Stocks continued their upward move into record territory on Friday despite lower than expected employment growth and a continued escalation in the number of Covid-19 cases in the U.S.
It continues to be hard to fathom how stocks move higher despite the worse than expected news. We are at a point in the reporting cycle when few corporations are reporting earnings, but those that do have generally reported good results. Of course, those are backward looking. Most data do suggest at least a slowing in economic activity associated with the recent spike in cases. For instance, TSA statistics show the number of airline passengers who boarded flights on Saturday was the lowest for any Saturday since October 31. Restaurant reservations, similarly, have rolled over from November peaks. Retail store and mall traffic was lighter than expected. Clearly, Americans have become a bit more cautious.
But this isn’t a repeat of last spring. Most businesses continue to operate even if office occupancy is well below historic levels. The NFL plays football even with Covid-impacted roster changes. But most importantly, investors realize that the long-term value of an enterprise isn’t impacted a great deal by a short-term disruption if the disruption creates little or no long-term damage. Investors last week were encouraged that Congress seemed to be moving ahead in the lame duck session to provide economic relief to those most affected, including laid off workers, hospitals, state and local governments, schools, and small businesses directly impacted, such as restaurants. To date, however, the bill hasn’t passed and there isn’t much time remaining.
While the above explains why the relatively short-term spike doesn’t send stocks crashing like they did in the early spring, it doesn’t explain why equities keep setting new record highs. Indeed, there may be no logical explanation. There is an explanation, it just might not be logical.
One reason is the calendar. Taxable investors in December often attempt to defer taking gains until January. New money at the end of the year flows into 401k plans. Since stocks follow the same economic laws as everything else, more buying and less selling pushes prices higher.
But that isn’t the only reason. Investors usually buy what is working. They are momentum chasers emotionally. They want to own stocks going up, not going down. New platforms, like Robin Hood, add a little speculative spice. Thus, you see heightened interest in SPACs (Special Purpose Acquisition Vehicle) that are essentially blind pools set up to buy one company in the future. Why would you logically give someone a pot of money to buy something in the future without much idea of what he might buy? Perhaps if he had a great track record it might be enticing. But most SPACs have creators with little or no track record. Instead they pay magical prices for hot business ideas, like electric trucks. The stock market success of a few SPACs has raised animal spirits. We’ll see where that heads. At the moment, the phrase irrational exuberance comes to mind.
IPOs (initial public offerings) are another hot spot. One of the most watched, Airbnb, just raised its expected offering price. It will, no doubt, open for trading higher than any price set. By the end of its first day of trading, Airbnb will likely have a larger market cap than Marriott, the world’s leading hotel operator. Granted, Airbnb has carved out a nice niche and is flirting with becoming profitable. Granted, in a Covid-19 world, an Airbnb rental is an appealing family refuge. But today we live in an upside-down world. Tesla trades at several times the market cap of Ford and General Motors combined. Maybe a dozen years from now it will sell more cars than any other company and the former Big 3 will be the bankrupt Big 3. But maybe not. Clearly, the margin for error for investors in the hottest names is thin. With that said, Tesla will be joining the S&P 500 later this month, meaning all ETFs linked to that index will have to buy Tesla and sell a bit of everything else.
So yes, this spike will pass. And yes, the impact on long term valuation may be minimal. But as stocks climb in disregard to changing near term fundamentals, it is hard to justify stocks going higher and higher. I realize growth rates from April 2021 on will be well above average for a time as there is economic catch-up from the virus’s impact. But if one chose to overlook the temporary negative impact of the virus, why should it suddenly reward the positive impact of simply getting back to normal? Maybe markets are suggesting that the pandemic purges weakness and what is left is strong and more powerful than anything that existed before.
There may actually be some merit to that point. What has been working in the market this year has been stocks of companies that either adapted quickly or that took steps in front of the pandemic that were destined to gain share. Buttressing online presence is a perfect example. The pandemic accelerated online order, curbside pickup, etc. Those benefits will be permanent. If you live in an urban area, look at what well-funded restaurants have done to actually expand dining offerings, from elaborate takeout to winterized structures. The disease will leave long before the structures disappear. Americans will still eat out after Covid-19 is gone. Big restaurants will simply gain share while the small ones disappear.
But let me end by getting back to supply and demand. Companies are not buying back stock the way they were pre-pandemic. IPOs are coming daily. The laws of supply and demand suggest that should have a negative impact. We have not had a 10% correction since the February-March bear market. November was the best month for stocks since early 1987. Some correction is due. Sentiment readings suggest overwhelming optimism. That is a negative sign, not a positive one. Markets are factoring in no blips with a change in administration. They are assuming vaccines can reach everyone by mid-year. They are assuming economic acceleration quarter-by-quarter in 2021. They are assuming short-term interest rates stay at zero for the foreseeable future and long rates stay anchored near where they are. They assume corporate earnings skyrocket throughout 2021 and that unemployment gets back close to the early 2020 lows by the end of next year. For all practical purposes, Covid-19 will simply be a bad memory a year from now.
All this may in fact come true. I, like everyone else, hope that’s the case. But these also sound like best case assumptions. What if vaccines have side effects or fewer people take them than expected? What if the current spike lasts longer than expected and Congress gets so tied up in political gridlock that it doesn’t respond? What if surging home and oil prices help to create unexpected inflation? You get the point. The margin of error is all to the downside.
So, I do expect a correction. A correction is not a bear market. It is a mid-course correction whose impact will last weeks or months, not years. They more resemble February 2018 than February 2020, sharp, gut-wrenching, but quickly reversed. When and if it comes, it will purge some of the excesses of today. And you have to be blind not to see some of them. Corrections hurt when they happen but do little long term damage. When might the correction occur? I have no idea. Nor does anyone else. The spark is unknown. Random. It could be a Jerome Powell slip of the tongue. Or a misguided tweet. Or it could be nothing at all.
Once it happens, it is too late to do much unless you react instantly. Rather, now, especially at year end, is the time to look at your portfolio, rebalance if appropriate, and take some money off the table from stocks that have moved from full value to frothy. It is also time to weed out companies that have been persistent underperformers.
Today, Larry Bird is 64. If the Eagles are looking for help, one of their most controversial favorites, Terrell Owens, is still out there celebrating his 47th birthday. Last seen in 2018, he tried to catch on with Edmonton of the Canadian Football League. He can’t be any worse than a few of the guys on the Eagles team today.
James M. Meyer, CFA 610-260-2220