There’s a little whiplash on Wall Street as investors struggle to reconcile record-breaking asset prices with all our hard-won experience of how markets should work.
Decades of statistics say stocks normally suffer in a recession. Money simply stops flowing across the corporate landscape, leaving executives staring at the consequences of decisions made under better circumstances.
Thanks to the pandemic, at least 30 million Americans are living on restricted budgets and whole sectors of the economy are struggling to avoid shutting down completely. While the details this time are unique, the impacts add up to a serious shock to the financial system.
That’s what disturbs so many of my colleagues. They see earnings plunging 33% in the recent quarter and wonder how such a dismal “growth” curve can support the market at this level.
After all, the last time stocks pushed into this previously unclaimed territory, we were looking forward to another healthy growth year. Back in February, the S&P 500 deserved to trade at 19X earnings.
Now, while the economic environment has gotten a lot worse for many companies, valuations have actually gone up. And that’s what gives my colleagues pause.
Why are we paying 22X earnings now for stocks that are much weaker than they were six months ago? Unlike a lot of people on Wall Street, I have an answer that goes deeper than “free money from the Fed.”
Three Sectors Suffered Painfully
We talked last week about how well the technology sector has responded to the new economic climate. This week, I’d like to focus on the areas of the economy that took the full force of the pandemic impact.
When the Fed cut interest rates to zero, every company that can borrow money to support its operations felt instant relief, but those that make money lending also felt the chill.
I’m now expecting earnings across the financial sector to plunge 35% from last year’s level. And since these stocks are heavily weighted in the S&P 500, that deep dive will account for close to 30% of the broad market’s earnings decline.
Put simply, it’s a miserable time to be a banker. The Fed has done its best to ensure that these institutions won’t meltdown like Lehman Brothers and Bear Stearns did a decade ago, but that cushion comes with a price.
And while Amazon.com Inc. (NASDAQ:AMZN) and smaller online retailers are doing well, the quarantines guaranteed that most consumer discretionary stocks will post gloomy results this year.
Even counting Amazon’s numbers in the mix, I’m looking for the pandemic to cut earnings at this end of the consumer sector in half. If you’re looking for the pain of the pandemic playing out on Main Street, this is the place.
Since these stocks account for another 11% of the S&P 500, their pain is deep enough to account for another 30% of the earnings gap Wall Street is now trying to comprehend.
Then there are the classic industrials. Manufacturing took a hit when production facilities had to shut down and customer order flows froze.
While these stocks aren’t hugely weighted in the market as a whole, an alert investor who screened them out of the portfolio would avoid another 25% of this year’s earnings gap.
As stunning as it sounds, the other eight sectors in the S&P 500 are holding up relatively well. Real estate, technology, healthcare… all stalled but far from wounded.
That’s why I always emphasize tactical stock selection over simply buying an S&P 500 index fund and holding it forever. You want to be able to avoid obvious weaknesses and concentrate on strength.
Build an eight-sector portfolio that eliminates the industrials, consumer discretionary stocks and financials and you won’t see much of an earnings gap at all this year. And remarkably, you’ll end up paying about 19X earnings.
That’s not inflated at all, especially with the Fed ensuring that liquidity is flowing fast and furious. It is what we were all happy paying for world-class stocks back in February.
Is it any wonder my High Octane Traders are effectively shorting these sectors? When Wall Street is confused, this is where the easy money can be found.
And if you’d simply rather keep your head down and cash dividends, I’m giving out my favorite stocks at that end of the market on this week’s Millionaire Makers radio show. (Click here for recorded episodes and local stations.)
Some names are familiar to Value Authority subscribers. But many are new to all. I think you’ll like the list.
