Bank of America's chief investment strategist made some extremely strong comments recently which are sure to resonate whether you are a bull or bear yourself. Following the bank's survey of large asset managers, it reported an optimistic consensus about stock market growth based on economic recovery, low interest rates, and stimulus.
This raises the question: Are we looking at nothing but blue skies ahead, or is everyone overconfident as we march toward a cliff?
Lots of good news
There are certainly reasons to be optimistic right now. Signs of economic recovery are becoming more clear, with unemployment falling, consumer sentiment rising, and better-than-expected corporate financial results dominating the most recent quarter.
Many economists are calling for more than 6% GDP growth in the U.S. in 2021 as pandemic restrictions are relaxed, which would be the highest rate since 1984. Manufacturing activity is also heating up. All of these factors will drive strong financial performance for businesses, and good fundamentals are usually sufficient to support the stock market.
Fundamentals are important for investor confidence and long-term growth, but fiscal and monetary policy are more relevant factors in short-term stock prices. All signs point to policies that will continue to support the market right now. The federal government is passing unprecedented stimulus through tax breaks and direct transfers to consumers, which will lead to increased spending and more cash going into retail brokerage accounts.
The Federal Reserve has consistently reiterated its commitment to keeping interest rates low, showing a focus on supporting employment rather than avoiding inflation. Fed policy keeps interest rates low, which stimulates economic activity, and it also creates extra incentive for asset managers to keep heavy stock allocations at the expense of cash or bonds. All of this is fueling the bullish fire, and these are undeniable catalysts.
The contrarian view
Contrarians see unchecked optimism as a warning sign of exuberance. If everyone is concerned that nothing bad can happen, then the first signs of trouble can induce some panic. While there's plenty to be excited about right now, there are some valid points in the bearish narrative.
Cash balances at large institutional investment funds are at the lowest level since 2007, and retail investors are taking successive rounds of stimulus and plowing that into the market. These capital flows are driving prices higher across almost every asset class. Major stock market indexes are near all-time highs, as the S&P 500 has climbed more than 30% above its pre-pandemic level. The median listing price for U.S. homes is up 13.7% year over year. Gold has gained more than 10% over the past year, and commodities are charging as well.
This is clear evidence that investors are fleeing en masse from cash and bonds due to economic optimism, inflation fears, low interest rates, and speculation. There isn't much cash left on the sidelines to bid equities higher, which means that there's now more fuel for downside than upside in the stock market.
Reputable investors are giving voice to this less-than-rosy outlook. Sam Stovall, the Chief Investment Strategist for CFRA, says that a pullback is inevitable. Other investment executives from organizations such as Ally Invest and Goldman Sachs have noted that historically high valuation levels across numerous asset classes are creating a scenario with more risk than growth potential.
Things could get choppy if the bullish narrative doesn't play out exactly as expected. A new strain of coronavirus that renders vaccines less effective could lead to more shutdowns, which would scare speculators and send stocks tumbling from lofty valuations. Faster-than-expected monetary tightening (which could be driven by rapid inflation) is likely to pull capital out of equities and back into bonds or cash, which could drive a "taper-tantrum."
Alternatively, economic recovery might simply take longer than expected if the mass layoffs and small business closures in the dining, travel, and hospitality industries don't get resolved with rehiring in the short term. That could drag stocks down, too.
Digesting it all
It's hard to say there is no reason to be bearish. Sure, there are great reasons to be optimistic right now, but clear risks remain in play.
I hope that the economy recovers quickly, the Fed slowly raises rates in a way that investors can stomach, inflation remains moderate, and the market is able to tread water until fundamentals are able to support historically normal valuations. That all may very well occur, so I'm staying invested.
However, I recognize that there are still risks that could derail the bull narrative, and we are currently at a point where bad news could have particularly dire consequences for the market in the short term, so I'm not chasing returns. There are accomplished and sophisticated investment professionals who have polar opposite views of the current situation -- things are uncertain.
That's why it's important to have a long-term view when it comes to investing. This is all basically an odd instance of cyclicality, which is a common occurrence over time in the stock market. Come up with a plan to balance growth and stability that's tailored to your goals and risk tolerance, and stick to it. Don't let emotions cloud your judgment in times of uncertainty.