Morgan Stanley
  • Wealth Management
  • Jan 4, 2021

Preparing for 2021 and a Post-Pandemic Market

The S&P 500 ended 2020 at new highs, but in 2021, market gains could run well ahead of fundamentals, creating risks for investors.

As we turn the page on 2020, the market has reached new highs, even as pandemic conditions seem far from ending. New COVID-19 infections remain elevated, along with deaths and hospitalizations. The rollout of new vaccines has sparked hope, but distribution in the U.S. has been slower than forecast.

Manage your Wealth

Find a Financial Advisor, Branch and Private Wealth Advisor near you

With the start of the new year, let’s take stock of where the U.S. economy and markets stand. Unprecedented Federal Reserve accommodation has left interest rates near historic lows. The largest fiscal stimulus in U.S. history seems to have successfully jumpstarted a V-shaped recovery into 2021, with the latest policy response due to send new checks to many U.S. households, while providing additional assistance in other critical areas. Plus, the Fed’s incoming voting members seem likely to be even more dovish than their predecessors, and we expect them to work constructively with incoming Treasury Secretary Janet Yellen. 

A Cautious Outlook

Both the S&P 500 and Nasdaq indices posted double-digit percentage gains for 2020—and they could do so again this year. But our view is more measured. We forecast that the S&P 500, now at about 3750, could hit 3900 by the end of 2021.

Here are a few reasons for caution. Monetary policy appears unconstrained, setting up the potential for both excess liquidity and extreme valuations, which could leave the market vulnerable to earnings disappointments and external shocks.

While many investors may ignore high valuations for the time being, we note that the 3900 price target factors in our estimate for 27% earnings growth this year, a very fast rate historically. Based on a forward price/earnings ratio of 22.4, the S&P 500 is already in the top 10% for valuation in the last 80 years. 

Even more telling: The Shiller Cyclically Adjusted Price/Earnings Ratio, which measures price divided by average earnings over 10 years, adjusted for inflation, has only been this high twice in the past 100 years—1929 and 1999-2000, both marked by significant liquidity and economic growth well ahead of real interest rates, similar to today. Both occasions led to steep stock-market declines.  

Reasons for Optimism

Yet, economic bright spots abound, including a robust housing market, surging investment in clean energy and an expected boom in corporate productivity due to new technologies, combined with workplace and behavioral changes brought on by the pandemic.

But the current policy regime of maximal monetary and fiscal accommodation, while debt and deficits mount, feels increasingly unsustainable. Potential consequences include higher long-term interest rates, inflation and a much weaker dollar, all of which could destabilize the broader U.S. market.

To prepare for a 2021 that may include a boom-bust cycle, I suggest investors focus their New Year portfolio actions on security selection, with an eye toward value, dividend income and shorter duration fixed-income securities. Look to add assets with low interest-rate sensitivity, inverse correlation to the dollar and inflation protection.

Investors can still position for more stock market highs this year, but they also can protect against a possible reckoning.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Jan 4, 2021, “Post-Pandemic Aftershocks.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

Have a Morgan Stanley Online Account?