Our Head of Research, Tom Lee, recently raised his 2021 P/E estimate on the S&P 500 (NYSEARCA:SPY) to 19.7X from 18.3X. A simpler way of saying this would be we are raising our year-end price target for the S&P 500 to 3,800 (based on projected EPS of $193) from the 3,525 it already took out. Right now, the market is slightly over 3,600. Thus, we think the market will rally into year-end. So, yes, there will likely be a Santa Claus rally this year. We also think it will be led primarily by the cyclical “Epicenter” stocks so named because of their proximity to the pandemic’s consequences.
Why Is Raising P/E Target So Important?
We want to explain why we believe equity prices will continue going up, and a lot of it has to do with Equity Risk Premia collapsing, which is inversely related to the P/E ratio. Thus, when ERP collapses, P/E rises. Understanding this relationship is crucial to understanding our post-election investing strategy. Our new target represents a 5% upside into the year-end as of November 31st, which is a reasonable expectation given previous time periods. This is, all and all, a pretty normal expectation for a Santa Claus rally in an otherwise highly anomalous year.
Our target P/E of 19.7 may even be conservative since the high-yield implied P/E is 20.6. There is a reason we are choosing to focus on P/E expansion rather than on the price target itself. Think about the most important things to a stock; earnings, management, and company survivability/balance sheet are all key areas that all investors will agree are of major importance.
Source: Fundstrat and BofA
The survivability piece is one of the most important when determining what a price-to-equity multiple should be. The debt of many companies we look at, as is shown above, is suggesting higher survivability than their equity is. We discount based on the chances future earnings will be there, which obviously diminish as time increases. One of the main reasons why high-flying Technology stocks have undergone dramatic P/E expansion since the crisis began is their fortress balance sheets, and the fact that consumer demand for their products was surprisingly robust. In many cases, it increased during the post-pandemic economy.
When you think about it, many of the cyclical/value plays leading the November rally have done the same thing minus the demand part (which is actually more impressive). However, this perhaps makes the implied effect on their P/E expansion potentially even greater relative to what occurred with the Technology companies. The bottom line is their pre-COVID-19 highs should not be seen as a price ceiling. Surviving a healthcare crisis with burgeoning consumer demand and accelerated secular trends in your favor is one thing; surviving a period with nearly no demand to make it to the upcoming period of robust and rapid expansion and economic normalization is something altogether different.
Source: FSInsight, Bloomberg
To survive, many of what we call the “Epicenter” stocks, due to their closeness to the economic hit caused by the coronavirus, have had to make massive operational changes and dramatic do-or-die cuts that significantly increased operating leverage and thus the ability to outperform dramatically on earnings per share. By the way, we don’t hate on Technology stocks at all – quite the contrary. Our basic strategy is a barbell anchored in secure positions of the best technology and FAANG names. We advise tilting exposure to the beleaguered social distancing casualties that we think may be about to have their day in the sun. You may say they just led the rally in November. We think that this is just the beginning.
Economy Passed Ultimate Stress Test So Equity Risk Premia Should Collapse
Source: Federal Reserve
To give you an idea of what “All the Kings Horses and All The King’s Men” had as an idea for a bad economic situation, we have provided the 2019 Dodd-Frank Act Supervisory Stress-Test Scenarios that banks are required to undergo by law. This is the Severely Adverse scenario, and it projected the nadir of an economic crisis being less than a 10% GDP contraction. We recently survived a 32% contraction in GDP, but the “Epicenter” names have survived in many cases more than one quarter of entirely or severely curtailed demand whether by government edict or changes in consumer behavior. If you look at the last crisis in 2007-2009, one of the harder-hit cyclical sectors, Consumer Discretionary, had many sub-sectors and industries that returned to pre-crisis EPS well before they returned to pre-crisis revenue. They did it by increasing operating leverage. It is likely, given the economic pressures they faced in the recent crisis far exceed the loss of demand experienced in the Global Financial Crisis, that the effect will be even more pronounced once demand violently returns for a lot of goods and services that have been adversely affected by the pandemic.
Source: FSInsight, Bloomberg, FactSet
The election has been resolved, and this is one of the main things markets were consternating over. The outcome has been more favorable for markets than most pundits predicted. The worst-case scenario has been avoided for both political and virus risks. There has been positive vaccine news, which is key. But wait, how can you say the market will go up, and the worst-case scenario has been avoided for the virus? Isn’t the virus raging? Well, yes it is and markets can still go up, because they can now see past it.
Risks And Where We Could Be Wrong
We are undoubtedly undergoing a vicious third wave of COVID-19 in the United States. This, as it has been for most of the year, is the primary risk that could lead the S&P 500 lower rather than higher by year-end. This wave is very serious, in fact, Governor Cuomo recently announced new measures to fight growing levels of hospitalization in the state of New York. So, we certainly don’t want to minimize the severity of a bad situation. However, despite the undoubtedly grave developments with regard to COVID-19, we do think the stock market will continue going up. We discuss why in our first of ten reasons below. We also think Wave 3 has peaked in several of the hardest-hit states based on the data below.
