It’s wise to be skeptical of 2021 market forecasts

As long as Wall Street has been in existence, it has been a tradition around this time of year for market participants to make predictions about what might happen to stock prices, interest rates, commodities and exchange rates in the following 12 months.

These predictions garner a lot of attention, as they are made by very smart people with access to the best data and with vast resources at their disposal. And yet, far more often than not, these predictions end up being hilariously wrong.

If anything, 2020 should have proven once and for all the futility of trying to make accurate market predictions.

Coming into this year, nobody said a killer virus would emerge that would plunge the global economy into the worst recession since the Great Depression, leading to one of the biggest stock market crashes in history and the price of oil tumbling to below zero dollars a barrel, only to be followed by one of the fastest economic and market recoveries in history. Yet, a strategist who predicted the S&P 500 Index would be up more than 15% in 2020 would have been proven right—but for the wrong reasons.

So, while big, sweeping forecasts are the ones that draw the headlines, the ones to pay attention to are those that look only one to two months ahead or 10 to 20 years ahead.

The easiest forecasts to make are over the very-short or very-long term. That’s because chances are high that one-year predictions will be disrupted by exogenous events, unlike a very-short- or very-long-term outlook. (Besides, the nice thing about extremely long-term forecasts is that, by the time they arrive, everyone will have forgotten you made them.)

For those compelled to forecast financial markets in 2021, the first place to start is the Federal Reserve. The second is the federal government.

Monetary and fiscal policy are the two biggest inputs to financial markets, and we don’t seem to be getting a lot of restraint in either.

The Fed has pumped $3 trillion directly into the financial system this year, mostly via its purchases of bonds, increasing its balance sheet assets to $7.24 trillion. It’s planning to continue to pump $120 billion into the bond market every month for as far as the eye can see while keeping interest rates at zero well into 2023.

Although we don’t at the time of this writing know the outcome of the Georgia Senate runoff races, a result that could give the Democrats control of the U.S. Senate to go along with the House of Representatives and White House, it seems as if both major parties are in favor of providing a lot more fiscal stimulus in addition to the $4 trillion or so expended already.

In essence, the two major conditions that led to strong market performance in 2020 will still be present in 2021, along with an additional one: the distribution of tens—perhaps hundreds—of millions of COVID-19 vaccine shots.

The thoughtful Wall Street types point out that the starting point for valuations is much higher than at the bottom of previous recessions.

But as recent history has taught us, it’s difficult to make predictions based on valuations, because extremes in valuations can always get more extreme.

For evidence, just take a look at some of this year’s biggest gainers. And yet, it’s possible that valuations will compress as earnings recover from the pandemic.

Another thing to consider is the huge sentiment implications of the recent elections and how they are pushing the public discourse away from polarization and toward moderation.

Six months ago, people were getting killed in left-versus-right street battles. Now, we’re arguing about whether Jill Biden should address herself as “doctor.” With a centrist Joe Biden in the White House and an almost evenly divided Congress, we’re shooting straight down the middle.

If history is any guide, political moderation is great for financial markets. Consider the 1950s and the 1990s, when the ideological differences between Democrats and Republicans were relatively small. We’re not there yet, but the 2020s have the potential to be very friendly to financial assets.

As for interest rates, we’re in a bit of a pickle. With an expanding economy, longer-term rates should rise from these record low levels, and the difference between short- and long-term bond yields should expand.

But from a practical standpoint, rates cannot be allowed to rise far because the federal government has borrowed so much that there’s the potential risk of insolvency.

The upside is that, with former Fed Chair Janet Yellen poised to become the next Treasury secretary, there is potential for a great deal of coordination between the government and the central bank. That’s code for saying there will be a tacit agreement for the Fed to continue to monetize the nation’s debt.

In reality, all that strategists really do when making their year-ahead predictions is look at what happened the last couple of months and extrapolate it out a year.

In this case, that means value stocks outperforming growth stocks, a weaker dollar and rising commodity prices.

It’s possibly those trends will continue, but the only reliable prediction to make is that there will be plenty of surprises in 2021.