Stocks Only Go Up

If you follow the financial media you’ve come across numerous stories on day traders taking over the stock market on their Robinhood app.  People with little investment knowledge making large and loud bets on airlines and cruises using scrabble tiles to pick tickers.  The line has been drawn between “Davey Day Trader” and his army of twitter followers versus established investment professionals calling this a sign of a market that has run too hot too fast. 

We won’t form an alliance with either side because nobody knows the actual consequences of a global economic shutdown alongside unlimited central bank stimulus.  Sorry to disappoint. The truth is both sides could be right, and the most likely outcome is far more nuanced and probably somewhere in between.

Here are the Facts:

The stock market is huge.  The value of all listed US stocks is in the neighborhood of $35 trillion.  Most of that money is held by large institutions (pension funds, insurance companies).  The idea that thousands of bored millennial day traders can move a market that size is a stretch.  Sure they can gyrate individual companies stocks (especially if the market cap is small), but it’s likely that the real volume is coming from hedge fund algorithms that can quickly capitalize on the noise created by these accounts and large institutions playing catch-up with the market rally. 

The Federal Reserve proved (yet again) that it can force money into risky assets.   The Fed dropped interest rates to record low levels through its massive programs of debt purchases and money printing.  Corporate bond yields for most companies are lower than they were in February and purchasing an A rated bond today almost guarantees a negative real return if there’s any inflation.  Nobody can survive on such meager income so investors are forced into riskier bonds and stocks. 

Somebody continues to chase “work from home” stocks to insanely high valuations.  You can’t even pretend to buy them with earnings in mind. And it’s not just the FAANMG stocks – although Apple is now selling for a higher multiple than it did in 2007 (the year the iPhone was introduced). Pick any other tech or subscription software company and they are priced to perfection.  These companies combined market caps are way too large to be solely influenced by day traders, so there must be institutional money participating in this momentum trade.      

The market is NOT actually trading on the hope that we get back to normal sooner rather than later.  If that were the case Zoom wouldn’t be priced at 40 times next year’s sales, United Airlines would be up 60% (not down), and fears of canceled Netflix subscriptions would be rampant.  Bank stocks have barely recovered.  Oil is still $40 a barrel.  None of this represents a normal economy. 

Stocks are expensive based on next year’s earnings multiples.  Institutional money managers point to this fact as a reason to not invest, but this is a meaningless fact.  Companies have no idea what the next two months will look like, let alone the next twelve.  These broad market gauges are often useless, but especially so today with the amount of guesswork involved.   

Cyclical stocks are a great way to play the recovery.   True, but there is still a lot of uncertainty around the economics of businesses built on pre-Covid behavior.  For example, airlines are cyclical, competitive and capital intensive, requiring constant investment (fleet maintenance, upgrades, new planes for growth, new terminals, etc.).

Over the past decade, there was a rationalization of the US domestic market through consolidation allowing the largest airlines to fend off “discount” airlines more effectively.  Covid threw a major wrench into that equation.  A popular choice for traders, United Airlines, has seen its debt double ($25 billion), its cash flow turn massively negative ($3 billion of cash flow in 2019 to losing $40 million a day) and has leveraged every asset (airplanes, airport gates, and now customer SkyMilles) in order to survive.  Even with a return to normal, United is years away from financially looking like the company it was in February.    

If you are going to bet on a sector recovery, the companies with less debt such as Southwest or JetBlue give you better survival odds. Anything else is a pure gamble given the legacy of bankruptcies in the airline industry during far less turbulent times. 

Trading is not investing. It doesn’t matter if you are day trader or an algorithmic hedge fund, trading takes advantage of short-term market movements, while investing requires a long-term view.  Getting caught up in the daily movement of stocks is a bad idea for anybody investing for the future. There will be good economic reports and bad ones.  Covid outbreaks and Covid declines.  Bankruptcies and record earnings growth.  Good and bad days.  Best to leave the emotions out and wait for a true recovery. 

Stocks only go up.  This is the rallying cry of the day traders.  While the slogan has merit over the long run, in the short-term stocks can be very volatile and will likely remain so until there’s resolution around Covid. Pretending that we’ll be able to predict the shape, durability, or timing of the economic recovery is a fool’s errand.  Far better to commit ourselves to the belief that good companies will be standing on the other side of this.  Paying a reasonable price for those companies is our rallying cry. 

In Summary:

If the traders are right (we hope they are!) and the economy gets back on track, then the market is due for a major rotation from the “work from home” stocks to fundamental analysis of businesses recovering from a crazy, but short recession.  If they are wrong and liquidity dries back up, the momentum driven trades of money losing companies that require access to capital markets will return to earth.  But don’t make us wager on which it is or when it will happen. We’ll leave that to the traders.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}