Today, trying to get to the bottom of where we are, I am going to use a question and answer format.
What caused the decline? While a large options trade may have been a contributing factor, the irrational sudden surge in stocks like Tesla and Amazon that sent both, and others, into a parabolic ascent, almost certainly set the table for an equally sharp decline. It has often been noted that stocks go up an escalator and down an elevator. When the escalator gathers runaway speeds, the impending decline in inevitable. Tesla may be down 35% in less than a week, but it merely returns the stock to levels of a few weeks ago. It is hardly cheap today by any normal valuation standard. When fear sets in, or simply momentum swings the other way, the 5 members of the S&P 500 who comprise 20%+ of the average are destined to take a big hit. And so Apple#, Microsoft#, Amazon, Facebook# and Alphabet# have had bad weeks. But all five are still up significantly for the year.
How long could the decline continue? Just as we can’t say when a parabolic rise will end, I have no idea when this correction will end. With that said, fundamentals of all the leaders remain intact, and the bond market remains stable. That suggests the bottom won’t be catastrophic.
Should we buy the dip? It depends on when the dip ends. As noted, none of the above mentioned names are hardly cheap at the current time. But long term, many of the high flyers are still some of the greatest companies out there…. But not all. Technology moves rapidly. Today’s disruptors can become tomorrow’s disrupted. Don’t fall in love with an idea. Be analytical and watch for newcomers who come up with an even better idea.
OK, the high flyers were ahead of themselves, but what about the other stocks. Are they expensive as well? When selling becomes heavy, it affects stocks. But like Covid-19, every storm has its own eye. Using the hurricane analogy, the center of the Covid-19 pandemic was the leisure, transportation, banking and energy sectors. In the market decline that began last week, the epicenter was a small set of high flyers. But the damage in a storm fans out from the center. So almost all stocks take some sort of hit until the storm passes.
How do we know the bottom? Look for signs of selling exhaustion. A huge spike in the VIX volatility ratio, a huge number of declines, a morning crash followed by an afternoon recovery are all possible examples. But beware of brief sharp rallies that don’t last. That is why I abide by my two-day rule. I don’t feel comfortable until we experience two solid days after an extended decline. So far, we haven’t had two solid hours. Be patient.
Could this become a bear market like February/March? I don’t think so. There is no fundamental cause. Interest rates and inflation remain ultra-low. The number of Covid-19 cases are falling although, post-Labor Day and school reopening, some sort of rise is likely. A vaccine isn’t far away. Reopening continues although the pace of recovery is slowing. This is simply a valuation correction. Stocks rebounded too far, too fast.
If not a full-fledged start to a bear market, how bad can it be? In 1998 and 1999, tech stocks corrected 20% or more before quickly recovering. Ultimately, the Internet bubble ended in the spring of 2000. Tops roll over. Bottoms are V-shaped. We only set highs a couple of weeks ago. Before there is a true bull market top, we would have to see at least one and probably more than one attempt to break out to new highs.
Are we seeing the start of rotation from growth to value? That’s possible. But more likely is that growth is hitting a valuation wall. That suggests names like Tesla may have reached their 2020 highs. But it doesn’t mean that airlines, hotels, and banks are ready to boom. That depends on a real economic recovery. It probably requires more fiscal support. And it certainly requires no serious Covid-19 spike this fall. I realize there will be a lot of Presidential pressure to approve a vaccine in some manner before the election. While there may be an emergency use proclamation, it is highly unlikely that a vaccine will be broadly available before late winter or early spring, if then. Until then, it will be hard for the recovery to continue at the same pace as this summer with flu season and cold temperatures not far away. We have already seen the outcome of college reopening in the face of campus parties. The disease is as virulent today as it was in the spring. Only proper social behavior is going to contain the spread. Humans are social animals, keeping them separated for extended periods is difficult. For the value stocks to really take charge, investors need to see the end to the Covid-19 damage within 6-9 months. Even if a vaccine is approved in Q4, widespread adoption will take time. Value stocks should certainly see better times ahead. Whether those times are soon or not is an investor’s dilemma. But even if Covid-19 disappears tomorrow, all those shuttered stores on Main Street won’t be reoccupied for months, if not longer. Do you know anyone opening a new restaurant this month? I can point to a lot that will close, particularly in places that don’t allow indoor dining or only allow 25% capacity.
What about fiscal and monetary policy? Passing any legislation over the next 60 days while incumbents run for reelection won’t be easy. Recent improved data decreases the likelihood anything will pass. However, if the 3-day decline in the stock market turns into a rout, the odds improve. Any bill will be closer to $1 trillion than $3 trillion. What happens after November 3 is anyone’s guess. The Fed will do what it can but it won’t make rates go negative and the financial system is already flush with money. Thus, its ability to stoke more growth is limited.
What should investors do know? If you haven’t sold yet, it’s probably too late. If you are way overweighted tech stocks, you could sell a bit. Otherwise, build your shopping list. Set ideal entry prices. If stocks fall to that level, buy a little. Add on any further weakness. For my list, I buy into the Warren Buffett mantra that says buy great companies at fair prices rather than mediocre companies at cheap prices. That doesn’t restrict you to tech. But it does require you to cull your list of companies that aren’t quick to adapt to the current environment. Good management teams adapt to change quickly. Bad managers use Covid-19 or weather as an excuse. Obviously, there is little an airline can do to make money in this environment. But most companies aren’t airlines.
Better earnings and ongoing low interest rates near zero are in my favor. Right? That makes this decline buying opportunity. Correct? That could be precisely right. But don’t step in front of a moving train. The big question is whether this remains a “buy the dip” market, or a “sell the rally market”. Covid-19 is a change accelerant. That could apply to markets as well as everything else. Make believe heroes try to pick a bottom. Stocks don’t move in a straight line. It has only been a few days, but a lot of damage has been done. If stocks rally this morning, the key is whether they close near their highs for the day with follow through tomorrow. Barring that have some patience. Zero interest rates and super high P/E ratios give you little margin for error. Despite a modest correction, stocks are not cheap by any historic measure. If stocks haven’t fallen to your buy points, wait a bit longer. As noted earlier, this isn’t the start of a new bear market unless we are about to face an explosion of new Covid-19 cases. It is simply a correction of a straight up 50%+ run since March. But a correction bringing prices back to where they were just a couple of weeks ago may not be enough to rout the excesses. Be ready, but stay patient.
Actress Michelle Williams turns 40 today. Singer Michael Buble is 45. Hugh Grant is 60.
James M. Meyer, CFA 610-260-2220