Understanding the stock market’s K-shaped recovery
US stock markets may have hit fresh record highs last week, however, the $2 trillion valuation of Apple, now the world’s most highly valued company, does not show the whole picture. Firstly, there are national divergences. The US market has risen to fresh record highs; however, this hasn’t been followed by record highs for most of Europe. Also, and most worrying for some investors, is the sectoral imbalance of the US stock market rally: three sectors are dominating the rally, while 20% of S&P 500 companies are still 50% below their February highs.
The K-shaped chart is visible when you plot the performance of the likes of Apple, Amazon and the other tech giants alongside energy stocks, financials, utilities and real estate, you realise that the S&P 500 is being driven by the technology sector (up nearly 14%), consumer discretionary (basically Amazon, and is up 15%) followed by the communications sector, which is up a mere 4.2%. This contrasts with energy (down nearly 35%), financials (down nearly 22%), and utilities, down more than 15%.
Amazon outpaces US fashion royalty
The problem is not just the wide difference in performance between sectors, but also within sectors. If you look at consumer discretionary stocks, it may be the best performing sector in the S&P 500 to date this year, however its performance is driven almost exclusively by Amazon. Unsurprisingly, Amazon has risen nearly 80% this year, in complete contrast, luxury fashion retailer Ralph Lauren is down 40%. The rally in the S&P 500 is narrow and its continuing march into unchartered territory depends on the continued outperformance of the likes of Apple, Amazon, Facebook et al, with a little help from consumer staples like Colgate-Palmolive and Dominos Pizza, which is also trading at a record high.
Does value matter anymore?
The other aspect of the stock market rally is the focus on growth stocks – share prices that have surged even though valuations are sky high, relative to value shares, that are trading at much lower valuations. To highlight this, take Amazon, which is trading at a price-to-earnings ratio of 126 times earnings, compared with 74 for Ralph Lauren, 35 for Chevron and 50 for Exxon Mobil. This is to be expected due in part to the vast difference in these stocks’ performances so far this year, it is also a warning sign, ten years ago Exxon Mobil had the highest valuation in the US market. A lot can change in ten years.
Crystal ball territory
The question now is, should we be worried about the divergence in the fortunes of corporate America? Will investors and traders start to balk at the K-shaped recovery and all rush to the exits at the same time? The only reason to do that is if you think that Amazon, Apple etc will lose their grip on the global consumer, that Facebook will be replaced by someone else or that these FANG stocks will experience some other calamity. While Netflix has seen a fall in subscriber numbers as global lockdowns have eased, which has been reflected in the underperformance of its share price compared to its peers in the high-performing bubble of tech titans, we think that there is a reasonable chance that these stocks could continue to push higher for the next 3-4 weeks.
Why the US election matters
Tech stars like Apple, Amazon, google and Facebook withstood political scrutiny in the US last month, which barely left a dent in their stock price. Looking ahead to the rest of the year, the biggest risk could be the US Presidential election in November. The concern is that if Joe Biden beats Donald Trump to the White House, and if the Democrats dominate in the Senate and the House, then tech giants who have done phenomenally well as a direct result of the pandemic, could be tax targets as the US embarks on the difficult journey of paying back its huge Covid debt load. If that seems likely in the weeks and months leading up to the election then we could see volatility in the FANG stocks, in particular.
Regarding the valuation gap, traditionally traders and investors spurn stocks once they reach record highs and have three-figure P/E ratios, instead choosing stocks that they believe are under-valued. However, the new normal could see a different dynamic, where the market shuns stocks, even if they look cheap. For example, Amazon, Apple etc are likely to see a continued upswing in sales as a result of the pandemic. Of course, there will be competition in time, but that is unlikely to be any time soon, which makes us confident on the outlook for the US’s top performing tech stocks. The market wants to follow the cash, and right now that is not energy stocks, which could struggle with low demand due to the expected global recession, neither is it financial stocks, which could suffer from bad loans and low interest rates for many years to come. This is why we say don’t be afraid of the K-shaped recovery and sky-high P/E ratios for the top performers in the S&P 500, things will eventually level off, but not for the foreseeable future.