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By Pete Biebel, Senior Vice President

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Once upon a time, about a year ago, the stock market dwarfs were all merrily skipping along, whistling a cheerful tune. They were climbing up the side of Mount Appreciation and they were climbing higher than they ever had before. Conditions were idyllic. The market dwarfs were as happy as could be. Suddenly, they were confronted by a treacherous hobgoblin, the specter of a worldwide COVID pandemic. The evil COVID so frightened the dwarfs that they tumbled back down the mountainside.

Just when it seemed that there was little hope for them to regain their footing, their fairy godmother appeared and promised the dwarfs that she would keep short-term interest rates at zero and would also support the credit markets. Then charming Prince Congress offered to help by mailing stimulus checks to all the subjects in the kingdom. And, the dwarfs loved it!  Those promises gave them the wherewithal and the optimism to resume their march higher. And higher they climbed. While the evil COVID continued to darken the skies, the dwarfs were able to look ahead to sunnier days, ignoring the pandemic fears and dreaming of a future with no COVID.

By late summer, they had ascended beyond their previous acme. Though COVID had grown to be much more ominous, they continued to ignore the threat. By now, there was a significant difference in how far the individual dwarfs had climbed. Some of the more technologically advanced dwarfs, like Streamy, Social and Etail, actually gained strength as a result of the pandemic. Several others lagged far behind.

In early-autumn, there was a new concern: There was to be a contest for leadership of the kingdom. The dwarfs initially believed that it would be best if the red knight was re-elected. They feared that, if the blue knight won, he would increase taxes and regulation, and that would place a heavy burden on their ability to advance. The initial results showed a blue knight win but with limited powers. Not only did the dwarfs unexpectedly rejoice in that outcome, but they somehow concluded that it was the best possible scenario.

While the dwarfs debated the impact of the election results, the good witch Pharma appeared and told them that she could cast a spell that would gradually kill the COVID. And the Dwarfs loved it. The combination of the blue knight’s win and Pharma’s spell so enthralled the dwarfs that they ran higher with no concerns at all about what dangers might lie ahead. There now seemed to be nothing that could possibly impede their climb higher. And they lived happily, ever after.

The fairy tale optimism that pervaded 2020 seems to still be evident as the new year begins. All of us who were hoping for a more normal year had to be disappointed by developments in the first week of the year. Yet, despite the outcome of the senatorial elections in Georgia, and despite the mob violence in the Capitol, the first week of the year saw stocks climb higher again. There was little if any bullish economic news to support the rally. The most popular theory is that the now confirmed blue sweep likely means even fatter stimulus programs and massive spending on infrastructure. And, more free money means buy, buy, buy.

One casualty of the news that spurred stocks higher was the bond market. All the deficit spending that the stock market is betting will materialize will need to be financed. One index of longer-term Treasury securities fell more than 4% last week. The yield on Ten-Year Notes spiked over 1% for the first time since March, ending the week at 1.12%. The spike in rates caused most other fixed-income sectors and several interest rate sensitive equity sectors to end the first week of the year in the red. If interest rates continue to trend higher too far and for too long, they would become an increasingly negative factor for stock prices.

Even after a rocky start on Monday, the major averages all gained between 1 ½% and 2 ½% for the week, setting new record highs in the process. The Dow Jones Industrial Average (DJIA) gained 1.61% and closed above the 31,000 level for the first time. The S&P 500 Index (SPX) added 1.83% and closed above 3800 for the first time. And, even though the Technology and Communication Services sectors had relatively tiny gains for the week, the NASDAQ Composite Index (COMP) tacked on 2.43% last week, climbing above the 13,000 level and ending the week at 13,202.

Dwarfing the returns of its larger-cap peers, the Russell 2000 Index of small-cap stocks (RUT) had a giant week following its mythical gains in the last two months of 2020. RUT hit several new highs on its way to a nearly 6% gain last week. Believe it or not, since the end of October, RUT has soared nearly 36%. The election results and the availability of COVID vaccines seem to be the primary catalysts that have rejuvenated interest in these smaller company stocks.

Unfortunately, the huge run in small-caps is another symptom of the overall market’s extended condition. Measured against expected earnings, sales and GDP, stocks appear to be at very expensive levels. The signs of excess speculation that appeared in mid-December haven’t gone away. The market is overdue for a timeout, though not necessarily a top-out. The election results, the vaccine availability, the promise of massive stimulus have all been excuses for the market to celebrate. But the market has now climbed to levels that can’t afford any disappointment.

The market still seems to be in a no-news-is bad-news mood. To me, that will be the one factor to watch in the days and weeks ahead, even more than rising interest rates. When we see that the market actually sells off on bad news, we can be fairly confident that the timeout phase has begun.

So, I’ll repeat what I wrote a few weeks ago, “None of that means that the market cannot continue higher. Irrationality knows no bounds. Most analysts seem to be expecting further gains in 2021. After all, the economy will probably be on the upswing. While some experts are forecasting 20% and 30% gains, many more are down around the 10% range. Even if a big gain is in the cards for next year, the current extended condition, rich valuations and excessive speculation are warnings that stocks probably need some sort of timeout or consolidation phase before they’ll be able to climb much higher.”

How happily this week ultimately unfolds could depend heavily on how the market reacts to news Friday morning. Other than the Unemployment Claims data on Thursday, all the potentially significant economic reports come on Friday morning. That morning will also see the first major reports of the new earnings season when several big banks release their quarterly results.

Date Report Previous Consensus
Tuesday 1/12/2021 NFIB Small Business Optimism Index 101.4 101.4
JOLTS Job Openings, November 6.652mm 6.500mm
Wednesday 1/13/2021 Consumer Price Index, December, M/M +0.2% +0.4%
CPI ex-Food & Energy, December, M/M +0.2% +0.1%
Thursday 1/14/2021 Initial Jobless Claims 787K 788K
Import & Export Prices, Dec., M/M, Imports +0.1% +0.5%
Import & Export Prices, Dec., M/M, Exports +0.6% +0.4%
Friday 1/15/2021 Producer Price Index, December, M/M +0.1% +0.3%
PPI ex-Food & Energy, December, M/M +0.1% +0.2%
Retail Sales, December, M/M -1.1% -0.1%
Retail Sales, ex Vehicles & Gas, December, M/M -0.8% -0.2%
Empire State Manufacturing Index, January 4.9 6.0
Industrial Production, Production, December, M/M +0.4% +0.4%
Industrial Production, Manufacturing, Dec., M/M +0.8% +0.3%
Business Inventories, November, M/M +0.7% +0.4%
Consumer Sentiment, January 80.7 80.0

 

Links to previously published commentaries can be found at benjaminfedwards.com/For Our Clients/Educational Resources/Market.

January 11, 2021 |