Exactly a year ago a new bull market was born. Fueled by unprecedented momentum, the stocks crawled out of their deep pandemic and sprinted.
History shows that after the decline of the big bear market, strong bull markets usually follow and profits move into a second year. However, investors should expect a lower return over the next 12 months if a more troubled road leads there.
It was on March 23, 2020 when the S&P 500 bottomed after the Covid crisis caused the stock benchmark to drop 30% in 22 days. This was the biggest drop in such a short period of time. There have been five more bear market sales of 30% or more since World War II, and the market has risen for the second year every year with an average return of nearly 17%, according to LPL Financial.
Still, the comeback rally is usually difficult to beat in the first year. It wasn’t until after the 1987 crash, according to the data, that stocks rose more sharply in year two than in year one. Plus, the second year of a new bull market is prone to pullbacks with an average drawdown of 10%, LPL said.
The S&P 500 has recovered about 80% from its low in March, marking the best start to a new bull market, LPL data showed. That historic start could open the door to more dips and more volatility on the horizon.
“Entering the second year of the current bull market could 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 non-sports agent who disappoints after the nine-figure contract, or the sequel that just doesn’t do the original justice.”
4% profit from here?
According to the CNBC Market Strategist Survey, which rounds up the projections of 15 top strategists, Wall Street’s consensus year-end target for the S&P 500 is 4,099, up 4% from Monday’s close of 3,940.59 .
The bull market was officially declared when the S&P 500 erased its pandemic losses and hit a record high on August 18. Then the beginning of a bull cycle was retrospectively traced back to the market trough.
Still, the “Black Swan” event of 2020 makes the current bull market unique. In contrast to the previous crises, which were caused by the malfunction of the financial markets, this time the downturn was triggered by a pandemic. And, unlike the slow and steady recovery in previous cycles, that recovery has been extraordinarily rapid thanks to the trillions of dollars in help from Congress and the Federal Reserve.
“This is the first bull market that any of us have gone through that was essentially made by the government and the Fed,” said Tom Essaye, founder of Sevens Report. “The huge equity gains were not organic. They were essentially decided by the government to take on huge debts and deficits to stimulate economic activity. That changes the outlook for the future.”
While history is on the market’s side, many believe the new bull’s enduring strength will depend on its ability to sustain the rally without massive impetus. A new round of stimulus checks hit Americans’ bank accounts this month. Once the stimulus wears off, Wall Street is betting that corporate earnings will hold the heavyweight and deliver on the high promises that stock prices have made.
What are the risks?
At the current level, the S&P 500 trades more than 21 times with forecasts for next year’s earnings, a level that, according to FactSet, has not been reached since 2000.
“You are essentially switching from a rally shaped by the government to a rally that we will hopefully be organic, at which the economy will reopen and which in turn will only be self-sufficient,” said Essaye.
Meanwhile, given the historic economic reopening and massive stimulus, inflation expectations are rising, making it harder to justify the high valuations of stocks. Concern has manifested itself in the underperformance of the tech-intensive Nasdaq Composite since the beginning of the year as higher inflation and interest rates undermine future earnings for growth-minded companies.
Another potential threat as this bull market ages could be higher tax rates as President Joe Biden is set to propose higher tariffs to fund a major infrastructure program. Goldman’s U.S. equity strategist David Kostin warned investors that Biden’s tax plans could cut S&P 500 earnings per share by 9%.
Biden has signaled his willingness to raise the corporate tax rate to 28% as part of a partial withdrawal of President Donald Trump’s 2017 tax overhaul. Meanwhile, Biden also advocated raising the highest marginal tax rate to 39.6% and taxing capital gains and dividends at the higher ordinary income tax rate.
Wells Fargo expects corporate tax rates to rise but not fall below Biden’s 28% proposition, and that damage from higher taxes will be mitigated by stronger corporate profits.
“We believe that record economic growth and household spending will support higher profits and potentially offset the burden of a higher tax regime,” said Ken Johnson, investment strategy analyst at Wells Fargo, in a note.
– With the assistance of Nate Rattner from CNBC