Stocks face a tougher climb in 2021 due to 'inevitable hangover of policy,' top Wall Street strategist says

• Stock valuations were already outpacing the economy in 2019, and the coronavirus pandemic only exacerbated the issue.
• That poses a risk to the market's climb in 2021, Seema Shah, chief strategist at Principal Global Investors, said in a blog post.
• Fundamentals and valuations continue to play second fiddle to the Federal Reserve's unprecedented policy backstop, Shah said, but that support will eventually need to be pulled back.
• Monetary policy is reaching its limit, and once the economy returns to pre-pandemic levels of activity, the central bank will then need to focus on the US's massive debt pile.
• The second stage of the US recovery "will involve dealing with the inevitable hangover of policy, debt levels, and dependency on low rates," Shah said: "That's when things will get a whole lot tougher."
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One of the biggest hurdles facing stocks existed well before the pandemic and only got bigger through 2020, a top Wall Street strategist says.

Stock valuations sit near record highs despite the broader economy still operating well below pre-pandemic levels and slowing its pace of recovery. Equities ran "far ahead of economic realities" in 2019, a disconnect that only intensified during the COVID-19 crisis, Seema Shah, chief strategist at Principal Global Investors, said in an October 28 blog post.

Last year's dislocation between growth and value stock performances also widened through 2020. Such gaps pose significant risks to stocks until they're addressed, Shah said.

"2020 is the year we would all like to forget — and somehow, equity markets have already done just that," Shah said. "Indeed, just as it was in late 2019, fundamentals and valuations appear to be of limited relevance in this market."

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Much of the market's gains can be tied to the Federal Reserve's unprecedented policy support. The central bank's asset purchases, credit-market backstop, and historically low rates helped pull investors back into the market and stave off bankruptcies expected to take place through the recession. Investors who stuck with the "don't fight the Fed" strategy should continue to do so in 2021, because monetary policy support is the "key determinant" for markets next year, Shah said.

But just as the central bank's support lifted markets, the unwinding of such aid could slam valuations. The Fed is expected to keep rates near zero for several years to aid the nation's recovery, but markets have grown unhealthily dependent on low rates, Shah said.

Once economic activity returns to pre-pandemic highs, the US will inevitably need to turn its focus to its massive debt pile. Markets are poised to face some turbulence as the Fed retracts its policy support and reins in the liquidity that helped pad the economy — and investors — from additional damage.

If the first part of the market's recovery came from the central bank's support, the Fed's withdrawal will kick off a new, more challenging climb, Shah said.

"Part two of the story will involve dealing with the inevitable hangover of policy, debt levels, and dependency on low rates," Shah added. "That's what things will get a whole lot tougher."

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