As the Dow continues to rise, the NASDAQ continues to fall. Interest rates are inching up, but it is hard to say that inflationary worries are increasing. The 10-year Treasury yield is only up by about 10 basis points from its recent mid-point and still below Spring highs. Economically, there has been a bit of a scare related to Covid-19. Pockets of case increases make headlines, and a modest Winter surge is possible, but stocks have been dealing with Covid-19 for many months. Jerome Powell was selected by President Biden to serve another term. Markets always prefer the known to the unknown. So, what gives? Why is volatility up and why are so many stocks acting so badly?
There is no one reason, but let’s start with inflation. While rates in general are contained, the yield curve is definitely flattening. That means shorter-term rates (2-5 years) are rising faster than long-term rates (10 years and longer). This coincides with statements from Fed officials, including Chairman Powell, that inflation appears stronger and more persistent than originally thought. It doesn’t mean that long-term inflation expectations are moving sharply higher. They aren’t, but they are creeping up a bit. Persistent strength in wages and accelerating rents are two key culprits, even as supply chain problems slowly start to clear and price increases related to supply chain snarls start to slow down. Whereas six months ago, the odds of more than one Federal Funds rate increase next year was less than 50-50, today two increases are expected with as many as four to come in 2023. The rise in shorter-term rates accentuates the change in expectations even as longer rates, and longer inflation expectations, remain anchored.
This becomes very clear watching markets. Higher rates, even modest rate increases, will be reflected in the stock market via lower price-earnings ratios. But perhaps most important, the range of P/Es will compress, meaning the spread between low and high P/E stocks will get smaller. Since the economy is growing, and many low P/E stocks are currently benefitting from policies emanating from Washington (e.g., a flatter or rising yield curve is good for banks), the way yields compress is for high P/E stocks to fall. In addition, as low P/E stocks appear increasingly attractive, money rotates in their direction. In the short term, money always flows from assets with weakening momentum to those with accelerating momentum.
You see that most clearly in the carnage taking place over the past few weeks in some of the hot story stocks of the recent bull market. Last week, I highlighted the weakness in Peloton and Beyond Meat. Another pandemic-related rage was Zoom. We all know it, most of us have used it. We will likely continue to Zoom with long-distance family and business relations, we just aren’t likely to do it as much. Video conferencing wasn’t invented during the pandemic. It won’t replace personal visits. You can’t get much satisfaction hugging your laptop. So, it was inevitable that Zoom’s growth rate would fall. That is exactly what its management said on its earnings conference call Monday night. Tuesday, the stock, which was already setting 52-week lows lately, dropped another 20%. Indeed, the new 52-week low list is littered with story stocks, names that had high visual appeal but no earnings, just promise. Look at on-line gaming. It’s going to be big. Sports fans love to bet. It adds excitement to the game. But dozens of companies have entered the fray. They all offer the same odds. They advertise and spend heavily to attract customers. But given that there is little to differentiate one from another, retaining customers isn’t easy. In the casino business, high rollers get hosts that give them all sorts of goodies. There are no hosts online. So far, online gaming is a fast-growth money pit for everyone.
The list continues. Telemedicine is great and will be with us a long time. But a Zoom physical exam isn’t the same as one in the office. Investors in Teledoc Health are starting to get the message. Back in 2000, just before the Internet bubble burst, the red flag warnings went out for stocks selling at more than 10x revenues. One of this year’s hottest new names is Snowflake, a company born in 2012 that will reach $1 billion in market cap this year. What does Snowflake do? Essentially, it allows users of multiple databases to interact seamlessly, improving database management. The incremental value is exciting, and the company is growing fast. Investors love it also…at over 100 times revenues. Didn’t I just say 10x was a red flag in the past? Can 100x be sustained? Even if the company grows 100% per year for the next two years, the price/revenues would still be 25x.
In the Fall of 1998 and again in 1999, there were sharp corrections to frothy markets. Overall, stocks had solid corrections but escaped bear market territory. The declines were sharp. But after the corrections ended, the losses were reversed, and equities marched to new highs until April 2000 when the Internet bubble burst. The NASDAQ leaders fell close to 80% while companies that were all hype and never earned any money went to zero. Note that the stock market decline of 2000 wasn’t the result of a recession. A minor recession did follow, but that mostly related to the events of 9/11/2001.
What we face today is acknowledgment that economic growth over the next two years will slow as fiscal and monetary stimulus fades. That isn’t a damning statement. It is a conclusion that has been obvious for over a year, but it is a reality now. Stocks look ahead. They don’t price for years ahead; they price 6-9 months ahead. What markets see today is decelerating earnings and the likelihood that 6-9 months from now the Fed will begin to raise short-term rates off a floor of zero. While that is an expectation, not a certainty, inflection points in monetary policy bring with them a rise in volatility and some rotation in leadership. Most important, these inflections lead to more uncertainty and less willingness to speculate.
Perhaps the biggest messages today are the following:
1. Stay balanced. Those who vastly overweighted technology and recent speculative winners are feeling the most pain today.
2. Valuation always matters in the long run. Growth at any price works when euphoria dominates. It does horribly when euphoria morphs back to reality.
3. Bonds remain unattractive until real rates are positive. If you feel an urge to buy bonds to lower volatility, keep duration short. In the 1970s, locking in long-term rates was a good idea. Today, locking in 2% makes no sense with inflation running at a rate of almost 6%.
4. If you do own some of the hottest names with no earnings and no real prospect of earnings for years that are already down 30-50% or more, you may not want to stay. When the party ends, losses may reach 80-100%. Ultimately, there will be one or two winners in online gaming or electric vehicles. But how many personal computer companies made money 5 years or more into the boom? Remember Commodore, Toshiba, and Atari? If you are staying with these names, you are betting on 00 at the roulette wheel.
Don’t ignore the most important facts. The economy is still growing, and inflation is likely to be contained, even if it runs a bit hotter than it did post-2008. Just pay attention to valuation and you will be OK. We have said often that the next 6-months is likely to be bumpier than the last six months. That’s OK, especially after two years of very outsized gains. But portfolios always require attention. Don’t overstay your welcome in stocks with little fundamental support. Unless you expect euphoria to resume, the underpinnings to last year’s hot stories are falling apart rapidly.
Today, Katherine Heigl turns 43. If you remember the A-Team, you can’t forget the crazy Murdock. He was played by Dwight Schultz who celebrates #74 today. Lastly, Peter Best is 80. Another name that will leave many scratching their heads, but true Beatles fans will know that he was the original drummer of the group before being replaced by Ringo Starr.
James M. Meyer, CFA 610-260-2220