Stocks rose yesterday but gave back a good part of the morning rally by the close. Most of the economic story centered on the aftermath of Black Friday weekend and Cyber Monday. The conclusions were obvious. Americans are shopping more and more online, partly due to Covid-19 and partly out of convenience. Over time, one will go away, the other won’t.
The other news so far this week was the return of Merger Monday. In the past, especially after strong market rallies, Mondays have witnessed the announcement of major mergers. This Monday there were several, led by a planned takeover of IHS Markit by S&P Global, a deal valued at about $44 billion. There were at least 3 others in the $2-10 billion range. Last night, Salesforce agreed to buy Slack in a deal valued at over $27 billion. For those involving stock, high equity valuations were catalysts. For those involving some debt, low borrowing rates made the deals more enticing. It is rare to see such high P/Es and low interest rates at the same time. Although economic growth in 2021 will be higher than normal on a year-over-year basis due to the expected rebound from the pandemic-induced recession, longer-term growth is expected to slow in a world that suffers from excess supply. The combination of high valuations, low interest rates, and a need to consolidate suggests that we will see an elevated level of merger activity for some time. Pushing back may be some scrutiny from Washington.
I want to switch gears and talk about a type of mutual fund some of you may never even have heard of, target date funds. Target date funds are most popular in 401k plans. They are also used extensively in 529 education plans. The concept is simple. If you are a long- term investor planning to retire in 30 years, you might choose to invest in a fund that targets your retirement 30 years from now in 2050. Stocks are long duration assets. If you hold them for a year, no one can accurately predict your rate of return. But history shows that the longer the duration, the more accurately you can predict the average rate of return. If you plan to hold stocks for 30 years, a return of 8-9%, or 6% plus the average rate of inflation, is likely to be a very accurate guess. Bonds have shorter durations tied to their maturity dates. Simplistically, a 10-year non-callable bond has a duration of about 10 years.
A target date fund geared toward retirement in 30 years will be heavily invested in stocks at the beginning. But as retirement approaches, and the duration shortens one year at a time, the mix shifts, moving more toward bonds and less toward stocks. In the last year, it will be invested mostly in bonds. These funds have formulas. They are precise. They require annual rebalancing. In addition, long maturity target date funds are almost always seeing net inflows. Short dated funds are seeing net outflows as investors withdraw cash for retirement or education needs.
Target date funds have become a big business. Collectively, they are now approaching $2.5 trillion in total value. How big is that number? The Fed has bought a bit over $3 trillion to prime markets this year to offset the ravages of the pandemic. If you watch markets, you can see the impact of $3 trillion in net purchases. $2.5 trillion is a big number.
In flat markets, the rebalancing, generally done in the last month of every quarter, isn’t all that market moving. Of course, only a fraction of the $2.5 trillion has to move at any one time. But when markets move sharply, the rebalancing can be market moving. Rebalancing rarely creates a market correction but it can accelerate it. Last month (meaning November), leading averages soared by more than 11%. That means, without any adjustment, these target date funds are out of balance. That can be fixed in one of two ways. New inflows (which are normally highest in December and January) can mostly be redirected to bonds to achieve a proper balance. But if that isn’t enough, the funds will have to sell stocks to buy bonds.
These funds are dominated by three fund families, Vanguard, Fidelity, and T. Rowe Price. All use broad market passive index funds as equity proxies. So, if they have to sell stocks to rebalance, they will sell these all-market or other broad-based equity funds (e.g. an S&P 500 index fund) to achieve their goals. This rebalancing is normally spread between the 2nd and 23rd day of the last month of the quarter. Thus, this long-winded discussion (sorry for being so arcane this morning) is a warning sign that there will likely be some degree of selling pressure over the next three weeks as these funds readjust.
That doesn’t mean markets are destined to crash in December. There are many other reasons to buy or sell stocks. Hedge fund liquidations should be more moderate this year. That’s a plus, for instance. We have already seen the impact of good vaccine news. If case counts start to decline later in the month, that could be another positive. But as important as December is economically, we won’t know all that much about December for several weeks. We will get a lot of data this week and it is likely to be mixed. On an absolute basis, the data is likely to show ongoing growth. But on a comparative basis, some will show a moderation of growth from November.
There are several reasons for this. Because of pandemic related reasons, Christmas season is going to be longer and flatter than in the past. Part relates to the expectation that one has to buy earlier to ensure delivery by Christmas. Part relates to more time on our hands. Part relates to fears of going to malls. Whatever. At any rate, that means that November is going to look better than normal and December, particularly later in the month, is going to look worse. Piecing it altogether will be a challenge.
In addition, many of the CARES Act support programs have run off or will run off by 12/31. Congress is talking again, but politics is getting in the way. It is problematic whether anything will get done. Yesterday morning’s rally was tied in part to expectations that centrists in both chambers could bring a compromise deal together, but it died. Suffice it to say, no deal in the lame duck session means no further support until February. That could be too late for a lot of small businesses.
The bottom line is that markets remain news dependent. Vaccine news will become less dominating. We may see a short pop when the Pfizer or Moderna vaccines get final approval, but that is largely baked in by now. As noted, I don’t think Christmas sales trends will be very clear for several weeks. Obviously, if Congress does come up with something, that would help. Conversely, the two parties can butt heads and see the government forced to shut down. That would certainly be a bah humbug event! I would say the odds of that are slim, but this is 2020 and no one knows President Trump’s mindset at the moment.
Thus, while November was very enjoyable and December is usually one of the best months of the year, this year it could be a bumpier ride. That means don’t chase, respect valuations, and think rationally, not emotionally. Rebalancing is a temporary thing. If there is a correction, it won’t be a reflection of economic weakness. Even if the government were to shut down, it wouldn’t be for long. The public simply wouldn’t stand for it. This would be Trump’s legacy, not Biden’s. He doesn’t become President until January 20th. I am only warning about bumps in the road. Earnings and interest rates will define the long-term direction as always.
Today, Aaron Rogers is 37. Britney Spears turns 39. Lucy Liu is 52.
James M. Meyer, CFA 610-260-2220