Stocks were mixed on Friday, a slow typical end of a summer week. Earnings season started last week with the banks. No real surprises. It gets underway in earnest this week.
Of course, Covid-19 continues to be the big story overhanging the market. It remains a “Tale of Two Cities”. In the South, cases continue to rise as do deaths and hospitalizations. Florida is now seeing more new cases daily than New York did at its peak. Worse, the average age of the newly infected is rising, as young adults infect co-workers and their parents. Still, throughout the deep South, restrictions are still fairly minimal. While there is some localized requirement to wear masks, statewide mandates are relatively uncommon. That will change if the infected counts continue to rise. Meanwhile, in the Northeast, where tough early restrictions successfully reduced the rate of infection, cautious reopening has kept the infection, hospitalization rates, and death rates to manageable levels.
The net has been that the rate of overall economic activity has slowed a bit over the past several weeks but is still improving. Improvements in New York are offset by softening in Florida and Texas. The next big hurdle is the reopening of schools. While the White House wants all schools to reopen in normal fashion, that is only likely regionally. More common is some combination of virtual and in-school classes. In a few areas, classes will be all virtual while in others, they will be 100% in class. Obviously, that is neither the best nor the worst of all worlds. It means some parents will have to stay home and sacrifice work, at least part time, to care for school age kids. I suspect this is built into equity markets and investor expectations.
Many times, I have spoken of a world of haves and have-nots. There is actually a third class of companies, those that might be affected, one way or the other, by Covid-19 in the near term, but whose long-term outlook post-virus doesn’t change much. Look at Procter & Gamble, for instance. Certainly, in the toilet paper and paper towel scares, it got a boost. But we have changed our bathroom habits permanently based on the virus and we brush our teeth about the same amount. While there will be some near-term bumps, in PG’s case mostly positive, long term expectations of the company’s growth prospects shouldn’t change materially. I could add to PG most consumer staples, utilities, etc.
Thus, what we have are a select group of very large companies whose businesses were growing before the pandemic and who are experiencing accelerated growth as a result of the pandemic. The pandemic has actually served them well. In numbers, these companies are in the minority, but in terms of market cap and impact on the stock market, they are huge. At the other extreme are companies severely impacted by the virus. In some cases, like cruise lines, they are shut down entirely. It isn’t clear who will even survive. The same goes for commercial real estate owners, airlines, hotels, restaurants, travel enterprises, and movie theatres. While these business segments will all rebound post-virus, whether current companies will survive without going bankrupt is uncertain. Most will, some won’t.
In stock market terms, the winners comprise a dominant part of overall market capitalization. The losers comprise an ever decreasing portion of the total pie. Those in the middle are a solid core. Therefore, understanding the market means understanding the relative importance of the winners in overall proportion. Thus, while the S&P 500 is down only about a half of a percentage point year-to-date, an equal weighted S&P performance number (i.e. every component in the average counts the same) is down over 7%. In a world devastated by the coronavirus, being down 7% would hardly be viewed as a terrible performance. But the top half dozen stocks, all in technology sectors that actually benefit from online retailing, to increased use of the cloud, to more streaming activity, are up enough to pull the entire average performance of 500 stocks to almost break even.
Is it inevitable that this will continue? Clearly, these leaders are growing at a faster rate. That matters. But valuation matters also. With everyone seemingly trying to get aboard the same ship, the risk is one of overvaluation. We have seen several times in recent years that when sellers take over, the fall can be sickening. I have no idea whether the next correction or mini-crash happens next week or next year. But I do know when it happens, investors won’t be able to react quick enough to avoid the pain.
So what’s the strategy? When prices get too high, take some money off the table. If they go still higher, sell a bit more. Have some capital ready for the next sickening fall. There will be one. On the other hand, try to understand the fine line between values and value traps. Low prices don’t mean bargains; they mean low prices. Walk into a department store and examine the 50% off rack. Maybe there is a diamond in the rough. Most however, you wouldn’t buy at 99% off! You buy stocks that can go up and they won’t go up if they are on a path toward oblivion. Will your favorite airline avoid bankruptcy? Maybe. But will it have to sell so much cheap stock and raise so much debt at high rates that avoiding bankruptcy is faint praise? Be careful.
Thus, the best idea is to remain diversified but avoid companies for now in industries that have a very extended path back to where they were before Covid-19. Don’t just buy high tech growth companies with extended valuations. Own some rock solid blue chips as well. Dividends can be a floor if they are solid. Better yet, a history of rising dividends provides an even better floor. Finally, understand that the world going forward is going to be different than it was just a few months ago. Airline traffic numbers will take years to recover. Movie theaters may never match 2019 audience figures. Restaurants will incur greater costs. Ditto gyms.
Stocks can keep rising, particularly if the Federal Reserve plans to keep rates near zero for an extended period. But ultimately, earnings matter. They are the growth engine for the stock market. Right now, in a choppy world with unknown virus implications, discipline is important.
Today, Ben Simmons is 24. Sandra Oh is 49. Carlos Santana turns 73.
James M. Meyer, CFA 610-260-2220