Stocks were up again last week according to the broader averages, but 70% of stocks actually fell. In a world that has rotated from risk-on (favoring those stocks most affected by the pandemic) to risk-off (mostly big cap tech) and back again several times, signs that the recovery was slowing last week sent traders back to the risk-off stocks. While they are dominant based on market cap, the majority of S&P 500 names fall into the risk-on camp. For several months, it has been a back and forth tug of war. Overall, the big tech names have significantly outperformed those most impacted by Covid-19. The clear message, assuming stock markets look 6-9 months ahead, is that we will still be living in a world whose behavior is dominated by coronavirus factors, well into early 2021.
To be more specific, last week saw a jump in weekly unemployment claims for the first time in months. Once again, they totaled more than 1 million for the week. To put that into perspective, pre-Covid-19 the weekly average was just a shade over 200,000. One reason for the jump has been the slow pace of reopening in the Northeast combined with consumer behavior that is still reticent to get on an airplane or eat inside at a restaurant. The number of airline passengers per day is still down 70% year-over-year despite minimal restrictions on the ability to fly.
Congress hasn’t helped matters. Last week, they were called back into emergency session to debate additional funding for the post office. Meanwhile, a fourth aid package to support small businesses and others directly affected economically was essentially ignored. The Democratic convention last week was a combination love affair among the various wings of the party and a consensus that President Trump must be replaced. This week the Republicans meet. The mood will be very different. It will more likely be a pep rally for Trump’s base combined with a lot of hyperbole. In both conventions, specific plans for the next Presidential term are likely to be downplayed. With nominees for both parties certain, the purpose of both is to rally their respective bases. By the time the Republicans are done, Biden will still be leading in the polls, but that lead may well be within the margin of error. Wall Street continues to rate the election a toss-up. So far, stock movements haven’t been tied to an expectation of a clear winner.
While the Republican convention will be the headline grabber this week, the biggest news for investors will be the annual Federal Reserve conclave at Jackson Hole that will culminate with a speech Friday by Fed Chair Jerome Powell that will outline his vision for Fed policy going forward. It will be centered on a principal of soft inflation averaging. For years, inflation has been running below the Fed’s 2% target. Now the Fed wants to keep stimulating until inflation is persistently higher than its prior target. The Fed is unlikely to state a new upside target, nor will it state specifically how long it can stay above 2% before restraint is likely. The bottom line is that the Fed will be accommodative for longer than most believed a few months ago. More accommodative means low interest rates as far ahead as one can accurately perceive. For equity investors, that means P/Es stay high.
Right now, rates along the entire curve are negative in real terms. That means if you take the current rate of interest, a bit over 60 basis points for a 10-year Treasury, and subtract the rate of inflation, 1.5-2.0% depending on which measurement tool you use, you get a negative number. What that means, in English, is that investing in high grade fixed income, including Treasury bills, notes and bonds, CDs, or bank deposits, will not generate enough income to offset the cost of inflation. In real terms, you are losing money. In order to make money, one must take some degree of risk. That means lower grade bonds, stocks, real estate, etc.
What the Fed would really like to see is money sitting on the sidelines invested in assets that can help to increase GDP or increase productivity. But with capacity utilization just a shade over 70%, that isn’t likely. In the most recent reported quarter, the three months ended June 30, investment spending was down over 20% year-over-year. Clearly, that was impacted by Covid-19. But in the last Covid-free quarter, the fourth quarter of 2019, investment spending rose by less than a quarter of a percentage point. Excluding IT productivity spending, it was negative. One of the principals supporting the Trump tax cuts was that corporations, the primary beneficiaries of those reductions, would have more money to invest. While investment spending did rise after the cuts, the increases never reached 10% for any one quarter, the first time in a Presidential term that has happened since George H.W. Bush. Meanwhile, monetary velocity has fallen to record lows, and the savings rate has skyrocketed. The primary use to the additional cash generated was to ramp up stock repurchases and dividends. Both were rewarding to investors and supported higher stock prices.
