The stock market’s rally to a record on stimulus and vaccine hopes leaves little room for error

The bedrock of the market rally to historic highs is the trifecta of additional stimulus to get through the Covid winter, a smooth and effective vaccine rollout, and a significant second half reopening of the U.S. economy (the so-called “reflation trade”).

With markets at these dizzying heights, everything must go right, but pitfalls are everywhere. Biden may fail to get a stimulus program large enough to please the markets. The vaccine rollout may falter. New strains may emerge resistant to the vaccine. The recovery may prove to take much longer than anticipated, with unanticipated pockets of weakness.

“Right now, the whole reflation, stimulus, and vaccine story remains intact,” Alec Young, Chief Investment Officer at Tactical Alpha, told me. “But any change in that narrative will cause stocks to falter.”

It’s not just stock prices that are at extreme levels — the euphoria has driven investor sentiment to new highs, technicals to extremes, and expectations for earnings to very high levels.

Ed Clissold from Ned Davis Research noted that traders were exhibiting “extreme optimism” and wondered, “Are there any bears left?”

Technical levels are also at extremes. The 200-day moving average for the S&P 500 is a standard technical metric to measure momentum. The S&P 500 is now 16% above the 200-day moving average, twice the normal levels even in bullish markets. Other technical levels also are flashing overbought.

The S&P is trading in nosebleed territory: nearly 23 times 2021 earnings, well above the historic norm of roughly 15-17 times forward earnings. Bulls are insisting that a higher market multiple is appropriate when the economy is expanding as dramatically as is expected in the latter half of 2021, and that analysts are likely underestimating corporate earnings, as they did in the third quarter.

Others aren’t so sure. Among them are famous short seller Jim Chanos who quipped on CNBC that some stocks were getting far, far ahead of themselves: “The stock market is clearly looking ahead — at this point, I think it’s looking ahead to 2022, 2030, or 2050, depending on the stock.”

The good news: bulls have been right, so far. Early earnings reports have far exceeded expectations. The 43 companies reporting Q4 earnings so far have beat expectations by 18%, similar to the 19% beat in the third quarter, according to Earnings Scout. 

The bad news: Netflix aside, most companies that have reported are not rallying on strong earnings reports, a sign that while earnings are excellent, stocks have run up big and there is very little room for error.