Markets Broaden Out, Finally
The markets broadening out to financially strong, more economically sensitive companies is for real. Finally, we see better economic days ahead supported by all monetary bodies remaining all in. We see vast amounts of fiscal stimulus here and abroad shifting to demand-related stimulus programs next year; better/more effective therapeutics and vaccines on the horizon; and most importantly, the rollout of rapid response coronavirus tests with results in less than 10 minutes which will permit faster and safer openings.
Our economy, and that of the world, will accelerate sequentially as openings increase. Rapid response tests are the game-changer and bridge to vaccines, which will be distributed in mass globally by the second half of 2021, going into 2022. Again, we do not see our economy surpassing pre-pandemic levels until sometime in 2022. However, corporate earnings will exceed past peak levels during 2021 as operating margins widen dramatically.
Our stock market remains undervalued based on S&P earnings increasing significantly to $165/share in 2021 and $185/share in 2022, with interest rates remaining low supported by aggressive actions of the Fed. We are gaining more confidence by the week that corporate operating margins, at least for the larger, well-financed companies, will surprise on the upside as corporations have learned to do more with less while investing heavily in technology. Cash flow will be unusually strong, too, which will support higher dividends, buybacks, and increased M&A. Sounds good, but remember that all stocks are not alike, so the need for firsthand research is a necessity, which is our strength.
While we have funded our rotation by reducing our exposure to many of the new norm winners, we still find them attractive, long-term investments. Our society is still shifting to digitalization, cloud, software, smart devices, 5G, etc., at home. So, their growth rates are sustainable at many times real GNP for years to come. We acknowledge that many of these companies' valuations went out of whack in August, but have come down hard and represented good long-term values today for investors with a multi-year time horizon. We are not talking about companies selling at multiples of sales as we could never buy them as value investors. Notwithstanding, the Fed policy of virtually zero rates for many years significantly lowers the discount rate when valuing sustainable, high-growth companies with strong earnings/cash flow making them attractive, long-term investments. We continue to see a 25 multiple for the market on the whole based on 10-year Treasuries along with a sound financial system and higher multiples than that for these great tech companies. Nevertheless, these stocks are still over-owned and will be sources of funds as investors diversify to more economically sensitive companies as we did weeks ago before the massive correction in this group. But we will maintain them as a significant although much lower weight in our portfolios, acknowledging their long-term growth opportunities that are unparalleled in today's world.
The critical event of the week was the Fed meeting that was followed up on a conference call. While there were no real surprises, many were disappointed that the Fed/Powell did not discuss more specifically additional QE to keep long-term rates low. The Fed did signal that rates that it controls directly, the Funds rate, will stay near zero for at least three years. The committee reinforced its view to maintain an overly accommodative stance until inflation averages above 2% over time with long-term inflation expectations "anchored" at 2%. Since inflation has been running under 2% for an extended period, it is believed that the Fed will let inflation run above 2% well into a recovery. Hitherto, the Fed would have begun some tightening anticipating higher inflation but no longer. That is the game-changer assuring that the Fed will not remove the punchbowl too early, short-circuiting the recovery. Wow! While we expect the yield curve to steepen as the economy improves, we do not expect long-term rates to increase too much as inflation will stay controlled as we see big productivity gains ahead, significant global competitive pressures, major technological advancements, and many new disruptors along the way. Powell ended with a call to the government to do its part as the Fed can't support the economy alone during the pandemic. What a government!
The outlook for a stimulus plan rose last week as Trump appeared to get behind a $1.5 trillion project supported by moderate Democrats and Republicans. Those most in need, including the lower/middle class and small-/medium-sized companies, desperately need additional support to make it to the other side. Foolishly, the Democratic leadership actions are hurting most who they want to help while boosting the relative position of the upper class and more dominant, well-financed companies. Just nuts! The pressure is building, and we expect something before the House/Senate adjourns in a few weeks.
We had an opportunity to review Biden's fiscal plan, which includes raising taxes on the wealthy/large companies and higher capital gains rates. We still do not see how his plan will stimulate economic growth, increase jobs, research spending, and capital investment; all sorely needed to enhance our global competitive position. We are also concerned by his intention to re-regulate our economy, which has historically been detrimental to growth. We cannot wait to hear the debates when, hopefully, all our questions will be answered. If Biden were to win, we still do not believe that his tax plan would be implemented in 2021. Growth is a necessity to lift all boats.
There was not much news last week on additional therapeutics and progress on vaccines besides positive comments from Moderna (MRNA) and Pfizer (PFE). We continue to agree with Dr. Fauci that we will have mass availability of highly effective vaccines by the second half of 2021, which paints a favorable outlook for 2022. We still expect that J&J (JNJ) and Merck (MRK) will have the best vaccines, which will be readily available before mid-2021. The key to accelerating the opening of our economy is the roll out of Abbott's (ABT) and Roche's (RHHBY) rapid response antibody test. We expect a rapid ramp-up followed by wide availability by the first quarter of 2021 - all good news supporting sequential gains in economic activity throughout 2021 into 2022.
Retail sales rose 1.1% in August after increasing 1.2% in July while industrial production increased too for the fourth straight month in a row. We continue to hear that manufacturers cannot keep up with demand, and inventory levels continue to fall. The I/S ratio fell to a multi-year low of 1.33 in July, which supports our view that industrial activity will meaningfully pick up in the fall even if just to rebuild inventory levels to more normal levels. The larger, well-financed companies appear to be increasing market penetration at the expense of the smaller-/medium-size companies. Interestingly these companies are also reducing costs too, which will translate into much higher than anticipated operating margins, earnings, and cash flow over the next several quarters. That's where we are invested! These stocks are under-owned too.
Finally, consumer sentiment, conditions, and expectations all had surprisingly strong numbers reported yesterday. Interestingly, inflation expectations fell. All in all, the economic outlook has improved.
The shift in the stock market accelerated last week as investors sold off the highfliers while investing in more economically sensitive companies that have underperformed for most of this year whose fundamentals have turned for the better. As fundamentalists, we continue to believe that the market is undervalued as we expect surprisingly strong earnings due to significant improvements in operating margins to go along with low interest rates supported by an overly accommodative Fed for many years to come. It remains hard for us to get that the Fed has committed to leaving short-term rates near zero for three years. Simply amazing! Since Fed policy plays right into stock valuation/discount rates, it supports much higher multiples ahead for the market and especially for real growth companies. Yes, we recommend maintaining some exposure to the great tech, new norm winners while shifting our emphasis to the well-financed, market-dominant industrials that have tremendous operating leverage as the economy improves sequentially. We continue to recommend industrial commodities, except oil, and gold. And continue to avoid all bonds.
By the way, money continues to leave stock funds finding its way into bonds and cash. There is now over $4.5 trillion in cash and equivalents waiting to get off the fence.
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