Stocks rebounded Friday although they ended the week lower. Leading averages remain contained within a range going back to the beginning of November. Lower long-term interest rates, reacting to news of softening inflation and a slowing economy, help to push prices higher, while fears of recession and valuation concerns work to keep prices contained. What we are left with is sideways motion and heightened volatility.
While the leading averages move sideways, individual stocks follow their own patterns. Nonetheless patterns are developing.
1. The havens of safety during the 2022 bear market are struggling to hold their ground. This would include energy, consumer staples, and ethical drug companies among others.
2. Early cycle stocks, reacting to a softening of interest rates at the long end of the curve, have rallied nicely off their lows. Included here would be homebuilders and retailers with strong long-term fundamentals. Notable exceptions are department stores and selected retailers which are losing market share largely due to bad execution.
3. The largest tech names have experienced solid rallies in response to signs that they are reining in costs as growth slows. Nationwide, layoffs to date have been contained to this part of the economy. Last week, Alphabet# and Microsoft# alone announced more than 20,000 pending cuts. That may sound like a lot, but in the case of Alphabet, it is less than half of the number of people it hired just this past year.
4. Companies whose fortunes are tied to the whims of Washington have risen or fallen with the news. Defense stocks, in particular, have been hit as Republicans in the House seek to rein in defense spending.
Simply said, in a flat market stocks are reacting more to their own fundamentals than to macro factors. That is becoming apparent during the current earnings season which will gain serious momentum this week and next.
As bear markets morph into recovery mode, it is often the case that stocks that were hit the worst in the downturn outperform markets during early stages of recovery. This phenomenon is often called a dead cat bounce. In this case though, speculators are trying to catch a falling knife. For sure, some beaten down names will recover or even flourish over time, but more often the bear market exposes the weaknesses of companies whose stocks were elevated by hype more than any sober reality. This can be true for new IPOs or for very large companies. Let me give a few examples.
1. Bed Bath & Beyond was an iconic store chain that has lost its direction. Several changes have been made that chased loyal customers away while attracting few new ones. Now it is in a struggle to survive. Losses have weakened its financial condition to the point where vendors want to be paid in cash. Bed Bath IOUs are no longer acceptable. Bankruptcy seems inevitable. Nonetheless, the stock has doubled off its recent low amid speculation that somehow it can survive.
2. If you read my notes, you know that I have picked on Peloton and Beyond Meat as poster children of the hype of 2020-2021. Both make good products, but valuation was always an issue. Neither makes money yet. Both built infrastructures to be much larger companies than they have become. There are many meat substitutes competing for a modest market. The appeal for an expensive indoor bike waned when doors closed by the pandemic reopened. Both could survive, but more likely not as independent growth companies. Valuations of both remain problematic.
3. Perhaps the company that has garnered the most attention lately is Tesla. No one can question its innovations. For several years, it had very little competition in the electric car market. Its founder, Elon Musk, is certainly a genius, but even geniuses have limits. Musk is trying to run at least three companies (Tesla, SpaceX, and Twitter) simultaneously. Tesla hasn’t introduced a major new car model in three years, while dozens of competitors emerge. Is Tesla a growth company, a technology company, or an auto manufacturer? Probably a bit of each. Tesla will probably continue to grow. It will retain certain technological advantages simply based on its multi-year experience in automotive software, but it will also lose market share, be forced to spend money on marketing, and see gross margins come under pressure. Its stock is down by 2/3s in just the past year. Is that enough to adjust to a new reality? It’s too soon to tell. But forget about the highs of last March. Tesla is unlikely to regain those levels for many years to come. When stock markets go from euphoria to sober cynicism, valuation metrics change. Hype disappears.
The three cases, and many others, remind us of two important facts. First, the hype that accompanies euphoria has little place in a market built on caution. Second, markets are forward looking. Investors today have to adjust to new financial and economic worlds. Money today has a price. Balance sheets bloated with debt are albatrosses. In the world of technology, still the largest segment of the stock market by far, the days of explosive growth for digital advertising, social media and streaming entertainment are over. That doesn’t mean companies active in these segments can’t grow. They just can’t grow at the rates they did two years ago. But tech is still the engine of growth. You hear a lot of hype today about artificial intelligence. As always, some is real and some is overblown. Some early pioneers succeed while others get overrun. Many of today’s leaders are still private and unprofitable. Giants like Microsoft, Apple#, and Alphabet are going to embrace AI in everything they do. Word processing programs will become intuitive. Software development time will be cut dramatically. There are certainly flaws within some of the highest profile offerings you see today, but they will only get better with time. As investors, this is one of the vast new economic horizons just as search and social media were two decades ago. The same can be said for CAR-T and mRNA technologies being applied to new drug developments. These are only two examples.
For more prosaic companies, the question will surround their abilities to adapt to changes generated by these technological developments. Conventional retailers learned to embrace digital retailing as an ally, not a foe. Look at the successes of Nike and Walmart, for instance. Contrast that to the confused offerings of many department store chains.
Technology offers obvious advantages for defense companies making the most sophisticated weapons systems. It also offers great advantages to the most prosaic companies, improving their logistical capabilities while allowing them to target prime consumers most effectively. Our corporate giants have the great advantage of being able to invest at a hyperscale to widen their gap from competition. Just as many investors look backwards and not ahead, the same can be said for Corporate America. Indeed, Bed Bath & Beyond is a perfect example of just that point.
I want to switch gears and end with one final point on the market. By now, virtually everyone believes that the FOMC will increase rates by 25 basis points next week. Any alternative will be a shock to markets. The Fed doesn’t want that. The next meeting is in mid-March. Some believe there will be another increase in March followed by one or two more later in 2023. Others think only one more increase or even none is in the cards.
Don’t waste your time listening to all of this. No one knows. If inflation continues to fall and wage growth moderates, there will be one or none. Otherwise, there will be one or two more. The real question is will the Fed go too far, causing a more severe recession than is contemplated today? Said differently, will another 25-50 basis points be enough to cause a severe downturn? We already saw long rates fall. Housing demand is stabilizing. In some markets, there are signs of life. The better run retailers are doing OK. The employment rate is still over 96%! It’s hard to see a severe recession on the horizon. As we have noted, markets could remain bumpy until the storm clouds start to break, but they will. The Fed will stop before mid-year. Although the economic impact could last until early 2024, markets will see a bottom well before it happens. Stay patient and focus on opportunities of tomorrow.
Today, Mariska Hargitay is 59. Do you remember Chesley Sullenberger? He was the pilot who saved everyone landing in the Hudson River in 2009. Today he turns 72.
James M. Meyer, CFA 610-260-2220