Observations On The Recent All-Time Market Highs

Summary

• Recent all-time market highs have masked astonishing disparities in valuation across different sectors, depending on how hard-hit (or not) they have been by the pandemic.
• Sustained polarized views on what post-pandemic life will look like have most likely contributed to these highs.
• Ironically, a retreat of the pandemic is one outcome that could lead to a slide in the market.
• Even after the rally over the last 3 months, I expect that there are still specific value-oriented stocks that will lead to worthwhile returns over a medium-term horizon.

The recent all-time market highs that have occurred against a backdrop of economic lockdowns and underperformance could understandably lead to wariness about downside risk and prospective future returns.  As far as aggregate North American market indexes are concerned, I think such caution is warranted, and one should have muted expectations for returns over the next few years.  

Much of the aggregate market index, though, has been driven by tech mega-caps and other companies that have benefitted from trends like e-commerce, work-from-home, streaming, and cloud computing, which the pandemic has helped to pull forward. Such companies have seen their valuations balloon --- e.g. QQQ, a popular ETF that tracks the Nasdaq 100, had about 52% of its weight in its top 10 holdings, as of February 10. It has become commonplace to see enterprise valuations that are 10x, 20x, or >50x revenues (e.g. ZM, ETSY), even for companies with tens of billions in market cap.

Meanwhile, hard-hit sectors such as real estate, retail, and energy have seen a partial recovery, as many companies have been more resilient than expected and have been boosted by hopes for a vaccine-aided recovery. Still other sectors like pharma and financials haven't really advanced that much since a year ago, and a value-oriented standard-bearer like BRK.B has only recently edged to new highs.

Value-screens show some well-known stocks with valuations that are lower by an order of magnitude or more (e.g. for EV/Sales, BRK.B is at 2.1, F is at 1.4, for forward EV/Ebitda, ABBV and other pharmaceuticals are at or near single-digits, etc. etc.). Real estate companies like SPG and OTCPK:CWYUF are still well below previous highs, despite resilience in the face of the pandemic. This is a quick and simplistic comparison, but there are a lot of places to look, for things that are not outrageously overvalued. A recent article on SA expressed a similar view.

Of course, massive amounts of government stimulus have also helped to cushion the pandemic's economic blow, thereby lending support to asset values.

Polarized Views of the Future

Roughly speaking, one can discern two polarized camps, those that believe that life has changed irreversibly because of the pandemic, and those who believe that "this too shall pass" (e.g. for the latter, see this interview with Bruce Flatt, CEO of Brookfield Asset Management).  Both camps are confident about their own narratives, and hence have helped to boost the valuations of their respective sectors. 

Both views can't win completely, in the long-term -- but as long as both camps can hang on to their own narratives, I'd expect that the all-time highs could continue. 

I tend to lean towards the latter view. Human beings are social animals (for the most part) and have been seeking out the company of others for millennia. In developed countries, I expect that people will also end up wanting to keep the best of both worlds, whenever possible.  E.g. the option to telework when convenient (not unlike before the pandemic!), but with the continued ability to go to a workplace.  Employers, schools, businesses that don't offer suitable options will eventually have a harder time attracting employees, students, and customers, respectively.

The pandemic is already a near-perfect scenario for some of the trends mentioned above. The set-up isn't going to get much better for e-commerce than when brick-and-mortar retailers are literally prohibited from being open, or for video-conferencing when school and office work can only take place online. And much of the strongest e-commerce performances, measured by revenue growth, have come from brick-and-mortar retailers themselves. 

Jeremy Grantham reminds us that past returns come at the cost of future returns. Astronomical multiples are pricing-in expectations of a lot more than just holding onto recent revenue gains -- they assume continued torrid growth.  But in developed countries, almost anyone that was ever going to take up video-conferencing or e-commerce probably would have already done so by now. Sky-high valuations also attract new competition.   

Thoughts on vaccines and mutant variants

Perhaps obviously, as far as covid is concerned, the emergence of more contagious variants is what looks most concerning to me.  Even though the speed of vaccine development was unprecedented, the rollout has been slower than ideal, and there will be a lot more opportunity for recent and yet-to-emerge variants to propagate, setting back economic re-opening efforts. It's possible that covid will become endemic (e.g. see here and here), to some extent, as it continues to evolve.

At the same time, though, many efforts are underway to evaluate potential treatments, while updated vaccines will also be developed. Rapid testing will become more prevalent. It's also kind of surprising that better PPE (i.e. versus cloth masks) isn't more commonly used by now, given the seriousness of covid for some people.

If pandemic fatigue hasn't already set in, by the time the first vaccines have rolled out, I doubt that extensive lockdowns would be socially or economically viable. Intermittent lockdowns have so-far managed to stave-off health care system collapse in most advanced economies, so I am optimistic that vaccines will work well enough to prevent such a collapse while having much less frequent lockdowns. 

One Risk to the Market Highs: Victory Over the Pandemic?

Given my optimism for certain sectors, I wouldn't want to dwell too much on the risk of an epic market crash in the near- to medium-term.  In any case, I agree with the widely-held view that timing the market, especially in terms of after-tax returns, is mostly futile. Nevertheless, market crashes are an entertaining topic to ponder.

Ironically, a retreat of the pandemic is one outcome that could lead to a market correction.  This would force a clash of views between the "everything-has-changed-forever" camp, versus the "this too shall pass" camp, as we ultimately see which of these futures unfolds.  In the coming quarters, as we lap the financial results of high-flying pandemic beneficiaries, some year-over-year comparables could also look less impressive and dampen valuations.

I am guessing there are still continued opportunities in more value-oriented sectors, e.g. real estate, pharma, etc., and other specific stocks. I am more cautious about airlines and hotels, and don't currently own any. Admittedly, valuations have been edging upwards with each passing week, making future returns less attractive. 

Of course, SA authors are always coming up with stocks that they argue are compelling opportunities...   no shortage of ideas to consider.