Why the stock market’s COVID vaccine-inspired rally could soon face a big test – MarketWatch

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It paid to look ahead in November as stock-market investors cheered progress on COVID-19 vaccines by rushing into shares of companies expected to benefit the most from a return to some semblance of normalcy.

The week ahead, however, could test the belief that investors can continue to ignore the present, as COVID-19 cases stage a resurgence, magnifying the human tragedy and threatening to undermine the economy’s rapid recovery from the initial near-shutdown caused by the pandemic earlier this year.

The market’s relentless rally, which saw the Dow Jones Industrial Average DJIA, +0.12% both trade and close for the first time above 30,000 on Tuesday, has more than a whiff of “euphoria” about it, said James McDonald, chief executive James McDonald of hedge fund Hercules Investments, in an interview.

McDonald is bracing for a pullback of 20% — or more — of the S&P 500 index SPX by the time of President-elect Joe Biden’s inauguration on Jan. 20. With that in mind, the analyst naturally recommends holding off on buying equities until after the expected smoke clears.

“Twenty percent just gets [the stock market] back to July numbers,” McDonald said. “I think the situation on the ground is less promising than seen in July. ”

The week ahead could bring a test as investors focus on first-tier economic indicators, including the U.S. Institute for Supply Management’s manufacturing report on Tuesday and its services report on Thursday, McDonald said.

Other key indicators include weekly data on U.S. jobless benefit claims on Thursday, which have shown two consecutive increases in first-time applications for benefits for the first time since July. On Friday, the November jobs report is due from the Labor Department.

Investors will also be sifting through real-time data for clues to activity on the retail front on Black Friday and over the weekend, traditionally the biggest shopping day of the year for Americans. That will offer a test of bullish expectations for spending to remain resilient overall, courtesy of a sharp jump in the savings rate as consumers banked fiscal aid dollars and saw spending opportunities curtailed by the pandemic.

The market, meanwhile, has seen a historic November run accompanied by a recent shift in leadership that has resulted in shares of companies and sectors left behind in the pandemic rally, staging a comeback against the large-capitalization tech and internet-related shares of companies that have benefited from the work-from-home phenomenon.

The more cyclically oriented Dow on Tuesday topped the 30,000 milestone for the first time, with the blue-chip gauge outpacing the broader, large-cap S&P 500 SPX, +0.24% for the month to date. The Dow ended Friday trade up nearly 13% for the month, versus an 11.3% gain for the S&P 500.

More impressively, the small-cap Russell 2000 RUT, +0.55%, has put in an almost 21% gain so far this month, outpacing the tech-heavy Nasdaq Composite COMP, +0.92%, up a not-too-shabby 12%, and the more large-cap tech-concentrated Nasdaq-100 NDX, +0.87%, up almost 11%, as of Friday’s close.

Growth stocks, companies whose earnings and revenues grow more quickly than their peers, have solidly outperformed value stocks, those seen as undervalued relative to their peers based on metrics like price to earnings or price to book value, over the last decade. That outperformance accelerated as the pandemic took hold.

Value stocks, however, have outperformed growth since the fall began and has continued to do so in November. The Russell 1000 Value Index RLV, was up around 14.8% in the month to date, outpacing a rise of more than 9% for the Russell 1000 Growth Index RLG, -0.67%.

Growth stocks had seen their valuations relative to value stocks stretch sharply over the course of the 2020 rally, leaving ample room to snap back like a rubber band. For the year to date, the value index remains down 2%, while the growth gauge is up more than 30%.

The strong market gains and the rotation have been accompanied by what many market watchers see as other signs of excess, including a robust market for initial public offerings and a sudden rush of controversial SPAC, or special purpose acquisition company, listings, not to mention bitcoin’s BTCUSD, +4.39% attempt at taking out its 2017 record high.

The fuel has come from a spate of positive reports on COVID-19 vaccines from late-stage trials, while some also attribute the past week’s gains to enthusiasm over President-elect Joe Biden’s selection of former Federal Reserve Chairwoman Janet Yellen to serve as his Treasury secretary.

“The combination of a Treasury secretary that markets believe will help economic recovery, a Fed that will underwrite the whole thing by allowing the economy to run hot and inflation to overshoot before they tighten, and a handful of very promising COVID-19 vaccines set to arrive in weeks, has sent risk sentiment into overdrive,” said Kit Juckes, global macro strategist at Société Générale, in a Nov. 25 note.

Indeed, even some analysts who remain upbeat on the market’s near- and long-term prospects see room for caution.

“The two biggest questions investors need to answer right now is, how will they react if the economy and corporate earnings fail to beat expectations for 2021,” said Michael Arone, chief investment strategist at State Street Global Advisors, in an interview.

Much of the market’s 2020 rally has been built on beating very low expectations for earnings and the economy, he noted.

Meanwhile, signs of froth have emerged, leaving parts of the market overbought and perhaps vulnerable to some near-term weakness, he said.

Arone, however, stopped short of describing the market rally as euphoric. Investors have been supported by expectations that Federal Reserve Chairman Jerome Powell will work well with Yellen to ensure both fiscal and monetary policy remain accommodative. Meanwhile, corporate earnings and the economy continue to recover despite the rising number of COVID-19 cases and investors are understandably looking forward to the eventual end of the pandemic.

If those things stay in place, it would “suggest a solid foundation for markets longer term,” he said.

If investors can look beyond what’s likely to be a near-term hiccup in the economic data, there is room for further gains through at least Biden’s oath of office in January, he said.

What about the rotation?

While there may be scope for some near-term outperformance by value-oriented sectors as the economy nears full reopening, the pandemic has accelerated economic trends that remain favorable to the stock market’s pandemic winners, said Tom Plumb, president of Plumb Funds and lead portfolio manager of the Plumb Equity Fund and the Plumb Balanced Fund.

“Value companies that don’t grow are value traps…There are going to be a lot of value traps out there,” Plumb said.

Arone argued for a barbell approach that would see investors maintain exposure to both growth and value stocks.

As the economy and earnings recover, there will be room for cyclical industries and sectors to close the gap to COVID-inspired highfliers, he said, a pattern that is likely to continue over the next six or 12 months.

But that doesn’t undermine the secular trends in favor of growth that have been set in motion by the coronavirus epidemic, he said.

“Life has changed permanently,” Arone said.

Spending by consumers and businesses will continue to be tilted toward technology, as will the majority of excess capital. “You can’t ignore those long-term secular trends, but in the short term, the cyclical trade has legs, in our opinion,” he said.

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