Just a year ago, a new bull market was born. Driven by an unprecedented stimulus, the stock emerged from its deep pandemic and began to skyrocket.
History indicates that, following the decline of the big bear market, strong bull markets generally continue with gains carrying over to a second year. However, investors should expect a lower return in the next 12 months, with a more hectic road to get there.
It was on March 23, 2020, when the S&P 500 hit its bottom, after the Covid crisis caused the stock benchmark to plummet 30% in 22 days, the biggest drop in such a short time. There have been five other sales down 30% or more since World War II, and the market has risen every year in year two, with an average return of around 17%, according to data from LPL Financial.
Still, the first-year return rally is generally difficult to overcome. Only after the 1987 crash did stocks advance more in the second year than in the first, according to the data. In addition, the second year of a new bull market is subject to setbacks, with an average reduction of 10%, said LPL.
The S&P 500 jumped about 80% over its March rock bottom, marking the best start to a new bull market on record, the LPL data showed. This historic start could open the door to second-year recessions and more volatility on the horizon.
“Embarking on the second year of the current bull market may be just as exciting for investors, but it is easy to question whether the strength will continue,” said Lindsey Bell, chief investment strategist at Ally Invest. “Think of the free sports agent who disappoints after getting the nine-digit contract, or the sequence that just doesn’t live up to the original.”
4% gain from here?
The Wall Street consensus goal for the end of the year for the S&P 500 is 4,099, representing a 4% gain over Monday’s closing of 3,940.59, according to the CNBC Market Strategists Survey, which brings together the forecasts of the top 15 strategists.
The bull market was officially declared when the S&P 500 eliminated its pandemic losses and hit a record high close on August 18, so the start of a bullish cycle was traced back to the market valley with the benefit of a retrospective.
Still, the 2020 “black swan” event makes the current bull market unique. Unlike previous crises, in which the malfunctioning of financial markets was to blame, this time the crisis was triggered by a pandemic. And, in contrast to the slow and steady recovery in previous cycles, that recovery was extraordinarily fast, thanks to trillions of dollars in aid from Congress and the Federal Reserve.
“This is the first bull market that any of us went through, where it was essentially manufactured by the government and the Fed,” said Tom Essaye, founder of Sevens Report. “The huge stock gains did not come organically. They were essentially decreed by the government assuming huge amounts of debt and deficits to stimulate economic activity. That changes the outlook going forward.”
Although the story is on the market side, many believe that the new bull’s lasting power depends on its ability to sustain the rise without large amounts of stimulus. A new round of stimulus checks has just begun to hit Americans’ bank accounts this month. As soon as the stimulus ends, Wall Street is betting that corporate profits will do the heavy lifting and keep the high promises that stock prices have made.
What are the risks?
At its current level, the S&P 500 is trading more than 21 times the projections for next year’s earnings, a level not seen since 2000, according to FactSet.
“You are essentially making the transition from a government-infused rally to what we hope will be an organically infused rally where the economy reopens and which, in turn, only feeds itself,” said Essaye.
Meanwhile, inflation expectations are rising amid the historic economic reopening and massive stimulus, making it more difficult to justify high stock valuations. The concern has manifested itself in the underperformance of the year until the time of the high-tech Nasdaq Composite, as inflation and higher interest rates erode the future profits of growth-oriented companies.
Another possible threat as this bull market ages would be rising tax rates, with President Joe Biden set to propose higher rates to finance a major infrastructure program. Goldman US stock strategist David Kostin warned investors that Biden’s tax plans could cut S&P 500 earnings per share by 9%.
Biden signaled his willingness to raise the corporate tax rate to 28% in a partial reversal of President Donald Trump’s 2017 tax review. Meanwhile, Biden also endorsed the increase in the marginal marginal tax rate to 39.6% and the taxation of capital gains and dividends at the highest ordinary income tax rate.
Wells Fargo believes that corporate tax rates will increase, but will fall short of Biden’s 28% proposal, and any higher tax damage will be mitigated by stronger corporate earnings.
“We believe that record economic growth and fiscal spending will support higher profits, potentially offsetting the impediment to a higher tax regime,” said Ken Johnson, investment strategy analyst at Wells Fargo, in a note.
– With the help of Nate Rattner from CNBC