Stocks gave back some ground yesterday after last week’s strong rally. The losers yesterday were generally the big winners last week, including banks, airlines, other leisure stocks, REITs and industrials. The winners yesterday were the FANG names as the NASDAQ Composite set an all-time high.
Lately there has been a push and pull between growth and value names in the market. Growth has led value for many years. The disparity in valuation has widened toward record levels. That has led investors to be skeptical of how much wider the gap could become, even recognizing the appeal of growth to equity investors.
With the arrival of Covid-19 and the subsequent lockdown of our economic society, many began to question whether restaurants, hotels, airlines, cruise ship companies and shopping malls could survive extended periods of closure or activity levels so low that fixed costs simply could not be covered. It may be good public health policy for a restaurant to reopen at 25% of capacity with tables widely spread apart, but how does a restauranteur make money operating in that fashion?
As the world reopened and none of us were swallowed by the Loch Ness monster, it seems apparent that most of the public companies operating in industries decimated early on will survive. Airlines may still only be running at 20% of capacity, but each day more and more people are beginning to fly again. We may find out three months from now how reckless those people are. But for now, if you look at hospitalization and death rates from Covid-19, they are declining. Everyone talks about a fall surge, and if you read about the Spanish flu outbreak of 1918-1919, there are reasons to fear such an event. But there is no certainty when dealing with a novel virus, and a warm summer might provide some respite. Time to calm nerves a bit. With that said, restaurants are far from full, and I don’t know anyone planning to vacation on the French Riviera this year.
As a result, there are good reasons for the recent rallies in airlines, hotels, etc. They are still well below 52-week highs, but they should be. After all, even if a real resurgence doesn’t doom them to bankruptcy court, the costs to add the necessary capital to stay alive will permanently injure valuations. Citigroup today sells for a tiny fraction of its stock price in 2007. It survived, but had to sell so much equity at such dilutive prices in 2008 that the hole it dug was too great for legacy shareholders to escape.
Thus, while the oversized fears of March and April created unusual bargains, those have either disappeared or the opportunities have gotten much smaller. In our investment world money flows and momentum changes quickly. As the deep value bargains disappear, money begins to flow back to where it was most comfortable. And that is the growth stocks.
That doesn’t answer the valuation question. We all know of the success of Amazon, Netflix, etc. But no one wants to be the last guy to jump aboard the gravy train. Low interest rates allow for higher valuations, but even with rates on bonds below 1%, there is a limit as to how far up stocks can go.
Which brings us to today’s conclusion of the two-day FOMC meeting. The Federal Reserve isn’t about to change interest rates any time soon. The Fed Funds rate is already within a few basis points of zero. There is little evidence that going to negative rates would be a positive step. First, there is scant evidence from nations that have tried negative rates that they work to increase growth. Second, once central banks step into the negative rate quagmire, it is extremely difficult to escape. As for the possibility of higher rates, there is no chance of that while GDP growth is negative, and unemployment is at double digit levels.
As everyone knows, the Fed has used its ability to backstop lending and to add liquidity through security purchases as its primary tools lately. Right now it is buying assets at a $3 trillion annual rate. We have seen repeatedly over the past decade that significant monetary easing helps to lift asset prices. That is most apparent over the past two months. Thus, it is no surprise that owners of financial assets want the Fed to keep doing what it has been doing for as long as possible. There are clearly negative consequences of too much sovereign debt and too much bond buying, but explaining that to investors today is like telling a young child that you are taking away the cookie jar because you don’t want him to get diabetes when he is an adult. Thus, the trick for Jerome Powell today is to tell markets that the economy is fragile enough to continue its pace of monetary easing, while acknowledging that the economy is starting to come out of the abyss. Should he emphasize good economic news, investors might worry that he will buy bonds at a slower pace. If he is overly negative in his outlook, they could worry that he sees something they don’t. It is a fine line and tough to stay on course. Mr. Powell hasn’t always stayed on the fine line, although he usually recovers quickly if markets say he strays too far.
Futures this morning are fairly close to even, suggesting no real conviction which way he will go. Instead of boldly taking a stance in front of the meeting, watch for reactions afterwards. In any case, the Fed is going to stay accommodative, and the economy will continue to recover. Valuation matters, however, suggesting the path forward from here may be a bit bumpier than it has been for the last 10 weeks.
Today, Kate Upton is 28. Prince Philip turns 99.
James M. Meyer, CFA 610-260-2220