Stocks retreated yesterday. The selling accelerated into the close and appears to be carried forward this morning as futures are down once again. Much of the selling is concentrated in tech stocks and the speculative favorites of just a few months ago, especially SPACs.
As noted previously, when stocks fail to go up on good news that is a telltale sign that most of the good news has already been discounted in the market. Home Depot# reported blowout earnings yesterday. The initial reaction was a 2% gain but that evaporated even before the market opened. It ended lower on the session. It is just an example. Macys, which has been brutalized in the market for years, but made a comeback in recent months, also reported good numbers. But it saw selling pressure build during the session.
As for the SPAC fervor of just a few months ago, names like Virgin Galactic, which was up as much as 150% in January alone, is now down significantly for the year. No revenues, no earnings, and a lot of hype. In January, the hype won, today it appears the reality is rising to the surface. Will Virgin Galactic one day take some of us for a real ride into space? Maybe, maybe not. Will it be a money making success? Today, the message is maybe not. I suspect its shares and those representing other SPAC dreams have more downside left.
I have no idea whether or not what is happening now is the real purge, that cleansing that stops for a significant time the crazy speculative wave we saw at the start of this year. If it is the real purge, there is still a lot of pain for speculative investors as hype gets replaced by reality. Hydrogen isn’t going to be the dominant energy source any time soon. There may be a lot of electric cars on the road in five years, but most are likely to be built by names like Tesla, Volkswagen, and General Motors, not Fisker or Lucid.
As for the rest of the market, in 2020 stocks fell over a third in five weeks as the pandemic struck and we went into collective lockdown. The decline turned out to be an overreaction. Covid-19 didn’t kill the world, it put it in lockdown for 60 days. Subsequent waves scared us and too many people lost their lives. But economically, the past twelve months have been a period of recovery. With the arrival of vaccines, the recovery accelerated. Demand, sequentially, took off as we began to do most of what we had been giving up for a year. We returned to malls and restaurants. We got on planes again. Today, city after city is lifting all restrictions. By mid-summer, ballparks will be full. Broadway reopens in the Fall. Masks won’t disappear entirely, but they won’t inhibit what we do.
The surge in demand these past few months has surprised businesses. Inventories had been depleted during the pandemic peak as everyone tried to conserve cash during worst of times. The rush of demand, combined with low inventories, meant many items quickly got into short supply. Can’t find propane for your barbecue as Memorial Day approaches? Don’t worry, your hardware store probably doesn’t have any of the grills you wanted to buy anyway!
Minimal inventories help to boost short-term profits, but retailers don’t boost profits by telling customers they don’t have what the customer wants. So, for the next several months, maybe longer, we will go through an inventory replenishment cycle. The surge in profit margins will end. Prices that spiked during times of shortage will return to normal. You are starting to see it in some of the commodity futures markets. Lumber futures, for instance, have declined for seven straight days even as lumber remains in short supply. But now you are seeing builders laying foundations but delaying completion until lumber prices, not just futures, start to fall. All this is normal. It will take a few months to sort out. But just as the toilet paper shortage of last spring went away, so will other temporary shortages we see today. In the South today, private owners are cutting down trees to take advantage of record timber prices. That is a sign of a top, not a bottom. Just like everyone selling old jewelry when gold prices spike.
How does all this translate into stocks? We are in the best of times. Demand is exceeding supply and corporations are reporting record earnings. Resurgent demand, and elevated government spending add to the mix. Margins are at peak levels. Some of this was a bit of a surprise. While we all knew vaccines were a game changer, I think markets were surprised how fast they could be deployed and how rapidly we would get back to normal. The process isn’t over. Workers are just starting to return to the office. Ballparks and venues are still largely empty. In weeks that will all change too. By mid-summer, most of us who have been vaccinated will only be using masks in crowded settings. This is now all reflected in the stock market. Equities have been reacting to the reset of profit expectations. The question going forward is not whether earnings will keep rising, they will. It is whether they will rise faster than we currently expect or not.
The peak in sequential growth is probably right now. Q2 will be the best year-over-year, as we were in virtual lockdown for much of Q2 last year. But from there, growth, either sequential or year-over-year, starts to slow. The heady supercharged growth rates of recent months will recede toward normal.
There is nothing wrong with normal. Moreover, because of the noted shortages, some industries will benefit from the process of catching up. It may take a few years for balance to be restored to the housing market. Demographic change, mainly millennials moving to suburban homes, is a process that will take years. That process will also increase demand for cars for some time. On the flip side, offices may never fill up 100%. Working from home won’t suddenly disappear. Parking lots won’t get full. Restaurants whose key meal was lunch for office workers will have to recast their businesses. Demand for suits may rise initially, as most return to the office, but long term this isn’t a growth business. Pandemics accelerate change.
Note, however, that the spike in lumber prices hasn’t witnessed a spike in sawmills. No car company is building new assembly plants in response to the current rise in demand. While that means it might take longer for the shortages to clear, new plants only follow long-term demand trends. Thus, you will see new semiconductor plants long before you see new sawmills.
Bull markets rarely end before profits peak. There is no recession at hand. Quite the contrary. Growth should remain elevated through 2023 as the impact of easy money and massive government spending flows through the system. But the pace of growth will slow and so will the pace at which stock prices go up. The market mix gets complicated by the excessive speculation that appears to have peaked, at least for now, early in the first quarter. As I note often, stocks of companies most impacted by the speculative wave will suffer the most as the speculation is purged. It isn’t just SPACs. It could be digital art or Bitcoin as well. A month ago, Bitcoin was praised as a better store of value than gold. Bitcoin’s value is down a third in less than a month. If it isn’t a good store of value, what is it? It certainly isn’t a currency, except in the underworld. So what is it? Until shown otherwise, I would call it an object of speculation, nothing more or less. Blockchain technology is real and useful. Someday, probably sooner rather than later, there will be a stable, regulated, universal digital currency that will speed transactions and do it at a lower cost. I have no reason to believe Bitcoin is going to be that currency.
Thus, we have a speculative purge of some sort going on while the overall economy grows at a decelerating pace. Interest rates remain stable, suggesting the spike in prices today is transient as the Fed believes. With that said, inflation pressures are building and will continue to build, but history tells us that inflation builds slowly. Today’s market dilemma focuses on the pace of rising inflation. The answer is likely months or even years away. In the meantime, expect a choppier market in the second half of this year, as decelerating growth clashes with a slow steady rise in rates. Market choppiness isn’t conducive to massive speculation. That usually accompanies market surges. The Robin Hood kids are licking their wounds. They will be back but not right away. With all the excess money sloshing around, speculative waves will reappear somewhere.
Stock prices are a combination of earnings, interest rates and investor optimism. Earnings are great, interest rates are relatively flat, and investors are sobering up. The sobering part may be a bit painful short term, but it won’t be long lasting. With that said, valuations are full. The good news is that with profits rising even faster than stock prices, P/Es are actually declining right now. If the market simply moves sideways for a few more months, P/Es will return to more normal levels. That’s healthy.
Today, singer Sam Smith is 29. Grace Jones turns 73.
James M. Meyer, CFA 610-260-2220