2020 has been a remarkable year for the U.S. equity market. After plunging by 34% from peak to trough in the first quarter, the market staged its fastest rebound in history, hitting a series of new all-time highs during the second half of this year. A large part of this had to do with the fiscal and monetary policy response, but also a willingness on the part of investors to look through the pandemic and any associated weakness in the economy and corporate profits. However, with the S&P 500 up 14% year-to-date through the end of November, investor attention has begun to focus on what might be in store for 2021.

From an earnings perspective, a strong bounce seems likely. Consensus estimates for 2021 S&P 500 earnings currently stand at $166 per share, which implies 38% growth for the year as a whole. This does not seem completely unreasonable, and as a result, profits could very well hit a new all-time high by the end of next year. A large part of this view on the level of 2021 earnings is driven by stronger than expected economic growth in 4Q20, as this should translate into a higher dollar value of earnings at the start of 2021 than we had previously forecast. That said, we are a bit more pessimistic than consensus on the pace of earnings growth, as better than expected earnings during the back half of 2020 may limit the magnitude of profit growth going forward (Exhibit 1).

Exhibit 1: Earnings should bounce strongly in 2021
S&P 500 EARNINGS PER SHARE, INDEX ANNUAL OPERATING EARNINGS

Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Historical EPS levels are based on annual operating earnings per share. Earnings estimates are based on estimates from FactSet Market Aggregates. Past performance is not indicative of future returns. Data are as of November 30, 2020. 

Turning to valuations, it would be surprising to see further multiple expansion. Rather, next year looks set to be characterized by multiples that gradually decline on the back of stronger earnings. We agree with the idea that lower interest rates do support higher multiples—as lower discount rates increase the value of future earnings—but as the world returns to normal we expect long-term interest rates will move higher and exert modest downward pressure on equity valuations (Exhibit 2). There is also a sectoral argument: will investors continue to pay such elevated multiples for mega-cap growth stocks that have benefited from the pandemic, even as that pandemic draws to a very welcome close? The answer is probably not, and with these names commanding such a large share of the indices, the path of least resistance for valuations is lower.

Exhibit 2: P/E ratios could fall from elevated levels as interest rates rise
S&P 500 INDEX: FORWARD P/E RATIO

Source: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since December 1995, and FactSet for November 30, 2020. Current next 12-months consensus earnings estimates are $166. Average P/E and standard deviations are calculated using 25 years of IBES history. Shiller’s P/E uses trailing 10-years of inflation-adjusted earnings as reported by companies. Dividend yield is calculated as the next 12-months consensus dividend divided by most recent price. Price to book ratio is the price divided by book value per share. Price to cash flow is price divided by NTM cash flow. EY minus Baa yield is the forward earnings yield (consensus analyst estimates of EPS over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. Std. dev. over-/under-valued is calculated using the average and standard deviation over 25 years for each measure. Data are as of November 30, 2020. 

We have received lots of questions about whether the recent outperformance of value relative to growth is the beginning of a broader rotation in the market. While the coming year will likely be characterized by an ebb and flow between growth and value, it seems reasonable to argue that more cyclical assets will outperform. Another round of fiscal stimulus, coupled with accommodative monetary policy and the potential for widespread vaccine distribution in the second half of 2021, all support the narrative of accelerating economic activity and rising inflation next year. While this may translate into mid-single digit gains at the index level, there will likely be a greater opportunity beneath the surface. We still like growth stocks in the long run, but the clouds do seem to be breaking over cyclicals and small caps as we round the bend into 2021.