Stocks went on a roller coaster ride yesterday, first falling sharply in reaction to rising bond yields, but reversing course mid-session after Fed Chair Jerome Powell told Congress that the Fed would keep rates low and monetary policy accommodative for a very long time to come.
At the start of trading in September, Amazon# and Facebook# set new all-time highs that haven’t been exceeded since. Both Netflix and Apple# made slightly higher highs this January, but both now sell 5-10% below not only the January highs but those achieved last September. Of the FANG names, only Alphabet# (nee Google) has moved well beyond the September highs. Back in September, the five largest S&P components, all big tech names, accounted for almost 25% of the average’s market cap.
On the other hand, industrial components that lagged early in the recovery came to life. Dow components like Chevron#, Honeywell# and even Boeing are up 20-30% from their Labor Day values. Financials like Goldman Sachs and JP Morgan Chase# are up over 50%. Names given up for dead, including most airlines, hotel chains and cruise ship lines are up a commensurate amount. If you take a multi-year view in the rear view mirror, the domination of the tech stocks and growth names will still dwarf the performance of the industrials and Covid-19 injured names that have been part of the recent recovery, but one cannot hide the rotation that has been taking place in the market.
Part of that relates to momentum investing. Psychologically, chasing winners is emotionally appealing. One tends to buy what has been working, not what has been falling in value. But there is another important factor at work, the rise in bond yields.
Back in early August, the yield on 10-year Treasuries was as low as 0.55%. This week it has climbed above 1.35%. That’s 80 basis points over a bit under 7 months, an average of about 12 basis points per month. That sort of rise hasn’t made a major dent in the overall stock market, even with the top 20%+ of the S&P 500 going nowhere.
But what lies ahead? I doubt Goldman Sachs, JP Morgan Chase or Caterpillar are going to go up another 50% over the next few months. Many of the leisure companies so impaired by Covid-19 now find their market caps back to or above pre-Covid-19 levels. Yet it could be years before they completely recover. Perhaps, after a hiatus of 7 months, the FANG stocks could be set to recover. All this is observation and speculation. What I do know is that the math tells me that if interest rates continue to rise, even at the relatively slow pace of September through February, the downward pressure on P/E ratios will be greater for the high-growth stocks than for the cyclicals. For a brief period, cyclical companies will have more rapid earnings growth coming back from near death toward some semblance of normality. But the word cyclical implies a dependence on the economic cycle. While the economy could be at the start of a new cycle and continue to grow for years, the biggest year-over-year gains will be happening this year. GDP forecasts for growth range as high as 8-9%. That is more testimony to how weak the economy was in 2020, not how outstanding the world will be in 2021. Beyond 2021, as Covid-19 hopefully fades in its impact, growth will return to historic norms closer to 2%. Maybe 2022 will still see a bit more than that, but not much. In a 3% growth economy, it is likely that the true growth names, like the FANG stocks, will look prettier once again.
But until we get there, it is going to be a battle of higher earnings versus higher rates. The pace of rising rates has actually accelerated over the past month or so. While the Fed has used words to hold down inflation expectations, the bond market isn’t going to flatten out if growth accelerates and prices from oil to houses rise at double digit rates. The Fed is continuing to buy $120 billion of bonds each month, two-thirds of that being Treasury securities. That sounds like a lot, and it is. But it is only a small piece of the market. While the Fed can control the Fed Funds rate and have dominating influence on short-term rates, it has much less impact on long bond yields. If I had to use a round number, I would suggest 10-year Treasuries will reach 2% by the end of this year, and if that is a wrong guess, right now I would bet that the rate is more likely to climb above 2% than stay below.
That doesn’t mean I anticipate runaway inflation or even worrisome inflation. To be sure, commodity and home prices are surging. Improved demand is key, but what may be more important is the lack of available supply either due to pandemic cutbacks or disrupted supply chains. With that said, commodity prices are not the most important cost input. Wages are far more important. In addition, we still live in a world with a lot of excess capacity. There is plenty of manufacturing capacity with some notable exceptions. Supply chain factors and an unwillingness of manufacturers to carry enough inventory, for instance, has caused a shortage of certain semiconductors. The inventory of homes for sale is near record lows. Higher prices will bring more supply to market. Meanwhile, we are still overwhelmed with too many retail stores, too much office space, and plenty of rental properties. While pricing power may be improving it is still relatively weak. In addition, technology continues to make price discovery ever easier, putting further downward pressure on prices. If you want to buy a widget, a few minutes searching on the Internet will give you the best price.
Thus, while inflationary pressures are rising, there are still 10 million fewer Americans working today than a year ago. Technology and remaining economic slack won’t stop inflation. But they will contain it. With that said, there will be times when markets fret over inflation and rising bond prices will squelch stock market rallies. Then rates will flatten for a while and strong economic trends will push stocks higher. That yin and yang will likely continue for most of 2021. But if the trend in rates is higher, P/E compression will continue. The massive outperformance of growth stocks is probably over. That doesn’t mean growth is dead. But if real yields turn positive over the next year or so, bonds will suddenly become a viable alternative again.
Chairman Powell can talk about how economic slack allows him to keep monetary policy very accommodative. But there will come a time when that slack disappears. Both he and Treasury Secretary Yellen suggest full employment could be reached by the end of 2022. If so, the Fed won’t be buying $120 billion in bonds each month. Clearly, there will be a transition. If their timing is in the ballpark, that suggests some messaging will be needed in the second half of 2021. No matter how they sugar coat it, markets will not react well to any suggestion that the lid is going back on the cookie jar. That doesn’t mean a recession is coming or that stocks have to experience a bear market. Economic growth is still king. The task ahead is to moderate the pace of rising rates so that they don’t overwhelm the benefits of economic growth. That is a tough task. Markets can tolerate 12-15 basis points of rate increases per month. That’s why, despite the sloppy markets of recent days, stocks remain within shouting distance of all-time highs. Speculative fever may interfere and needs to be tempered at times. We saw a bit of that on NASDAQ over the past few days. More is needed.
The bottom line is that there is good reason to be cautiously optimistic. With that said, some of the silliness in the market needs correction. There aren’t enough good private companies for 300 SPACs to buy. Bitcoin isn’t going to be worth more than the GDP of the U.S. or Western Europe. Nor is it likely to be a substitute for stable currencies while it vacillates in value by as much as 10% per day. Concept stocks selling at 50 or more times revenues will find fair value at a much lower price. But these speculative fringes shouldn’t distort the real picture. Stocks are fairly priced for today’s environment, growth in 2021 will accelerate, and we can live happily in a world where rates rise at a modest pace. There will be times when the picture isn’t that pretty. There will be corrections. Volatility could rise. But the economic backdrop of surging earnings amid modest inflation creates a powerful base. Use corrections wisely and pay attention to valuations, especially when euphoria creates excesses.
Today, Floyd Mayweather, Jr. is 44. Nike founder Phil Knight turns 83.
James M. Meyer, CFA 610-260-2220