November Market Commentary
On the eve of elections, Eugene reminds investors of a key lesson from 2016: avoid making big bets that rely on one particular outcome to perform well. Eugene comments on encouraging economic and earnings data, even as the US struggles with the pandemic and Europe announces new lockdowns.
Our motto: Stay positive and keep long-term perspective!
US Economics: Business activity improved significantly following the early spring COVID-19 collapse. However, after that initial advance, the comeback has turned somewhat choppy. On one hand, we recently saw better data on the consumer side, as reports showed a nice jump in retail sales and further strength in housing activity. On the other hand, there were surprising declines in industrial production and factory use. Nowhere, though, is the picture more mixed than on the employment front. There, job growth has slowed, and weekly jobless claims recently were approaching 900,000. So, it is not surprising that the Federal Reserve has been clamoring for a new fiscal stimulus package from Congress.
The amount of fiscal stimulus expected is related to the election result. If Congress remains under divided control next year, one would expect fiscal stimulus to a few percent of GDP. This would be the case regardless of who wins the White House. By contrast, a congressional Democratic majority would likely result in substantially more fiscal support. The consensus is that spending would increase the most under a Democratic sweep of the House, Senate and White House. This would likely include a stimulus package in Q1, followed by infrastructure and climate legislation. A Democratic Congress also would likely reach agreement with President Trump on a substantial fiscal stimulus package if he wins reelection. An infrastructure program might also be possible in this scenario. As Professor Siegel of Wharton Business School stated many times during the last few months in his regular calls: the size of the majority in Senate becomes significantly more important. A narrow Democratic majority in the Senate (e.g. 50 or 51 seats) would likely result in less fiscal stimulus than a larger majority (e.g. 53 or 54 seats) but also smaller tax increases.
Global Economics: For the second week in a row JP Morgan has lowered the outlook for current quarter European growth. In most countries, the restrictions to date have been limited to high-risk activities and are geared toward limiting economic disruption. However, Ireland, Wales, Belgium, and the Czech Republic have now followed Israel in imposing extensive lockdowns. October surveys across Europe show declining consumer confidence and service sector activity. It looks like Europe might stall this quarter. In contrast to the latest headwinds, the medium-term outlook for Europe has improved in response to greater expected fiscal stimulus.
As for China, while China’s 3Q GDP report disappointed, September activity data point to a broadening recovery according to JP Morgan. Retail sales in September were stronger than expected and services production accelerated last month. Improving labor market conditions, increased confidence, and low infection rates all should contribute to further normalization of consumption, which has lagged China’s post-pandemic recovery. And, like the rest of the region, Chinese exporters are still benefiting from the rebound in global demand, even if the latest news from Europe may dampen some of that impulse.
US Stock Market. Earnings: So far, third-quarter earnings are coming in better than expected. While the Large Cap Growers are very richly valued (see Valuation Spreads and Value vs. Growth charts below), the rest of the market doesn’t seem to be stretched. Nevertheless, markets are trading sideways for the most part. Such a resilience reflects the fact that the Federal Reserve is pulling out all stops to keep the economy rolling. Also, attractive alternatives to equities are hard to find in a low interest rate environment.
Stock Market Leadership and Potential Triggers of Leadership Change: As we go into print, elections are one day away. According to Empirical Research Partners, the Biden tax plan is just one thing among many which they still think can impact the market’s leadership if we have a change in Administration. When you’re flying at high altitude it doesn’t take much turbulence to alter one’s trajectory. It turns out the Biden plan could reduce 2022 estimated net profit margins by about (8)-to-(10) % for the tech/growth leadership, compared to around (5)% for the market at large. Zooming into the Big Growers specifically, the stocks in the worst quintile of a potential margin decline would see their 2022 estimated net profit margins fall by something like (20)% whereas the stocks in the least-impacted quintile would see their margins remain intact. The problem is, the Big Growers in the former category trade at an average forward multiple of 130 times 2022 estimated earnings whereas those in the latter bucket are trading at about 70 times. A fifth of the Big Grower universe qualifies for the highest quintile of forward-P/Es market-wide and the worst quintile of potential tax-induced margin compression. That’s the highest of any sector in the market. More so than in the past the highest flyers are exposed to a reversal in prevailing tax policy.
Moreover, the Big Growers are also the most negatively exposed to positive vaccine sentiment and the broader market is expected to react stronger to another stimulus package, no matter who wins the White House. So, it does make sense to keep the barbell approach, which we at Signet keep doing diligently. On one hand, we recognize that a lot of things people adapted to will stay well beyond this pandemic. On the other hand, the broader market and businesses which were affected by the shutdowns are expected to respond to vaccine and stimulus stronger than the Large Growers.
A key lesson from 2016: Avoid making high-conviction bets that rely on one particular outcome to perform well.