If in early January, you’d have described to us
everything that was to happen with the world and global economy and then asked
us to guess where the stock market would be, we would not have guessed it would
be at today’s level.
Looking at the stock market today, the first thought that comes to mind is that
it is divorced from economic reality. The S&P 500 is only a few percent
away from where it started 2020.
On the surface it looks like stocks discount one incredibly rosy version of the
future. In that version everything goes back to normal like nothing happened;
we basically just entered and quickly exited a sharp recession and earnings
came back to pre-coronavirus normal. Though that is a possible outcome, it is
not a probable one, judging by what is happening right now. We’d like to note
that, in any scenario, we’ll exit with close to $10 trillion of additional debt
on the government’s and the Fed’s balance sheets.
I used the word discount. To discount something you bring future earnings (cash
flows) at a discount rate to today’s dollars. The Federal Reserve bought
trillions of dollars of US Treasuries and corporate bonds of suspect quality
through ETFs, taking interest rates to almost zero. This act has pushed the
discount rate lower and wound up the spring of the music box in the Fed’s game
of musical chairs. So the market behavior to a large degree reflects not the
sum of future scenarios but the much lower discount rate by which these
scenarios are discounted.
Since the Fed is buying, the music is playing, and investors keep dancing
(speculating). Greed is back. It seems that this music just keeps on playing.
But will it?
The economy is a very complex organic system created by trillions of individual
transactions. The Fed’s involvement introduces inorganic matter into the
ecosystem that slowly poisons and atrophies the system. The Fed’s active
involvement distorts price signaling (higher prices lead to higher demand and
vice versa) as it manipulates the price of the most fundamental commodity in the
system – interest rates (the price of money).
The Fed’s buying junk bonds through ETFs has brought us closer to a Walking
Dead economy. It has given a further lease on life to mostly dead companies
that otherwise would have perished. But it’s easy for me to sit here and
criticize. If I ran the Fed in March 2020, I probably would have done the same
thing – the possible cost of doing nothing would have been a global depression.
The bottom line is that the Fed temporarily stimulated a humongous amount of greed
in a system that was shaking in fear.
We are not investing in the economy we’d like to have, but in the one we have.
However, this dance cannot go on forever or at some point the Fed will own all
financial assets and the US economy will turn into a Potemkin village. This is
why, though it has been unfashionable and even counterproductive lately, we’ll
keep sticking to buying great, undervalued companies, not just great companies
irrespective of price.
Nifty
FANGAM
While you are pondering on this, here is another observation.
If you look deeper under the hood of the stock market, you’ll see that there is
a significant dichotomy between bytes stocks and atoms stocks. The atoms are
losing to the bytes, badly. If you compare performance of the S&P 500 (SPY)
traditional market-capitalization index – the one you see in the news – to its
less-known cousin, the S&P 500 equal-weighted (RSP), you’ll see a
significant disparity in performance.
In the market cap-weighted version, the top five stocks (all five are members
of FANGAM gang – Facebook, Amazon, Netflix, Google, Apple, Microsoft) now
represent 21% of the capitalization of the index (the last time this happened
was 1999) and thus account for 21% of the returns. In RSP these stocks have a
weight of 0.1% (they’re just 5 out of 500 stocks).
SPY is down 6% for the year, where RSP is down 16% – remember, same stocks,
it’s just that SPY is heavily weighted toward bytes stocks, as they have larger
market caps, and RSP treats bytes and atoms equally. The virus has been much
kinder to bytes than atoms stocks; it has benefitted those companies as our
world has become a bit more virtual and atoms were impacted by social
distancing. The problem is, bytes were very expensive going into the
coronavirus crisis, and they just got even more pricey (unless their businesses
have improved to a greater degree than their stocks prices appreciated, which
is possible but unlikely, with the possible exception of Amazon).
Just as any propaganda needs a certain germ of truth to grow from, so do
bubbles. The FANGAM are incredible companies (germ of truth), and they function
better in the virus-infested world (another germ of truth). But at the core,
their existence is grounded in the world that is built of atoms, not bytes.
For instance, Google’s advertising business will continue to take market share
from non-digital forms of advertisement (not sure if any are left), but
atom-based companies are the largest source of Google’s advertising revenue. If
the atom world is not doing well, neither will Google. Also, the law of large
numbers usually kicks in at some point: A company cannot grow at supernormal
rates forever or it will become bigger than the market it is serving.
The Nifty Fifty stocks come to mind here. Those were the fifty stocks – the
who’s who of the 1960s –that made America great (then): Coca Cola, Disney, IBM,
Philip Morris, McDonalds, Procter & Gamble … the list goes on. Though today
we look at some of them as has-beens, in the ’60s and ’70s the world was their
oyster. Coke and McDonalds were spring chickens then, spreading the American
health values of diabetes and cholesterol (okay, maybe I’m being too hard on
them) across this awesome planet.
Although it was hard to imagine in the ’70s that any of these companies would
not shine forever, they are a useful reminder that even great companies get
disrupted. Avon, Kodak, Polaroid, GE, Xerox –all were Nifty Fifties, and all
either went bankrupt or are heading towards irrelevancy.
In the 1960s and early 1970s these stocks were one-rule stock – and the rule
was, buy! They were bought, and bought, and bought. They were great companies
and paying attention to how much you paid for them was irrelevant.
Until.
The Nifty FANGAM is arguably not as expensive as the Nifty Fifty was in 1972. Lawrence Hamtil put this nice table together,
using data gathered by The Brooklyn Investor blog, which divides the Nifty
Fifty stocks into two groups. The cheap basket traded at around 28 times
earnings and the expensive basket at about 60 or so. Neither the cheap nor the
expensive basket did well in the decade of the ’70s. Today, FANGAM stocks in
general trade closer to the cheap basket’s valuation.
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