Stocks fell Friday as both IBM# and Intel responded negatively to weak earnings reports. With that said, there was some rotation last week from the value stocks that have been rising since Labor Day amid hopes of economic improvement as the pandemic wanes, to the tried and true growth names that have led the market for years.
This will be the biggest week for earnings, and many of the market leaders report this week, led by Apple# and Microsoft#. Expectations have been high. In fact, in regard to the banks, for instance, they were so high that even very good results led to stock price declines. There was simply no room left for further upside to near-term forecasts. As to longer term, for the banks that depends on the course of rates, something investors have no serious ability to forecast.
The other big event this week is the conclusion of the 2-day FOMC meeting on Wednesday. Chair Jerome Powell has already telegraphed the outcome. While there are some signs of economic improvement, the gap between today and a full employment economy that could push wages and inflation expectations materially higher is so large that absolutely no action is either necessary or likely. Thus, while acknowledging some improvement in housing and manufacturing, the Fed will keep rates near zero and will continue to buy bonds at the present pace. It is unlikely to offer any timetable as to when that strategy will change. Whether that is completely baked into markets today, or gives investors more motivation to buy almost any asset, is something we will learn Wednesday afternoon. Given how well the message has been telegraphed, I think there is little upside left.
So where is the upside? It comes from two places. The first would be during earnings season if managements raised guidance and expectations. That could be the case in a few high corners of our economy, mostly centered on technology. But for the most part, the near-term future is still too uncertain to give managements cover to raise guidance. We saw that last week when the banks reported. We still could see it in companies pretty much unaffected by the economy, or those benefitting from the pandemic. Netflix was an example last week.
The other push upwards would come from an escalation of speculation and investor euphoria. Two signs are the explosion in the number of SPACs and the surge in equity option activity. Daily volume on the New York Stock Exchange (NYSE) is a bit over 1 billion shares per day. Option activity (puts and calls) now average about 40 million per day. Since each option represents 100 shares, that equates to 4 billion shares. Options can be, and are often, used as hedges. If you have a large gain, you might sell a call against it, for instance. Pros commonly use spreads with a combination of puts and calls to achieve a desired result. Thus, don’t read too much into the ratio of total option volume to NYSE volume. But do read a rise in speculation into the fact that option activity has more than doubled since late 2019 after being fairly flat for 4 years. The speculative side of options is that owning them in an unhedged manner magnifies an investor’s possible gain or loss. If a stock sells for $25 and you buy an option to buy the stock at $27 for $1, you can make 3-5 times your money if the stock goes to $30 before the option expires, or lose 100% of your investment if the stock falls below $25. In a market as volatile and speculative as this one, to many it’s worth a shot. History shows repeatedly that speculation like this almost always ends badly, but tell that to someone making money during the current speculative surge.
I have talked about SPACs before. They are legitimate vehicles used mostly by young companies with great stories and little in the way of earnings to raise capital and come public. There are dozens of upstarts who want to get into the electric powered van market either as standalone companies or in conjunction with existing auto makers. The idea of an electric van to deliver goods over the last mile for Amazon or UPS makes a lot of sense. They can be recharged every night, make a positive environmental statement, and have low operating costs. But all the upstarts aren’t going to make it. I suspect that Ford, GM, and Toyota are all interested in the same market. Maybe one or two will be big winners. Maybe none will. Time will tell. But they all won’t. With SPACs raising hundreds of millions of dollars apiece, all one needs is a design and a non-binding commitment from a large customer to enter the market. In the 1980s we saw this as newcomers scrambled to make PCs. Look at all the new streaming services today. A generation ago, casinos were the hot story; today it is online gambling. Are there going to be 50 successful online gaming sites?
Speculation leading to euphoria is clearly a sign that a correction is coming. Whether it starts tomorrow or two years from tomorrow is a guess. How much air can a balloon hold before it bursts? But as option volume goes parabolic and the number of SPACs issued every day does the same, it is time to limit the amount of money you have at risk in the speculative corners of the market.
Make no mistake about it. When the speculative fever is extinguished, the pain will be centered on those parts of the market, but it will extend over a much wider swath. Being in the eye of a hurricane can be devastating. Being within 100 miles can still be quite damaging. Not all parts of the market are equally at risk. But the whole market bears some risk.
Yet as speculative fever rises, investor complacency grows. The last time we saw this was a year ago as stocks were setting new highs as Covid-19 was coming to our shores. President Trump wasn’t the only one who viewed it as a non-event at the time.
Corrections caused by speculative activity rather than economic deterioration tend to be short. Depending on the degree of froth they can be painful. However, they must be severe enough to stop the issuance of SPACs for companies with no revenues and earnings. They must spank the Robin Hood neophyte to find another venue to gamble. It means Bitcoin rushes back to $10,000 rather than surges to $100,000.
Again, long-term core positions don’t have to be touched. They will recover fairly quickly. There are many who believe a correction can’t happen now with the Fed anchoring interest rates near zero while injecting $120 billion of additional capital into markets. Maybe they are right.
If you are old enough you might remember that Saturday morning matinees started with a serial usually involving a hero chasing a bad guy. The episode ended with the train or vehicle going over the cliff. The next episode started with the hero jumping off just in time, hanging onto a tree branch. That’s Hollywood. In real life, when the trains go over the cliff, so does the hero. It is time to pay attention to your risk exposure and make sure the recent rally doesn’t have you a bit overextended.
Today, Alicia Keys is 40.
James M. Meyer, CFA 610-260-2220