Coronavirus Quick Take – August 19, 2020
August 19, 2020
Welcome to another day of Coronavirus Quick Takes. It’s been a while since our last one, but you may not have missed it much because the markets have been doing well. Today, we’re going to focus on a question that we’ve heard a lot recently: Why do stocks keep going up while the economy remains lousy?
Our last Quick Take was written on June 16: since then, the All-Country World Index (ACWI) has climbed +8.9% and the S&P 500 is up +8.8%. Not bad for two months! And yet, investors remain nervous, worried that a market collapse will be just around the corner once Wall Street realizes that the economy is nowhere near normal yet, and likely won’t be for many more months.
There are two main reasons for this apparent disconnect, and you’ve probably heard them before:
1. The stock market is not the economy.
2. The market indexes are not the stock market.
Let’s look at #1 first.
Stock prices derive from several factors, none more important than corporate earnings. Investors try to divine what earnings will be in the future and price stocks today accordingly. In 2019, companies in the S&P 500 earned about $163 per share; in 2020, they are expected to earn only $130, about a 20% decline. Why isn’t the S&P 500 down –20%? Well, for 2021, analysts expect S&P 500 companies to earn over $165 per share, more than in 2019. With 2021 less than 6 months away, stock prices are already looking at next year’s higher earnings and pricing them into stocks. Knowing this, it should come as little surprise that the S&P 500 is now a bit higher than it was at the end of 2019.
But wait, there’s more! While it may seem like the stock market looks only at the short term, in reality company value derives from earnings projected well into the future. Even with a big drop in corporate income this year, the long-term impact on share values is really quite small (less than 10% according to the graph below). From this longer-term vantage point, there’s no reason for stock market to still be down –20%.
You might also look around and see many companies—some publicly traded, many not—whose earnings are down much more than 20%. Many have losses. And some of these companies are in the S&P 500 index. For example, Chevron, Delta Airlines, Carnival Cruises, and Wells Fargo all reported multi-billion losses last quarter. But if we look at the entire index, losses in this group of companies were offset by higher earnings at other companies, including big technology names, healthcare companies and utilities. This carries over into stock prices, with many individual stocks down over 20%, but the index as a whole being more impacted by companies that are doing well.
More importantly, large public companies that have had losses this year are unlikely to go out of business, as they have ample financial resources to tide them over until the pandemic ends. A few big companies have filed for bankruptcy (e.g., Hertz, Neiman Marcus, Ultra Petroleum), but they represent a tiny fraction of the S&P 500. When you look at all the struggling and shuttered small businesses, realize that, though they represent an important part of the economy, they are separate from the businesses in which you and I invest our savings.
Now let’s look at point #2.
Most market indexes, including both the S&P 500 and the ACWI, are capitalization weighted. This means that each stock’s weight in the index is proportional to the total value of its equity relative to the other companies in the index. As a result, bigger companies have a greater impact on index performance than smaller ones. A company such as Apple, with a market capitalization of nearly $2 trillion, has far more impact on the index than an equally well-known company like Colgate-Palmolive, whose $66 billion market cap is nearly 30 times less.
And the big are getting bigger. The 5 largest companies in the S&P 500 (Apple, Microsoft, Amazon, Google and Facebook) now represent 23% of the index, a higher percentage than at the peak of the dot.com boom in 2000. And these huge tech companies have seen their earnings hold up well during the pandemic. The chart below shows earnings estimates for those top 5 companies compared to the rest of the S&P 500 and to the Russell 2000 index of small companies. With 23% of the index doing extremely well, the other 495 companies can do comparatively poorly and the index can stay strong.
On the flip side, entire industries can tank yet barely impact the S&P 500. Airlines and department stores are two examples. They are both losing money hand over fist right now. But airline stocks account for only 0.18% of the S&P 500 index. And department stores? 0.01%. Both these industries could disappear entirely, and your portfolio wouldn’t even notice.
The disconnect between the biggest stocks and all the rest can create opportunity. The pandemic will eventually end, and as the world gradually returns to normal, companies that have been left behind will thrive again. For example, the stocks of 100 companies in the S&P 500 are down –30% or more this year. These include well-known names like Boeing, General Electric, Marriott and Citigroup. These stocks won’t stay down forever, and when they do recover, their effect on the S&P 500 index will be modest. But in a portfolio that more equally weights individual holdings, their impact will be far more noticeable. This illustrates one of the benefits (and risks) of an actively managed, but diversified, portfolio that isn’t a slave to capitalization-weighted indexes.
This is not to imply that there aren’t still risks that could derail both the economy and the markets. But right now it appears that the greater risk is missing out on potential upside by being excessively cautious. As we’ve said many times in the past, it’s when everything looks great that market risks are highest; now is clearly not such a time.
We’ll continue to write Coronavirus Quick Takes periodically during the pandemic. Please feel free to comment and ask any questions that come up.
The KCS Investment Department
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