Stocks were volatile on Friday, strong at the open, weakening sharply in midday, and rallying into the close. The end result was a modest decline with the NASDAQ leaders having another difficult day. Futures point to an extension of the Friday afternoon rally this morning, as several large M&A deals were announced and Pfizer suggested it might be able to achieve broad distribution of a Covid-19 vaccine by the end of the year if all goes well.
When I look at this market, I see three buckets. The first includes the Covid-19 winners, from Clorox to Peloton, plus the tech high flyers that we all know. That bucket has great underlying fundamentals but valuations are full. For multiples to rise even further, they require that interest rates for 10-30 bonds fall from current levels. That isn’t likely unless the economy takes a downward turn. That could happen if there is a virus spike or Congress decides to pass no further stimulus. As the weather turns cooler, the attraction of sidewalk dining will fade in the northern two-thirds of the country. Indoor dining at 25% of capacity or less won’t be an adequate solution. So far, governors and mayors in New York, New Jersey and Pennsylvania are holding firm but we will see if they continue to do so when real cool weather actually arrives.
The second bucket consists of companies that are starting to do well in the current environment that may have been left behind in the first wave. Homebuilders and companies tied to the housing industry are a good example of components of this bucket. One common thread here is that companies succeeding today have pricing power. Simply said, demand exceeds supply. Covid-19 has disrupted supply chains. Changes in consumer habits (i.e. more people working from home) has created shortages in key items. Try and find a low-cost laptop or printer, for instance. Some of these shortages ease quickly (e.g. toilet paper), but others linger on. Sometimes the shortages are easy to fill. Have you ever seen so much hand sanitizer for sale?
The third bucket are the companies in trouble, enterprises that are in deep holes that will require a long time to return to any semblance of normal. These include most of the travel and leisure industry, the banks, and the energy sector. When there is rotation in the market, as we saw the last two weeks, these stocks might catch a bid. But the excitement doesn’t last, because the fundamentals are barely improving. I guess the airlines going from 20% of capacity to 30% is an improvement, but 30% is far away from levels necessary to support even the current depressed levels of these stocks. Furthermore, all the added debt acquired during the pandemic has to be serviced (i.e. the interest has to be paid). And that means a longer time until profits return to pre-pandemic levels. The banks may see an increase in the yield curve as the economy recovers but with zero as a starting point, rates will remain ultra-low for an extended period of time.
Certainly, the arrival of a vaccine will be a game changer. But even if we start to see anything near broad distribution in the first quarter of next year, the turnaround is going to be gradual. As we have seen with testing, getting broad distribution and ubiquitous access isn’t trivial. Second, not everyone will take the vaccine. With the whole process of vaccine approval and production politicized, the trust people have in the CDC and FDA is declining. Some will take it right away anyhow. But others will wait. That means it will take a while to fill restaurants and airplanes.
There is also the issue of state regulation. States in the Northeast in particular, have been ultra-careful about the pace of reopening. Most public schools in these states are now virtual. Even colleges and universities are mostly virtual. The more we are prevented from doing normal activities, the slower the recovery. Thus, while the economy is running much better than it was in April, further progress from here requires greater state and local government flexibility.
Many of the states that are most cautious are high tax states already. The cost of their caution is high. Some are already reacting by raising taxes and fees. Tolls on New Jersey roads are rising sharply today. New Jersey is already the highest taxed state in the nation. For every person entering New Jersey to live, three leave. It has the nation’s highest exodus rate today. Other similar states, like California, Illinois, New York and Connecticut are seeing residents flee. Raising taxes, particularly on the wealthy will only chase their tax bases away. Real estate values in places like New York are declining at double digit rates. While one state’s losses is another state’s gains, there is no overall benefit. The temptation to fill a fiscal hole with more taxes and fees is tempting but it simply doesn’t work. In fact, it does the opposite. Once the upper class leaves, an even heavier tax burden will fall on middle and lower classes as service quality declines. What states and cities need to do is find ways to attract money, create new jobs, and expand the tax base, not chase it away.
For investors, especially municipal bond investors, one must be careful and understand what assets and cash flows support their bonds. Empty dormitories, subway cars, and toll roads are examples of concern.
On top of all this is the election. I find it hard to believe that there are many undecided voters out there. Those that are will be persuaded by the debates that start two weeks from tomorrow. Voter turnout will be key. President Trump’s fuss about mail-in ballots has some merit, but it is also a toll to stifle voting in certain states and within certain demographics of those who might be more pro-Biden. Other last minute surprises could include a vaccine approval for emergency use by late October, an outline of a cross recognition treaty before the election between Israel and Saudi Arabia, and a preliminary report from the Durham investigation into the probe of Russian meddling in the 2016 election. It will be an interesting last 50 days to be sure. If close, we might not know the winner for weeks. That can only weigh on the market.
Thus, uncertainty relative to the virus, increasing pain for certain states with no Federal help coming, and Presidential politics are likely to keep markets choppy for the next two months. It doesn’t mean stocks are going to continue lower, but without major positive news, I think new highs will have to wait until after the election.
Today, former Sixer Jimmy Butler is 31.
James M. Meyer, CFA 610-260-2220