It is hard to explain why stocks are now within 10-15% of their all-time highs set in February. Then again, looking back, it is hard to explain why stocks were at their all-time highs in February while Covid-19 was already lurking on both of our coasts.
Those of you who have followed my writings over the years know I like to make complex subjects as simple as I can. With that in mind, I divide the basket of public companies today into three buckets. The first, the one we all want to sift through, is comprised of companies that not only are holding up fairly well at a time when economic activity is likely falling 20-40%, but companies that will also gain long term advantages courtesy of the virus. Who gains from a virus? Supermarkets clearly do. But whether they can sustain those gains once the virus is a distant memory is a different question. More on that in a moment. More obvious winners are Netflix and Amazon for reasons I don’t have to explain. And how many of you knew Zoom three months ago?
The second bucket are companies that may be hurt at the moment but, in the long term, will go back to doing business as they did 90 days ago. Let’s put Coca-Cola in that bucket. I could say the same for companies that make paint or, yes, even toilet paper. One thing I can say with reasonable certainty is that two years from now you will find toilet paper easier on the store shelves.
The third bucket is comprised of companies right in the epicenter of the current storm created by Covid-19. We can all easily name these. Cruise lines. Movie theatres. Shopping mall operators. Airlines. Companies that make airplanes. Oil producers. There is a long list and every one of you can add to it.
Economically, the virus is an accelerant. It is accelerating trends already in place. Most of us will find that we need to carry around less cash in the future. I mentioned Zoom earlier. We have all learned to telecommunicate reasonably effectively. That doesn’t mean tomorrow’s wedding will be Zoomed. It doesn’t even mean Zoom will be the way we all telecommunicate three years from now. But just as we all learned to communicate with Facebook and other forms of social media, we now know how to incorporate video and groups, making digital communication more effective.
This morning, I saw a headline that AMC movie theatres are going to boycott Universal films because Universal says it plans to offer more first run movies digitally. Seriously? I am not suggesting the demise of movie theatres, but I am reasonably certain that there will be a lot fewer screens in a few years than there are today. There will also be too much office space, too much retail space, and fewer restaurants. Airline traffic will eventually get back to normal because there is no more efficient way to go from A to B. But it will take a long time to get there and a long time before airlines need all the new planes they have ordered.
Right now, I can make some pretty obvious conclusions.
1. Bucket #1’s leadership companies are obvious and well-known. Their stocks are very expensive, allowing little room for error. That is not to say you shouldn’t own them. Indeed, long term, you want to own a lot of them. But, if you don’t already own these stocks, you have to pick good entry points. With some of these names already 10-20% higher than they were in February, now doesn’t seem the right time.
2. Bucket #2 clearly is full of companies feeling various degrees of short term pain. But when business normalizes, they should either climb back to where they were or even gain a little share as weak competitors drop by the wayside. Pandemics and recessions cleanse the world of weaker participants, leaving fewer behind to divide the pie. That is why, economically, good companies gain the most share during recessions. Even in 2008-2009, the four largest U.S. banks, the Darth Vaders of the Great Recession, gained significant share.
3. It is tempting to sift through Bucket #3 for bargains. And, for sure, if you pick the right one, the company on the edge of failure that makes a strong recovery, you will be a winner. But most are going to come out of this recession a lot more damaged than they were going in. Many malls will close over the next decade. Many chains that inhabit those malls will also close. Anywhere between 10% and 30% of the restaurants open in January will not be open two years from now. The major airlines will probably survive, but all may need more government assistance than they already receive.
4. It is easy to make an argument that equity investors today are overly optimistic. Money infused into markets by central banks is helping to lift asset prices. The lack of any return for bonds is also pushing money into stocks, where the spread between dividends and 10-year Treasury yields is the highest since the early 1950s. I get all that. But rates were pretty low in February as well.
I think two other factors are driving stock prices now. The first is the fear of being left behind. There have been a lot of bearish hedge funds, institutional traders and individuals who have been bearish over the last month since stocks recovered from their late March lows. They were waiting for a pullback to get in. But, as is often the case when bear markets end, the V-shaped recovery has occurred without any pullbacks. These bears, fearing being left behind, are covering shorts and going long. That is why some days, like yesterday, the weakest names suddenly do well. It’s short covering more than sudden optimism.
The second factor is that states and cities are starting to reopen, giving rise to an optimistic view that life can return to normal soon. Some suggest very soon. Some say normal won’t begin until there is a vaccine. Some hope for a vaccine as early as this fall. Others don’t see that happening for two years. The same applies to therapeutics. Some believe medicine will be able to mute the impact of the virus within months. Others are more skeptical. All we know for sure is that lots of companies and universities are trying, and we only need a few successes to make a difference. But with all that said, it is still reasonable to assume that it will take many months, if not years, to fully recover. Stock markets can recover on their own schedule, but economies don’t recover overnight.
As cities and states start to reopen, it will start with very tentative steps. Where restaurants are allowed to reopen, filling the tables will take time. Government rules and regulations are going to seem very draconian and, in some cases, absurd. They will relax over time. It’s all part of the process. Will there be another surge of disease? We don’t know. We don’t know a lot. We don’t know what effect, if any, summer heat will have. Without rigorous testing, we won’t know for weeks whether reopening results in any surge. Right now, markets are voting in an optimistic way leaving less margin for error.
I understand that one or two bad years, impacted by the virus, doesn’t make a big difference to the long term value of a company. But it does make a difference. Stocks today, overall, are selling at the same prices they sold at in September-October. Yet earnings expectations for 2021 won’t be reached until 2023. Even accounting for the flood of money, that suggests to me that stocks need some sort of pullback to create bargains once again. I don’t think we will pull back to anywhere near what they were in late March. But we do face two possibilities ahead worthy of consideration. First, as with any storm, there will be carnage. A lot of businesses, big and small, won’t survive. You might not care if JCPenney makes it. But if you sell stuff to them or lease them a store location, you do care. Second, reopening America, with all the safeguards you can conjure up, means we will all once again be in closer contact. That means more virus exposure. It isn’t going to take long for people to congregate, first in small groups, but soon in larger parties. Any spike in new cases is going to raise alarm bells. Anyone thinking reopening is going to be risk-free isn’t thinking rationally. I am not going to guess how we all react from a public health standpoint, but I think the stock market won’t like a spike in new cases, here or anywhere else in the world.
Thus, I think we are clearly on a path forward. Economically, we are leaving the abyss. Hopefully the pain of Covid-19 can be contained to a point where we can continue on the path toward normality. That is already baked into the stock market to a large extent. There are reasons to be optimistic. But pick your spots. Now might not be the best buying opportunity.
Today, Uma Thurman is 50. Michelle Pfeiffer is 62. Jerry Seinfeld turns 66. Willie Nelson is 87.
James M. Meyer, CFA 610-260-2220