Fed Chairman Powell’s last speaking event before the FOMC meets on March 16th certainly impacted markets yesterday. Most major averages were positive before he spoke, then began sliding with the S&P closing down 1.3%. The Nasdaq again led the negative tape, declining 2.1%, and has now dropped 10% from all-time highs set a few weeks ago. Semiconductor companies reported more supply issues (too many sales is typically good news) which brought that area down 5% alone. The catalyst for most stocks, yet again, was a spike in long-term interest rates, which are back to 1.55% on the 10-year Treasury, up 8 basis points.
Powell didn’t change his tune too much as the Fed expects short-term rates to stay near zero. More importantly, he thinks the economy will see “transitory increases in inflation” and they “will be patient” in response to any rise in prices. With a market concerned about inflation and rising long-term rates, this brought about heavy selling. Many were expecting some hint towards reopening the Operation Twist portion of the Fed’s playbook or other yield curve control measures.
Operation Twist occurs when the Fed sells short bonds and buys long bonds to slow the ascent in rates. This was last used in 2011 and the 10-year Treasury yield dropped from 3.75% to 1.43%. They can’t control the long-end of the curve forever, but can certainly slow the rise if needed. Overall, a growing economy can handle some inflation and gradually rising interest rates. A quick tripling in 10-year yields brings angst to investors. Nothing said today is changing that tune, so more equity selling is occurring, especially in high P/E growth stocks.
It is clear that lower rates drove P/E’s higher and vice versa over the past year. This originally helped the fastest growers, who were trading at very lofty levels, but were growing sales and earnings at high rates during lockdowns. Most were in the Technology sector. Low interest not only raises P/E’s but is also fuel for loan demand, capital expenditures and investment allocations. Now that the longer yields have nearly tripled in just six months, the discussion around yield curve control is critical for this sector.
Rates are one input to the equation but we’re also not in the same environment from a revenue standpoint relative to 2020 either. Amazon# is not going to see 40% growth in sales again, but they do have millions of new customers who are now more frequently buying something online. Similar stories can be said for Zoom, Teladoc, eBay and Shopify. When growth rates peak like they did in 2020, stocks tend to consolidate. This does not mean upside is done, but outsized gains like we saw last year are more difficult. When you add in higher interest rates it becomes a double whammy and leads to profit taking.
On the other end of the investment spectrum, this year will bring massive revenue growth, albeit off of a low base due to a pandemic induced shutdown, in many consumer discretionary, industrial and cyclical industries. The expected good news is getting priced in. Even looking at just this year, the Nasdaq is down 1.3% while the small-cap and more economically sensitive Russell 2000 is up 8.7%. Over the past four months, the Nasdaq is +17% while the Russell is up a whopping 40%.
When does this rotational trading end? When valuations reach a level commensurate with normalized growth rates. Just as we raced too far too fast on certain shutdown stocks last year, there will be a point when the cyclical trade ends and reverts back to normal growth rates. It doesn’t seem like we’re there yet.
Where do we stand now from a valuation view? Glad you asked. The five largest technology stocks trade at 35X forward earnings. Take out Amazon’s 65X multiple (which drops to 42 on next year’s earnings after a 50% rise in 2021) and the average P/E is 27X.
The fifteen largest names in the S&P 500 outside of Technology currently hold a 24x forward PE as well. Take out Disney’s 92X multiple (which still has minimal park and movie revenue relative to historic norms) and the average P/E is 19X.
The end result? Neither is cheap by any historical measure, but unexpected with long-term rates where they are. Technology is 40% more expensive that non-tech. Note, this is just the mega cap leaders.
Now, onto the growth side of this equation. Earnings for the big tech leaders are expected to grow by 22% this year. Taking out oil stocks, which mostly lost money last year when oil prices went negative, the largest non-tech names are going to grow at a 14% clip. A commonly used metric in the industry is to take your P/E Ratio relative to Growth, aptly termed a PEG ratio. The higher the PEG, the more an investor is paying for growth. Tech has a PEG ratio of 1.6 while non-tech is 1.4. Not too far off from each other.
The cyclical trade has trumped growth for several months after growth led for several years. Many cyclical stocks will handily outpace their technology brethren from a revenue and earnings standpoint this year. Everyone knows, and has positioned themselves, for a reopening of the economy. Great news is getting priced in. Valuations for both big-cap tech and non-tech are quite similar when accounting for growth rates.
The ability to continue beating lowballed estimates and position for unexpected growth is the next hurdle, if those stocks are to continue leading. When coming out of a recession, typically cyclical stocks are underestimated by the market and handily beat estimates. Yearly EPS guidance was raised across the board for this group during earnings season and should continue to occur. Stock selection is more critical today than ever from this point on.
By the end of calendar 2021, we will be looking at a much different earnings multiple picture in all sectors. Where interest rates land, how fast they get there, and how our economy reacts to an ending of government handouts are all ingredients for how to reposition portfolios over the coming months.
Remember, most bull markets in stocks are accompanied by rising interest rates. The only difference today is that those rates are coming from zero to a more normal range, but it is happening in rapid fashion. Too much, too soon does not give time for adjustments. Many are concerned that inflation is now secular as opposed to transitory. When that is proven to be incorrect, hopefully, rates will normalize and get back to a slow and steady pace upwards in conjunction with growth. Tech and non-tech can win in that environment together. We just may have to suffer some back and forth before that occurs.
Actress Eva Mendes is 47 today. Potential Eagles draft pick Justin Fields is now 22.
James Vogt, 610-260-2214