It was a tough week for stocks particularly on the NASDAQ. The speculative end of the market took the biggest hit as bond yields rose in line with continued economic growth.
I noted last week the relevance of the January barometer. While not always valid, there is a trend that says, “as goes January, so goes the market for the rest of the year.” We are only one week into January and the relevance of the first week to the whole year is even less statistically relevant than the whole month. Nonetheless, trends evidenced last week have been in place for some time and are always worth noting.
Here’s what we observed last week.
• While Omicron is less severe than prior variants, it is more contagious. It also can be very disruptive in the short-term. While December employment numbers were below expectations, Omicron’s impact is much more likely to be felt in January given the polling week for survey data is in the middle of the month. It will be this coming week for January. Weekend headlines highlight the number of schools going virtual or deferring reopening. That will leave parents scrambling for childcare or staying home. Over 1 million cases per day are being reported and that vastly understates the real impact as it only measures those who both test and report results. I million, or 7 million per week is 1 in every 50 Americans getting infected in just one week’s time. The real number is probably closer to 1 in 25. While few are dying, the disruption is real. The good news is that soon there won’t be anyone left to infect, and daily infections will fall precipitously. That will happen before February begins.
• Despite Covid, the economy continues to move ahead at a pace well above historic averages. Q1 GDP will clearly be impacted, but some of the lost business will be recovered in Q2. Few are changing full year forecasts in a meaningful way. With that said, disruptions in the economy include disruptions to supply chains. Shortages remain everywhere, especially when it comes to Covid-19 tests. In many parts of the country, at home tests are almost impossible to find, but shortages aren’t just related to tests. They are everywhere. Fedex can’t find enough healthy drivers. Container ships remain lined up offshore California. Prices are rising as shortages persist. The CPI report for December will be released Wednesday. Once again Washington will try to put a spin on a bad number. Last Friday’s employment report saw wages rising at a 6% annualized rate, close to the most recently reported pace of inflation (7%), but with wages rising at an accelerated rate, getting inflation under control won’t be easy. That is why markets are now forecasting as many as four interest rate hikes this year, and the Fed is contemplating steps to reduce the size of its balance sheet simultaneously.
• The PMI report on manufacturing activity has shown some improvement in supply chain snarls. Perhaps that is the beginning of resolution. It is too early to say.
• While all this is happening, the Fed is still buying bonds, and interest rates, long and short, continue to rise. That isn’t good for stocks, but it is particularly bad for the speculative parts of the stock market. It’s possible that the pace of interest rate increases will rise as the Fed withdraws its bond buying stimulus.
When speculative fever dissipates, it does so beginning with the most speculative parts of the market and then works its way back to the more stable sectors. SPACs peaked early in 2021. They haven’t recovered. Many never will. Next to fall were those story stocks without any earnings and only modest revenues. They soared on promises of future nirvana. As Warren Buffett notes, you don’t know who is swimming naked until the tide goes out. Some of these story stocks are real companies. Peloton makes a nice bike. Beyond Meat makes appealing non-meat burgers, but these aren’t companies that will grow to $100 billion in size. They are in the process of being revalued to reflect real expectations, not promises. Most likely the revaluation process isn’t over. All the hot new names making electric cars and trucks won’t get 20% market shares. Most won’t get 2%. They too are getting revalued. I could go on, but you get the point. When a serious correction happens (and we can’t label the current one serious yet), the move peak-to-trough is often more severe than pundits predict.
As this correction goes on, the revaluation spread to companies that are less insanely overvalued, but overpriced nonetheless. As rates rise, as the specter of 2% Fed Funds and 2%+ 10-year Treasuries becomes more real, the idea of big growth companies selling at 40, 50 or more times earnings becomes harder to rationalize.
It is quite possible that bond rates will peak soon, at least for a while. If so, there will be a bounce in stocks that have taken a big hit over the past few months, but if the Fed stops buying bonds in a couple of months and starts to reduce the size of its balance sheet, billions of new money that have fed the speculative bubble for years, will disappear. Any speculative wave needs a persistent inflow of new money from somewhere to keep the bubble inflated.
Perhaps no asset defines the speculative bubble more than bitcoin. Despite its name, bitcoin isn’t a currency, unless you are living in El Salvador. Nor, given its sustained volatility, up and down, is it a secure store of value. Bitcoin bulls will tell you a dozen reasons why it will soon sell for $100,000, but if speculative fever dissipates, that isn’t likely to happen, at least in the short-term. Is it an attractive alternative asset class? Not if it simply tracks the ebb and flow of other speculative assets. There will come a point in a speculative correction where newbie speculators give up and leave. That could happen soon, or it could take many more months. All I will note is that there are few signs yet that speculative fever is about to reaccelerate. Beware of sharp one-day rallies. If they don’t follow through for at least a second day, such rallies are more likely to be bear traps than real.
Investors, seeing the demise of speculative fever have been rotating to more secure stocks, companies with real earnings, dividends, and rising cash flows, but beware. Such rotations can get overdone. Emotionally, it is easy to go with the flow and sell Alphabet#, a hit tech juggernaut which has been a market leader for years, and buy Procter & Gamble#, the epitome of stability. After all, don’t we always need paper towels and toilet paper? Alphabet regularly grows at twice the rate of Procter & Gamble. Its search franchise is even more dominant than P&G’s hold on the paper products markets. P&G pays a dividend and has been around for well over a century. However, it is hard to argue why P&G deserves to sell at a higher P/E than Alphabet. If investors continue to rotate from tech to consumer staples, soon it will be Alphabet that will be the bona fide cheap stock. In other words, rotation is natural in the stock market, but like speculation, it can go too far as well.
In conclusion, higher rates and less new money from central banks are destined to reduce speculative fever. They feed the rotation process. It is evolving. It can also become overdone. I don’t think the speculative excesses have been wrung out. Even with a large number of NASDAQ stocks down 50% or more from 52-week highs, I think there are a lot of names headed much closer to zero before all is said and done. The weakest investor hands must fold their cards and walk away before all is said and done. I don’t know if it is the second inning or the 7th inning of that process, but these kinds of speculative purges usually end with a thud, not a whimper.
As for the week ahead, it will be an interesting one. As noted, the CPI report Wednesday morning will get a lot of attention. PPI gets reported on Thursday. Earnings season starts Friday with big banks reporting. In general, Q4 earnings should please investors.
Today, Pat Benatar is 69. George Foreman turns 73. Rod Stewart is 77. Perhaps most important, my granddaughter Joely turns 8.
James M. Meyer, CFA 610-260-2220
December 2021 Economic Update – “2022 Outlook”