The inevitable pullback is finally upon us. After a 48% rise in the S&P 500 from the lows, a pause is welcome news. The market overdid it on the downside then shot too high, too fast on the upside. In total, the Dow Jones was down 1,861 points or 6.9% yesterday. The Nasdaq held up somewhat better, dropping 506 points or 5.01%. That index finally broke through the 10,000 point barrier earlier in the week to set new all-time highs. A truly amazing feat during a global recession. Futures this morning are pointing to decent gains at the open, recouping 1/3 of the losses.
There are reasons for optimism when looking past 2021 but a straight line up makes little sense until we are back on firmer footing. The catch-up trade in financials, travel stocks and retailers over a 3-week period also reeked of too much enthusiasm where gains of 50%+ prove unsustainable. We will get there. It takes more than a few positive trending data points to prove it. Valuations do matter after all.
Aside from profit taking and overbought conditions, the recent decline can be explained by a couple of news items. The main one is the rise in new infections across the country. Memorial Day weekend gatherings, lax social distancing measures in early opening states and future cases from congested protests are bringing back some fear. To date, hospitalization and death counts aren’t spiking but some states are seeing slow rises like California and Texas. “Reopening” stocks were stopped in their tracks, leading on the downside.
Judging by recent conversations, most of us are getting out and moving around. However, there is still a decent portion of the world that will not go to a restaurant, fly on a plane or step foot in a nursing home. Until they feel safe, consumer spending will be below normal.
Lastly, the Federal Reserve’s comments were not overly encouraging. A subdued jobs forecast and an expectation that long rates will be guided down for longer is not great for the reflation/reopening trade of the past several weeks. The 10-year Treasury saw its yield drop from 0.81% to 0.65% in 2 days. Neither number is great for income, but one is 20% higher than the other. However, a lower for longer theme is usually good for high growth companies as they can keep an elevated P/E ratio.
This is a continuation of recent action that can be seen in the graphic below. A growth basket of Facebook, Apple, Google, Amazon, Netflix and Microsoft drove almost all of the market returns for the past few years. The average stock is only up 20% over the 5 year period. This follows earnings as the Big 6 grew profits 80% while the other 494 names have seen earnings flatline. There are winners in there as well, but, simply put, if your portfolio is diversified you’re having a tough time generating outsized returns.
The Big 6 above now have a total market cap greater than the combined GDP of Germany and Italy. For anyone who has been in the market a while, this reminds them of the late 90’s. That period was dominated by Y2K stocks or the New Nifty Fifty. The other 450 stocks were poor performers. There are several differences though. First, valuations are nowhere near as extreme. Extended yes, but not 175x earnings like March 2000. Second, interest rates are much lower today. The average 10-year Treasury yield in 2000 was 6.0%. Fed Funds were 6.0%. Tech stocks today can handle 30 P/E’s if earnings are going to grow 15% and the other option is sub-1% bonds. The rest of the market is not growing that fast, making the 20+ P/E of today a bit of a stretch.
There have been some excesses though. Stay-at-home orders created a new group of day traders. Online brokers saw a tripling in new account growth measures in March. The advent of zero commissions and too much time on our hands created a mini bubble. Everyone is a genius when the market is going up.
They helped bankrupt companies’ prices skyrocket to the moon before this correction: Hertz is still a quadruple since filing for bankruptcy. JC Penney’s jumped +300%. The craziest may be Whiting Petroleum. They filed for bankruptcy on April 1st when the stock was worth $0.33. The bankruptcy plan is handing over 97% of equity value to bond holders, leaving existing shareholders with just 3%. The stock subsequently ran to $3.50 last week. Letting the air out of these bubbles is a good thing.
We have added $21 trillion in global equity value since March. This puts the worldwide valuation framework at its highest level since 2002. Our economy will eventually get back to normal. To some investors, they are realizing that is not happening in 2020. A consolidative phase that teaches new Robinhood investors a lesson in valuation or gambling on penny stocks is welcome news to students of the market who care about things such as multiples, earnings & revenue growth.
There are new values being created with this decline. Just as before, investors should identify the winners in a post-pandemic world. The market could drop another 10% from here or just stabilize. Anything can and has happened already this year.
Pick price targets to nibble at for companies that have long-term merit. Build up positions during these corrective phases. The Fed has the market’s back. Money printing is not ending anytime soon. Another stimulus bill from the Government in the $1T+ range is likely over the coming weeks. We will get past Covid. Opening efforts will work, over time. Earnings on a normalized basis make some stocks look buyable now. Some are still over leveraged and overvalued. Give them time to correct. Patience should be rewarded.
Actor Dave Franco is 35 today.
James Vogt, 610-260-2214