Although news events over the past few days weren’t shocking by any stretch, reactions indicate the fragility and volatility of a fully valued market with more questions than answers in the near term. Wednesday morning’s bounce higher erased half of the early week losses, but proved short-lived due to a few intraday news updates. South Africa noted a doubling of hospitalizations stemming from Omicron and also detailed a dramatic rise of infections for older citizens. Shortly after that, outgoing German Chancellor Merkel and her replacement Olaf Scholz further detailed a “lockdown for unvaccinated”. The icing on the cake was our first confirmed Omicron case in California. Over this news period, which lasted 4 hours, the Dow Jones incurred a 1,000-point negative swing.
None of these news items should be shocking to anyone following Covid trends. In fact, this was anticipated by many. It is likely there are thousands of undocumented Omicron cases in the US already. However, investors are also on edge with a “tightening” Federal Reserve, a possible Government shutdown, a Build Back Better plan still waiting for Senate approval, relentless inflation, a stronger US Dollar and a supply chain debacle. More questions than answers always lead to profit-taking and risk management measures. Omicron was but one reason, albeit a big one, for this recent sell-off but we have been seeing underlying pressure for weeks now.
On Wednesday alone, Salesforce# dropped 11%, while well run, new, large cap favorites like Square, Palantir, Bill.com, MongoDB, Docusign, Workday, Roblox, Zoom, Fortinet, Snowflake, DoorDash and Crowdstrike dropped another 5%+ on top of their 20% – 60% existing collapses. That was one of the worst software performance days in recent memory after being a safe haven for much of the past two years. Even though long-term interest rates have dropped, inflation expectations have dropped even more, following Fed comments about increasing the speed of tapering. In total, this means real yields are actually increasing (for example, a 1.6% Treasury minus 3% inflation versus a 1.4% Treasury minus 2.5% inflation equates to a rise of 0.3% in real yields) which also points to lower P/Es, on the margin.
Looking at current P/Es of those dozen companies and you can see plenty of risk if earnings don’t keep expanding at a rapid clip, or if real rates rise. In fact, nearly 1/3 of the Russell 3000 stocks have negative earnings today. This helps explain why the small-cap index has undergone one of the quickest 10% drops in history, hitting correction territory in just 15 days! For comparison’s sake, on an intraday basis, the Dow has declined 7.0%, the Nasdaq 6.6% and the S&P 500 5.0% from peaks set a few weeks ago before another rebound attempt yesterday where averages gained ~1% – 2%.
Not to be outdone, airlines, cruise companies, several basic material and energy companies tacked on another 5% loss on Wednesday as well before roaring back yesterday. A full round trip but still down substantially since Omicron was found. These are diverging sectors to say the least. During the lockdown of 2020, the aforementioned tech stocks were winners while travel and commodity stocks were tanking. Transitioning from early to mid-cycle is meeting a covid-induced stock sell-off creating a wild time where winners and losers are all over the map from last year’s playbook. The good news is acceleration in market volatility like we saw earlier this week is typical at the end of a correction. No crystal ball will tell us when it is over but many companies are back below fair value and this could prove to be a decent entry point.
Yesterday brought forth another attempt at recovering from those stunning losses. While high Price/sales and high P/E stocks were generally mixed, 90%+ of the market saw solid rebounds. Financials, Industrials and REITs led the way with ~3% moves helping the Dow Jones recoup 1.9% while Nasdaq only gained 0.8%.
On the other issues noted above, we seem to be getting some answers, helping alleviate downside pressure. Word out of DC is a compromise has been met with a continuing resolution to fund the Government thru February 18th, therefore avoiding a shutdown just before Christmas. One less item to stress about. The looming debt ceiling concerns are still with us though.
Inflation enthusiasts will get more data to chew on this morning with another employment report. A rosy scenario would show 600k+ newly employed, wages rising but at a decelerating rate and, most importantly, more participation from our labor force. There are still some 5 million people off payrolls from pre-pandemic levels. Many have retired forever while others are utilizing Government funds from earlier in the year still parked in checking accounts. More participation is critical in tamping down wage costs and inflation over the coming months. Lower participation and higher wages will help force the Fed’s hands to tighten more quickly.
With respect to our “tightening” Federal Reserve, we should take a page out of historical trends. First and foremost, bull markets don’t end until earnings peak. Expectations for next year are at least 10% higher from an earnings perspective. Most economists expect a solid 2023 as well. Chairman Powell’s admission that tapering could be accelerated is not a huge negative. In fact, they are late in doing so. There is no reason to be purchasing Mortgage-Backed securities or long-term Treasuries today.
Real concerns arise that Fed Funds will take flight once tapering is completed. With 10-year Treasury yields at only 1.45%, it won’t take many rate hikes to get an inverted yield curve. That is when investors should worry about peaks in a bull market. Chairman Powell has said nothing to indicate they will be accelerating tightening measures. With negative real rates, the proverbial punch bowl is still very accommodative. Tapering is simply increasing stimulus at a slower rate. Further, stocks generally provide sizable returns well after the first Fed rate hike, which isn’t expected for several months. Following historical trends, this is all par for the course. An initial wave of selling occurs when accommodative measures are slowed. Realization that companies can stand on their own two feet comes next and stocks rebound. We’re in the middle of this right now.
Regarding the US dollar, currency inflections heading into 2022 are becoming a bigger headwind going forward. The dollar is up 6%+ from the beginning of the year relative to a basket of currencies. Many S&P companies generate half of their revenues overseas. While not an exact science, when reporting 6% international revenue growth and converting back to US Dollars, that growth gets cancelled out by 6% currency conversions. The end result is that sales metrics look worse than what is happening internationally and EPS growth gets held back. Normally, this does not change investor behavior too much. However, when stocks trade near all-time high P/E ratios, anything that slows the “E” part of the equation is detrimental. Shoot first, ask questions later as we’ve been seeing for weeks now. It is not a long-term concern though. Most of the large capitalization companies we own have great hedging programs and localized sourcing methods.
The good news is this mini-correction won’t last forever. A lot of damage is already done. Major averages are within shooting distance of all-time highs yet nearly 500 stocks are down 25% or more over the past month. That is a lot of dispersion, creating severely oversold conditions in varying sectors and industries. Some will still drop from here; others are dead money while many are buyable opportunities. If we can hold this week’s lows over the next few trading days, a Santa Claus rally likely ensues especially in oversold stocks assuming data on Omicron progresses in a positive fashion (less deadly, less transmissible than Delta). This morning, the FDA announced their aim to approve a new generation of Covid treatments with the Merck and Pfizer pills. We will get past this.
Ozzy Osbourne is 73 today. Tiffany Haddish turns 42. “He can’t see without his glasses”, actress Anna Chlumsky is 41 while movie stars Brendan Fraser and Julianne Moore turn 53 and 61, respectively.
James Vogt, 610-260-2214