Hit ‘Em Where They Ain’t

Posted on Nov 12, 2020 in Economics

Hit ‘Em Where They Ain’t

Generally speaking, the developments over the past couple of weeks have been received positively by investors…VERY positively. As I write, the S&P 500 is up nearly 9% over just 8 trading days in November. That’s a remarkable move in such a short period of time, and it’s especially notable given the early anxieties about a Biden presidency. But just as it’s clear that optimism has prevailed (at least for the moment), it is also true that threats remain. We thought it would be a good time to take stock of both the positives and the negatives that could impact the markets in the months to come.

On the positive side of the ledger . . .

  • We are no longer living with the uncertainty of a starkly polarizing presidential election. While President Trump has yet to concede, a Reuters/Ipsos poll out yesterday found that 79% of Americans believe that Biden is the winner, and that 79% includes more than half of Republicans polled. The same poll said that just 3% of respondents believe Trump won the election, while 13% believe the outcome has yet to be decided. A strong election consensus was an imperative, in our view, because allegations of widespread election fraud could have led to a game-changing constitutional crisis. We’re not completely out of the woods yet on this issue, but as long as a large majority of voters believe in the integrity of the election, President-elect Biden should be moving into the White House in January.
  • One reason for the market’s warm embrace of Joe Biden is the fact that the Republicans are highly likely to hang on to the Senate. This is important because President-elect Biden will have a difficult time raising taxes, as he telegraphed, if he cannot get a bill through the Senate. Moreover, a divided congress is generally viewed as a positive for equity investors because dissent will prevent radical agendas, whether from the left or right, from being implemented.
  • We also received very positive news on the COVID-19 front earlier this week. We first learned that a partnership between Pfizer and a German biotech company called BioNTech has produced a vaccine that appears to be 90% effective. This rate of effectiveness was far better than the 50-70% most had been expecting. Second, we found out that Eli Lilly received “emergency use” authorization for its COVID-19 antibody treatment. These developments represent further evidence that it may be possible to return to business as usual at some point in the latter half of 2021 or 2022.
  • The Fed continues to say it will keep short-term interest rates pegged at zero for the indefinite future, even as longer-term interest rates are beginning to increase. In my view, the increase in longer-term interest rates represents a sign that the economic outlook has improved. Up until now, the bond market had not been confirming the stock market’s positive economic narrative. But now, the bond and stock markets appear to be on the same page.
  • A new president should bring increased predictability and transparency with regard to economic policies. During Trump’s tenure, it was nearly impossible to foresee what was coming next. One day Chinese President Xi and President Trump “love each other”, and the next day he is “the enemy.” The constant drama surrounding the US-China relationship under President Trump is emblematic of the constant state of flux regarding economic issues. Unpredictable policy has made it very difficult for business leaders to have the confidence to plan, invest, hire and grow.

On the negative side . . .

  • We are in the throes of a third surge in COVID-19 infections. According to the New York Times, there were nearly 150,000 new COVID-19 cases on November 10, well above the previous peak of around 76,000 cases per day in July. Various states and municipalities have already started to issue various mandates designed to limit the spread, but it appears as though much of the damage has been done at this point. Ongoing business closures will obviously affect the pace of economic recovery.
  • We mentioned above that gridlock in Congress is generally perceived to be a good thing for stock investors. However, the aforementioned surge in COVID-19 cases will almost certainly require another round of economic assistance from the federal government. It may prove difficult to get a bill passed given that: 1) Congress remains divided; and 2) we now have a vaccine has been proven to be 90% effective. My worry is that Congress won’t act until the hospitals begin to overflow and/or the markets begin to swoon.
  • We also mentioned in the list of positives that longer-term interest rates have been creeping higher. This is a positive in that it shows that investors are beginning to become more optimistic about the economy. However, there are risks associated with higher interest rates. Most notably, low interest rates have been the fuel behind the massive increase in stock prices and the strength in the housing market. If rates rise too quickly, we could be at risk for a drop in asset prices. Secondly, the rising optimism regarding the economy could translate to expectations for higher inflation. If the Fed begins to feel threaten by a spike in inflation, the central bank will have to act (raise interest rates) to forestall the types of inflation that can imperil the economy. There is not much evidence of runaway inflation right now, but that can change, and sometimes rather quickly.

The decision to embrace the optimistic or pessimistic economy narrative will have dramatic implications on investment performance going forward. For the past many months, investors have been embracing the FAANG stocks and their ilk because 1) growth was at a premium during the COVID-19 outbreaks; 2) these companies actually benefited from the lockdowns that occurred; and 3) ultra-low interest rates lowered the opportunity cost of owning these stocks while also increasing the present value of their future cash flows. At the same time, value and cyclical companies underperformed due to the huge questions marks surrounding our economic health in the age of COVID-19. To the extent that COVID-19 is brought under control through vaccines and therapeutics and the economy and interest rates start to pick up, we could be at the beginning of a rotation out of what’s worked for a long time (FAANGs) and into the perennial laggards. In the chart below, the blue line shows that the combined weighting of the Technology, Consumer Discretionary and Communications Services sectors has risen from 40% to 50% while the cyclical sectors Energy, Financials and Industrials have gone from 28% to 21%. And this happened over a period of less than two years.

When people ask me how can stocks keep going up after such a massive move from the lows in March, this is what I tell them.  For all the strength in the major market indices, there are stocks and sectors that remain extremely beaten down.  If these companies and sectors start to benefit from the tailwind of a better economy – unencumbered by coronavirus shutdowns – there is no telling how much higher stocks could go.  I’m not predicting massive increases from here, but it’s certainly helpful to know where the preponderance of opportunities lie.  An investment strategy of blindly buying the FAANG stocks may not be as successful anymore.