Is the stock market on something (or am I)?
Note: this is not investment advice, nor does it represent the opinions of my employer.
The biggest fact in writing about finance is that making predictions is the dumbest thing you can do. So I’ll try to stay away from making predictions, and try not to interpret this as one. (If you do, please read the last section on risks!)
But I have seen a number of commentators and friends in near shock at why the stock market is at the levels it is. Has the market turned completely irrational? Is the relentless index buying of the last couple years driving this? Is it political interference from the Fed and Trump’s stocks obsession?
Not quite, in my view. What we are seeing is a reflection of the stark difference between the stock market and the economy, as well as key underlying trends that have accelerated due to the unique way the virus is affecting the economy.
It’s not 2008, at least not for stocks
Goldman Sachs just projected a 35% GDP contraction for this quarter, and we are looking at the total shutdown of sectors in a way no one has seen since the World Wars.
So shouldn’t this be worse than 2008? Aren’t we looking at Great Depression level numbers?
The last few weeks everyone has become a financial historian. CNBC anchors pore over the charts for 2008 or 2001 or 1987 or 1896, looking for clues on what we might see.
But there is one massive difference from those bear markets and the current one. In 2001 and 2008, the sector that blew up the market - tech and finance respectively - were also the most highly valued sectors and were the main driver of the previous bull (meaning both earnings and multiple compression). In 2020, the scenario is completely flipped.
In early 2000, tech made up nearly 35% of the total SPY. The most valuable company in the world was Microsoft, worth over $500B. Tech was an infinity money machine, forever, until reality set in. In 2003, tech was down to a historical average of 15% of the market and Microsoft down to $270B, a fall of nearly 50%.
In 2007, finance made up nearly 23% of the total SPY. The most valuable company in the world was Exxon Mobil, but banks including Citigroup and Bank of America had entered the top 10 (#4 and #8), both around $250B. Finance was an infinite money machine, forever, until reality set in. By 2010, finance was 15% of the market and no American bank ever appeared in the top 10 again. This chart only goes to 2016, but this trend has become stronger - shrinking to 13%.
In 2020, tech was again king, up to 23% of the SPY. Apple, Microsoft, and Amazon were playing musical chairs for the title of largest market cap in the world, north of $1 trillion. The tech index XLK has fallen just over 20% since last month, reflecting general recession concerns. But it has actually stayed fairly flat as a share of the SPY, because it reflects an area of safety.
Energy and industrials, two other industries getting slammed, have been shrinking for a decade and as of EOY 2019 were down to 4.4% and 9.0% of the index, respectively.
Due to recency bias, most people are overindexed on 2008 as a benchmark. Just because the market fell by 45% then, does not mean it will this time, even for a similar market or GDP shock.
Josh Brown made an interesting comparison on CNBC the other day to the 2000-2001 tech bubble and how that recovery was volatile for nearly two years. He also wrote on why it’s not 1929 either. It’s a good point on how no two recoveries are alike. But this bear market is also unheard of - a global pandemic of scale not seen since a century ago - and so is the way it has affected the economy.
This takes us to the second point which may seem obvious - that the stock market is not the economy.
The stock market is not the economy
In the normal economy, a dollar is a dollar and a job is a job. GDP is not weighted by industry. But that’s not how the stock market works. It is, as Keynes once described, a beauty contest, and some are more beautiful than others.
Since the market hit the recent low of 2190 on March 23rd, there has been a massive re-rating of different industry stocks due to the completely varied effects of the virus - seeking “safety” in the digital world and fleeing from the risk of the physical world. Compound that with the “safest” sectors being the most valuable, and you have the formula for an overall market picture that can seem puzzling.
Tech is the most valuable, as noted, yet least affected sector of the economy. Amazon is the third most valuable company in the world, and yet if anything it is seeing more usage. The digital “information economy” has largely been untouched: both on the demand side, which is based on annual subscriptions and ads - there has been some budget tightening, but not massive churn - and on the supply side, where most workers have simply switched their “production” to their homes. If anything, Facebook and Netflix are being consumed more than ever. These stocks all had lofty valuations reflecting their future growth, which has been largely unaltered.
On the other hand, the “physical economy” has been decimated. Restaurants, retail, movie theaters, and airlines are all in limbo and many in danger of bankruptcy. But these sectors were already “cheap” - a company like Macy’s (M) was already trading at 7-8 P/E even before March. AMC, the movie theater chain, had already fallen from $35 towards the end of 2016 to trading in the teens for most of 2019 to $7 in early 2020. Multiples are like ratings in the beauty contest, and these “physical” businesses were already losing badly.
Comparing employment numbers versus valuation gives a great example of this. Restaurants employ about 15 million workers, ten percent of the labor force, but their collective market cap is a drop in the bucket - with hotels (another 2+ million jobs) they still have a combined market cap of $542B (note: many restaurants are private small businesses and so not reflected). The collective market cap of the retail industry was barely $1T, despite employing another 15 million workers. Even doubling these market caps to account for private businesses would be paltry compared to their employment impact. The tech industry, on the other hand, employs about 12 million workers, with a market cap of nearly $8 trillion. In other words: even in a zero interest rate world, the cost of capital for businesses with workers and physical space seems to be going up.
Source: Fidelity, Sectors & Industries Overview - US Sectors
In some sense, the virus has simply accelerated the market trends from before the pandemic. A few stable companies are growing slowly (think Nike, Wal-Mart) while most industries are gradually shrinking (banks, energy) and tech eats everyone else’s lunch.
The math here might explain why according to UBS, 69% of investors expect a recession in the next 12 months, but only 11% plan to take money out of the market.
Risks
I don’t have more to add on why the stock market is going up, but more adding this section to cover my butt. There are a number of factors on why the trend the last two weeks up could reverse, many of which hover over the fact that the market is usually looking three to six months forward which is also in line with expectations for when life will return to “normal.”
If that expectation turns out to be inaccurate, it’s very likely the market we will revert to panic mode. Potential reasons for the pandemic to continue might be secondary outbreaks (which are fairly likely in the fall, given similarities with SARS), an even worse outbreak in the Southern Hemisphere (where temperatures are dropping and poorer countries have worse healthcare), or that we have underestimated cases and return to work too early.
Additionally, the liquidity picture for sectors like hotels, retail and restaurants are unclear, and bankruptcies could spill over to the general economy or even drive a commercial real estate apocalypse. Cash strapped businesses might be slow to hire, even if business ticks up quickly, just out of fear of being burned on another outbreak.
Lastly, the tech stalwarts could tire of holding up the market and eventually succumb to selling pressure - who knows.
There of course is room for another massive move down. But for anyone seeing the 20% rally in the last 10 days as “irrational,” it may be anything but.