Stocks were mixed yesterday and market rotation continued. Former high flyers continued to weaken and the year’s weakest sectors, especially energy, had another strong session. More on that in a moment.
A couple of months ago, economists were worried that bond markets were signaling recession with near record low interest rates and an inverted yield curve. Today, 10-year Treasuries are up about 40 basis points from summer lows and the curve is no longer inverted. In fact, it is steepening, a clear signal of rising economic confidence.
What happened? For one, the Fed has reversed course lowering the Federal Funds rate three times since the summer after 4 increases in 2018. Monthly employment gains have continued strong even as we get closer to full employment. Inflation is stable within a cross current of higher labor costs and weak commodity prices.
It isn’t that the economy has suddenly gained new animal spirits. Investment spending remains very weak, a consequence of political uncertainty and tariff policy. Manufacturers have been working down excess inventories most of the year. Tariffs have slowed the flow of trade. Overcapacity continues to pressure commodity prices.
But there are hints of improvement coming. Continued consumer strength around the world will help to reduce excess inventories over time. Commodity prices seem to have stopped falling. Housing activity has picked up thanks to the three Fed rate cuts. Trade negotiations with China could result in a slight rollback in tariffs. The stock market senses these trends and has moved to new highs. But to sustain the rally, earnings have to reaccelerate.
Where there has been economic strength, in technology and health care for instance, good times continue. Rising rates and a steepening yield curve will help the banks and other financials. Their stocks have been strong performers lately. Industrials would be a big beneficiary if trade friction were to be reduced. Their stocks have had a glorious few weeks.
With that all said, let me get back to rotation. Often in mature bull markets, leadership narrows. Growth slows down and investors all concentrate in the few growth segments left. In 2019, at least through the summer, that meant technology, most specifically software, cloud, and medtech. The strength in consumer spending helped lift restaurant stocks. They were big winners as well.
But investors often overplay their hand; their collective urge to buy the same hot stocks leads to overvaluation. The poster child of this may be Beyond Meat, a stock that rose to close to 50 times revenues at one point, about 8 times its IPO price. Since summer, the stock has lost about 2/3 of its value, not because the company did anything wrong, but because valuation got completely absurd. Beyond Meat may become a preeminent food purveyor someday, but I doubt its stock will ever see its 2019 high again.
As investors all flood to the same hot names, they abandon the losers. In 2019, that meant energy and industrials. There were good reasons to leave the energy complex. Prices were weak, drilling activity slowed, and there was a lot of talk of alternative fuels and peak energy. But that story was probably overplayed. While there are still a few who believe we will all be driving Teslas and their relatives in five years before giving way to autonomous vehicles a decade from now, I suspect electric cars will remain a niche market for many more years than most believe. As for autonomous vehicles, maybe in a few years there will be some niche applications in a few markets. But the crossover point where the economic and safety equations strongly favor alternative vehicles is still many years away. The Jetsons are still cartoon characters. Yes, we are all wearing Dick Tracy watches today and, someday, autonomous vehicles will be the real deal. But not in the near term investment horizon that would threaten the existence of the fossil fuel industry. Moreover, existing oil wells pump less and less oil every year. New oil has to be produced to fill the gap. The industry isn’t exactly a growth industry, but it does have value. While I am not suggesting investors load up on energy names, they simply got undervalued as investors rotated to growth.
In fact, the spread between growth and value this summer got wider than at any time since 2000. We all remember what happened then. The Internet bubble went poof! What we are experiencing right now is a modest repetition of 2000. It is modest because the bubble never got anywhere near as big this time around. I don’t think the rotation is over. But given the sharp recent gains in energy and manufacturing stocks, I would expect some backing and filling to occur soon. Stocks simply don’t move in a straight line. At the same time, I don’t believe the correction in valuation of high-flying growth stocks is over yet either. The failure of many of 2019s most high-profile IPOs is actually healthy. This week, both Uber and Peloton reported mixed results on very strong revenue growth. It is still unclear whether either, however, will ever reach a level of profitability to justify today’s market price, let alone their IPO prices a couple of months ago. What happens to all the private equity unicorns lined up waiting to come public is an open question. Hedge funds have had their wake up call over the past decade. I suspect the bloom will come off the rose of some portions of the private equity market over the next few years.
In the meantime, we enter a fairly quiet period in the market as everyone awaits the Christmas season. Generally, it is a time for optimism. Stocks often do well in November and December. But not always as 2018 demonstrated. However, with economic data showing health and perhaps even acceleration, further gains are more likely than not.
Today, Ethan Hawke is 49. Sally Field turns 73.
James M. Meyer, CFA 610-260-2220