Stocks tumbled yesterday after Apple# warned that the coronavirus would negatively affect first quarter earnings. That didn’t come as a complete surprise. In fact, some impact was obvious. But the fact that Apple came out so soon in the quarter and was fairly explicit in its estimates spooked investors that other companies would likely do the same.
The obvious question is whether the impact of the virus will be longer lasting than the virus itself. In other words, will lost revenues and sales quickly be recovered in subsequent quarters. For some, the answer is yes. I think Apple fits into that category for the most part. If you want a new iPhone, most will wait a month or two if necessary. But for other companies and industries, the impact will be more lasting. The buildup of oil inventories, for instance, may take months to work off. The only way to accelerate the depletion is via lower prices.
But today I want to move away from the virus, which is going to be fairly short term in its impact and look at the dominating trends that affect stocks. I will focus on three.
- The world is oversupplied with everything but labor. By everything, I mean absolutely everything. We live in a world with too many commodities for sale, that has too much retail selling space, and even has too much money sloshing around. That means prices stay low, producers lack pricing power, and the buyer has the upper hand. Thanks to the vast expansion of capacity in China and Asia as the world was coming out of the worst recession in over 60 years, this condition of overcapacity is not going to be corrected for many years to come. In fact, to the extent lower interest rates encourage any new capital spending, the problem will only be prolonged.
- Demographics point to slower growth around the world. This trend is a slow one, but it will not be reversed for decades to come. It is one of the reasons so many economists suggest that growth beyond 2% in the U.S. and 3% worldwide cannot be sustained. The growth engines of the past two decades, demand from China and India, will no longer be sustained at rates anywhere near what they have been so far this century.
- Technology is accelerating change, mostly disruptive to the ways we have lived for our entire lives. It is moving people to cities. It is making us less dependent on traditional energy sources. It is replacing less intelligent tasks with computers or robots. It is changing the way we execute commerce from cash to cashless. It is helping to cure diseases heretofore resistant to attempts. It is obsoleting traditional media, the postal system, the way we buy goods and services, and even the way we communicate. We talk less and text more.
The first trend won’t last forever. The second will. The third will only accelerate. Today’s disrupters will be tomorrow’s disruptees quicker than anyone realizes. A decade from now, our new cars will be electric and hybrids. Solar and wind power will become major sources of energy. Signatures will be digital. Progress against Alzheimer’s and cancer will lengthen life spans faster than we think. While some companies and products will be more immune to change than others, none will be able to function effectively without making major changes. Those that either don’t change or are slow to adjust will die. Think Kodak. Macy’s debt got downgraded to junk status yesterday. Cutting costs simply won’t solve the problem.
There are overlays to these dominant trends that are important to consider. First, we are starting to see governments take action to ensure that rapid change doesn’t do more harm than good. Facebook# can no longer say it simply provides a platform. It needs to protect both the platform and its users, plus those affected by its users. Amazon cannot abuse its technological advantage to drive out competition. Governments don’t want to control the pace of disruption, but they do want to control the concentration and misuse of power that accumulates to those that rise to the top in an economically disruptive world.
Second, oversupply of money (if you haven’t noticed, central banks are flooding the world with more money than is needed) will keep interest rates depressed making it expensive to simply sit on cash. Some of that cash is likely to be invested badly. “Free” money has a way of doing that. Some day, interest rates will rise and the costs to borrow will become too costly, forcing debt defaults. Central banks worldwide are already devaluing their currencies collectively. One can argue that shows up as higher stock and bond prices. But perhaps the best proof is the recent rapid runup in the price of gold. Gold was the de facto backbone of the world’s monetary system until most countries went off the gold standard. Gold is yellow, pretty, makes nice jewelry and can be kept as bricks, but it doesn’t have a lot of functionality beyond serving as a money substitute, a role bitcoin may fill eventually but hasn’t yet. Gold prices have surged twice in the past year, both times coinciding almost perfectly with accelerated periods of monetary easing. Central banks can drop money out of helicopters, but too much money cheapens its value. It diminishes the value of cash. Holders of cash are, therefore, encouraged to spend or invest it. Spending it helps to maintain and increase GDP. Investing it in real assets increases excess capacity. Investing it in financial assets increases stock and bond prices.
While some new age economists say the level of debt outstanding doesn’t matter and nations are virtually free to spend and invest all the money needed to support their societies, there are centuries of evidence that show that to be false. Eventually, (and I don’t know when eventually is) prices spiral out of control, money becomes worth less, and a crushing level of restraint become necessary.
Remember one old saw. Recessions and financial crises happen when economic imbalances occur. As we learned in 2008, when the amount of debt leads to an inability to service it, you have trouble. Right now, with interest rates so low that isn’t an issue. Despite rising debt levels, the demand for fixed income, created by the flood of new money created, has offset the rise in supply. Rates remain low. One can argue that this state can continue indefinitely. As long as governments flood the market with money that gets reinvested in fixed income, rates will remain low and debt service costs can be contained. But that all assumes the newly created money finds its way into the fixed income markets. What if it doesn’t? What if negative rates stop enticing fixed income investment?
I noted that excess money contributes to higher stock and bond prices. But I also noted that excess investment creates oversupply. In that case, prices fall. Look at virtually all commodity markets as examples. Lower prices lead to bankruptcies. The vast majority of coal companies are now in bankruptcy as the demand has fallen along with increased supply. Next could be oil. Not today, but eventually. And this time, eventually isn’t some far out date beyond the horizon. The rapid declines in costs for solar and wind power mean less demand for fossil fuels. The impending rapid adoption of electric powered vehicles similarly reduces demand for gasoline. Industrial plants use technology to reduce energy consumption. Only the natural production decline rate of existing wells is saving the oil and gas industry for the moment. But before long, there will be significant bankruptcies and overleveraged small exploration and production companies will fail when lower prices leave them unable to service their debt.
Retailers are also going bankrupt, disrupted by a combination of the growth of online retailing and too many square feet of selling space in malls and shopping centers. The trend of Americans to gravitate toward cities is reducing the demand for autos. Eventually, electric cars, more urbanization and autonomous vehicles will reduce demand for gas stations and parking lots.
I am not trying to be scary. Out of the new disruptions created by technology will come whole new industries. Social media and streaming are just two recent examples. But the key point here is that printing money isn’t a panacea for all problems. It’s ultimately dangerous. For now, more money with no inflation is raising stock prices. But not across the board. The money is flowing to the disruptor and away from the disruptees. The latter may be oversold at times and could bounce, but as long-term investors you want to use the bounces to lighten up on any company or industry that can’t adapt well to change. As for the disruptors, valuation is an overlay that matters. There is an old rule of thumb that says markets are fairly priced when the sum of the market’s P/E ratio and inflation are 20. Today’s markets are trading at 19x forward earnings, with an inflation rate of 2% or a little higher. The sum, 21, doesn’t seem that high. In the late 1990s the sum was sustained above 20 for several years. But that is the only example since the mid-60s. We can’t make the exception the new rule. Markets peak in euphoric times. I am not sure we are there quite yet, but 5% daily moves in Tesla raise the question of how far away euphoria can be.
As long as central banks continue to be accommodative (maybe overly accommodative), stock and bond prices will probably keep moving higher. President Trump would even like to see our Federal Reserve become more accommodative. But there is an end, and we have to be watchful that skepticism disappears entirely, leading markets toward that game-ending euphoric state. We aren’t there yet but there are some hints in the air.
Today, Smokey Robinson turns 80.
James M. Meyer, CFA 610-260-2220