The financial markets have been driven by the coronavirus, Fed policy, government stimulus, and politics up to now, but a change is in order.
We now see an earnings driven market, which will benefit active over passive managers and hard research, which is our forte. We recommend focusing on operating margins as corporations have done a great job navigating through the pandemic cutting costs, using more technology, shifting more functions online, and restructuring operations/supply lines. All of this is occurring faster than we assumed a few months ago when we began focusing on improving operating margins, operating profits, and cash flow.
Not all companies will benefit equally. We expect the larger, well-financed companies with forward-thinking management to significantly increase market share at the expense of small and medium less-financed competitors. Expect many of them to provide dividend hikes, renew buybacks, and make bolt-on acquisitions. Listen closely to the upcoming earnings calls as opportunities abound as change is truly in the air as we enter a new market phase.
The pace of the economic recovery in 2021 still rests on how well we handle the coronavirus. The news here last week was very favorable with Lilly’s (NYSE:LLY) announcement of its active antibody cocktail, additional information out of Regeneron (NASDAQ:REGN), and especially Gilead (NASDAQ:GILD), and, finally, Trump’s fast recovery using many of these therapeutics. It appears that therapeutics may be available for home use too, limiting hospitalizations, time spent at hospitals, the severity of symptoms, and, most important, the death rate.
Gilead just announced that using its cocktail reduces the death rate by over 70%. That’s right! News on vaccines also was promising, and we were told by the government that there would be enough availability for all Americans before the end of the second quarter. Finally, rapid response tests are rolling out as the government began distributing several hundred million test kits. We heard that JFK airport in New York City would start rapid response tests for all passengers, indicating that opening may accelerate. All good for the economy!
Talks on the additional stimulus were stopped by Trump mid-week only to begin a day later after seeing the stock market’s reaction. We just don’t get why they can’t pass everything they agree on, which totals around $1.6 trillion to support those most in need, small and medium-sized businesses, and the airlines. It seems so obvious, but politics seems more important than doing the right next thing. While the odds of a deal have risen, we still can’t count on one near term, but we are certain of many more stimulus packages after election, our focus as investors. We expect the new President to introduce and pass several bills to help individuals and small and medium-sized businesses along with demand-focused programs to stimulate growth/employment.
Fed officials appeared to be everywhere last week discussing Fed policy and the need for more government stimulus. The Fed notes came out last week, noting there was a three-part test before they would even consider lifting short rates from near zero. First, maximum employment would have to be met. Second, inflation must have increased 2%. Third, inflation will continue to run above 2%. The Fed reiterated that it would continue buying debt of all kinds and durations to keep downward pressure on the yield curve. Fed Chairman Powell commented that they and the Federal government risk doing too little, not too much. That says it all. The Fed will remain all-in well into the recovery and will not remove the punch bowl prematurely as has happened in the past.
If Trump Wins
We have a good idea of what a Trump economy will appear like if he won. He would continue with his tax cuts, have additional targeted tax cuts, introduce several stimulus programs to support those most in need plus demand focused on boosting employment/the economy, and further reduce regulations. Yes, the deficits will go up, but so will economic growth, earnings, and the stock market.
If Biden Wins
If Biden were to win, we are looking at much more economic stimulus, totaling over $12 trillion over four years, higher taxes at some point in time, and more regulations eventually. Deficits would run higher under a Biden administration but so would economic growth. Some well-known economists – Goldman, Morgan Stanley head economists to name just two – believe that growth would average over 4.2% per year under Biden vs. 3-3.5% under Trump. Stock markets usually do well under a Democratic administration as they tend to be more stimulative, which appears to be the case here. We do not think that Biden would raise corporate taxes until the economy was well above pre-pandemic levels, which won’t occur until sometime in 2022. We are not worried that he will increase taxes on the wealthy, giving all the benefits to the lower/middle classes as their higher propensity to spend will only add to economic growth.
Our economy is improving. Real GNP may have expanded by 35% in the third quarter and could grow by another 6-8% in the fourth quarter if stimulus were passed. Even without added stimulus now, there is enough momentum and money in the system to support continued growth in the fourth quarter, which will only accelerate next year as we get our hands around the coronavirus, and additional stimulus bills are passed. The surprise is the strength of operating earnings as corporations reacted swiftly to the coronavirus, cut costs, increased operating efficiencies, and improved supply lines. We believe that overall operating margins, which peaked at around 12.5% in the third quarter of 2018 and fell to 9.4% last quarter, will exceed prior peak levels by the second quarter of 2022. S&P earnings, excluding any change in tax rates, will exceed $165/share in 2021 and $190/share in 2022 vs. $163/share in 2019 and an estimated $134/share this year. Therefore, the market is selling at 20.8 and 18.1 times our estimates, which we find attractive with the Fed all in keeping rates so low.
The market is transitioning from solely being supported by the Fed and government’s excess liquidity to an accelerating economy for all the reasons stated above, which will lead to stronger than expected earnings as operating margins increase dramatically as costs, which were cut due to the pandemic, stay controlled. Regardless of who wins the election, we expect many more stimulus plans, which will also boost demand and employment. Global trade will improve meaningfully too, as we see renewed life already in China, India and Brazil, which will expand to other countries as control is gained over the coronavirus. The global economic outlook looks bright, indeed, for 2021 and 2022.
We have continued to move our portfolio to have more economic sensitivity to benefit from the environment that we see moving forward. While we still hold significant technology positions and the new norm winners, we have continued to reduce our exposure somewhat to finance the new purchases with economic exposure where we expect big margin expansion. For example, we own PPG as its businesses are tied to housing and autos, both of which are recovering. We saw terrific cost controls in their second quarter results plus a plan to further cut costs and increase productivity which we liked. Thursday, management raised their third quarter guidance from $1.40 per share to $1.90-$1.95 per share vs. $1.65 per share last year. While their volume forecast improved, it was still down 5% year over year. The sharp improvement in earnings had all to do with improved margins/efficiencies. After speaking with management, we can see a $10/share earnings power sometime next year as volume recovers. The stock is worth more than $170/share. Our cost was $110 purchased last month. It closed at $136 yesterday, up $6. Our portfolio is comprised of companies with similar characteristics and potential. We also like industrial commodities and gold. And we recommend the sale of all bonds as we expect the yield curve to steepen albeit slowly due to downward pressure from the Fed.
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Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; do independent research, listen to the earnings’ calls and …
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.