Market holidays give us all a chance to catch our breath and take a closer look at how we got here. It’s a great opportunity to review the assumptions we take for granted about why Wall Street behaves like it does.
And since the past week has been a little frustrating for the bulls, let’s focus the discussion on whether the “new normal” as the pandemic recedes will feel any better than it does now.
After all, as far as Wall Street is concerned, COVID is over. It’s still a medical threat, but it’s only an economic problem for investors in other countries now.
And with the Fed eager to push pandemic inflation back into the bottle, it’s an open question whether the economic landscape the virus leaves behind is any better than it was in 2019 . . . or much worse.
Start with the dynamics that drive the market itself. Back at the end of 2019, COVID was only a distant cloud on Wall Street’s horizon.
Analysts had zero idea that we were facing a global pandemic that would require the Fed and Congress to unleash trillions of dollars simply to keep all the wheels turning.
At the time, the S&P 500 looked a little rich at 17.8X earnings, but we were hoping the “E” side of the P/E calculation would expand nearly 10% in the coming year . . . enough to support slightly bubbly stock prices.
Here we are now, nearly 30 months later. Free money has crowded into the S&P 500, inflating the overall market valuation to 19X earnings.
I’ll be pleasantly shocked if earnings grow much more than 10% this year. But I’m not looking for a dramatic earnings slowdown, either.
If the end of 2019 felt pretty good to you as an investor, the fundamentals suggest that we’re in a similar place now. The only question mark here, as always, is whether estimates are unrealistically high in a world of inflation shocks and rising interest rates.
We’ll learn more over the course of this earnings season. For now, the targets are the targets and there’s no special reason to doubt the guidance we’ve received.
Of course there’s a significant difference between being asked to hold stocks at nearly 18X earnings in a zero-inflation world and having to hold your nose to buy at 19X when the Fed seems eager to crash the party.
Sector Rotation Needs To Happen
And the market itself has shifted. Technology stocks dominated the pre-COVID economy and only cast a bigger shadow now.
While names like Amazon (AMZN), Tesla (TSLA) and Alphabet (GOOG) obscure the problem by formally being classified in different sectors, investors have yet to shake the assumption that these are all “tech” companies.
“Tech” is poison right now. Doing the math, I doubt the mood will improve until Silicon Valley (in the broad sense) surrenders at least 7-8 percentage points of weight in the overall S&P 500.
For that to happen, either those stocks need to collectively drop that much across the board or the rest of the market needs to soar 15-20% while Big Tech holds still. The latter scenario would be nice, but it’s unlikely.
Admittedly, we need to see a little more adjustment before the market as a whole leaves the pandemic world behind. Energy stocks, for example, still have a long way to go before they’re back where they were in 2019.
The industrials also look ripe for recovery. And healthcare stocks have gotten a little behind where they would have been before the COVID shocks.
I don’t know about you, but I don’t see a weaker case for Big Pharma and the hospitals now than I did in 2019. These companies have proved that they can roll with whatever punches Nature decides to dish out.
Regardless, if you’re looking for the next wave of leadership in the post-COVID world, I’d look to the three sectors I just mentioned. Tech truly has gotten a little ahead of itself and as remarkable as it sounds, the market is a little overweight the financials as well.
The silver lining is that the other components of the economy haven’t gotten too far out of line in the last 30 months. Real estate, utilities, consumer stocks and commodities are tracking roughly where they were before the pandemic.
These stocks haven’t underperformed, but they haven’t tripped a lot of bubble alerts either. They simply kept supporting the essential business of life in the United States and beyond.
Food packagers kept the boxes moving toward grocery stores. Landlords largely kept collecting rent and the utilities kept the lights on. Business as usual.
And because these sectors collectively represent under 14% of the S&P 500 . . . less than healthcare or the banks . . . their success doesn’t swell the numbers across the market as a whole. It takes a lot of hard work to create a contagious bubble in commodity stocks or consumer products.
Granted, the value of these companies’ assets has inflated, but so have costs. These are strategic questions for their management teams to address. Investors have other concerns.
I also have to highlight that on the whole companies in these industries tend to pay quarterly dividends. Getting cash income back from your investments may not be sexy, but sometimes we crave something a little more stable.
If you felt like we were going over a cliff before the pandemic struck, you probably wanted to lock in dividend yields back in 2019. In that scenario, you’ve felt that steady cash pulse, quarter after quarter.
You know how good it feels. And if it feels like a cliff opening up under your feet now, guess what? It’s time to lock in those yields.
Leave the other 86% of the stock market to speculators. It’s their problem.
The Rate Stuff
Now will the Fed crash the economy? It’s hard to argue that 5% mortgage rates aren’t going to be a drag on the housing market or that rising borrowing costs won’t make it uncomfortable for families to live on the credit cards.
Yes, long-term Treasury yields are already higher than they were in 2019, when the Fed was happy to keep rates low as long as inflation remained elusive.
Going into the pandemic, 10-year bonds paid 1.9% a year. Today they pay closer to 3% . . .and once the Fed starts dumping its holdings, yields will only go higher in the future.
But go back to another post-crisis period. After the 2008 crash, Treasury yields remained well above the levels that investors today see as a pain point.
Before that, yields in the 4-5% range were anything but alarming. You have to ask yourself what has shifted in the world that makes those interest rates seem so dangerous now.
Has the economy as a whole gotten more brittle? The Fed doesn’t think so. People are still employed. Families keep making it work.
Is the golden age of American innovation over? I don’t think so. As long as we haven’t lost our nerve, we can handle a little drag in the financing environment and still generate a lot of wealth.
Have we lost our nerve? If the answer is “yes,” there’s no shame in it. Just rotate your investments into something less speculative.
I’ve always maintained a defensive line throughout my Wall Street career. That’s what gives me the courage to keep reaching for bigger returns through the stormy seasons.
It didn’t feel one bit like the world was ending in 2019. The only thing that’s changed now is that investors are nervous and the Fed thinks we’re strong enough to handle tighter conditions.
That’s not an economic problem. It’s a morale problem. I think of the Fed as a tough fitness coach now, insisting that we work through the burn because achieving our objective is worth it.
There’s no crying on the gym floor. No pain, no gain.
And if the Fed sees that we truly can’t handle the load, they’ll scale back. We have historical proof of this.
Remember when it looked like the yield curve was inverting in 2018? The Fed gave up on tightening interest rates. We weren’t ready.
The minute the job market twitches in pain, the Fed will take a break. These are the same people. Their priorities haven’t changed.
That might mean letting inflation linger longer than it would otherwise. That’s the real threat here: not Treasury yields going all the way to 2010 levels, but watching the dollar’s purchasing power erode day by day.
After all, the Fed let inflation accelerate for months in order to make sure the pandemic was finally under control before they started loading up the weights. Their goals are clear.
Inflation is the new pandemic. As investors, we need to be emotionally ready to put in the hard work it takes to work through the pain.
That means picking a sane spot on the risk-return graph and sticking to it. It means discipline. And it means conviction.
It means picking the stocks that align with your sense of where the economy is going and holding them until something forces you to change your mind.
I loved stocks at the end of 2019. I love them now. Over the last 30 months, even index fund investors have banked a reasonable 27% return . . . through the most savage pandemic in a century.
Global lockdowns couldn’t depress those stocks for long. What’s changed? Is it them? Or you?