2021 Economic Forecast – Pt. 5 – The Stock Market

Part 5 of our series on 2021 economic predictions covers the stock market. Topics include the business valuations in the S&P 500, P/E ratios and subsequent historical and projected earnings, and our predictions of who will be the 2021 winners.

And in case you missed them, see parts 1 through 4 of this series below.


Hi, this is Bob Fraser. I’m the founder of Aspen Funds, and this is our 2021 Economic Forecast. We’ve previously looked at the general economy, the Biden tax plan, the COVID recovery, and the real estate effect. Now we’re going to look at the stock market in this section. So we’re going to jump in right into the slides and take a look at what’s our forecast for the stock market.

First thing that we need to know is that the S&P 500, and really all the indices, it’s very popular today to buy simply the S&P 500. You’ll buy an index fund. You buy the SPY, or the DIA, or something like that, and you buy an index. But what’s happening is these… The S&P 500 is overweighting a couple tech giants, and PE ratios are pretty insane.

This is the S&P 500, and this is the top five companies in the S&P 500, Facebook, Amazon, Apple, Microsoft, and Google. You can see how much they are affecting the S&P 500. And this is the other 495 stocks down here. The tech guys are on fire, and the PE ratios are kind of crazy.

Amazon’s at a 93 PE ratio. Now what is a PE ratio? Well, PE ratio is the price per share divided by the earnings per share. It’s how much you’re paying for a stock relative to earnings. So the idea is this, a PE ratio of 93 is like paying $93,000 for a business that earns $1,000 per year. A business is earning $1,000 a year. Would you buy that business and pay $93,000 for that business? That’s in essence what you’re doing if you’re buying Amazon. As long as that business is in global supply chain and it’s called Amazon, yes. The answer is yes, you would. So but it’s very pricey on any basis you look at.

Tesla, which was just added to the index, is actually a 1,300 PE. So Tesla shares are paying $1.3 million for a business that’s earning 1,000 in essence. So would you for your thousand-dollar business that makes electric cars… with $1,000 of earnings, which you pay $1.3 million for that? Well, the answer is yes if it’s Tesla. So the valuations are just insane, and valuations matter.

Right now the total stock market price to earnings ratio is at 33, which means on average, investors are paying $33,000 for $1,000 of earnings. And the reason you buy businesses is for the earnings. So this is definitely a caution zone. When the PE ratio is here, you can see here is 1929, the 2000 dotcom bubble. We’re definitely higher than a lot of people are comfortable. Why does it matter? Well, it makes sense that the more you pay for something, the less likely you’re going to profit from it when you get rid of it, right? So the bottom line is price earnings ratio matters, right? You want to buy when stocks are cheap and sell when they’re high, not buy when they’re expensive.

So what this chart does, this is a scatterplot chart, each dot is one month in history since 1950. And it plots the PE ratio at that time right here along this axis. So this is the PE ratio. So right here is probably sometime in 2000. Had you bought in January 1 of 2000, you’re at a 40 PE ratio. And your returns over the next 10 years were -5%. So this is the PE ratio had you bought. This is historical, this is historical fact. Had you bought the stock market at this point and at that 40 PE, you would have lost 5% per year over the next 10 years.

And so you can see, this is not a random chart. This is actually a correlation. So contrary to what modern portfolio theory asserts, that one should always be in the stock market, it matters what time you are in the stock market. History shows that valuation and timing greatly affect returns. So you can time the stock market, and it’s when the stock market is cheap.

This is one of the reasons why strategies like dollar-cost averaging work because you buy it when it’s cheap and you buy it when it’s expensive. Overall, you’re not overpaying, you’re not underpaying when you’re doing dollar-cost averaging.

So where are we now? Well, at a 33 PE, that puts us right on this axis. So you can see right there, we’re going to see returns probably in the negative to plus 5% per year in the stock market if history is any indication of the future. So, not great. The PE has been a very good predictor of stock market returns, and today’s expected returns in the 1% range. And we’ll say -1% to 5% range is probably likely, given historical averages.

The Buffet Indicator is what he claims is the best single measure of where evaluations stand at any moment. Warren Buffett is the most successful investor of all time. He started with very little and has created billions and billions of dollars in wealth. And he said this is what he looks at, the total stock market value. Add up the market caps, so the stock price times the number of shares for every company relative to the economy. So if the stock market is valued more than the entire economy, it’s probably overpriced since it derives its value from the economy, right? So it actually makes a lot of sense. And if it’s a fraction of the economy, then it’s probably a good price. And so you can see here in 1999, not a good time to buy the stock market. You would have had some losses.