Source: Fundstrat, COVID-19 Tracking Project
Hopefully, the virus continues rolling over. Another risk that may be developing and is considered relatively remote is that political acrimony could lead to another government shutdown in December. However, our Policy Specialist, Tom Block, sees some promising signs of incentives developing on both sides to get a deal done before the end of the year. The recent restart of bipartisan stimulus talks is a major potential positive catalyst for markets into year-end that could make our new target seem low, depending on the deal.
The COVID-19 Vaccines and Therapeutics Take Worst Case Off The Table
Earlier this year, when vaccines were speculation and not a reality, many pundits theorized that at the best case, we might receive a vaccine that offered 70%-80% rates of success. In fact, we hosted one of IHME’s main scientists who said because of the projected success rate in this area and a lack of willingness to take a potential vaccine that mask-wearing would be just about as effective. Well, we can now say without a doubt that we have been graced with miraculous vaccines from Pfizer (NYSE:PFE) and Moderna (NASDAQ:MRNA) that allow the stock market, remember this giant discounting machine, to see into a future full of profits and enjoying a conspicuous lack of pandemic problems. If you own a stock that trades at 15X earnings, then you own the next 60 quarters of growth. Before the vaccines came, there was a chance that a significant portion of those quarters would have economic activity hampered by COVID-19. Despite a current situation with the virus that is undoubtedly perilous for reasons we outlined in our risks section, the medical developments make it almost certain that whatever forces affect the fortunes of corporate success, COVID-19 will likely not be among them in a few quarters. Remember, in March, the market was pricing in the possibility of a completely overwhelmed hospital system and millions of US deaths.
There is undoubtedly bad ahead of us, but markets and statistical projections can now see through it. But how could markets go up when things are going so bad? Well, markets tend to go up when things are going bad. In fact, markets nearly always bottom before the bad news does. Take, for example, an extremely perilous situation for Britain 80 years ago. It was alone against a seemingly indomitable and hostile Nazi state. Britain endured unthinkable military defeats and, of course, the abject terror of aerial battles over its cities and bombs raining indiscriminately on civilian areas. Still, the British stock market bottomed in June 1940, before these horrors transpired. As the battle wore on, it became apparent that Germany would not or could not mount a cross-channel invasion, and the worst-case scenario was taken off the table.
Policymakers are Pursuing Soft Lockdowns, Not Broad Ones That Needlessly Kill Economic Activity
Even the WHO is now recommending targeted action instead of the broad and blunt lockdowns that were pervasive early in the pandemic. Again, this is another case of one of the market’s “worst-case” scenarios being taken off the table. Even though the virus is clearly surging across the country and the Presidential Administration has changed, it still appears that the vast coordinated and mandatory cessations of virtually all economic activity will not return.
We see this as a major positive. So far, it appears the Wave 3 cases are rolling over, as we mentioned in our “risks” section. However, lack of compliance with holiday travel advisories could certainly reverse this in many geographies.
Pent-Up Demand Will Cause A Violent Rotation Into Neglected Cyclical Stocks
The output gap is a little-known metric that is usually used by Fed-watchers to try to predict monetary policy. The metric is essentially real economic activity over economic potential, so when the economy is “heated” up and operating at or near full-potential, in the past, the Federal Reserve will raise rates to cool things down. Despite the economic toll caused by the coronavirus, the consumer is strong and will be stronger once more stimulus comes. The consumer has an unprecedented willingness and soon will have an unprecedented ability (after new stimulus) to drive economic growth levels in certain cyclical sectors that have likely never been seen. What went down must come up.
There is $4.5 Trillion of Dry Powder on the Sidelines
Have you noticed that every time there is a pullback, it is shallow, and money shortly piles into buy-the-dip? That’s because there is an enormous amount of money on the sidelines waiting for the risk level to be right for them to re-enter. Some is institutional money, and some is retail money, but one thing is for sure, there is a lot of it. Once it becomes clear that the healthcare situation no longer threatens economic activity in the way it has in the recent past, this money will violently enter the market, driving prices high and high fast.
Source: Fundstrat, Bloomberg, ICI
China Is Seeing An Explosive Recovery
China’s economic recovery likely portends a similar one in the United States once major healthcare concerns have subsided. We are even more bullish on the US and US assets in a post-COVID-19 new normal than we were before the crisis. We think that China’s current economic success portends an even greater one for the United States in the near future.
Our best guess for how the new economy will affect different types of capital, both international and domestic, is below. We think the following dynamics will make growth in the United States even more robust once economic activity normalizes.
Conclusion and Recommendation
We believe that the S&P 500 will continue going up through the end of the year in the approximate path of a normal “Santa Claus” rally. We see the index reaching 3,800 before year-end. If you are interested in trying to beat the S&P 500 returns, then you could potentially try some of our active sector allocation strategies that focus on going overweight winning sectors like Industrials and Consumer Discretionary which we believe will outperform the wider market.
If you still need a little convincing, then check out this work our data science team did. We analyzed the stock market for December performance across a range of historical scenarios. Look at the win-ratio we found for the stock market since 1945 in scenarios that resemble 2020.
Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.