Strong moves continued this week in the have-nots as reopening efforts of the world continue to play out. This has led to some profit taking in the old winners, those who benefited from stay-at-home orders. Netflix, in particular, has lost over $40 in price over the past ten days, or 10%. It is safe to assume that being cooped up for two to three months has caused some people to watch too much TV. They are excited to get back outside and move around again which leads to different spending habits. While home product retailers are still thriving as we spruce up our yards and decks, indoor beneficiaries like Peloton are now being sold. That stock dropped 20% over the past two weeks but is still up 40%+ year to date. This transition from a closed economy to reopening has many moving parts.
This also means a much broader rally. During the shutdown, we can go to Wal-Mart# but not to our local small business shop. Big restaurant chains had the capability to offer online ordering and offer free delivery. Many smaller eateries could not. Golfers had to practice putting in their basements but can now go out in foursomes. Cash was nearly useless as online ordering drove an influx of new users to Venmo. Judging by my new curls, many people haven’t been to a hair salon in a long time. Some dental offices haven’t purchased toothpaste since March. Hospital orders for consumables are well below normal. This is all slowly changing. It also leads to a repricing of certain assets.
A rotation into the reopening bucket of stocks is a much wider list of names. In a fully operating economy, money doesn’t solely flow towards the biggest companies, some of whom benefited greatly after many small businesses were forced to close.
The market typically gets extreme on the bullish and bearish side. The massive drop in March came with a lot of forced selling due to cash needs and margin calls. That dislocation proved to be a massive buying opportunity in the mega-cap arena, especially Technology.
The Nasdaq 100 is actually up 8% on the year while the small cap Russell 2000 is still down 16%. This has started to change as we reopen though. In just two weeks (basically since half the country went back to work), the small cap index is up 20% while the technology heavy Nasdaq in only up 3%. This week alone, the Russell 2000 is up nearly 4% (8% before yesterday’s pullback) while the tech sector is flat. Even Europe is getting in party mode as the Vanguard FTSE Europe ETF is up 5% this week and 12% over the past two.
This is a very healthy exercise for the markets and the economy. We cannot continue to be led by a handful of stay-at-home names while the other 450 stocks in the S&P 500 languish. That being said, valuations are out of this world and could be an issue if unemployment levels don’t rebound quickly and/or we don’t get more positive news on the prevention and treatment aspect of Covid-19. The aforementioned Russell 2000 is now trading at 62 times forward earnings. The Nasdaq and S&P 500 are 28x and 23x forward estimates, respectively. That is high by any historical measure.
Granted, some of this is due to forced closures and not indicative of the true earnings power of many companies once we get back to normal, or close to normal. A piece of Tower Bridge’s process features “normalized earnings” as we attempt to gauge fair value prices for individual equities. Today’s revenues and bottom line earnings are not overly concerning if you have a world-class operator with lasting brands, reputable management teams and a clean balance sheet.
For example, let’s take a look at Yum Brands (which we do not own and is not a recommendation). They own and franchise KFC, Pizza Hut and Taco Bell restaurants. The stock typically trades at a 20% premium to the market, or 22x earnings, due to the cash flow rich franchise model and solid growth rates. The closure of dining rooms and added costs to get online ordering and delivery expanded will cause earnings to be ~25% lower than previously expected this year. That brings it down to $2.75 a share. In a “normal” environment, they will generate $4/share in earnings. In March, the stock got down to $55. Using a 22x multiple on $4 in EPS leads to a price target of $88, or 60% higher. Granted, it may take the company two to three years to get back to normal profit levels. By looking at normalized earnings, instead of current, one can get a better view of the long-term value for a world-class company that has staying power and a preferred business model. Even if it took 3 years, you had a solid risk/reward profile when paying $55/share.
Here comes the issue today. YUM is already back to $90! The stock is back to our normalized fair value price and nowhere near back to full operating mode. This is just one example and there are many names still well below long-term price targets but this 35%+ market rally has priced in a lot of upcoming good news, possibly too much. The easy money off the lows has been made. Getting aggressive here is not the same risk/reward profile from two months ago. Not even close.
FOMO, fear of missing out, is back. So are the printing presses as trillions of dollars in numerous currencies are being produced in a very short time frame. Europe surprised many with another stimulus package near $1T. Japan did the same. China is investing an added $1T to help their technology companies. The Senate is speaking softer on the next package from the US which should come to fruition over the coming weeks.
This is on top of the 200 central bank rate cuts over the past year and the trillions in fiscal and monetary measures already implemented. The typical time line is that rate cuts take 9-12 months to cycle thru an economy before we see the positive effect in GDP. That puts most of these measures in the first half of 2020, where many expect some sort of vaccine to be ready as well. The kindling is there for a massive boost to global GDP. There is no guarantee, but investors are focused on normalized earnings power coupled with the added money supply and are pricing in a bullish scenario. The economic numbers may look like a U but the stock market is starting to look like a V.
Again, the easy money has been made in this bounce. To see higher prices, one has to expect a rapid earnings recovery and life getting back to normal quickly. That scenario is hard to envision with a chunk of the population still in some sort of lockdown mode and fearful of close interaction. Stimulus checks helped stem the tide for now, but when these benefits run out and the money printing machines start to slow, we will start to see the opposite side of this recession.
Many will still be unemployed, others will be coming back to jobs that pay less than before in the hospitality and leisure world. Those who live on tips will see 25%- 50% less customers, initially. The shift to online business models means a lot of people won’t have the skills necessary to be employed. Changes like these are supposed to happen over years, not months. Money printing does not get John Doe the skills to operate a factory filled with robotic workers. More working from home certainly lowers the need for office space and the ancillary services that came from full towers of workers.
The rally lends itself an opportune time to reassess financial plans. Your equity exposure may have gotten extended if you recalibrated near the lows. Prudence means taking some profits in the fast movers. Momentum is powerful right now and could keep the markets elevated. However, it would not surprise us if the next few weeks/months is characterized by a wide trading range as we digest the impressive gains.
Soccer star Tobin Heath is 32 today. Actress Annette Bening hits 62 while Comedian Daniel Tosh turns 45 and 76ers 1st overall pick/flop Markelle Fultz turns 22.
James Vogt, 610-260-2214