While the news backdrop this week has been the beginning of a Biden administration and good news on the Covid-19 vaccine front, the big stories in financial markets have been a jump in long-term interest rates and a marked rotation from the high-growth tech stocks to the companies that will benefit the most from the reopening of the economy.
Briefly let me set the backdrop. Markets have been reacting favorably to a forthcoming Biden administration with the strong likelihood that Congress would be split. This suggests no big progressive steps forward with significant economic impact. No big tax increases. No Medicare for all. Mr. Biden is also viewed as less chaotic than a more impulsive Donald Trump. The other story was news that broke early Monday morning that Pfizer’s Covid-19 vaccine under development has proven to be 90%+ effective in trials to date. That sent markets soaring as much as 5% in premarket trading Monday morning, although the gains were pared in half by the close. But underneath the headlines we witnessed gains far higher than 5% in stocks of banks, hotels and airlines. Money rotated out of the big tech winners of 2020, particularly those companies labeled as stay-at-home beneficiaries like Zoom and Peloton.
Against this backdrop, 2020 has been a year of big divergences in the stock market. The S&P 500 is up over 11.5% so far this year, led by its 5 top members, Apple#, Amazon, Alphabet#, Facebook#, and Microsoft#, names that now comprise over 20% of the index’s value. On the other hand, value stocks, as measured by the Russell 1000 Value index, are still down over 3% even after the massive rally in some value sectors over the past several sessions. Thus, despite rallies of 20-30% or more in just a few days in the bank, cruise ship, airline, hotel and restaurant stocks, they are still down for the year-to-date and, in many cases, 20%+ below their pre-Covid highs.
The dichotomy between the performance of growth and value stocks has been noted for some time. It is not just a 2020 event, although clearly the pandemic has accelerated the differences as it has accelerated so many other trends in motion. There are some very good reasons for outperformance. First and foremost, these tech names at the forefront are growing significantly faster than the average American company. Amazon has not only maintained its meteoric growth rates, but the pandemic has actually helped it grow faster as shoppers moved online at a faster pace and online activity generated greater demand for cloud services. People searched more on Google. They bought more PCs to work or study from home. Etcetera. At the same time, no one flew, ate at a restaurant indoors, or stayed in resorts. There were good fundamental reasons for the spread in performance.
But these trends were obvious. And in some cases, they weren’t going to last forever. Maybe the volume of business travel in the future won’t get back to 2019 levels for a long time. Maybe we won’t eat out quite as much. But does that mean values should stay 30-50% or more below former peaks? The vaccine news really didn’t change the timeline to the end of the pandemic as much as it reminded us that there will be an end, and it is not too far away. Even as we live through what may be the pandemic’s biggest surge right now. If vaccines are highly effective and available broadly by mid-2021, then life will get quickly back toward normal by the end of 2021. Now we can envision packed stadiums for NFL 2021. There will be live concerts next fall. Broadway will return. None of this changes what faces us this winter. In fact, there could be a nasty period ahead pandemic-wise. We are starting to see football games postponed again. Schools remain virtual. Case counts are spiking, and hospitals are filling up again. If there is any good news, death counts so far are well below those of last winter.
But markets are forward looking. They will adjust to the short-term implications of a surge larger than expected. But those adjustments won’t mean much to the long-term valuation picture. Investors are focused on mid-2021 and beyond. That picture is improving. Thus, the vaccine news has everyone suddenly piling back into those stocks left for dead.
We have seen this before. In June, there was a similar reaction. At the moment, stocks of banks, airlines, and energy firms are close to where they were in June. There hasn’t been a real breakout quite yet, despite the sharp rally of the past two days. Coincident, there has been a moderate 10-20% correction in the previously favored tech names. But for the most part, they have not broken down technically yet. The same is true for bonds. Yields also spiked in June only to quickly recede.
It turns out June was a false alarm. Waning virus counts quickly reversed, especially in the South. Thoughts of a weak surge in the Fall proved to be false. There are reasons to suspect that this time is different. The vaccines appear to be the real deal. Scientists predicted a big Fall surge all along. But this could be the last act. The question now becomes whether the rotation taking place is real (I think it is) and how much further it can run. The latter is the bigger question. All the industries in question have been impaired. Airlines may not recapture all their business travelers. Ditto for hotels. Retail chains are going bankrupt. Who will fill the vacant spaces? What about empty office buildings in a world where work-from-home has great appeal? Do banks do as well in a cashless economy filled with digital wallets controlled by the likes of Apple and PayPal?
But life may not be so rosy for the big tech winners either. An end to the pandemic means an uptick in business activity. That raises the idea of greater demand and rising inflation expectations. Before the pandemic, 10-year Treasuries traded between 1.50-3.25%. If they return to that range over time, a reasonable expectation, equity P/Es should decline. That will impact companies selling at 30-50x earnings or more, a lot more than it will impact stocks selling at 10x. There are many who suggest that inflation won’t return. There is so much excess capacity and so much excess money sloshing around that thoughts of inflation are nonsense. But are they? Housing prices are already rising close to double digit rates. Gasoline prices hover near $2 per gallon. But should we expect a lot more driving next spring and summer compared to this year? If so, and demand rises faster than supply, it won’t require rocket science to envision higher gasoline prices. Unemployment is still around 7%, but the empty jobs are largely lower paying jobs in retail. There are no excesses in software designers or home repair trades. Collectively, we haven’t been spending money because we were stuck indoors or near home. Next Fall, a ticket to a featured rock concert may be as valuable as a roll of toilet paper was this Spring. I am not predicting runaway inflation any time soon, but I am suggesting that interest rates are more likely to rise than fall as the pandemic wanes.
The bottom line is that the current sudden lurch to value may not continue all that much longer, at least at the pace we have seen the past few days. But investor optimism, near term, is likely to match our overall optimism that we can see an end to this pandemic. There are still some bumps ahead as virus case counts spike and Washington changes administrations, but for now the trends point higher. How long that continues will be more dependent on the course of interest rates than anything else. 20 times in the last 60 years, earnings have risen by 20% or more. Stocks fell during 9 of those years and rose 11 times. Earnings growth alone doesn’t get you across the finish line. Valuation matters and nothing impacts valuation more than changes in rates. I offer no prediction other than the trend of rates over the next twelve months will be higher. Earnings will rise as well. One is a headwind for stocks; the other a tailwind. How those crosscurrents play out will determine whether 2021 is a good year for stocks once again, or not.
Today Leonardo DiCaprio is 46. Demi Moore turns 58. Today is Veteran’s Day, a day many forget. Take a moment to remember what our veterans have done for our country. In honor of Veteran’s Day, bond markets are closed.
James M. Meyer, CFA 610-260-2220