Happy Thanksgiving to all. Unless there is an unforeseen monumental news event between now and Friday morning there will not be a Market Comment on Friday. No sense in writing a bunch of words when no one is around to read them.
Stocks celebrated yesterday, setting record highs once again. There is no really good explanation other than at least for now, the path of least resistance is higher. Bonds, currency and commodity markets showed little change.
If you spend too much time watching the media, the list of concerns is long and lengthening. The yield curve is flattening. Tax reform is uncertain. Trump’s tweets constantly create chaos (perhaps by design). There are rising political tensions in the Middle East pushing oil prices higher. The resultant rise in gasoline prices is a tax on the consumer. Retailers are still facing difficult times competing against online markets. Auto sales are starting to top out. There are some signals in the junk bond market that risks are getting alarming, at least in the telecom space. Bitcoin speculation shows all the characteristics of a bubble forming. Leadership at the Federal Reserve is about to change.
Yet despite all the above, stock prices keep climbing.
To understand this, just look at earnings. Earnings are the big driver of stocks. Interest rates and currency markets are benign, at least for the moment. The rate of increase in stock prices has been a bit faster than earnings growth, suggesting that we shouldn’t get too complacent. Some sort of correction would seem logical. Most likely it will happen when complacency peaks and we least expect it. But a 10% correction isn’t something to be feared. In bull markets, these are common. They reset attractive buy points before ultimately, stock prices move to new higher ground.
But while the leading indices are setting record highs on a regular basis, not all stocks are at or near highs. On any given day, the list of new lows, in fact, isn’t that much smaller than the list of new highs. Again, it comes down to earnings, both present and expected.
I have noted often how since the Great Recession, shareholders have pressured managements to harvest and maximize free cash in order to return more money to shareholders in an environment starving for income and yields. There was a time not that long ago, that when the S&P 500 yield fell below 3%, it was a signal to sell stocks. It was a sign of too much speculation in the market. Today, with the S&P yielding less than 2%, despite persistent dividend growth for the last 8 years, stocks paying more than 3% are hard to find, and actually, not all that attractive if they can’t find a way to grow.
Despite collective efforts to harvest cash, there is a class of companies that have taken the exact opposite approach. They have reinvested every last dime in order to accelerate growth. Most of these are in the tech space, but not all of them. But certainly, today’s emerging giants like Amazon, Facebook#, and Alphabet#, have done just that. Moreover, their business models are asset light. They don’t have to spend very much on bricks and mortar. Amazon has to build distribution centers and carries lots of inventory, but distribution centers are just metal buildings that can be built on relatively inexpensive real estate. That contrasts to retail stores that need to locate in high traffic areas where rents are highest.
In contrast to Amazon, Facebook and Alphabet, many old-line companies, in order to harvest cash, have concentrated on cutting costs. At the beginning, it is easy to remove the first layers of fat, but over time, the dividing line between fat and muscle are tougher to discern. Companies stop doing ground floor research. Putting smaller Oreos in a 100-calorie bag isn’t innovation. The food companies that supplied the center of supermarkets have finally started to figure out that their customers are going to the edges of the store to buy fresh and prepared foods. They are going to specialty stores that sell nutrition, not empty calories. Department stores are slowly figuring out that they can’t control markets selling products made by others. The manufacturers of the most popular brands now control them. They must ask themselves today, how can they provide superior value to their customers. Looking at sales trends, most haven’t found the answers yet. It’s not that they are losing to Amazon as much as they have failed to adapt to a changing customer fast enough. As a result, they now offer an inferior value.
Technology accelerates change. It shows up everywhere, not just in department stores or supermarkets. Owning TV stations is a bad business where seemingly everyone is going to the Internet for entertainment. Find me someone under 40 who still reads a newspaper. Car rental companies have to compete with Uber and Zipcars. Solar energy and wind are making inroads into the power generation market. Tesla is reinventing the car of the future.
The disruptors don’t own the world. They simply have a head start. Big Corporate America has the resources to catch up, but only if they have the speed and energy to move as quickly as possible. Microsoft# was a Windows-centric PC company not long ago. Now its focus is on the enterprise and the cloud. Tesla may have generated a lot of buzz, but in five years, every major car company will be making electric and hybrid vehicles. First movers aren’t always long time winners. Show me your Bowmar calculator. Do you use MySpace as your social media platform? Do you still use your Commodore PC? Are you headed to the Resorts casino this holiday weekend?
Betting on the early disruptors can be dangerous. Also note that the most successful change rapidly. Amazon sold books originally. Today it is the world’s largest cloud service company. Facebook wouldn’t be successful if it stayed desktop centric. Apple# for years was an afterthought in the PC market. That all changed with the introduction of the iPod. The ensuing iPhone was the result of simply adding a phone chip to the iPod. The rest is history.
We are in an aging economic recovery that has been jolted by ever faster evolution spurred by technology. Virtually no business is unaffected. An aging recovery doesn’t mean one that has to end any time soon. It won’t end until there are imbalances that aren’t apparent yet. But within this aging recovery, those that create change or react to change rapidly and correctly will win, while those that act like deer in the headlights or are slow to react will lose. Some of those changes will be permanent. The cloud is changing computing. The desktop and even your phone (your new computer of tomorrow) will be slaves of the cloud. The cloud changes the entire media world. It is the foundation of tomorrow’s autonomous driving vehicles. It is the base of the Internet of Things, the highway that data travels as it moves from pure data to actionable information.
No one wants to buy the company that sells block ice or manufactures buggies to be pulled by horses. There is little doubt that a decade or two from now, a lot of what we do today will be obsolete. This always happens, but it is happening even faster today because technology forces rapid movement. Simply said, the cloud, plus adding intelligence to almost everything we touch, fosters innovation and facilitates ease of entry. That means disruption is only going to get faster. No one, not even the Amazons or Facebooks of this world are immune.
As investors, this means that we have to be nimble as well. That great company that grew for decades may be about to develop its own form of corporate cancer. You need to look at every single investment and ask yourself whether they are repositioning for tomorrow’s world or not. Be ruthless. Don’t ride yesterday’s blue chip if it won’t survive the changes that are upon us. To paraphrase Warren Buffett, I would rather own a great company at a fair price, than a mediocre company at a cheap price. You have a few more weeks to set yourself up for 2018. Start doing your homework. Ask questions. Be circumspect. But remember that you are buying stocks, not companies. Valuation always matters. Stay disciplined as you realign.
Today Scarlett Johansson is 33. Jamie Lee Curtis is 59. Billie Jean King turns 74.
James M. Meyer, CFA 610-260-2220
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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
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