Third Quarter 2020 Commentary: The Beat Goes On
October 1, 2020
Mark Oelschlager, CFA
A man named John Adams attends every Cleveland Indians home game, sitting in the last row of the outfield bleachers. What makes Adams unique is that he always brings a large drum to rhythmically beat at various moments in the game. The sound reverberates throughout the stadium and into the homes of people watching the game on television. The team does not compensate him for this; in fact, until recent years he bought his own ticket. Adams has been beating his drum at Indians games for about 47 years. This season there were no fans allowed into the games due to the pandemic, but the beat went on, as the organization piped in sounds of a beating drum to give the game a little more of a normal feel.
The beat went on in the third quarter as growth stocks once again shone, propelling the S&P 500 to a 9% gain. The market continues to be narrow, with the index being carried by a relatively small number of companies. While the index is up this year, the average stock is down. This is generally considered to be unhealthy.
Another unhealthy development is the aggressive action by many market participants, particularly in the options markets. A call option on a stock can be thought of as a turbocharged position in that stock. The swings in value, and the ultimate risk, of an option are much greater than simply owning shares of the stock. It recently came to light that Japanese multinational conglomerate Softbank had bought $4 billion of options on US tech stocks over a short time period. The notional value of these was $30 billion. In addition, many more retail investors than usual have been playing the options game, again in the tech area. All this demand for options has not only caused options premiums (the price one pays for an option) to spike, but it also has helped drive the rally in the prices of the underlying stocks, as the sellers of these call options are forced to hedge themselves by buying the underlying shares. The rise in value of the shares creates more excitement for options, which again results in more demand for the shares, and so on. Late in the quarter this upward spiral unraveled a bit as some of the tech stocks sold off, but many retain lofty valuations.
Two examples of stocks that experienced frenzied rallies are Tesla and Apple, each of which announced stock splits in the quarter. Even though they have no effect on the true value of a company, stock splits in the frothy market of the late 1990s led to spikes in the prices of the companies that announced them. Though splits are much less common these days, the phenomenon has resurfaced. In the three weeks after Tesla announced its stock split, its stock price rose 76%, or roughly $200 billion in market value. It is important to note that there were not any significant developments at the company during that period that would explain the move. For perspective, only 30 public companies in the entire US market are worth at least $200 billion, which is how much Tesla’s market value increased over just three weeks. In the month after Apple declared a stock split, its market value increased by roughly $600 billion. There are only six companies in the US market with a market value that large, one of which is Apple of course.
We are seeing froth in the initial public offering market, with such new securities enjoying unusually strong first-day pops in price. There has also been an explosion in something called special purpose acquisition companies (SPACs), a new structure in which firms are given a large pool of money to invest however they see fit.
All of these are worrisome signs and a result of both the Fed’s extremely loose monetary policy and a shortage of attractive investment alternatives. The Fed has moved short-term rates to zero and has increased its balance sheet from $4 trillion to $7 trillion just in 2020. It is trying to support the economy in a time of crisis, but it is having unintended effects that may create other problems.
The market frothiness in the late 1990s was primarily driven by a loose Fed (in preparation for Y2K) and a revolution in technology. Today we have the same thing. While most of the measures today are not at the extremes of that era, the similarities are striking. One of the commonalities of the two eras is the hunger for “growth” (mainly tech) stocks and the disdain for “value” stocks. Starting with the first quarter of 1998, the Russell Growth Index outperformed the Russell Value Index in nine out of ten quarters. This was a remarkable run, and when it ended, value made up ground in a big way. Today, incredibly, growth has had an even longer run of outperformance. With the quarter that just concluded, the Russell Growth has beaten the Russell Value in 14 of the last 15 quarters. Given the natural vicissitudes of the market, that is astounding. In our estimation, in both eras some of this divergence was justified, as technology was and is truly revolutionizing our way of life and, particularly today, some businesses enjoy tremendous economies of scale and their platforms become even more valuable as they add customers. Additionally, some of the sectors characterized as “value” face secular headwinds. But as often happens in the stock market, sensible themes can get carried too far, especially when accompanied by the tailwind of a loose Fed.
We have beat this drum before, but just as it did in the late 1990s, the strong outperformance by growth stocks has driven the valuation differential between the two groups to unusually wide levels. In 2000 there was a big reversal in relative performance that brought the differential back into a more normal range. We believe this will happen this time as well - we just don’t know when. In our opinion the catalyst for a reversal of fortunes is likely to be progress in the fight against Covid-19. The pandemic has created a chasm in the market between those companies hurt by the effects of the pandemic (such as cruise lines and traditional retailers) and those that have benefited from it. Evidence of an effective vaccine, we believe, would draw investors back into many of the companies that have seen business decline dramatically due to the pandemic. Of course in the meantime some of these companies have had or will have trouble paying their bills or staying solvent, and others may struggle with the trend toward online commerce which was accelerated by the pandemic, so the trick is figuring out which ones have the best risk-reward. There are many businesses that were healthy before the pandemic that one could reasonably expect to prosper again but that are trading far below where they were eight months ago. As long-term investors we are conscious of the fact that the value of a company is a function of the sum of all its future profits, not just this year’s. We are looking ahead. Just as in 1999, many of the growth stocks and the indices appear to be priced too dearly, but that belies the opportunities that exist in those issues that are out of favor for short-term reasons. When the reversal happens, we believe it will be sudden and memorable.
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