Stocks were mixed once again. It has been an odd week, at least compared to prior trading patterns. The leaders this week have been the former bull market laggards, namely energy, banks and industrials. Meanwhile, the former tech darlings, including many prominent IPO names, saw significant profit taking. There must be a message in there somewhere. We’ll take a stab at understanding it.
The first most basic answer is that in separating the wheat from the chaff, investors simply went too far. In bull markets, growth at a reasonable price often morphs into growth at any price. I must confess that I have yet to eat a Beyond Meat burger. I like veggie burgers and even prefer them to regular beef-based ones at times. But last week, in a local joint, I had the option of either an $11.99 burger or a $16.99 Beyond Meat burger. I had an omelette instead.
But the world isn’t about my preferences. Plant-based burger substitutes are the rage of the moment. Popeye’s sold out of plant-based chicken sandwiches in hours. Whoever heard of lines to get into a Popeye’s store? Of course, we all know this phase will pass and normality will be restored. Perhaps over time, Beyond Meat and Impossible Burgers will reign like Coke and Pepsi. But any student of economic history will remind us that the early winners aren’t always the lasting winners. If you are interested, I will list for you 100 personal computer companies that were hot names before Dell was even created by a teenager. Or do you remember those great search engines like Lycos and Alta Vista, eventually slaughtered when Google emerged? None of this is meant to disparage today’s newbies but is simply an attempt to put risks and rewards in perspective. As stock prices for Beyond Meat soared, it clearly went from growth at a reasonable price to growth at any price. I think the same thing happened to tulips some years ago. In fact, it also happened to Cisco, Intel and Microsoft a bit over 19 years ago. All are much larger today but only Microsoft’s stock has reached new record levels. And many of the stars of 2000 are only an asterisk in a history book.
OK, so the darlings deserve a break. At some point, the break is going to be a lot more painful than a few down days like we saw this week. When the real pain arrives, there will be lots of capitulation. I can’t tell you that correction has started or that the last few days are a momentary head fake. But there will come a time when reality sets in. The new age winners deserve high valuations. Many are true bona fide growth companies. But when multiples of market price to sales start to get near triple digits, clearly euphoria was replacing sanity.
But what of the surge in oil and bank stocks? Perhaps in those cases, investors were throwing out the baby with the bath water. Oil prices normally weaken even before the summer driving season peaks. But they are nowhere near their 2016 lows and supply/demand equations look to be in relative balance today. Many stocks of oil producers were selling for a significant discount to the value of their oil reserves in the ground. They were due for a rebound. As for the banks, everyone seemed fixated on the threat of low interest rates and a flat yield curve to their earnings. While net interest margin is an important factor, it doesn’t move around as quickly as rates change. At worst, bank earnings are going to flatten for a while assuming a recession isn’t just around the corner (more on that in a moment). Meanwhile, banks have much better balance sheets than they had a decade ago, and they generate a lot of cash to pay handsome dividends and buy back stock, often at or below book value. Book value at a bank is a real number comprised mostly of loans, cash and other financial assets that are easy to value. In most stock markets, investors chase momentum. They buy what’s going up and sell what isn’t. Reversals like we are seeing this week are a reminder that momentum is not always your friend. In the end, valuation matters.
That isn’t to say growth is dead and value is due for a comeback. In fact, many traditional value stocks, like utilities, REITs, and consumer staples, have become market darlings over the past several months as investors searched for yield in a world where a 10-year Treasury only provided less than 1.5%. You have seen me note that when the yield on the S&P 500 is greater than the yield on a 10-year Treasury, as it is today, stocks are much more attractive than bonds. That still holds true and it will limit the downside to some of these safe havens. But they too probably went a bit too far and some correction is warranted.
Thus, there is rationality to what is happening now. It doesn’t have to be a long drawn out process. The bounce in bond yields was a triggering factor but valuation, in the end, trumps everything.
As for the economy, everything is fine at the moment. Tariffs to date have served to slow growth. But other than the effect of tariffs, all else is going reasonably well. World slowdowns are affecting manufacturing and capital spending but consumers all over the world remain confident spenders. Obviously, if trade wars escalate, all this could unravel. If the next round of tariffs is implemented in mid-December we may have to reassess. But let us not put the cart before the horse. There is a long time and a lot of trade negotiations between now and then. Mr. Trump doesn’t want to create a recession on the eve of elections. He has a lot of incentive to find a less hostile path. Markets today are betting he will. We will see soon whether they are right.
In times of change, pay close attention to valuation. Don’t be afraid to take profits in stocks that moved too far, too fast. And don’t be afraid to buy real bargains. But don’t chase either. Oil stocks aren’t growth stocks. They simply got too cheap for a time. Banks have some growth characteristics but they aren’t going to grow faster than GDP. Valuation matters once again.
As for IPOs, watch what happens over the next few weeks to Peloton and We, two very high profile new names that are attracting a lot of attention even though both still lose a lot of money. To me, We is the typical end-cycle story riddled with flaws and bad governance trying to get out the door before it slams shut. The success of its offering will answer the question whether avarice can defeat rational behavior. If you want to read more about We, Google the name and have fun reading all the goings on. It’s better than reading Trump tweets and watching the media fight over what he says.
Today Taraji Henson is 49. It is also a day to remember those who lost their lives in the 9/11 tragedy 18 years ago.
James M. Meyer, CFA 610-260-2220