Over the Top?

In September the S&P 500 clocked a monthly loss of 3.85%.  The tech sector during that same period was down nearly twice as much as the broad market after leading during 2020.  Does this selloff represent a “top” for stocks, a long overdue reckoning with reality as the prices of these stock climbed out of all proportion to the ability of these firms to produce growing profits, or does the decline in these shares represent a “pause that refreshes” from which the redoubtable “FAANG” (Facebook, Alphabet, Apple, Netflix, Google and incongruously Microsoft) will ascend to even higher heights?

That is the 64-billion-dollar question of the moment.  Following are our thoughts in this matter.  We believe it is more likely than not that U.S. stocks as measured by the S&P 500 will be higher a year from now than they are today based on a strengthening U.S. economy, recovering profits and a supportive Fed.  As for the technology shares at the center of the latest selloff, we are less certain since the August leg up for these high-flying investments was built on a speculative furor which became apparent in the summertime and cooled quickly in the first days of September.

The “FAANG” Elevator ~ The recent mania surrounding Facebook, Apple, Amazon, Microsoft and the like began, as with most speculative episodes (railroads in the 1880s, car manufacturing in the 20s, transistors in the 60s, Japanese stocks in the 80s and the first tech boom in the 90s) as a logical reaction to trends that seem to become immutable.  The growth in revenues and profits long touted by those bullish on these stocks became manifest and accelerated during the pandemic as “stay-at-home” and cloud computing stocks surged.  Those investors who missed the elevator on the lower floors have piled in, paying up to secure their position on the upper floors only to be schooled that elevators travel down as well as up. To justify the prices of late August, more of the future was discounted into current prices.  A weaker U.S. dollar accentuated tech’s rise in dollar terms.

With its latest passengers aboard, the express elevator to the summit began its inevitable trip towards the lobby.  As long-time investors in these remarkable companies, we have been more than happy to sell some of our shares to others as we approached the uncertain topping out of the sector.  We remain invested in these technology leaders because of their relevance to the future.  To stretch our elevator analogy to the breaking point, we do not believe the car will make it all the way to the lobby. Enough passengers on the mid to upper floors will press the “UP” button to stem the car’s journey sending it skyward once again. The timing of this process is uncertain.

Stocks in other areas of the market will likely be the beneficiaries of tech’s pause.  Stocks in more attractively valued areas like industrials and financials will draw more interest. Smaller stocks like those in the Russell 2000 index of small cap stocks may also get a bid.  Since bond and cash returns are currently so low, we believe much of the proceeds of tech stock sales will stay in the stock market.

Looking to Next Year ~ Further ahead, perhaps in 2nd half of 2021 or 2022, the stock market may have to compete with the bond market as rock-bottom 5, 10, and 30-year bond yields climb to levels appropriate to a recovered economy.  The Fed will keep a firm grip on shorter term rates, but if the market sniffs out incipient inflation, longer term rates may rise.  We believe the improvement in profits in the broad stock indices coming out of the pandemic will prove to be more than equal to the task of overcoming the headwind of higher long-term rates.  An inflation push driven by a tightening labor market would certainly be a great problem to encounter.

So, while it is quite possible we have seen the pandemic high for the Nasdaq and the S&P 500, improving profits and a helpful Federal Reserve will provide support for stocks.  From the perspective of 2019, had we been told in advance of COVID-19, it would have been implausible the S&P 500 would have rebounded to the extent we have experienced.  Staying invested through the initial shock of pandemic was the right thing to do.  Similarly, in September of 2020, we believe a diversified portfolio of stocks will serve investors well as the economy recovers.

The Altavista Investment Team ~ Fall 2020

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