The rotation we mentioned a few weeks ago is picking up steam again this week as FANGMAN and other growth stocks are slowly taking the leadership baton back from cyclicals and are beneficiaries of higher rates. Yesterday alone, the NASDAQ was up 1%, while the Dow Jones was basically flat.
In February, interest rates were spiking higher as 10-year yields jumped from 1.0% to 1.7%. Long duration assets, i.e. growth stocks, took a beating. Industrials, banks and reopening trades went up on a daily basis. That tide has shifted now with interest rates slowing their ascent. Since early March, FANGMAN is up 10%, while Microsoft#, Facebook# and Google# are already back to making new all-time highs. The 10-year yield was only up 20 basis points during that time as well. Cyclical stocks are also moving higher, but at a much slower pace.
Markets are a discounting vehicle. Stock prices today reflect a consensus view on what will happen looking out a year ahead. Of course, momentum can bring prices too high or too low on occasion, but this theme generally holds true. So, what is priced in now? Pick out your favorite economically sensitive name from the Industrial, Banking or Commodity space. Many are significantly higher than pre-Covid levels. Not to pick on any one stock, but let’s use Caterpillar as an example.
At the end of 2019, pre-Covid, Caterpillar was trading at $150 giving them an $82B market cap which was near all-time highs. Today it closed at $230, bringing its market cap up to $126B, or 50% higher. Granted, governments around the world have printed a ton of money. Some will go to infrastructure and upgrading facilities. Covid induced closures wreaked havoc on supply chains. Availability for copper, steel and aluminum was restricted. This gets fixed via opening up old mines or moving production locations. There is clearly a near-term need for more construction and mining equipment. Investors are pricing this in. Have they gone too far? Is business going to sustain itself past this and next year? Should the company be worth 50% more than a year ago?
We’re about to see some commentary over the coming weeks with first quarter earnings reports, along with future demand, from Caterpillar and many others. If recent updates are any indication, there may be some corrective action. Over the past few weeks, we’ve heard from Adobe#, Nike#, FedEx#, Constellation Brands# and Carnival#. Their business lines cover a wide spectrum of different economic activities. Each one of them beat analyst estimates, most by a wide margin. The first quarter was a lot better than expected. However, almost all of them declined after they reported. Good, even great news, was expected and stocks still suffered. If this continues, volatility could creep higher and create opportunities for anyone still sitting on the sidelines. There will be drops in world class operators that bring prices back to attractive entry points. Those with rosier projections will keep chugging along.
After distribution chains are repaired in 2021 and commodity supplies get back to normal levels, growth will slow for today’s cyclical leaders. An infrastructure bill will extend the growth period for many, but that too has a shelf life. As noted before, easy money has been made here. Updates over the coming weeks have to be exponentially better than expected to see any short-term upside. Longer term, as they grow into currently elevated P/E levels, picking winners will be more difficult. Structural winners in “green”, infrastructure, housing, robotic or automation should hold up better than others in the coming years.
Prior to the recent growth / cyclical trade reversal, momentum brought a real concern to long-term interest rates. Spikes like we saw in February change a lot of investor behavior. However, we’re not going straight up from here. Expectations may have gone too far too fast. As much as the Fed wants inflation to stay above 2% for quite some time, it is easier said than done. Ask Japan about their past few decades.
There have been many periods where investors became worried about long-lasting inflation over the past 25+ years. We’re right back to previous peaks. See below:
Each one of those periods with higher expectations on the chart resulted in only temporary spikes for inflation, nothing long-lasting like what they fear today. Time will tell if this grand money printing experiment yields a different result, but we would not make long-term portfolio decisions on expecting this spike to last much further than a year or two. The 10-year treasury yield is not rushing to 6% like we saw 20 years ago.
Which brings us back to the Technology sector as it resumes a leadership role. Some of this may be due to a slowdown in the rise of interest rates. However, after lagging the overall market since last Fall, risk/reward is becoming more attractive. Their structural bull market never changed. The digitization of everything is here to stay. 5G is still expanding, with many new features we aren’t even thinking about yet. Artificial intelligence business extensions could be even bigger than the Internet. Cloud conversions are nowhere near completed. Augmented reality is miniscule today and will only expand. Simply put, technology growth rates aren’t dependent upon stimulus, or whether interest rates are 1.5% or 2.5%. Multiples have compressed a bit the past several months, but earnings will still be rock solid for most companies.
Spiking interest rates have clearly slowed, but the rise is not over, it will just slow down. A near tripling of 10-year yields deserves a break. While it consolidates, predictable growth, ala FANGMAN, will play catch-up to recent cyclical winners. Those 7 behemoths represent a near 25% weighting in the S&P 500. If they move, the index will move. It would not be surprising to see another 5-10% index rally before valuations become extreme. After a 9% run already in 2021, it is shaping up to be another banner year. Let’s make sure to stick to our asset allocations and not get too greedy.
Kristen Stewart, from the Twilight Saga, turns 31 today. Actor Dennis Quaid is 67.
James Vogt, 610-260-2214