Stocks In The Post-Covid World: What Now for Investors?
The United States equity market has bounced back from the Covid-19 shock more quickly than expected. In March, based on an analysis of historical drawdowns of the S&P500, I argued why S&P 500 levels in the 2,400s were good entry points for a long term investor. As of June 5, the market is up roughly 30% and 40% for the S&P 500 and the Nasdaq 100 respectively. While the market indices might grind higher in the next two months, investors might be better rewarded by investing in sectors or companies most likely to benefit from the enduring changes induced by Covid-19.
The major permanent change that is here to stay is the increased virtualisation of everything. Between March 2 and April 14, 2020, virtual urgent care visits at NYU Langone Health grew by 683% and non-urgent virtual care visits grew by an unprecedented 4,345% in response to Covid-19. Universities went online. Many businesses, including the financial system, operated virtually. This will continue, as firms and governments capitalise on the advantages of remote work. The technology during Covid-19 proved ready and easy to use, with some technology stocks tripling in value in less than two months as they establish themselves as virtual communication platforms.
An accompanying change of virtualisation is more ‘localisation’, a reduced emphasis on globally-optimised but vulnerable supply chains, and less physical interaction. People are likely to travel less for some time, especially globally. Businesses will encourage the use of communication technology to limit air travel to essential face to face meetings. Entertainment has been shifting online. Even when we start going to shows, streaming entertainment will dominate.
Implications Of These Changes, And Learning From The Last Crisis
The charts below show us that the market punished companies with large debt and those with large physical assets during the meltdown between Feb 21 and March 18, 2020, when the S&P 500 bottomed. The first chart shows the debt and physical assets to market capitalization ratios as of Feb 21 on the horizontal axis, and the average returns of each sector between then and March 18 on the vertical axis. The second chart shows a similar relationship with physical assets. This makes sense. Companies tend to fund large physical infrastructure with debt. During the meltdown, the market feared whether such companies, like airlines, would have sufficient staying power to service their debt burden if their revenues remained at zero for an extended period of time.
But we have seen the largest ever monetary and fiscal stimulus in history. Knowing that the larger companies will survive, once the herd is culled, will the market still care about the debt burden and physical assets of the survivors going forward? Perhaps it will, but more likely, it will focus on the more permanent supply and demand impacts on the market induced by Covid-19.
During the great financial crisis of 2008, the market most rewarded the hardest-hit companies.
If a stock went from 100 to 20 and another went from 100 to 80, the former did much better on average in the next two years than the latter. While the market also punished heavy debt during the downturn between June 2008 and March 2009—when debt burdens were on average more than double what they are now—the market’s emphasis during the next two years shifted towards growth. Indeed, companies with a debt to market capitalisation of over 50% achieved an average return of 262% between March 1, 2009, and March 1, 2011, compared to 148% for those with a ratio of under 50%. As the chart below shows, the market rewarded the survivors of the meltdown in inverse proportion to their damage during the meltdown. Real estate—the most battered with the average company losing almost 70%—performed off the charts during the recovery with the average company seeing five-fold returns between March of 2009 and March of 2011.
Should We Expect A Similar Outcome This Time?
The one major difference is that virtualisation is likely to keep a damper on commercial real estate, so we are unlikely to see an explosion of commercial REITs like we saw after the financial crisis. Companies realise that technology is ready for remote work, with less need for expensive office space. Data centers will benefit as will technology providers powering virtualisation. Operators of digital platforms and clouds are particularly well-positioned for the new normal. This includes the FAANG stocks, which will gain in market power by growing their platforms, but also have the ability to cut costs through remote work. However, given their already gigantic market capitalisations and strong recovery from the bottom on March 18, our return expectations should be modest but more certain relative to the less established and riskier digital platforms like Zoom. The risk with FAANGs is that society might get fed up with them, forcing policy makers to enact laws that regulate their business models.
Finally, investors would do well to consider the role of the U.S. dollar as the world’s reserve currency. If we do see inflation resulting from the massive stimulus, overseas investors would also do well to not bet against the U.S. dollar for the foreseeable future.
If we see inflation, as is hoped by policymakers, foreign investors could do well by buying gold, which is denominated in U.S. dollars and could provide a hedge against the devaluation of their local currencies.
It is worth recognising that the U.S. capital markets, which account for more than half the world’s market capitalisation, have dominated performance globally in the last decade. Prior to the crisis, some analysts believed that the decade of U.S. dominance in equity markets is over. Post-crisis, however, investors would be wise to reconsider that view. Rather, it is likely that the dominance of U.S. companies, especially in technology and healthcare, will continue. Investors globally should benefit from exposure to the U.S. sectors and companies that further virtualise their business model.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.