Americans have watched in disbelief during the past year as financial markets lost value in one of the largest and fastest recessions in history, followed immediately by one of the largest and swiftest recoveries in history. The signals seem lined up to push equity prices higher, though many historic indicators such as P/E ratios are flashing red and hint that markets may have become a bit overheated. What are the fundamental and historic forces that are pushing these trends and what strategy can reap the gains and avoid the dangers?

One complication is that there are causes on both sides of this recession — demand and supply. There are also responses on both sides, thus sorting out the full effect is a bit tricky but not impossible. The Bureau of Economic Analysis (BEA) reported that the U.S. economy contracted at an annualized rate of -5.0% in Q1 and -31.4% in Q2 of 2020. In magnitude, that is over a third of the nation’s output. We saw the effects as most activities that we associate with our normal lives came to a rapid halt.

The response was equally swift. In a series of rapid reactions during 2020, the federal government implemented six stimulus bills totaling $5.3 trillion or 25.5% of GDP. The Federal Reserve implemented credit measures of $4.0 trillion. Not all of that spending and credit has flowed into the real economy, and not all of it will. But the flood of spending and credit into the economy to restore demand has already had an effect. The BEA reported that growth in Q3 was 33.4% and Q4 was 4.3%, and 2020 closed with a net real GDP loss of 3.5%. Our economy grows by about 2.0% in real (adjusted for inflation) terms during a “normal” year, so that leaves us about 5.5% down. That’s consistent with unemployment of 6% so there is room to absorb those historic levels of stimulus.

Stock prices have responded accordingly, with equity markets recovering from their historic 32% peak to trough drop to close 2020 ahead by 16%. Through the 1st quarter of 2021, stocks are up 5.8%. Stock prices are forward-looking, so this would be consistent with continued recovery in 2021. Jay Powell, Chair of the Federal Reserve, has reported that he expects recovery to continue and that the “output gap” — the difference between what the economy is actually producing and what it is capable of producing — should be closed by the end of 2021 or early 2022 absent any further disruptions.

The easy part is to say recovery will continue and that equities will rise. The difficulty lies in looking over the horizon to assess the damage the pandemic has done to supply, the productive capacity of the economy. The risk is that that lavish stimulus will cause demand to exceed supply, the economy will overheat and cause inflation and rising interest rates. There is enough idle capacity at present to absorb stimulus in the short term. Also, companies learned valuable lessons during the pandemic that will result in productivity improvements and lowered costs. For example, improvements in online operations have allowed many companies to reduce office footprints and lower operating costs.

But perhaps the most telling trend has been the reduction in the nation’s labor force that has resulted from the pandemic. In December 2019, the participation rate was 63.3% and rising. Presently, it is 61.5% and falling slightly. Businesses are already reporting spot shortages of labor, especially in skilled manufacturing specialties. Clearly, the risks for inflation and interest rates lie to the upside in the medium to long term and bear monitoring. It is not a forgone conclusion that supply and demand imbalances can’t or won’t be resolved to keep inflation in check. For decades, investors have fretted over the prospects for above-average inflation only to watch inflation remain under the Fed’s two percent target all but for very brief periods of time.

So — as the old saying goes, “…make hay while the sun shines…” and seize the upside. It’s clear that the stimulus is having the intended effect of restoring economic growth both directly in the form of lower interest rates, notably lower mortgage rates and indirectly in the form of higher stock prices and the so-called “wealth effect”. At the same time, we stay vigilant for signs of inflation and higher interest rates.

Let’s not forget that each day more Americans get vaccinated and that each day, we get closer to herd immunity and a life we knew pre-COVID. Collectively, these factors suggest that stock prices in general can indeed go higher in 2021.

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