutional investors are relatively cautious. The gap between these two is
at an extreme not seen since March 2000 right before the tech bubble blew up,
he says. Ramsey also notes the gap between bulls and bears in an Investors
Intelligence survey on a trailing four-week basis is the highest in 35 years.
“There’s a bull market in complacency at the moment. The market is mispricing risk and overlooking potential issues,” says Union Bank equity strategist Todd Lowenstein.
This is a big problem because overconfident and complacent investors are more vulnerable to surprise. They buy stocks with 100% certainty their stocks can only go up. That’s how confident they are. So even a little slippage worries them. They can panic and sell, creating more selling, which begets even more.
What might set this in motion in 2021? Aside from the proverbial “unknown uknown,” there are five major risk factors that could bring about a market train wreck.
Risk factor #1: There could be more serious issues with vaccines and Covid-19
We’ve already seen signs of a potentially more spreadable version of Covid-19 in England, and unexpected health issues with vaccines like severe allergic reactions. Both of these problems could take a turn for the worse and upset the markets, says Lowenstein.
It’s also not clear how effective the vaccines are, or how long they last, and how many people will be OK with using them.
“People like linear stories and line of sight. But there are still so many open questions,” he says.
Risk factor #2: The Senate flips to the Democrats
Investors like to see political power split between the two parties, since this means politicians can do less damage. But if the two Senate seats in Georgia go to Democrats, that would upend this “goldilocks” split-power scenario in Washington, D.C. That could send stocks tumbling, as investors worry about excessive government spending and regulation. The Georgia elections will take place Jan. 5.
Risk factor #3: Inflation heats up because economic growth is so strong
There’s been so much stimulus injected into the economy, we could see excessive growth and inflation next year. This would have investors worried the Federal Reserve will hike rates to curtail inflation. Or the bond market would do this on its own — meaning investors sell bonds on inflation fears, sending interest rates higher.
Either way, it would be bad for stocks, especially what are known as “long duration” stocks in tech and biotech. These are companies whose valuations are based on earnings expected from products that come to market many years from now. Investors value these distant earnings streams by “discounting” them back to the present — using the current low interest rates — in their “net present value” models.
If those discount rates spike because inflation drives up
bond yields, then those future earnings will suddenly be worth a lot less today
in these valuation models. These stocks would fall a lot.
“If all the stimulus begets inflation and higher interest rates, discount rates could move up and cause multiple compression,” cautions Andy Braun, the portfolio manager of the Pax Large Cap Fund PXLIX,
He says many tech and biotech companies have high valuations that he has trouble justifying even considering earnings expected five or 10 years from now. “You have to have quite an imagination. It harkens back a little bit to the dot-com era,” says Braun.
This could be particularly problematic for the market since big tech names like Apple AAPL,
Even a hint of tapering by the Fed could cause problems since this would have investors moving to “risk-off” mode, as they did in the second half of 2018. We won’t have to see an actual contraction of monetary policy.
“The tide of liquidity has been the story in 2020,” says Leuthold’s Ramsey. “When liquidity gets so extreme, investors are attuned to the rate of change in liquidity.”
Liquidity growth will slow at some point in 2021, he cautions.
“We are not going to continue to see 25% money supply growth,” Ramsey says. In 2018 the Fed never trimmed its balance sheet. It just tapered bond purchases — and that lead to a sharp pullback in stocks, he points out.
Risk factor #4: Earnings expectations prove to be too high
Conversely, economic growth might not be enough to support the 20%-plus expected earnings growth for the S&P 500 in 2021, cautions Timothy Chubb, the chief investment officer at Girard in West Chester, Pa.
“There are signs the economy is beginning to stall out, and this is not reflected in earnings estimates. I have a high level of skepticism that earnings estimates are aligned with the economic reality,” he says.
Chubb cites recent weakness in jobs data, and the hit to the leisure and restaurant sectors as lockdowns get more severe.
Risk factor #5: Middle East tensions flare
Iran has threatened to retaliate for the recent assassination of nuclear scientist Mohsen Fakhrizadeh. This could set off a war, or at least counterstrikes in the Middle East which would have investors concerned about oil prices spiking enough to erode growth.
Otherwise, President-elect Joe Biden seems likely to resurrect the Iran nuclear deal — formally known as the Joint Comprehensive Plan of Action (JCPOA) — shortly after his inauguration. This might bring back concerns that Iran will move closer to nuclear weapons development, leading to a preemptive strike against Iran, thereby escalating tensions in the Middle East and, again, concerns about oil price spikes hurting growth, cautions Lowenstein.
Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested MSFT, AMZN, GOOGL and FB in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.
