Stocks and bonds took one on the chin again yesterday with losses across the board. As we’re becoming accustomed to seeing, last year’s winners are leading on the downside, while recovery plays hold up on a relative basis. High P/E stocks keep taking their cue from interest rates. At one point during Thursday’s trading session, the 10-year Treasury spiked 20 basis points, busting through 1.60% before closing at 1.52%. Higher rates equal lower stock valuations, plain and simple.
The shorter end of the curve saw the largest percentage moves with a 5-year Treasury jumping 31% in terms of yield, which is still a minimal 0.80%. Recall, when rates rise, bond prices decline. Investors who purchased a 10-year Treasury in January have already realized a principal loss of 5.3% in 2021, which wipes out over five years of income from interest payments. That is one of many reasons to not purchase long-term bonds when they are trading below the rate of inflation.
As we’ve noted on numerous occasions, a gradual rise in rates due to positive growth, an expanding job market, and higher spending levels are positive for the markets. Spikes like this are not. It creates uncertainty and a rising level of fear that inflation is taking over. Higher rates also change the TINA equation too (There Is No Alternative). A 10-year Treasury at 1.52% is now higher than the S&P 500 dividend yield. Income starved investors are taking notice where risk reduction is warranted.
If rates rise too fast, demand for loans will eventually decline. Mortgages are finally moving up as well, from 2.65% a few weeks ago to 3.00% today. Albeit, today is still a great time to lock in historically low rates. Right or wrong, markets are increasingly worried about a continuation of these rising inflation and interest rate trends.
The $1.9 trillion stimulus bill is set to be approved in the House today. Another stimulus bill focused on infrastructure is coming shortly thereafter. There hasn’t been much fiscal discipline for years, but this seems to be expanding that exponentially. On top of that, every Fed head speech points to no worries, no bubbles and no fear of keeping short rates lower for longer. Everything is fine out there according to them. This brings back memories of previous bubbles where they let markets run too hot before reacting too late. Inflation is likely to be a short-term issue, but that won’t stop a valuation correction from happening.
In total, the Nasdaq suffered the largest decline, tumbling 3.5% yesterday. Even a tremendous earnings update from Nvidia could not stem the tide as that stock dropped 8% on the session. After last year’s 122% return, a digestive period where Nvidia (and many like it) languishes in a trading range is expected. That says nothing about the long-term potential, but great news was priced in, especially when trading at 20X sales and 55X trailing earnings. Nvidia dragged the rest of the semiconductor stocks with it, declining nearly 6% as a group. I could list 50 names with a similar story. Massive stock gains preceded massive earnings growth. Great news gets priced in well before we read about it in the Wall Street Journal.
The more cyclically sensitive Dow Jones Index held up better than most with a 1.7% loss. The trend for last year’s laggards to be this year’s winners keeps working as a handful of these stocks were positive on the day. This isn’t new by any stretch. High flying, go-go growth FANGMAN stocks, as a group, are actually down over the past six months. The BEACHBODY (Booking, Expedia, AutoNation, Carnival, Hilton, Boeing, Omnicom, Delta Airlines, Yelp) reopening group is up over 40% during the same time frame. Too far, too fast? Probably. Half of those stocks still won’t make money in 2021, but the trend is certainly going to be in their favor from a revenue standpoint.
Massive earnings growth stemming from the shutdown is bringing the FANGMAN P/E down from 53x trailing earnings to 39X 2021 estimates. If history is any guide, these companies will beat estimates again, bringing valuations down even further. If interest rates can find a stable range, fund flows will revert back to secular growth stories. Until then, we’re likely to keep seeing whipsaws like much of the past few weeks. Futures this morning have already bounced wildly back and forth. International markets are seeing the same situation with much of Asia down 3% while interest rates perk up.
Again, this is very typical in a secular bull market. Downward spirals are strong, fast and painful. However, if you have been staying true to your asset allocation and booked profits along the way, these are great times to redeploy excess cash and/or improve the quality of your portfolio. Some of the FANGMAN related names still have a runway for more market share gains, while others simply pulled forward years of potential growth into 2020 and may consolidate for longer. Recall the Y2K bubble. Many stocks never touched those highs again. Others are well above those levels today. The difference between the two scenarios is where the hard work begins for investors.
On the cyclical side, reopening trades worked great the past several months. However, it will not be a straight line recovery upwards. Outsized short-terms gains or stocks that are already above 2019 levels should be reviewed again. Momentum works both ways. No one knows when the growth correction ends or when the recovery play is fully (overly?) priced in.
Taking profits here and there, pruning low quality stocks that have jumped is prudent portfolio management. Making 50%+ on stocks in just a few months isn’t common. Paper gains are just that, until you hit the sell button. We’ve already seen a great number of high quality stocks pull back. Imagine what happens to the lower quality stocks when the rotation hits them.
Michael Bolton is 68 today.
James Vogt, 610-260-2214