Weak Economy Stronger Earnings

In a week that saw the U.S. economy post its largest quarterly contraction in history, the market showed impressive resilience. The S&P 500 gained 1.5% on the week and moved within earshot of the February high. The strength came largely on the back of a slate of blowout earnings reports from the big tech companies. Facebook, Amazon, Apple, and Google posted numbers that shattered expectations, and 3 of the four surged to record highs. The strength of these names was enough to lift the entire index in the face of weakness from a large portion of the balance. This represents a sharp reversal from recent weeks where the mega-cap growth names had been breathing. The action this week further supports our hypothesis that growth is deserving of a premium in the current environment.  

The U.S. economy contracted 34.3% at an annualized rate in the second quarter. The severity of this number was not unexpected, but the slowing pace of recovery is catching some off guard. The bond market and gold prices continue to reflect skepticism about the health of the economy despite the strength of stock indices. We're dealing with rolling shutdowns, an exceptionally high unemployment rate, a bloated fed balance sheet, and a ballooning government deficit. These factors cast a long shadow over the economic growth rate we might expect for the next several years. For stocks heavily dependent on growth in the broad economy, this is worrisome.

However, not every company relies on the broad economy to grow. Those with lucrative avenues for strategic growth are quite valuable by comparison. The power of these types of companies was on full display this week. In the middle of a pandemic with dismal economic growth, these companies are delivering incredible sales and profits. In many cases, the effects of the pandemic are accelerating trends that these companies have been positioning for. After a brief reprise, capital is flooding back into these types of names and raising questions about their valuations. The truth is, it is hard to put a price on growth when it is absent from so much of the market. It is wise to be cautious, but momentum has to be respected.  

This group is obviously attractive, but we are getting more curious about where there could be hidden value. We continue to see a rapidly weakening dollar. For us, this means that U.S. companies with a high percentage of foreign sales should start to do better. A weakening dollar can boost earnings growth from the currency translation. In particular, we see the industrial sector as relatively cheap and highly global. It is a sector to keep an eye on, but we need to see some improvement in the economic story to dive in. 
 

Preston May, CBE®
Research Analyst