Is the rally over?

Good morning. We got a lot of mail about our Friday interview with antitrust expert Herbert Hovenkamp, all of it convinced he was absolutely right or absolutely wrong. People have strong opinions about the role of big tech in the US economy. If you have strong opinions about anything else, send them along: robert.armstrong@ft.com and ethan.wu@ft.com.

Is the rally over?

S&P 500 hit an all-time high on Friday but, as my colleagues Nicholas Megaw and Kate Duguid have pointed out, stocks limped to the summit. A fierce year-end rally that began at the end of October has given way to a wheezing sideways market in January, during which two-thirds of the S&P has had negative price returns and the gains, such as they have been, come from a handful of tech stocks, notably Nvidia. One cannot be blamed for wondering whether stocks, having reached a new peak, are in for a bout of altitude sickness.

Consider what has driven the market since October 27, when the rally began. The economic and policy backdrop is well understood. The economy remains resilient, backed by a tight labour market and correspondingly strong consumption. At the same time inflation is falling back towards 2 per cent, opening the way for multiple Fed rate cuts in 2024. That combination is pure oxygen for equities. If January’s relative weakness has a tidy explanation, it is that a slightly hotter than expected December CPI inflation report was matched with signs that employment and consumption are still quite warm. Those add up to a reason for the Fed to wait on those rate cuts, and a reminder that a soft landing is a delicate balance.

Before things levelled off, what drove the index higher? The magnificent 7, and big tech generally, were a big part of the story. AI hype accounts for some of this. In addition, lower interest rates driven by falling inflation expectations, rather than slowing growth, should be good for growth stocks, all else equal.

But the rally has not been just about growth stocks. In fact, from the end of October through the first week of January, growth stocks and value stocks performed about equally well. Why has value kept pace up until recently? One explanation, which fits the market’s internal dynamics neatly, is that the implied probability of recession has fallen by a lot. This is visible, for example, in the sharp move up in bank stocks, especially higher-risk regional banks such as Fifth Third, Citizens, KeyCorp, Zions and Comerica (all up 40 per cent or more since late October). While lower short-term rates are a drag on bank profits, in a recession driven by tight monetary policy the gains in interest income would be more than outweighed by higher loan defaults. Recessions are terrible for banks.

A rapid fall in recession expectations also helps explain the great performance of semiconductor stocks in recent months. The chip industry is hypercyclical, so lower odds of a downturn, with a dose of AI hype thrown in, works very well for the group. Also the highly leveraged cruise liners Carnival and Royal Caribbean, which could face serious trouble in a recession, are both up 55 per cent in the rally. In contrast, defensive sectors that provide shelter in a downturn (healthcare, utilities, staples) have all underperformed the index in recent months.

There have been other contributors to the rally, of course. Companies that directly benefit from low rates have done well. This includes the homebuilders (up 40 per cent or so) and commercial real estate plays such as Boston Properties and Simon Property Group. But the main contributors have been big tech being bid up and the falling odds of a recession. So the question is: is further upward impetus from either source likely? 

On big tech, the AI hype cycle is simply impossible to predict. Putting AI aside, then, the common thread between big tech and recession-sensitive stocks is that both thrive on the falling rates/solid growth combination. Can hopes for a soft landing grow even stronger than they are now? 

Two more stocks of interest

As we wrote last week, we are not placing our bets in the 2024 FT stock picking competition on an all-in macro bet, a strategy that worked well for us in 2022 (beat the market by 26 points) and disastrously in 2023 (trailed it by 95). It’s not that we have lost our appetite for risk. Risk-seeking is a dangerous investment behaviour, but a prerequisite for winning a stock picking contest (what follows is not, that is to say, investment advice!).

