Although the leading averages fell yesterday, more stocks advanced than fell in price. Two Dow standouts to the downside were Home Depot# and Walgreens. Home Depot reported very strong earnings but suggested that the pace of growth going forward might ebb. Heck, with comparable store sales growth of almost 25%, what else could you say? That was not bad news. More than likely it was simply some profit taking after a good year. Home Depot is one of the Covid-19 beneficiaries. Its stores were considered essential and stayed open during the pandemic, and people staying home spent time and money fixing up their homes.
For Walgreens, the news was Amazon’s announced entry into the prescription drug business. I should say formal announcement because ever since the company acquired Pillpack about a year ago, this was the obvious next move. Amazon promises 2-day delivery to its Prime members, and of course competitive pricing. While the stock of Walgreens fell sharply, along with others in the pharmaceutical distribution chain, time will tell how big a factor Amazon turns out to be. Conventional retailers have learned that they have certain omnichannel advantages. Best Buy can compete with Amazon on price, but it also can set up and configure your big screen TV or computer network. Advantage Best Buy. That doesn’t mean Amazon won’t sell a lot of TV sets. But those sales won’t come at Best Buy’s expense. Amazon has tried to push into other vertical markets with mixed success. Auto parts is another example where Amazon may not have all the advantages. When something breaks, who wants to wait two days? When your local garage has your car on the lift and needs a widget, does he call Amazon, Genuine Parts or AutoZone?
Amazon no doubt will sell a lot of prescription drugs, but if Walgreens and others press their advantages, it won’t likely come out of their hide, at least not as severely as the market reaction yesterday suggests.
Now to the bigger picture. With the election over (at least in most minds), there are two dominating themes, both Covid-19 related. The first is the current spike in the number of cases of the disease. Various locales are trying various measures to slow down the rate of infection. But so far, the number of cases is accelerating, not decelerating. Add weather factors, political rallies, street demonstrations, football games, the return to college, and just plain old Covid fatigue and you have a perfect storm. Now that the storm is raging, it probably has to run its course. With or without local restrictions, it is clear that human behavior is changing. And that means the pace of economic activity is bound to change as well. There will be fewer holiday celebrations, fewer parties, and fewer shopping trips. The recovery in airline travel has stopped. Cruises have been canceled for the rest of this year. Many schools are now totally virtual. GDP growth forecasts for Q4 were as high as 10% before the recent surge. They are now low single digit. They are headed lower.
That’s the bad news. On the other hand, we have learned over the past week that at least two vaccine candidates are 90% effective or more. If approved shortly for emergency use, which appears likely, front line workers and the elderly most at risk, such as those in nursing homes, will receive vaccines by early 2021. If progress continues on pace, the rest of us who are in higher risk categories, either related to medical conditions or age, are likely to be vaccinated by mid-year. That means the fears begin to subside by then and life can start to get back to normal later in 2021. Later could be as early as summer. That isn’t certain, but the probabilities that normality is in sight are higher today than they were a few weeks ago.
Thus, we have a tug. Near term, the outlook is crappy. Actually, miserable. The disease is spreading and it is going to spoil our holidays. Worse, many will get sick and some will die. You read all the same numbers I do. This will impact economic activity, the fuel that drives the stock market, and it will do so pretty harshly for a few months. But this won’t be a repeat of last spring. For one, we have learned how to cope. Second, not everything will be locked down. Third, we know this time there is light at the end of the tunnel. So, we will put on our masks and make the best of it. But most important, we have learned from the first spike, that this one has an end. And that is only a few months away. On an economic timeline, months isn’t very long.
Longer term, we know the sun will shine. A year from now you can expect that a lot of us, maybe most of us, will be back on planes visiting family or taking that trip that was canceled this year. We will want to get out of our sweat clothes and wear something that makes us feel good. But with that said, not everyone will be able to smile. Not everyone laid off during the pandemic will have found a new job. The stores and restaurants that couldn’t survive months of inactivity will still be closed.
But if we have learned anything during this pandemic it is resilience. We adjust. We adjust because we have to do. If that wonderful restaurant can’t survive, we search for alternatives. Doing nothing isn’t one of them. We regroup and restart. For those in the center of the storm, that will take a while. But it will happen. The gruesome truth is that a lot of businesses that will fail during the pandemic were probably destined to fail anyway. Walk up and down Madison Avenue in New York and see all the empty storefronts. Many were actually empty before the pandemic hit. These high-end retailers were serving a market that was disappearing long before Covid-19 struck. To be sure, luxury will never go away, but the definition of luxury changed and Madison Avenue did not. That is simply one example. Great malls will also survive, but ordinary malls are dinosaurs soon to be zombie malls before the bulldozer comes and changes them into something else.
You have heard me say for years that we have been living in a world of excess capacity fueled by ultra-easy money conditions since the end of the Great Recession. Well, conditions have gotten even easier leading to more overcapacity. The pandemic represents a breaking point. The weak die. The strong survive. What we see in the stock market is the strong. The big companies. The winners. Not all public companies are winners, to be sure. Department stores are dinosaurs destined to die unless they adjust. The list of old-fashioned retailers who have died over the past decade is too long for me to reprint.
Life will never be what it was before the pandemic. That is largely a good thing. We have learned a lot. We have learned how to be more efficient. We have learned how to use new technology to widen our horizons. Some have developed new hobbies. Some have built new businesses.
With all this said, there is one final key that needs to be analyzed. And that is valuation. Right now, with so much money floating around, valuation is taking a back seat. As long as markets are rising and cash earns nothing, money flows to what works. But that can’t go on forever. Some of the new Fed funding programs set up during the pandemic actually expire on December 31 with substantial unused lending capacity. They are unlikely to be renewed. They shouldn’t be. They weren’t needed as much as originally thought. It now appears that another stimulus bill will have to wait until February. My guess is that we will learn that the economy probably needs less additional stimulus than we thought even a few weeks ago. Do we really need to write checks for most Americans when unemployment is back below 7% and GDP is rising even with a virus surge?
But if the Fed stops pouring more money in and Congress slows the pace of handouts, which would be natural as the world heals, then somewhere down the road we can see a world of normal growth and modest inflation once again. If there is a normal to come, won’t valuations have to normalize? The answer is yes. Definitively. The question is when. If it’s 2023 or beyond, we aren’t ready to care very much. If its 2021 or 2022, then investors will start to pay attention.
Over the next few years, therefore, what we face is a steady rise in earnings (not necessarily in a straight line) and ultimately a decline in market P/Es. At times earnings will rise faster than P/Es fall, and stocks will go up. At times, interest rates will rise faster than earnings and stock prices will correct. Right now, with the Fed committed to backstopping any viral related dip, it appears earnings are rising faster than interest rates. Stocks are going up. But sometime next year, as virus fears fade, we have to watch whether the Fed is ready to adjust its tune. When that time comes, we will all have to pay attention.
Today David “Big Poppy” Ortiz is 45. Owen Wilson turns 52.
James M. Meyer, CFA 610-260-2220