In our annual market outlook (“2021 Market Outlook”, January 12, 2021) we indicated that the market was bound to be volatile in 2021 due to factors such as the uncertainty of growth factors coming out of a recession and vacillations on vaccinations, but volatility caused by retail investors pumped with stimulus funds, zero-cost trading, time on their hands, and ubiquitous social media platforms upon which to organize their onslaughts on securities where their coordinated efforts could move prices? As President Biden would say, “C’mon man!”.
An Eye Opening January
For those of you stuck at home lamenting over the intolerable boredom, January was a real jolt to the system.
We started the month off with an improbable win by both Democratic challengers in the runoff election for the two Georgia senate seats which resulted in a 50-50 split of the upper chamber effectively giving Democrats control as the Vice President casts the deciding vote in case of a dead heat. The very next day there was an insurrection at the U.S. Capitol by President Trump supporters resulting in five deaths. In the aftermath of this U.S. Capitol riot, the House voted to impeach outgoing President Trump for an unprecedented second time due to his inflammatory speech which his accusers allege incited the ensuing riot.
We were all wide awake at that point, and boredom was replaced with a sense of fear and loathing. But there were positive developments.
The Twin Towers of Monetary & Fiscal Stimulus
On the monetary front, the Federal Reserve Chairman Jerome Powell testified that he does not see the Fed raising rates anytime soon, and he reiterated his desire to allow inflation to run above the 2.0% target for some time (we expect that “some time” to be about a year).
Now, the Fed has gone to great lengths to communicate its desire for higher than targeted inflation rates to recalibrate the capital market expectations with respect to inflation. But that will not stop jittery investors to dump stocks at the first sign of inflation. We will get our first test on this point in the March/April timeframe when I expect a spike in inflation due to purely technical reasons on how they calculate inflation on a year-over-year basis.
The March/April of 2020 timeframe was a highly deflationary period and comparing the 2021 March/April price levels is bound to result in a jump in the headline inflation rate.
I can see it all now. Talking heads and market prognosticators will say that the Fed is “behind the curve”, they do not know what they are doing, and we are in for a free fall in stock prices. In Washington, Fed Chairman Jerome Powell will be understandably frustrated behind close doors that no one is listening. The market will come to its senses eventually, but not before impatient investors sell their shares to us and others able to look through this headline to see the truth that inflation is merely on its intended path.
On the fiscal front Congress passed an additional $900 billion stimulus package, and President Biden has proposed an additional $1.9 trillion stimulus package that many believe is necessary to support our economy until it can function on its own as the economy opens post-COVID.
Although the market will continue to be volatile, we believe that the twin towers of monetary and fiscal stimulus will provide a safety net under the market, and any fearful plunge in the market will ultimately prove to be temporary and present a buying opportunity for patient, long-term investors.
GameStop & Other Corporate Zombies Captivate Investors
Like watching a dumpster fire, investors have been captivated by the trading in various heavily shorted stocks such as GameStop and AMC Theatres, among others. On Tuesday, one of our core portfolio holdings, Microsoft (MSFT) said that its 4Q20 revenue was $43.1 billion, up 17% from a year ago, beating Wall Street consensus estimates by $3 billion. Its profits came in at $2.03 a share, up 34%, destroying Wall Street consensus estimates.
The stock was flat on the news, but not because no one noticed. There was heavy volume on the news, but buyers and sellers were equally balanced. My theory is that a material amount of the selling was from all the Wall Street guys who got caught in a “short squeeze” on GameStop, among others, and were forced to sell high quality assets to meet ever increasing margin requirements on their short positions or to raise capital to buy back shares to close their short positions. Absent this idiosyncratic selling, Microsoft would most likely have enjoyed a more normal, positive response to these blowout numbers.
Another oddity was from another core holding, Apple (AAPL) which reported the next day, and its numbers were even more impressive. Revenue was a record $111.4 billion for the previous quarter, up 21% from a year earlier, beating consensus estimates by an eye popping $8.5 billion. Profits were $1.68 a share, up 35%. How did shares react? Apple lost 3.5% on the news! Short covering anyone?
It is true that rising inflation and interest rates will lead to margin compression among technology firms, but we are avoiding the profitless cloud software firms selling presently at high multiples that will be more adversely affected by this eventuality. Microsoft and Apple both have impressive top line revenue growth, expanding profit margins, and tremendous and sustainable free cash flow in durable businesses. Those fundamentals will lead to long-term investment success even if their current price vacillates between over and under priced.
In the short run the market is a voting machine susceptible to biases, fear, manipulation, and greed, but in the long run the market performs its true function as the purveyor of the truth and appropriate valuation which ultimately follows earnings power and sustainability. The ultimate day of reckoning for firms like GameStop will be upon us soon, and those left holding the bag will discover the folly of their involvement.
John P. Swift, CFA®, CPA
Chief Investment Officer