And here’s the mean, the long-term average. I only have just the latest here, since 1990 right here on. But you can see. We’re at a record high, so again, it shows the stock market is high. And this is a result of liquidity, and again it’s a result of the massive stimulus programs. Some of that liquidity flows into the stock market. So if you could borrow a billion dollars at 1%, what would you do with it? Well, you might buy stocks, and stocks go up. And not based on value necessarily, but based on the fact that you think someone else is going to pay a higher price than you will pay regardless of what the actual earnings are.

One of the things that is underestimated is the risk versus reward of the stock market. It never ceases to amaze me how existing financial advisors tell people to be in the safe investment in the stock market versus alternatives, which is our space. Many alternatives do not have nearly the volatility of the stock market.

And if you actually look at just since 2000, this is the yield and max price draw downs. Here’s the MLPs, this is KYN. There’s actually stocks in the KYN. It’s a MLP which is a midstream oil transport. And you can see one, two, three, four, five, six draw downs of 20% or more, and as high as 70%. So one morning you wake up and you’ve lost 70% of your investment. So you’ve had six of these just since 2000.

EQR which is an office REIT. You’ve had one, two, three, four, five, six, seven draw downs of 20% or more. So it’s pretty significant. And this is in order to get a 3% yield, you’re taking a 60 or 70% risk. The S&P 500, it’s the same. So people stretching for income not aware of the volatility risk. And which is why we’re in the alternative space which have superior characteristics in many ways. You simply do not have the volatility at the expense of some liquidity.

Why volatility matters? Well, this is what people also don’t realize. You’ve heard of the magic of compounding. I think it was Einstein who said it’s the greatest equation in the world is the fact of compounding. So here is one scenario. You invest $100,000 over 30 years, and your average yield is 9%. And look at this. So you at the end of 30 years at 9% growth, you have $1.3 million compounded. So that’s the power of compounding, right? And everybody should be doing this. Everybody should be working hard to make your money work for you. We all know that.

But here’s a comparative scenario. So scenario two is your average yield is 10%. But in this case, you gain 50% one year, lose 30% the next year. Gain 50%, then lose 30%. Now the average is 10%, right? The average over 30 years is 10%. But look at your overall what you end up with, a fraction. And so volatility is the destruction of compounded returns. And so people should avoid volatility wherever possible. This is one of the things that people simply don’t realize.

Bottom line for the stocks in 2021…

We will see a continued upward bias. And this has been our thesis for the last 10 years is we’re going to see a continued upward bias, but with volatility. So the stocks are going to go up, but be volatile. And the reason is stocks will benefit from a global stimulus, but valuations are generally unattractive. Indexes are increasingly plagued via concentration risk, and all these factors increase volatility. At the same time, the upward bias because of the global stimulus. So when money is being printed, asset prices rise. Anything that can’t be printed will go up. So you’re going to see stocks go up. You’re going to see real estate go up. You’re going to see gold go up. Although gold I don’t recommend as a big investment. And you will see Bitcoin up. You will see pretty much anything that can’t be printed going up. And it’s because of this global stimulus.

The outsize opportunities in my opinion for 2021 are the REITS with lodging and retail exposure. Some are down as much as 90%. Regional banks, again some are down 70 to 80% still, and they have never participated in the big gains yet, so they’re laggards. And the stock market is very faddish. The big boys have not yet started buying this stuff. So there’s a bunch of laggards. Entertainment shares like movie theaters, IMAX, et cetera likely. And also energy has been pummeled. Although I’m not very… I think caution is in order because oil prices are capped by untapped production and technology. The largest oil producer in the world is the United States, and it’s due to technology. And what happens when that technology is deployed in Siberia, and Russia, and Saudi Arabia, these large fields, oil prices are just capped. As soon as prices rise, you’re going to see production increase and flood the market. So I’m not very excited about energy in general. But there’s going to be some outsize opportunities in the 2020 laggards.

And there’s our bottom line for the stock market in 2021.

Related Articles

2021 Economic Forecast – Pt. 1 – The Economy

2021 Economic Forecast – Pt. 2 – COVID19 Recovery

2021 Economic Forecast – Pt. 3 – The Biden Tax Plan

2021 Economic Forecast – Pt. 4 – Housing Market

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