Stocks staged a sharp rally led by NASDAQ shares early yesterday. While the Dow gave back much of its gains as the session progressed, the battered tech sector and other speculative arenas, such as the SPACs, held onto much of their gains.
In market corrections, amid volatility, you often see sharp intraday or one-day swings in the opposite direction. Late last week markets witnessed such a comeback before a sharp decline set in on Monday, especially among the more speculative issues. Yesterday’s rally felt good for those who had seen their favorites fall by 25-33% or more in just a few weeks. But real rallies, those that signal a true bottom, must have follow through. Hence, today is important.
I should note that the blue chip stocks, away from technology have been acting fine lately. They have not been in correction mode or anything close to it. They have responded to an accelerating economic rebound and brighter earnings prospects. However, with so much money flooding into the market, it has been the more speculative sectors that have witnessed the euphoria. This includes big names like Tesla, new names like Airbnb, and the more speculative SPACs. While many of them have corrected by 20% or more in recent weeks, they are far from cheap on any rational or fundamental basis even after the corrections. Many investors playing in those sectors have never witnessed a bear market.
They haven’t seen the savagery that can drive prices down 75% or more. To them, the strategy remains buy the dip. We saw that again yesterday.
A poll broadcasted on CNBC yesterday said that over 50% of adults 25-34 who will receive $1,400 stimulus checks in the coming months plan to invest part or all of their money in the stock market. That floored me. It reminded me of 2005 when 1 out over every 2 homes sold was purchased by a non-occupant. We all remember what happened to the housing market after that.
Which brings me to another point. A common characteristic of markets coming out of a recession is that junk outperforms quality in the first 12-18 months. It held true in 1991, 2002, 2009 and since September of 2020. There is actually some logic to this. First, in bear markets amid a recession, blue chip businesses hold up better. Their stocks don’t fall as far. A corollary to this is that the stocks of companies given up for dead fall the most. This time around think of travel and leisure sectors like airlines and cruise ships. Thus, when the smoke clears, and it is apparent that those left for dead will live to fight another day, their stocks can easily double or triple in a matter of weeks. To be fair, some businesses did die and, of course, their stocks won’t bounce back. But most do make it. If you time it right, there are big percentage gains to be made early in a recovery.
But that rally carries only so far. Airlines still carry all the warts they had before the pandemic. Today, they are saddled with even more debt. They will have to spend more to keep planes clean and monitor passengers for signs of Covid-19. They will once again lose your bags, bump you from flights, and enrage you with delays. They are not growth companies. The next health scare or recession, they will be right back in the hot seat.
But in 2001, stores like Macy’s and Nordstrom’s might have had higher year-over-year percentage growth than Target or Walmart. That doesn’t mean over the long term you shouldn’t bet on the latter. Macy’s still doesn’t understand omnichannel retailing, so Target and Walmart will continue to take market share. But they both had outstanding years in 2020 when so many competitors were closed. Year-over-year gains this year will be a lot smaller, and their stocks are likely to lag the market a bit until everything evens out.
That doesn’t mean one has to or should sell Target to buy Macy’s. Target is the better run company. It will grow faster over the years. If you believe you can be a nimble trader maybe for a few months or a year, Macy’s will be the outperformer. But catching both the bottom and top are difficult. The bottom was many months ago, when the survival of Macy’s was in question. For long-term investors, I suggest stay with quality as long as valuations don’t get out of hand.
While the recent rise in interest rates creates a headwind, one would expect the pace of rising rates to moderate. In a little over two months, 10-year Treasury yields have risen by about 60 basis points. 60 basis points every two months, if stretched out to the end of 2021, would result in a yield of about 4.5% by year end. Anything is possible, but I haven’t seen a forecast for rates even as high as 3%. Markets don’t move in a straight line. Some temporary issues at play in recent weeks that have helped to push rates higher are already fading. Most importantly, the Fed and Treasury will push hard to keep the pace of rate increases down. The Biden Administration is at the cusp of passing a $1.9 trillion spending bill with no offsetting revenue sources. Next, it is contemplating another bill of similar size. That one is likely to have some revenue offsets (higher taxes), but not $2 trillion worth. It is premature to suggest the odds of such a bill passing, but the key point here is that the Federal debt is going to rise significantly in the years ahead. Debt service won’t be a major issue if, and that is a big if, interest rates remain low.
While the Fed has less control over the long end of the curve than it does at the short end, it still has the ability to buy hundreds of billions of dollars of bonds every month. We can argue another time the merits of such a policy (it certainly isn’t risk-free), but it will certainly put downward pressure on rates. Don’t wait for 4.5% at the end of the year.
That means the headwinds of rising rates will blow hard at times, as it has in recent weeks, and not blow at all at other times. Meanwhile, the tailwind of improved earnings will be a constant. Quality stocks will have their ups and downs but should end the year higher.
As for the speculative froth fueled every day by Fed bond buying and $1,400 stimulus checks, all I can say is that in the end, fundamentals and valuation matter. I mentioned on Monday the sale at Christie’s, the big auction house, of a piece of digital art with a non-fungible token (NFT) attached. I marveled at the $3+million bid 3 days before the end of the auction. Two days later, that bid stands at $9,750,000. I have no idea when this nuttiness comes to an end, but it will. Meanwhile, the core of the market remains rational. Valuations are sane. There are real businesses that pay real dividends.
Today, Carrie Underwood is 38. Jon Hamm is 50. Chuck Norris turns 81.
James M. Meyer, CFA 610-260-2220