It’s just that we don’t have any strong convictions about the macro environment. So instead, we are placing an all in-bet on an investment style: growth at a reasonable price, known in the trade as a “Garp.” Why? A few reasons. Growth, the dominant factor in markets in recent years, looks expensive. Yes, while valuations are a good indicator of long-term returns they are useless for timing the short term, but we do believe that relatively good things happen to relatively cheap stocks. But value stocks are at their best in a post-recession expansion, and we’re not in one of those. So we decided to look for stocks that are not just reasonably priced on a price/earnings basis, but also have solid (if not strong) growth in earnings and (where possible) in revenue too. We also looked for evidence that the stocks we picked were able to compound earnings decently over time, as evidenced by nice-looking long term charts. Finally, because of our uncertainty about the economic environment, we have avoided cyclical stocks where we could. 

One other point that defines our picks: we took them all from the S&P 500. This was an editorial rather than strategic decision. We are a US column, and we wanted to follow stocks that were big enough that our readers would have heard of and have thoughts on them. So no foreign stocks, and no small caps.  

Our first pick, the property casualty reinsurer and primary insurer Everest Group, ticked all our boxes well: a cheap stock with a history of delivering growth, and with industry tailwinds to boot. Our second pick, Cigna, is more or less of a straight value stock, although it did increase earnings per share at 15 per cent a year between 2012 and 2022, which goes a long way to explaining its lovely 10-year chart. It trades at 11 times forward earnings and Wall Street expects double digit earnings growth over the next few years.

As Jefferies analyst David Windley explained to me, Cigna is the cheapest of the big health insurance stocks in part because it has the least exposure to Medicare Advantage — that is, to managing older patients’ government-sponsored health benefits. MA has been the industry’s growth area. But early indications of MA enrolment for 2024 have not been great, and if that plays out, Cigna’s greater exposure to commercial health plans may turn into a relative advantage. A big chunk of Cigna’s earnings per share growth comes from buybacks, which is not great. But the stock is really cheap! 

Our next pick, Dollar Tree, is riskier. The dollar store model has seen great growth over time and generates a lot of free cash flow. And the model can be a defensive in an economic slowdown, because of its low price points (the hint is in the name). But Dollar Tree has suffered some hits in the past few years. Inflation took a toll on the chain’s core middle/lower income consumer, and pandemic supply chain snarls were particularly painful for the company, which imports most of its products. The net result was tighter margins. The acquisition of a competitor, Family Dollar, eight years ago has never really been successfully integrated. 

Involvement by an activist fund, Mantle Ridge, helped force the appointment of a new CEO, Rick Dreiling, a year ago. He had success running rival Dollar General. Peter Keith, an analyst at Piper Sandler, told me that he has confidence in the new management team, but the risk is that the timing of turnarounds is inherently uncertain. The need to close stores, for example, could create volatility in the stock. And at a forward price/earnings ratio of 20, Dollar Tree is not obviously cheap. But if the turnaround story takes hold, the stock could look suddenly cheap relative to its growth prospects.

If we were looking for a safer “Garp” pick in retail, we could have picked, say, AutoZone. But we need risk if we are going to place well in the contest, so we went with the turnaround story.  

Two more picks tomorrow!

Addendum

Last week’s piece on commercial real estate made a rash comparison that we should acknowledge. In arguing that public markets had already priced in plenty of CRE distress, we wrote: 

An index of US CRE real estate investment trusts sits 35 per cent below its highs. Compare that to what forecasters expect for CRE more broadly . . . a peak-to-trough price decline across property types of about 20 per cent.

As one sharp reader, Peter, pointed out, this compares apples (the value of real estate assets) to oranges (the value of real estate investment trust equity). Reits are financed with both debt and equity, so an accurate comparison requires a bit more work. 

Suppose a Reit has a loan-to-value ratio of 35 per cent (as was the case on average in mid-2023). All else equal, a 20 per cent asset price decline should translate to a 31 per cent decline in equity. The table illustrates:

Some of the sources we talked to for last week’s piece, who argued public Reits were oversold, run far more detailed analysis at the property level, including crucially taking views on properties’ rental income and operating expenses (which would impact NAV in the table above). Regardless, we should’ve been more careful, and are grateful as ever to our eagle-eyed readers. (Ethan Wu)

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