Investors are herd creatures. We can’t help it; 100,000 years of programming is hard to unlearn. That said, what enabled our ancestors to survive on the African plains and later in medieval societies was the ability to quickly figure out which way the “wind” was blowing (as Bob Dylan put it) and get in step. The problem with this during periods of instability is that the herd doesn’t really know where it is going, so changes of direction can occur rapidly. The “herd” drove stock prices almost 30% lower between March 4th and March 23rd because the downside to the economy seemed limitless. A sustained upside move followed as the Federal Reserve and Treasury Department took steps to say, in essence “we won’t let it get any worse”.
The S&P 500 hit 2948 late last Wednesday afternoon, a level first reached during the second week of October 2019. The thought that stocks should trade on April 29, 2020 at the same level as October 11, 2019 seems absolutely ridiculous! Forward earnings estimates today are dramatically lower than they were six months ago. Yet here we are, all because the narrative the herd was following had changed from “the world is falling apart” to “there are incredible bargains to be had”.
Realistically, there aren’t many bargains to be had. Take the energy sector for example. The dramatic plunge in oil futures in late April led many to believe that oil stocks were dirt cheap. A closer look argues otherwise. Chevron stock closed at $110.74 on the February 19th, the day the S&P peaked. It lost a little over half its value ($54.22) at the March 23rd low, but trades at $93.41 as this is written.[i] This is much closer to its high than its low, despite the huge hit to prices and consumption. Maybe there is still value in small caps (which plunged over 40% between February 19th and March 23rd and have only retraced about half of that loss[ii]) but certainly not in the S&P 500. Sharp reversals in both directions are a known characteristic of bear markets. The idea that you have one sharp down move and then recovery and new highs is a bull market notion. We have to be open to the likelihood of several drawdowns before the market as a whole is healthy enough to make new highs.
Revisiting the notion of disruption that I wrote about back on February 21st, disruption is only going to happen faster now because business models that didn’t, or couldn’t, adapt are even more vulnerable in the new reality society is facing. Companies like JC Penney will probably fail faster than they would have prior to the pandemic and so will many of the malls that they operated in. The market is struggling with how to value those industries that made sense in a world where employees needed to work in close proximity either with their customers or with other employees. Can airlines make money if the middle seat is no longer booked? Will ticket prices need to be 50% higher? Will people fly as much if they are?
At the time of my February report I likened the faith in the disruption narrative and the Federal Reserve to the faith in the dot.com future the market showed in 1999. Back in 1999 I believed that investors were overpaying for Amazon relative to Sears because the latter was profitable, and the former was decidedly not. Obviously, not a great decision on a 20-year basis but Sears did outperform Amazon until about May 2007. The point I was making was that those companies that are positioned well for the future are definitely the ones you want to own for the long term, but if bought at a time when the herd is falling over themselves with greed they can be poor short term investments[iii].
Over the weekend, Berkshire Hathaway “hosted” its annual meeting. Though shareholders could not be present this time, CEO Warren Buffett made a speech and answered questions electronically. One of the most surprising elements of his remarks was that Berkshire had not done any major buying during the Covid-19 sell-off, and he didn’t plan to do anything in the near future. In fact, he was a net seller having drastically cut Berkshire’s airline exposure. Given Buffett’s comments 12 years ago in the wake of the Financial Crisis, the apparent conclusion has to be that stocks aren’t anywhere near the bargains today that they were back in 2008. If you believe Buffett still has the wisdom he possessed during his incredible 50+ year investing run, one really has to question the stock market’s rally at this point. If stock prices decline 15% but intrinsic values fall 20%, for example, the market hasn’t become “cheaper”.
It is a statistical truth that small caps outperformed large caps in April. That was a bounce-back from deeply oversold conditions in late March and has shown no follow-through in May. Value stocks had a nice run in the last two weeks of the month, but the story is the same here. Technical trends very strongly favor growth over value and large over small today. They are a little more ambiguous when looking at domestic versus international in the short run (we believe that longer term measures still favor overweighting domestic stocks).
One last item of note; on their conference call this morning, renowned strategy firm Bank Credit Analyst expressed a preference for inflation protected bonds on the idea that product shortages due to supply bottlenecks plus gradually rebounding energy prices would keep inflation levels well above treasury bond yields.
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[i] Source: YCharts.com
[ii] Source: YCharts.com, S&P 600
[iii] In retrospect, investors preferring profitless Amazon to profitable Sears were right, of course. The move from companies with a heavy “brick-and-mortar” footprint to those that could leverage digital technology had already begun by the late 1990s. They had a very deep “hiccup” between 2000 and 2003 as the recession made things very difficult for companies that didn’t have positive cash flow. Companies like Amazon had positive cash flow even though net earnings were negative. Interest rates were low enough that they were able to survive, and then, obviously, to thrive. This is something to keep in mind as one contemplates whether or not there will be a reversion to the mean that elevates “value” stocks at the expense of growth stocks. Digitization and low interest rates have completely changed the business and investing world. I cannot see a scenario where investors once again prefer high fixed cost companies like airlines, automakers, and steel producers over low fixed cost knowledge industries like software design and genomics.