The Fed knows that it cannot create growth. All it can do is provide an environment that fosters growth. Mr. Powell will lay out the case for a fourth stimulus package, and perhaps a fifth, if necessary, down the road. In terms of the economy, there isn’t much left to reopen except large venue events and full scale indoor dining. While we have seen anecdotal examples almost every night on the news of young adults flaunting restrictions on large gatherings, we also see school boards not wanting to risk community spread by sending students back to the classroom. Thus, over the next months we will be living in an experimental world both in schools and in sports, trying to find a balance between live and virtual that fits within the new norms of safety. Much will depend on how well participants self-police. In major league baseball, a few teams learned the consequences early how a night on the town can have unintended consequences. We haven’t seen any since, a sign that self-discipline works, especially when the stakes are high.
Overall, the virus itself appears to be in a bit of a lull. It is still there, for sure, and the number of cases, hospitalizations and deaths remain high. But recent peaks in the South have reversed. What we don’t know yet is what will happen when cooler weather sends us back indoors. The white collar business world probably offers us a clearer picture of what to expect. Many companies, maybe even a majority, are keeping workers out of the office until the data improves more. Some have postponed return to normalization until at least the middle of next year. While that may not negatively impact the abilities of these workers to get their jobs done, it will have profound impacts. Below is a partial list.
1. Less commuting means less driving. While that means less congestion, it also means less revenues for parking lot operators, a big drop in restaurant revenues for breakfast and lunch, and lower demand for business attire.
2. It means more IT support for home workers, particularly related to cyber security. Workers using personal computers and redundant passwords will be obvious targets for hackers. Criminals will find the weakest point of entry into a network and that almost certainly means they will attack the home PC.
3. We all know about Zoom by now. But collaboration doesn’t stop there. As we saw last week at the Democratic convention, a lot of tools and imagination can create a rather nice experience. While conventions will go onsite again in 2024, they will never be quite the same again.
The bottom line for investors is that what has been working will continue to work. Thus, Apple#, etc. continue to march to new highs. Meanwhile, the prices of Delta Airlines, or Carnival are the same today as they were in mid-March. We also have learned which companies could adapt in ways we didn’t anticipate in March. While Eastman Kodak may have blundered its way out of a contract to produce pharmaceutical products, the notion that a manufacturing company could use idle capacity to make needed goods is testimony to the success of capitalism and American ingenuity. A paint manufacturer shifted gears to make hand sanitizer. A commercial dishwasher manufacturer created a conversion kit for existing equipment to further sanitize restaurants. Home bakeries learned how to partner with delivery companies to dramatically expand. Demand for everything from tents to jigsaw puzzles exploded. Many adapted. Others watched.
But with all that said, with most business restrictions lessened, except for large venue activities, the burden is how to make the customer feel safe. While there are some with no fears to begin with, those who are nervous are not likely to be carefree overnight. Even if a vaccine can be approved in Q4, it will take time for normality to resume. That was the market’s message last week. It’s not about whether baseball can complete the current season, it’s about whether you will be in the stands watching a baseball game next spring when the season is due to open. It’s about how many small businesses can survive long enough to see blue skies again. Last week’s message was that it will take a while before the all-clear siren blows. Maybe this week the mood will improve. It is fluid and can change day-to-day.
At the same time, while we all know the Covid-19 winners, investors can’t ignore valuation. Some of the biggest names are up 25-50% in just a couple of months with no real change in their fundamental outlook. That can’t go on forever. Tesla today could have a market cap of $400 billion. It’s latest 12 month sales are $25 billion. It sells for 16 times revenue, an amazing number for a very capital intensive company. The old saw prior to this year was that any company selling for more than 10x sales was in nosebleed territory and that wasn’t a valuation one used for a capital-intensive industry. So, what is Tesla worth? In one sense, whatever the next guy is willing to pay. Clearly, today traditional valuation measures are being discarded. Analysts who follow Tesla and dared to say Sell based on valuation have been embarrassed. But that doesn’t mean they won’t be right in the long run. When markets become dominated by so few companies, it is a sign to be careful.
Today, Vince McMahon turns 75.
James M. Meyer, CFA 610-260-2220