Beyond The Headlines
The Three Disconnects
I often ask my partner and mentor, François Sicart, to share more about investing in the 1970s and the 1980s. We both like to find themes, parallels, lessons in the past that may help us understand today and the future. I can picture a younger client, or portfolio manager asking me in 2050 to tell him or her more about 2020. I will be a young 70-year-old at that point. I will refresh my memory and look for a theme or maybe even just one word. That word will likely be – the disconnect. There are at least three major disconnects occurring this year. First, the stock market has decoupled from the real economy. Second, a handful of mega-cap tech stocks took off and left the rest of the market behind. Third, those who were able to work from home have experienced a very different year than those whose jobs were lost because their work depends on the face to face interactions.
If we were to look at the economy and the stock market, we’d see two very different stories. The economy is still struggling to recover, while the stock market is reaching new highs. We often remind our readers that the stock market is not the economy, and the economy is not the stock market. The economy represents all the economic activity in a specific year in a particular part of the world. It’s all the goods and services that have been made available and found buyers. The stock market is a place where the ownership of many businesses can be exchanged in the form of shares. When we talk about the stock market, we often have an index in mind, the S&P 500, for example, representing the 500 largest U.S. corporations. We also have a tech index — Nasdaq, and broader indices like Russell or Wilshire 5000. The last one is often called the total stock market index since it attempts to capture all publicly traded companies in the US. We also have countless indices abroad around the world. The list goes on.
If the economy represents the activity and the stock market the ownership, they can sometimes tell the same story, but other times, they might be disconnected. Suppose the economy is doing well and continues to improve. In that case, it’s not unusual to see the stock market move up higher to account for more activity and likely higher corporate profits. The stock market tends to react quickly, and it usually leads rather than follows the economy. It’s far from a perfect leading indicator, though. If there is any doubt about the future growth in profits and economic growth, the market may promptly turn lower. The opposite happens when the market rises when investors find any reason for more optimism ahead.
This year between February 20th and March 23rd, the S&P 500 dropped 33%. The market lost three years of gains in a matter of three weeks. We like to compare it to an escalator ride up and an elevator ride down. We had a number of days with 5%+ drops, and the Dow Jones Industrial Average lost almost 13% on March 16th alone. The market decline started weeks before we saw any lockdowns in the U.S. Ten days after the U.S. declared the national emergency on March 23rd, the market bottomed though and began a quick rise. By August, the S&P 500 recouped March losses and reached pre-Covid February levels, and now in November, it’s hovering almost 10% above that earlier peak (Source: Bloomberg).
The March market correction was an exceptionally accurate estimate of what we were to see in terms of earnings drop and the business decline in the coming months.
When the S&P 500 bottomed in March, it was down 33% from its February high. In July, we learned the GDP; the economy contracted at an annual rate of 32.9% in the second quarter. The third quarter showed a 30%+ recovery from the previous quarter. The Brookings Institution reminds us that despite last quarter’s recovery, the economy is “still more than 4 percent below its level at the end of 2019, which is more than the farthest the economy ever was from its prior peak in the Great Recession.” We also witnessed a 33% decline in corporate profits in the second quarter, which was the largest quarterly decline since the first quarter of 2009. In the third quarter, S&P 500 profits were down 7% year over year. As much as we have seen improvement since the second quarter, the economy and the corporate profits still have a long way to go before full recovery.
We could say that the market went from discounting the potential economic downturn to ignoring it entirely and looking far past it. Ideally, we could see the economy and earnings converge with a rising market at some point. That quick path to recovery is far from certain, though. For now, we know that the number of companies issuing quarterly guidance dropped by 1/3, and more the 100 S&P 500 companies have either withdrawn or not provided annual guidance for 2020 and 2021. The forward visibility remains limited.
The second disconnect we see is between the performance of the mega-cap tech stocks and the rest of the market. We may think that the stock market experienced such an incredible recovery this year, but we’ll notice that there are two different stories to tell if we look closer. The entire S&P 500 year-to-day performance can be explained by the rise of the tech giants, the FAANGs; the rest of the market returned (after one of the wildest rides in the market history) 0% for the year as of mid-November.
