If you feel like the last six months have lasted an eternity, you are not alone. The historians will be able to write volumes about this pandemic, and we will all have stories for future generations. While it’s certainly not over yet, there has been good news in terms of potential vaccines and our health care system’s ability to help the infected survive. Many experts believe the fall will be difficult, but I’m hopeful that by spring our lives will look more familiar.
The stock market began this pandemic by over-reacting, dropping in record-setting fashion. By late March we all started to lock down at home, and the outlook for the economy was bleak, and rightfully so. Over the next few months, we experienced a 33% drop (annualized) in second quarter GDP and depression level unemployment. Even more recently, we have seen weekly jobless claims remain near one million as a second wave of cases hits parts of the country. And how has the stock market, the scene of panic and despair in March, fared? It’s now standing at about the level it was before most of us had even heard of Anthony Fauci.
Many people have asked me to explain how the market goes higher when the economy is so bad. Before I get to that, let me give you all some credit. As disturbing as life was in late March, and as bad as the market losses were, none of you made me sell our stocks. At the time I opined that selling at those prices would, over time, turn out to be a poor decision. Little did I know that “over time” would be measured in weeks.
Back to the market – there are two primary reasons in my view that the market has recovered as well as it has. First, the Fed has been aggressive in providing support to the bond market. By purchasing a wide variety of bonds, from US Treasuries to corporate junk, the Fed has given the market confidence that no viable business will go bankrupt due to a bond market freeze. Even the most damaged companies, like the cruise lines, have been able to borrow money in the bond market to survive the pandemic. Once investors realized most companies would survive, it removed much of the downside risk of owning stocks.
The second reason for the market’s health can be traced to the acronym TINA – There Is No Alternative. Bond rates are so low that investors believe that stocks represent the only way to make money in the current environment. The 10-year treasury bond yields 0.6% - do you really want an investment that earns so little over such a long time period? The answer for most is no. So investors buy stocks, and the market recovers.
Unfortunately, there are some unintended consequences that go along with the Fed’s actions and the strong market. First, by adding so much liquidity the Fed has significantly raised the longer-term risk of inflation, something we have seen little of since before the Great Recession in 2009. Another consequence, more a current phenomenon, is speculative trading. Maybe no stock better embodies this speculative spirit than Tesla, a stock that has risen more than 50% over the last eight trading days mostly on the news that it is splitting its stock. It’s like a baker increasing the price of his $10 pie to $15 because he plans to cut the pie into four pieces. Apparently some investors think that’s a great deal, but to me it’s a sign of speculative excess. Or as one client put it, “do luxury electric cars ward off Covid?”
While it has been heartening to see stocks come back from the lows in March, the market’s recovery has been far from even. Investors have shown a clear preference for the huge tech companies like Amazon and Microsoft. They are viewed by many as beneficiaries of the pandemic with long-term trends accelerating as society adjusts to a new way of life. This group of stocks is so large that it obscures the weakness in the rest of the market. The S&P 500 is a cap-weighted index, meaning the larger components carry a heavier weight. Apple, the largest stock in the index, counts as much for the S&P as all the stocks ranked from 300-500 combined. While the S&P 500 index is up for the year, the average stock in the S&P 500 is down for the year, as is the small cap index and the value stock index. This disparity is something of an anomaly that I believe is unlikely to continue for much longer.
Let’s consider two of those giants, Microsoft and Amazon, and two holdings that many of you own, Robert Half (temp staffing business) and American Express. Microsoft and Amazon trade at P/E ratios of 35x and 65x respectively, meaning that the stocks cost $35 and $65 for every $1 of earnings at the two companies. Robert Half and American Express trade at 14x and 12x P/Es based on 2019 earnings. Are Microsoft and Amazon overvalued trading at such a large premium? Here is how I see it. To justify Microsoft’s lofty P/E, one must assume that corporate America, Microsoft’s biggest customer base, will fully recover. If so, Robert Half will benefit greatly, making the stock’s current price far too low. If Amazon is fairly valued at 65x earnings, consumers will have to be financially strong enough to spend. If so, they will continue to use their AmEx cards and to pay their bills, implying that American Express stock is significantly undervalued.
I feel much the same about many of the stocks we own. If the giant tech companies are fairly valued, then the stocks we own should do really well. It might take a vaccine, or at least some more positive health news, for those stocks to shine. However, I believe they will, so I am confident in our portfolios.
I hope this letter finds you and your loved ones healthy and safe.