Factors that could be part of the 2021 wall of worry

There is a reason why they call investing in a rising share market climbing a wall of worry.

Using last year as an example, markets had to get over their worries about the COVID-19 pandemic and the economic damage it caused before they could climb higher.

The fact that markets overall managed to climb over such a hefty obstacle was a testament to the resilience of investors who are able to look forward to better times – and to the effect of unprecedented amounts of government and central bank stimulus.

In many senses the same challenges are still here for 2021, with the virus still causing plenty of damage even as a raft of vaccines begin to make some tentative inroads into returning the world to a more COVID-controlled future.

Other existing worries that will certainly continue this year and need to be “scaled’’ by investors include the rising Australian dollar and the continuing trade tensions with China.

There are some other elements that can already be added to the wall of worry for the coming year, although if there is one lesson the pandemic taught us it is the power of unpredictable “black swan’’ events to disrupt the best laid plans.

Lofty valuations

One fairly obvious obstacle that will have to be scaled on the wall of worry is the question of valuation.

With interest rates being crushed globally by central banks, investors were encouraged to keep pumping up the valuations of shares and property to ever higher heights.

That was most obvious around local and international technology shares, with the buy now pay later stocks bubbling up to values that quite frankly defy common sense valuation metrics as sky-high premiums were put on growth and the chance of higher future cash-flows.

Internationally, that was shown by the doubling of the Nasdaq 100 over the past two years, as the pandemic caused a new appreciation for the scalability and fast adoption potential of technology.

It is not just technology that arguably entered bubble territory, with stocks such as iron ore giant Fortescue Metals (ASX: FMG) more than doubling over the past year as the price of the steel making commodity soared.

Allied to the very steep rises in some stock sectors was a flood of new money coming into the market through share issues, floats and other forms of capital raising.

That was particularly pronounced in the US, with an amazing US$368 billion in new equity raised in 2020, 54% more than the previous record year.

US IPO’s raised a new record of US$180 billion, a boom figure was inflated by a lot of so-called “blank cheque’’ companies that are designed to buy private companies.

However, it is still incredibly impressive compared to the $5.2 billion raised by IPO’s in Australia during 2020.

To keep climbing, companies will need to increase profits to justify valuation levels that are getting stretched, with the S&P 500 now selling at around 30 times profits while the Nasdaq 100 is at 40 times earnings.

It is a similar situation in Australia, with the ASX 200 index selling at around 32 times profits, a fairly lofty level to justify unless profits rise.

Bond yields back on the radar

Another potential worry is the level of bond yields.

While here in Australia the Reserve Bank has been spectacularly successful at crushing interest rates and therefore bond yields, there has been a concerning spike in the yield of 10-year Treasuries in the US.

While the US Fed has also been successful at crushing short term interest rates, longer dated bond yields have been rising to above 0.9% and are worth keeping an eye on, given the potential for rising bond yields to derail share markets.

Just as falling bond yields (and consequently, rising bond prices) were highly stimulatory for share markets, the opposite is also true and if the ten-year US bond rate were to climb to 1% or above, that would have the potential to provoke a sell-off in share markets more generally.

There is also plenty of potential for higher US bond yields to leak into the yield on longer dated Australian bonds, increasing the risk-free rate of return here and potentially capping the potential for further share price rises.

General economic growth

Economic growth is the really big question underlying all share market performance and it could go either way this year.

All things being equal, you would expect growth to take off this year given the amount of central bank and government spending stimulus that has been pumped into the economy to battle the pandemic.

If anything, the chances are that the stimulus has been overdone and growth could be even higher than expected, bringing with it the chance of some inflation pushing though to commodity and other prices.

However, the COVID-19 pandemic is far from over and other factors such as the trade issues with China and the rising Australian dollar could provide some Australia-specific issues to keep in mind.

As with climbing any wall, climbing the wall of worry is a step-by-step proposition and no matter how good your powers of prediction are, there will always be some unexpected obstacles to surmount.

There are many bullish indicators for 2021 but they all come with worries that will turn the rest of the year into a challenging but hopefully rewarding climb.