Stocks gained again yesterday. But it was the cyclicals that took over leadership as the tech stocks took a breather. Few of the big name tech leadership companies have set new highs in recent days, perhaps a sign that they are about to enter a consolidation phase. With earnings season now upon us, it will be interesting to see how these companies, all with high built-in expectations, react to results.
On Monday evening, IBM#, which used to be the tech bellwether but is hardly so today, reported better than expected results. Its shares quickly rose 4% in afterhours trading and the shares still rose close to 3% when the market opened. But those gains were swept away during the session as technology in general faltered. Over the next two weeks, the new icons of technology will all report, and all have high expectations priced in. Some or all could beat forecasts but as expectations rise, the odds of a big beat decline. We’ll see. There hasn’t been anything close to a 10% correction since the late March lows. Such a correction could happen anytime. Maybe now, maybe many months from now. But valuation always matters. These companies have to meet ever higher expectations for their stocks to move up. Netflix has already reported. Great numbers and a good forecast. But its stock got hit, not a lot but enough to sober up Netflix investors a bit. We’ll see soon how others react as they report.
Meanwhile, modestly favorable vaccine news has helped to lift the cyclicals (i.e. the banks, oil stocks, airlines, etc.) a bit on hopes the virus can be contained sooner rather than later. But again, not to new recovery highs. Clearly, investors still favor the haves over the have nots. If one remembers that pandemics accelerate trends in place, the haves are gaining momentum while the have-nots are struggling to survive. No wonder investors are buying into successful businesses even if valuations might be stretched.
Clearly, Covid-19 remains the dominant near term force on the economy. If you read local newspapers or watch the network evening news, it sounds like an apocalypse is upon us. Every evening we are pelted with pictures of overwhelmed ICUs somewhere. It may seem that way in a few areas like Miami or Houston, but those are the exceptions, not the rule. Obviously, as the country reopened, there was more interpersonal contact. The incidence of infection rose. Anyone expecting otherwise was naïve. But that doesn’t spell catastrophe. In some areas that paid no heed to the spread or conditions of spread, significant hot spots have erupted. Besides Miami and Houston, we could add West Texas, Los Angeles, Birmingham and several other locales. But collectively, they aren’t representative of the entire U.S. Indeed, in some markets, like Phoenix, where steps were taken weeks ago to reduce direct contact (e.g. closing bars) virus counts are starting to fall. If the pandemic gets bad enough, people will react without additional government regulation. One only has to look at Open Table restaurant reservation totals in Covid-19 hot spots to see the impact.
We are getting close to school reopening. It will range from 100% in-class instruction in some areas to complete virtual education. It will take a few months to find the right balance across the country. Perhaps one positive is President Trump. Today, for the first time in months he took to the stage to proclaim that the virus was for real, that the situation would get worse before it gets better, and that masks are more than OK. He may not have helped himself going to a fund raising event immediately afterwards without wearing a mask, but the point here is that it has to help that, verbally, he is finally acknowledging that steps are needed to contain the spread. That won’t accelerate a cure, and it may only be talk. It may only be campaign talk. But it is the right talk and can only help. It will give cover to Republican governors in some of the most hard hit states to be more forceful. Thus, while infection rates, hospitalizations, and death totals have been rising, they are far from spring peaks. More importantly, they can be contained with proper reactions. We are beginning to see those. As Arizona shows, given time these steps will work. Everything won’t reopen but a proper balance can be found.
It is hardly fair to say the stock market rose yesterday because the President recognized the seriousness of the virus. I certainly won’t make that claim. But the fact that virus count increases are starting to slow a bit suggests that in hard hit areas, people are paying more attention, wearing masks, avoiding social contact, and taking the situation more seriously. All steps in the right direction. That clearly helps the companies most damaged by the virus. It suggests that the turnaround moment for them might be sooner.
But if stocks are going to move higher, it isn’t going to be the airlines, or the hotel companies that lead. In today’s investment world, they hardly matter. A mid-sized tech company has more equity value than the entire airline industry. While those with more courage have started to fly again, most of us are not ready. Traffic is still down two-thirds from recent peaks and the recovery has stalled. Retail stores have reopened over much of the country, but they are far from packed. The most successful retailers have seen online sales explode.
Indeed, if there is one formula for success, it has been the ability to adapt. In this world moving faster than ever, you either adapt or die. Buying cheap stocks that don’t adapt is not going to work. These are the classic value traps. They are tomorrow’s Sears, or Kodak.
And that is what’s key. Yes, at any given time some high flyers may be overvalued. There are only a few good entry points each year to buy Amazon or companies of that ilk. But they are our future. Not some lost retailer or a bank that still does most of its business through people intensive branches. Movies may have a great future, but movie theatres don’t. The cruise ship experience two years from now will be different than it was a year ago. The battered cyclicals hammered by the virus could provide traders profits when significant virus progress is reported. But those gains can only be sustained if (1) the end is in sight, and (2) the company survives with a balance sheet that can support renewed growth. After the 2008 financial crisis, banks like Bank of America and Citigroup survived. But they were so weakened financially that it took years to clear up bad loans, fix their balance sheets, and start to grow again. Airlines may survive but investors will have to ask how much volume will be necessary to cover all fixed costs and accumulated debt incurred during the pandemic.
At the other extreme, investors need to separate the real winners from the story stocks. How big is the market for plant-based meat substitutes and will any one company dominate that market? Will some real hot cloud-based application become quickly usurped by yet another upstart. Amazon and Microsoft# aren’t going to disappear. The same cannot be said of every hot new issue. Every new electric vehicle isn’t the next Tesla. Invest intelligently. Follow the growth path, pay attention to valuation, and don’t simply chase momentum.
Today, Britain’s Prince George turns 7. Selena Gomez is 28. Willem Dafoe turns 65. Danny Glover is 74. Finally, Alex Trebek is 80. I hope next year I can say 81.
James M. Meyer, CFA 610-260-2220