According to Yardeni Research, the FANGs represent 12.7% of the market capitalization of the S&P 500, but only 4.9% of earnings and a mere 0.5% of revenue. An image of a tail wagging the dog comes to mind. If we broaden the FANG index from the four stocks: Facebook, Amazon, Netflix, and Google, and add Apple and Microsoft, the tech giants account for 25% of the S&P 500, up from 8% only in 2013.
Tech giants reported record earnings last quarter. Apple was the only major tech company with profits dipping. The nature of their business and their growth profile helped them grow and even benefit from the pandemic downturn. More shoppers spent money online, and that’s where advertising dollars headed, too. If we look back at the fourth quarter of last year (which was reported weeks before the March crash), we’d see a very similar picture, though. Outside of the five tech companies, the S&P 500 recorded no earnings growth in that quarter. Even without the pandemic, the whole earnings growth for all 500 largest US companies already relied almost exclusively on a few tech giants pulling all the weight.
There is no question that tech companies caught a significant tailwind this year, on top of favorable long-term trends helping their businesses. NYSE FANG+ index tracking the tech giants rose over 100% since March, while the entire S&P 500 went up by 57% (Source: Bloomberg). The question remains if their eye-popping rally this year is fully deserved. Will, the rest of the stock market, catch up, or the tech valuations will come down and converge with the rest of the market?
The third disconnect has appeared between the work from home employees vs. face to face the economy. In March, everyone that could do it transitioned overnight to a 100% work from home model. They picked up their laptops and went home. They turned their attics, spare rooms, bedroom, kitchen table, porches into their home offices. I know that Megan and I did, so did our entire team. We realized, though, that we were the more fortunate group. Our work can be done from almost anywhere. I know it’s not all of it, and many aspects could be done better in person, but if we have to, we can make a lot happen remotely. This year, it has been a blessing and allowed us to conduct our business as usual smoothly and without missing a beat.
At the same time, during spring lockdowns, we saw many local bars, restaurants, gyms, barbers, coffee shops, and stores shutdown. Some of them were able to adapt and do business online one way or the other. Some switched to curbside pick up, delivery, or drive through. All those attempts to do business despite restrictions gave only that much benefit and hasn’t entirely replaced the lost business. Summer months brought some relief, with more businesses reopening around the country and the world. Here we are in November 2020, though, and we see more restrictions and lockdowns triggered by Covid cases spiking again. We might not be out of the woods yet. We also notice how major cities in the U.S., New York City, among them, have struggled to recover. It hasn’t been enough to just open doors again and let customers in. The new challenge has been the absence of traffic. The tourists aren’t back due to travel restrictions, and the daily commuter crowd is not there. The current office use in New York City has been under 10%.
The Covid pandemic made us realize how much of the economy and the employment relies on the daily commuter culture. I used to drop off my dry cleaning on the way to work, get coffee now and then, see clients for lunch, friends for dinner, catch a show or a movie in the theater. Our Manhattan life and daily routine kept a lot of businesses around. September’s article in the Medium pointed out a whole multi-trillion-dollar ecosystem built around a white-collar office worker in the U.S. alone. This might prove to be one of the biggest policy challenges for major cities and commuter areas. For now, though, we see the disconnect between those who were able to keep their jobs, do business remotely from home and those whose face to face interaction driven, location depended businesses have struggled. We are yet to see how we can reconcile the two over time.
The three disconnects are related. Would they have happened without Covid? My best guess is that work from home would have happened, but much more slowly. The U.S. stock market would have struggled to keep rising without such a massive pandemic booster shot in the arm from the Federal Reserve. Without lockdowns, the tech stocks would have still shined compared to the rest of the economy, but the difference wouldn’t have been a lot less striking.
Disconnects tend to close over time. Will the economy catch up with lofty market levels? Will the rest of the corporate world catch up with the high flying tech stocks? Will the face to face economy find a way to catch up with the work from home model? Maybe all three will meet halfway. I trust that when I get asked about 2020 in 2050, I’ll have all the answers. For now, we have to operate with what we know. The disconnects are there, and if the gaps were to close, we could see some interesting challenges and opportunities ahead.
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