Stocks rallied on Friday as some bargain hunting took place. Otherwise, there was little news to move stocks.
Economic data continues to show improvement, although the pace of gain is slowing. Weekly unemployment claims remain above 800,000, about four times what they were pre-pandemic. While some businesses continue to reopen or expand their allowed capacity, others that are bleeding red ink are giving up and closing. The pace of improvement is reflected in real time data such as daily TSA statistics that report the number of passengers embarking on a flight, or reservation data from Open Table. While indoor dining, for instance, is now allowed pretty broadly, those who feel at risk of Covid-19 infection are still staying away.
But as a vaccine gets nearer, and younger people who get sick largely avoid the necessity of hospitalization, the economic path overall is still forward. This week will mark the end of the third quarter. Estimates are that GDP grew about 30%. That, on the surface, is a huge number, but we still remain well below Q1 peaks, and the year will still show a solid GDP decline no matter what Q4 brings.
The uncertainties, which can be expanded to include the election and pending Supreme Court change, are keeping the Federal Reserve in a very accommodative mood. Everyone now knows that short-term rates will be kept at or near zero for the foreseeable future, which means well into 2022 and possibly well beyond. Some market watchers criticize the Fed for not being more specific on its near-to-intermediate term plans regarding how it will execute the moves necessary to keep rates low. But if rates stay near zero, stock prices and the values of other financial assets will remain high as long as the current status quo remains in place.
Looking at 2020 from 30,000 feet, the stock market suggests that it wasn’t that bad of a year. The S&P 500 and NASDAQ indices are in positive territory, bolstered by the remarkably strong performance of the largest tech companies. Other indices are down a bit, perhaps reflecting a broader reality of what the overall economy has been doing. Earnings are likely to decline about 25% overall, offset by the impact of a sharp drop in interest rates. But the overall picture hardly tells the overall tale. Our economy, and indeed our way of life, has changed dramatically during this pandemic. We work from home, we do much of what we used to do virtually, and we avoid most travel and leisure activities. Sports have restarted (not sure if that counts the Philly teams who remain comatose), but without an audience. In some stores and restaurants, staff outnumber patrons. With that said, there are many companies that have benefitted from these changes. At the top of the list are companies who make masks, bleach, and toilet paper. There are other obvious winners, including tech companies that thrive on virtualization, cloud computing, and online purchasing. I don’t need to list individual names; you all know them by now.
But there is an underbelly of winners. These can be divided into two parts. First are those in the right place at the right time. The aforementioned bleach manufacturers are a case in point. Ditto those that manufacture boxes made of corrugated paper. An obvious question is whether the gains resulting from a pandemic-caused change of life will continue afterwards. Are we going to spray countertops with Lysol for the rest of our lives? Probably not.
The second set of winners are those companies that saw quickly that Covid-19 changed the rules of economic engagement and reacted quickly. Retailers like Nike, Lululemon and Best Buy have thrived despite store closures because they could move their customer base online. Small retailers lacked the capital to do this. The results are evident everywhere. If thousands and thousands of restaurants are not going to stay in business, those that remain should grab market share. Homebuilders are clearly benefitting from a flight from city to suburbs. But they too are changing. New models now feature home office layouts, and are wired for high speed data. Kitchens become more important as more meals are consumed at home. Package delivery firms like Fedex# and UPS are obviously beneficiaries of the growth in online shopping. But they had to make major changes to deliver packages more efficiently. It is clearly more profitable to deliver a pallet of goods to a destination than a 10-ounce box to your doorstep. But reconfigured properly, these companies can make money shipping to your home. The margin per unit will be lower but higher volumes will be an offset.
In most industries, an observer can differentiate the winners from the losers. The winners adapt. Pandemics accelerate change. The winners accelerate their response to change. Some restaurants have discovered a new revenue source in take out and delivery. While demand may shrink as patrons return, it won’t disappear. Retail provides a perfect lens to understand the influence of the pandemic. Department store chains, for the most part, have not done a very good job building their own brands. Store brand apparel is almost always viewed as lower price and lower quality than the name brands carried. Department stores have been shaving service for years in an effort to cut costs and increase margins. With service and strong private label brands, price has become their one weapon of choice. That could work if one is the low-cost provider, but in a world that includes Walmart#, that isn’t likely. In addition, manufacturers of strong brands are pulling away from department stores because constant sales promotions cheapen their brands. You won’t find names like Lululemon, or top of the line sneakers from Nike, in department stores. Contrast the woes of department stores with the success of companies like Walmart, which has gone to great lengths to be a true omnichannel retailer. If you look at the stock market, Walmart is near an all-time high while Macys and Nordstrom hover at multi-year lows. I used retail as an example because it is obvious to all. But I could make the same case in almost every industry, with the exception of commodity sectors where supply and demand factors simply overwhelm, such as the energy sector.
The moral of the story is obvious. Change or die. It’s that simple. Defending a dying brand or an aging technology isn’t a cure. It is a recipe for death. Kodak is the poster child of a corporation unwilling to change. Sometimes the new upstarts are simply too nimble and fast for the bureaucratic incumbent. Take electric cars. Yes, Tesla is certainly going to be a winner, but who else? Tesla isn’t going to make every new car sold in the future. Ford and GM certainly have the financial and engineering muscle to succeed, but can they move fast enough? If electric cars aren’t as profitable as SUVs, will their dealers push them while pushing their customers away at the same time? My guess is that 10-20 years from now, the auto industry will be led by a mixture of new brand and old names that truly embrace change. Just as Walmart decided a few years ago that it would have to sacrifice a year or two of profit gains to get realigned in order to be a winner of tomorrow. Contrast that to IBM, whose new CEO at the time stuck to an inherited 5-year plan by cutting costs instead of blowing up the plan and investing for a cloud-centric world.
One last example. Intel has been the leading manufacturer of microprocessors for well over 30 years. It has been a great ride. Microprocessors are among the most powerful chips in the world and demand is broad. It remains broad and growing. But Intel faces more intensive competition. Graphics chips do much of what a microprocessor does. Old competitors like Advanced Micro Devices design their chips but don’t waste time, energy or capital on very expensive manufacturing plants. The value is in the design, not the manufacturing. Intel is finding out it can’t keep pace with the largest foundries. Rather than concede defeat, it continues to fight an uphill battle to catch up. While it is wasting its energy trying to retain that incremental margin that comes from building inhouse, it falls further behind the design leaders as well as the manufacturers who can offer their more nimble competitors more efficiently manufactured devices. Intel has time to right itself but not a lot of time.
Look at your portfolio. Are your companies changing? Or are they waiting and hoping that in 2022, the world will look like it did in 2019? Guess what. It won’t.
Today Gwyneth Paltrow is 48.
James M. Meyer, CFA 610-260-2220