Tale Of Two Cities
While all of us have been impacted by the coronavirus to some degree, none have been hurt more than the lower /middle class and small-/medium-size businesses. Our government needs to act immediately and provide the needed funds and relief to minimize, or at least delay, the damage. However, politics is getting in the way. Ridiculous!
Jimmy Dimon, head of JPMorgan (JPM), has it right saying that we will not know the full extent of the carnage until we get through all of this; the Fed eases off the accelerator; and the government cuts back on stimulus. Can you imagine Biden raising taxes until the economy is on firm footing with much lower unemployment?
The financial markets do not reflect today's economy, but rather they are anticipating better days ahead as additional therapeutics/cocktails and vaccines are on the horizon. But it will not be the same as before: unemployment will stay high as corporations learn to do more with less, more time will be spent at home, and the financially strong companies will take significant market share from small- and medium-sized companies. Target (TGT) said as much on its earnings call. A tale of two cities: the haves and the have nots.
The markets are being buoyed by the huge amounts of liquidity being provided by the Fed, which will not change for at least another two years if you accept, as we do, the most recent notes from the last Fed meeting. We expect more fiscal stimulus, too. Also, the strong companies, especially those that have benefited from the new norm, are knocking the ball out of the park with sensational results. Their futures are bright. They continue to lead the market and remain undervalued in a world with such low interest rates. Remember that Apple (AAPL) and Google (GOOG) (GOOGL) raised long-term money at less than 3% and short-term money at less than 1%. What is the proper discount rate to value these companies growing above 15% with better days ahead?
Fortunately, we have stuck to our guns maintaining above-average concentration in the "new normal" winners while beginning to diversify into some more economically-sensitive companies that are financially strong, doing better than expected, and will come out as big-time winners on the other side. Also, we expect to see above-average gains in production above growth in demand as inventory levels are built back to normal levels over the next six to twelve months.
Even though the market has continued to march upward on a wall of worry, it has been not broadened out as the pundits keep forecasting. The recovery will be slow, both here and abroad, and drawn out until we are all vaccinated, which will not happen until 2022 in our opinion.
Let us state unequivocally that the economy bottomed in May, the recovery has begun, but it will not broaden out and return to pre-pandemic levels for at least two years - until we are vaccinated. During the interim, the Fed will remain all-in; the government will offer stimulus plans; short-term rates will stay near zero; the yield curve will steepen slightly; the dollar will weaken; the income disparity will widen; and there will be clear-cut winners and losers in the economy and stock market.
Let's not fool ourselves. The key to the economy and, to a lesser degree, the financial markets is finding a vaccine. We remain optimistic that at least two companies will successfully conclude Phase 3 testing this fall, be accepted by the FDA for hardship cases, and there will be several hundred million doses shipped before year-end. We are even more optimistic that by mid-2021, there will even be more efficacious vaccines with easier delivery systems from great companies like J&J (JNJ) and Merck (MRK) with available doses for worldwide consumption in the billions. We must thank the health professionals for reducing the death rates finding better techniques using new therapeutics/cocktails. We are hopeful that the fast response saliva test will permit an acceleration in openings as we move forward. All the good news. This is the basis for our forecast of sequential improvement in the economy over the next year albeit slower than the pundits anticipate.
The Fed minutes from its last meeting revealed a high level of fear that the economy will stay restrained until there is a vaccine. Officials focused on ways to boost the economy when interest rates cannot be lowered further. It was acknowledged that it will be many years until the Fed raises rates, and that the Fed will be willing to accept higher inflation for an extended time to assure a healthy economy. The Fed's stance undergirds our thesis of a higher multiple than the pundits forecast for many years, especially for real, high-growth companies such as the new normal winners.
We continue to be disappointed by the failure of our government to rise to the occasion and put politics aside for the good of the nation. We remain hopeful that a skinny stimulus package will be passed soon with the contentious issues put off until after the election. If that is the case, it probably will not be enough to sustain both individuals and companies in trouble. We have not heard anything during the Democratic convention that makes us feel that a Biden administration has the answers to boost the economy sufficiently to lift the low and middle class and small- and medium-size businesses sufficiently to thrive in the new normal. We would expect a Biden administration, as well as Trump, if he wins, to introduce stimulus programs next year to boost demand and the economy. Again, no tax hikes in 2021 if Biden wins.
We see no reason to alter our view that the huge amount of excess liquidity creation will support higher stock prices, but not all stocks will perform equally. As we said, it is a tale of two cities as large, well-financed, well-managed companies will thrive increasing market share at the expense of their smaller competitors. Here is where research pays off which is our forte.
While our portfolios remain concentrated in the new normal winners, we have added some great companies with economic sensitivity as we see much higher margins, profitability, and cash flow than the consensus for 2021 and 2022. Part of our investment thesis is that the stock market multiple will be around 25 for the foreseeable future, reflecting very low interest rates and a strong financial system. What is the proper discount rate to value for great growth companies when they can raise long-term money at less than 3% - and 10-year funds at less than 1%? Did you notice that J&J raised 40-year money at less than 3% yesterday? Our government should be doing the same thing… lengthening maturities at ridiculously low rates.
We would continue to avoid bonds as we expect the yield curve to steepen, albeit slowly, as the economy improves over the next year, utilization rates increase and so does inflationary pressures. Notwithstanding, we expect long-term inflation to stay relatively contained due to globalization, technology, disruptors and rising productivity. As a substitute to cash, money market funds and bonds, we recommend owning moderate growth defensive companies yielding over 3%. These companies grow on average 8% per year, generate a lot of free cash flow and increase their dividends annually in line with earnings growth. We expect 8-12% total return on average from these stocks.
Finally, we would own industrial commodities and gold, too.
Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; turn off your business news; do independent research; and…
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
See also Business Cycle Indicators: 16 October on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.