Analysis: Wall Street brushes off political turmoil, looks to economic rebound

NEW YORK (Reuters) – The U.S. stock market is mostly unfazed by the political turmoil in Washington and fears of violence ahead of President-elect Joe Biden’s inauguration, with investors squarely focused on the probability of another sizeable stimulus package to boost economic growth and the rollout of coronavirus vaccines.

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The benchmark S&P 500 index stands near record highs while bond yields have rallied to their highest levels since the pandemic began, despite last week’s shocking assault on the U.S. Capitol by supporters of President Donald Trump – an apparent divergence between the political and economic realities on the ground and market valuations.

With Trump’s presidency due to end on Jan. 20, investors say they are looking ahead to the trillions of dollars of additional stimulus promised by President-elect Joe Biden and his fellow Democrats, who will soon control both chambers of Congress, and what it would mean for economic growth and corporate profits.

“It’s a market that actually says, ‘We are investing for 2021 and we see explosive economic growth in the back half of this year,’” said Art Hogan, chief market strategist at National Securities. “Because the market is a forward pricing mechanism, it frustrates the people that are watching the news in the here and now.”

Still, some investors wonder whether the market has gotten ahead of itself in a rally that has seen the S&P 500 surge more than 60% from its March lows. Rising Treasury yields threaten to dent the allure of stocks, which are trading near their highest valuations in 20 years, while the Federal Reserve could accelerate the timing of interest rate hikes if the recovery proves stronger than expected.

Among the investors that have recently expressed concern are Jeremy Grantham of money manager GMO, who said earlier this month that the stock rally “has finally matured into a fully-fledged epic bubble.”

Bond giant PIMCO was more circumspect, predicting on Tuesday that the U.S. economy could rebound to pre-recession levels later this year but pointing out a bevy of risks, including a sooner-than-expected withdrawal of fiscal stimulus. Meanwhile, regulation concerns loom over the big technology and internet stocks that account for more than 15% of the S&P 500, and wild rides in the shares of electric car maker Tesla and cryptocurrency Bitcoin are bolstering the case for those who argue markets have entered a bubble. As markets have climbed, some investors have been in sell mode: Net outflows in equities totaled $2.4 billion last week, coming on the heels of near-record withdrawals a week before, client data from BofA Global Research showed.

“Flows suggest clients may be cautious to add more equity exposure given index highs and extended valuations,” BofA Global Research said in a note on Tuesday. Doubts about the rally’s sustainability were a periodic feature of the decade-long bull market that followed the 2007-2009 recession and figured prominently in last year’s rebound, when many analysts and investors were struck by the dissonance presented by surging stock prices and the human and economic misery brought by the pandemic.

HIGH VALUATIONS

More recently, the market has looked past the Jan. 6 storming of the Capitol and the subsequent push by Democrats to remove Trump from office, with the S&P 500 rising 2% over the past week.

Should more political unrest occur around Biden’s inauguration, investors have said they expect any associated market volatility to be temporary. Upcoming corporate earnings reports may need to be strong to support stock valuations. The S&P 500 trades at 22.7 times future earnings estimates, well above its long-term average of 15.3, according to Refinitiv Datastream.

So far, that’s what’s expected. Earnings for S&P 500 companies are expected to rise nearly 24% in 2021 after falling 15% last year, according to IBES data from Refinitiv.

“I’m not concerned because I think market valuations are reflecting a quicker rebound in profitability than folks thought was possible in the spring,” Fed Vice Chair Richard Clarida said on Friday.

Low interest rates and Treasury yields, which keep borrowing costs attractive for companies and help make equities relatively more attractive in comparison with bonds, have provided another rationale for the high valuations. However, the yield on the benchmark 10-year Treasury note has risen recently, climbing to around 1.11% from 0.78% about two months ago. While that increase supported interest rate-sensitive stocks such as banks, a sharp rise in yields could hit stocks, particularly those with longer-duration cash flows such as tech and growth stocks.At the same time, markets are starting to push up bets on when the U.S. central bank could tighten monetary policy, with eurodollar futures contract prices reflecting growing odds that a rate hike could happen as early as June 2023, roughly three months earlier than was priced in a week ago. “On a 12-month horizon, we would advise investors to be overweight equities, but for shorter-term positions right now we are more neutral,” said Erik Knutzen, multi-asset class chief investment officer at Neuberger Berman.

Reporting by Lewis Krauskopf; Editing by Ira Iosebashvili, Megan Davies and Paul Simao