Our society has been transformed in a very short period of time. We have changed the way we work, the way we communicate and the way we shop – all due to a surprise pandemic and the impact it has had on many parts of our lives. We did not expect such a dramatic event to curtail economic activity and drive our economy into recession.
The stock market reacted initially and fell sharply in March 2020 as COVID shutdowns and fear gripped our economy. The Dow Jones Industrial Average lost 37% of its value from February 12, 2020 and March 23, 2020. However, stocks changed course quickly and the market recovery was sharp and swift as stimulus programs and unemployment benefits kicked in. Looking back, it was easy to panic and sell stocks which turned out to be the absolute wrong move.
Recessions are usually triggered by economic excesses, strong growth and a “hot” economy. The situation in late 2019 and early 2020 was the opposite. Economic growth was modest, unemployment was at 3.5% and interest rates were low. This healthy, not too hot economy is not a normal prelude to a severe recession. Investors saw beyond this recession and ultimately bid stocks to new highs. The S&P 500 Index advanced 15.6% in 2020.
The path of least resistance for stocks has been higher. Corporate earnings declined in 2020 only to recover in 2021. At the end of the second quarter, 2021 the S&P 500 Index reported earnings increased over 85% year over year- the highest quarterly earnings growth since 2009. It is not surprising that stock prices followed. Clearly, most corporations were not as impacted as feared and recovered quickly once vaccinations became available. Higher corporate earnings helped justify higher stock prices.
It does seem odd that stocks could move to all-time highs in the face of uncertainty and so many disruptions in our lives. The driving force behind the market advance has been low interest rates. Stocks have been the only game in town. Bonds are not attractive. The 10-year US Treasury yield is 1.5%. Inflation is trending at 5%. Cash is equally unattractive from a yield standpoint and only has value if you think the stock market will decline or bond yields will increase, offering better buying opportunities.
When we look to the future, we wonder if stock prices can move higher in the face of uncertainty and headwinds. Stocks have been climbing a wall of worry in spite of Covid headlines, chaos in Washington, geopolitical risks, concern for higher taxes and the fear of higher interest rates. Stocks are not cheap – trading at 20 times next years earnings and up 16% year to date. When the market changes course, it could be sharp and swift. The stock market has posted declines this year, only to recover the next day. This “buy the dip” with plenty of liquidity on the sidelines will abate if investors become alarmed or interest rates move considerably higher.
So far, the capital markets have shrugged off inflation fears, but corporate executives are mentioning inflation more and more and price increases are more common. The concern for stocks will be if companies can’t raise prices on their products to keep up with the higher cost of goods they produce and buy. This will impact profitability unless they can cut costs to compensate. A higher corporate tax rate, which looks probable, will also reduce profits.
Economic growth, earnings growth and interest rates are the drivers of the stock market. If inflation reduces corporate earnings below expectations or if interest rates increase steadily then we expect the stock market to react. Investors can ignore the narrative around higher rates or slowing corporate earnings only so long.
The Stock Market
Speculative investments, with asset prices unsupported by the underlying fundamentals, tend to react sharply when stocks move lower. Speculators invest in hopes that investment prices will be higher in the future with little regard for valuation or fundamentals. Today’s investment environment is characterized by excessive risk taking, high stock valuations and speculation in pockets of the stock market. Large, quick gains and strong interest in a theme or story drive speculative issues. Investing, unlike speculating, is boring. Investors focus on fundamentals and the underlying value of the investments, hoping for growth over the long term. Investing is not a “get rich quick” strategy. Returns are measured against risk and fundamentals matter. The lines between speculation and investment get blurred, as they are now.
The stock market is shifting focus away from speculative, “growth” issues and more toward companies that will do well as the economy adjusts to changes due to higher interest rates and inflation. Some technology stocks, new issue companies trading at very high valuations, and companies with little earnings or cash flow will not fare well. Inflation may be transitory, but for how long? The S&P 500 is trading at 20X earnings, well above the average. The focus is shifting to those companies that are more reasonably valued with dividends, a history of dividend growth and strong fundamentals.
Stock watchers who compare returns to the S&P 500 Index should take note that this index is more and more dominated by large companies, some trading at very high price to earnings ratios. The top ten holdings are 29% of this index, more concentrated than in the past. The top six companies, (Apple, Microsoft, Google, Tesla, Facebook, and Amazon) represent 24% of the index and tend to trade in lock step with one another. This means index investors may experience more gain in a rising market and more pain if the market declines, depending on how these few companies perform. Keep in mind that the stock market has been at all time highs and is up 16% this year. Microsoft is the only stock from the 2000 index top ten in the group today. This is not your grandfather’s index!
It is hard to say if the market is now in bubble territory, but certainly some stocks are. The stock market could easily continue moving higher as we approach year-end. Merck’s antiviral drug will reduce the tension around COVID 19 if it is approved. But given the crosscurrents impacting the economy and investor sentiment, the best strategy is to respect asset allocation targets and trim stocks when they move ahead of the targeted equity mix. Rebalancing the portfolio pays dividends over time.
Diversification and discipline will play a key role in preserving wealth in a declining market. Stocks of quality companies, with “real earnings” and strong fundamentals will weather any storm and should prosper in any market over the long-term. The stock market is higher this year by double digits and the rally since 2009 has been powerful. This may be the best time to trade a “get rich quick” strategy for one that focuses on fundamentals and valuation.