When you ask market participants what are some of the biggest lessons you learned in 2020, you will hear two common themes: Don’t fight the Fed and follow price action. These are important because they will continue to apply in 2021. Let’s start with price.
In late March of 2020, I wrote an article saying that just because the coronavirus numbers were likely to get worse, it didn’t mean the stock market had to go lower. The main reason I wrote this article was that the news was negative, but the price action in the stock market was telling a completely different story. Many people forget that the big institutions control the market and that the market is a discounting mechanism. In other words, the price action was firming up in late March and early April in anticipation of the economy rebounding later in the year.
A trader reacts as he works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., March 18, 2020. REUTERS/Lucas Jackson TPX IMAGES OF THE DAY
After the market recovered for approximately six months, two interesting “price thrust” events happened that could potentially give us a preview of what to expect in 2021. In early October 2020, we had a “Breadth Thrust Indicator.” This is a technical momentum indicator developed by the great Marty Zweig. Without boring you too much, it’s basically a rare event where the S&P 500 rapidly moves from an oversold condition to one of extreme strength. Thirty-two of the last 33 times this occurred, the index was higher one year later by an average of 16%.
Chart is provided by MarketSmith.
The second instance came via the “Three Day Thrust” signal, an event where the S&P 500 gains at least +1.5% on three consecutive days. This occurred in early November 2020. The other nine times this happened since 1970 all led to strong gains with the index up +14% on average six months later and 22% on average a year later. Bottom line, one of the biggest mistakes investors made in 2020 was getting brainwashed by the negative news and ignoring the incredibly strong price action in late March and early April. After a six month pause, this extreme strength resumed in early October and November. Institutional buying of this magnitude usually leads to higher prices one year later.
Regarding the Fed, the biggest difference between the financial crisis of 2008 and the coronavirus pandemic of 2020 is that the Fed acted IMMEDIATELY during the latter crisis. We were already in an equity friendly environment with plenty of liquidity being pumped into the financial system. The virus outbreak led to a globally coordinated stimulus effort on steroids. Whether we agree with it is not the issue. Our job isn’t to argue with Fed policy, it’s to take advantage of it. They say “Don’t fight the Fed” — well good luck fighting all the global central banks.
The market moves on two main factors
Many people forget the market moves on two main factors: earnings and interest rates. The actions of the Federal Reserve allowed the big institutions to put an insane amount of money to work in early April of 2020. In subsequent meetings, the Fed hinted that they will not raise rates until 2023. When you combine this extended low interest rate environment with the expected earnings recovery, it helps to explain the strong institutional buying in both October and November.
WASHINGTON, DC - DECEMBER 02: Federal Reserve Chairman Jerome Powell looks on during a House Financial Services Committee oversight hearing to discuss the Treasury Department's and Federal Reserve's response to the coronavirus (COVID-19) pandemic on December 02, 2020 in Washington, DC. Treasury Secretary Steve Mnuchin is also scheduled to testify.
You might be thinking this means it will be clear sailing in 2021. Absolutely not! There will be normal corrections and pullbacks along the way, especially to keep the bulls in check when investor sentiment gets too high. For example, right now many sentiment measures are showing extreme bullishness. From a contrarian point of view, this is important because the market tends to fool the majority. Although I am bullish on the market for 2021, I wouldn’t be surprised to see an 8%-12% correction in the first quarter. What would cause such an event? There really doesn’t need to be a reason. It could simply be because the market needs a pause before moving higher and a normal correction would wash out some of the excess bullishness. Keep in mind the average intra-year decline over the past 50 years is -14.5%.
Some other factors to consider in January are taxes (as some investors may wait until 2021 to sell stock in order to delay taxes for a year), the smooth transition of the new presidential administration, and the Georgia Senate races. If the Democrats win both Senate seats and corporate taxes increase, this could affect the aforementioned earnings recovery and estimates on the S&P 500 would likely come down. An increase in the capital gains tax might also put pressure on the markets.
Again, the price action will be more important to me than the news and the politics. Remember the words of Warren Buffett: “If you mix your politics with your investment decisions, you’re making a big mistake.”
In summary, 2021 should be a strong year for the markets based on all the recent institutional buying and the continued low interest rate environment. I am expecting a correction during the first quarter to shake out some of the excessive bullishness. But when the dust settles, this will be a buyable event. That’s why it’s so important to know your timeframe and stick to a plan based on your investment objectives.
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