A lot of investors are going into the scariest time of the year with a paradoxical attitude. In their world, bad news has become good news . . . because they can’t imagine anything better.
Take today, for example. It turns out that restaurants, hotels and tourist destinations simply stopped staffing back up last month to let the Delta Variant play out. So did retailers.
These numbers would ordinarily be considered ominous. Instead, you could practically hear the sigh of relief on Wall Street, where over 2,000 U.S. stocks gained ground in defiance of conventional wisdom.
Is it a good thing if the recovery stalls at 5.2% unemployment? Only if you’ve stopped paying more than lip service to the guiding principle of capitalism: progress will create wealth, without depending on the Fed or anyone else to save the day.
In that scenario, continued economic weakness and perpetual Fed support is all we can hope for. But from where I sit, that logic just doesn’t add up.
Great Stocks Grow Into Their Multiples
Start with the Fed’s agenda. Free money is fun, reducing the risk that any company will run out of cash and giving valuations room to reach into the bubble zone.
And right now, while multiples across Wall Street are stretched, the largest amount of free money has poured into the hottest companies. These are the growth names I focus on in IPO Edge and GameChangers. Usually they dominate Triple-Digit Trader as well.
Historically, a stock is well worth buying up to its annual earnings growth rate expressed as a multiple of current earnings. If, for example, you’re looking at a 20% growth trend, you can feel comfortable paying 20X earnings.
A year from now, if the trend holds, that multiple relaxes to something more like 16X current earnings. Or, of course, investors who know the stock is worth 20X under the right conditions will cheerfully keep paying that premium as earnings expand . . . and longtime shareholders will cheer.
Slower growth trends, on the other hand, take more time and patience to justify significant stock appreciation. These companies often abandon aggressive growth strategies altogether and focus instead on returning cash to shareholders as efficiently as possible.
This is the heart of my Value Authority: steady cash flow may not sound like a thrill, but at the right price it can be extremely lucrative. If we can capture 10% growth at 9X earnings, for example, we’ll probably end up making money over time.
The Fed distorted all these numbers but not the logic. Growth stocks require less patience. People can see these companies moving fast. That excitement is contagious. Value stocks, on the other hand, reward longer-term conviction.
Every month the Fed pumps another $120 billion into the market will stretch the highest multiples first, but sooner or later investors will feel a little vertiginous. They stop buying. And then money flows into lower-multiple stocks instead.
When the Fed feels comfortable enough to stop, multiples won’t have a reason to keep rising. Beyond that point, the primary driver of future stock gains reverts to old-fashioned growth.
Innovation Versus Efficiency
You can boost your earnings by expanding your business, your margins or both. The first scenario is straightforward. It happens when your customer base is getting wider, with more people living up to spend more on your products or services.
That’s actually the world we live in. Behind the Fed, revenue across the S&P 500 keeps rising. Every dollar that comes in on the top line turns into at least a little profit.
Corporations just aren’t cutting their way to growth the way they did in the disastrous 2008-9 layoff cycle . . . or the 2000-1 crash either, for that matter.
Believe it or not, 5.2% unemployment is far from apocalyptic. It isn’t great, but the economy and the market can survive these conditions.
Unemployment lurched above 5.2% in September 2001 and stayed there for nearly four years. The economy survived.
It took the market as a whole a long time to recover its momentum, creeping up barely 1% a year between 2001 and 20005. That period rewarded patient and cautious investors, who beat the market by holding stocks that paid dividends.
And it also rewarded the brave. Apple soared 400% over the same period. Amazon was right behind. They were growing fast. They deserved to trade at a premium.
I think we’ll all agree they grew into their multiples. They had innovation and vision on their side, creating whole industries that didn’t even exist in the first dot-com era.
They also created trillions of dollars in wealth. These are the stocks that interest me. The Fed doesn’t dictate their destiny. Free money accelerates their arc, but cutting off the flow won’t push them into a wall.
After 2008, a similar “stall” pattern emerged, this time lasting until 2015. This is the era when mega-tech stocks like AMZN and AAPL became juggernauts.
If you’ve started thinking bad news is good, I want you to ponder those long-term charts over the weekend. When the Fed steps back . . . and it will . . . the most dynamic companies of tomorrow will thrive.