Share

Kelly Bogdanova
Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.

With the unprecedented storming of the U.S. Capitol building following one of the most controversial presidential elections in history, and the related violence and bloodshed, why is the U.S. equity market acting as if nothing much has transpired?

On Wednesday, the fulcrum day, the S&P 500 rose 0.6 percent. On Thursday, it tacked on another 1.5 percent. The Dow Jones Industrial Average fared well also, and small-capitalization indexes were even stronger.

The S&P 500 is hovering near its all-time high and its valuation is well above average following the biggest recovery rally since the 1960s.

Yet we’ve just experienced a tragic day in American history, and there are a multitude of challenges facing the country. In the past, the market has sold off time and time again on issues of much lesser importance. Is the market defying logic?

The straightforward answer is yes and no.

Tolerance limits

First off, we think it’s naïve to assert that the massive ideological divisions that exist in the country—if left unchecked—won’t ultimately lead to negative consequences for broader society and the economy and asset prices at some point in the future.

And we think it’s equally naïve to assume the divisions will be mended anytime soon.

In this respect, the market could be rightly accused of defying logic with its sanguine response to the turmoil shaking the country.

The market isn’t “political”

But the U.S. equity market is not currently and has never been a real-time barometer of the overall ideological and institutional health of the nation. As we’ve previously written, “the market” doesn’t necessarily reflect Main Street or even American society as a whole.

Simply put, the major U.S. equity indexes represent the future prospects of corporate earnings for many of the largest and most successful companies in the world. When we own stocks, we own a portion of these profit streams.

The market is not blue, red, or even purple in its ideology. And to some degree, it’s not even red, white, and blue, as a portion of the revenues comes from overseas via large and mega-sized multinationals that are domiciled in the U.S. and also have operations elsewhere.

In reality, the market is mostly about green—as in profits.

The reason the S&P 500 and other major indexes were not defying logic by rallying on Wednesday and then scooting higher on Thursday is because at this stage market participants perceive that Democratic control of the Senate, combined with the House of Representatives and White House, will lead to greater fiscal spending on COVID-19 relief and other federal initiatives, and would support economic growth.

The market has had a voracious appetite for fiscal stimulus since the pandemic began, and wants more—above and beyond the significant stimulus that has already been doled out. It seems hungry for clean energy infrastructure spending, too.

We think the market is also at ease with the party control scenario because this Democratic “blue wave” will be somewhat restrained, in our assessment. There is a big difference between a 5–10 foot wave (akin to narrow control of both chambers of Congress that Democrats will have) and the power of 30–40+ foot winter waves that break at Mavericks (akin to strong congressional majorities).

Thus far, risks of tax increases are not at the forefront. We think this is because razor-thin Democratic control in the Senate, combined with the party’s narrow majority in the House, makes passing sweeping, substantial tax hikes difficult to achieve.

Also, in our view, politicians generally recognize that raising taxes in the early stages of an economic recovery and amid persistent COVID-19 economic challenges would be ill-advised, and this effectively reduces the risk of substantial tax increases—at least in 2021.

Constructive footing

The strong rally in the major U.S. equity indexes in the past couple months, combined with the significant surge since the March 2020 lows, raises questions about the sustainability of the moves. Technical indicators point to an increased risk of a near-term pullback, in our view. That said, most broad averages are not far above where they were back in Feb. 2020 before the COVID-19-related retreat began. Nor are the typical harbingers of a bigger, more prolonged retreat in share prices anywhere in evidence—e.g., a breakdown in market breadth or a sustained, multi-month decline in small caps. In fact, the opposite is true: advance/decline lines have been making new highs ahead of the indexes and small caps are leading the charge.

The market has rallied substantially since the March 2020 low, but isn’t much higher than the pre-COVID peak
S&P 500 Index level over two years
Line chart - showing the market has rallied substantially (current level: 3803) since the March 2020 low of 2237, but isn't much higher than the pre-COVID peak a month earlier on 2/18/20 (3386).
  1. February 2020 pre-COVID peak
  2. March 2020 COVID panic low
  3. Current level

Source - RBC Wealth Management, Bloomberg; daily data through 1/7/21

But even if the market takes a much-needed rest or retreats somewhat, we think it has the potential to deliver worthwhile all-in returns for the year. We expect corporate profits to gain more ground as the economic foundation becomes sturdier with the help of ongoing ultra loose monetary policies, another round of fiscal stimulus, and the ultimate taming of COVID-19 headwinds.

To start the year, we would Overweight U.S. equities. We would position portfolios with a mix of cyclical (economically sensitive) and defensive dividend-paying sectors, with a tilt toward the value side of the fence.


This article was originally published in the Global Insight Weekly with the title "Is the market defying logic?".

This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.

The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.

This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.


Kelly Bogdanova

Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.
We want to talk about your financial future.