One by one they are slaughtering the highest growth stocks, as the bond market signals that better times are ahead.
Remember how the market works: It anticipates -- or at least it tries to anticipate -- the future by looking at all sorts of inputs. It looks at how fast or slow the economy may grow. It looks at how high or low both short- and long-term interest rates are. It looks at how expensive the stock market is, at least certain sectors. It looks at the state of the talks with China.
And then it makes up its mind.
There. That's a simplistic way to look at what we in the financial markets do. It allows us to try to make sense of what is happening.
There's only one problem. This entirely rational set of inputs and outputs is missing a very important ingredient: emotion. Right now, emotion is not being checked at the door. Emotions must be checked, if you are going to be a successful investor.
Let me show you what I mean.
Let's start with Merck (MRK) . For the longest time, we used to call Merck St., Merck. It was the No. 1 pharmaceutical company in the world, with the best research and development. Then, amazingly, Merck spent almost two decades in the wilderness, doing nothing, losing its sainthood for certain.
Then Merck discovered Keytruda, perhaps the most important anti-cancer drug in ages, maybe in history. It did $7 billion in sales mostly with lung cancer, but it is in trials for doing so much more than that. This drug has been doing so much better than a rival drug by Bristol-Myers Squibb (BMY) , that many observers believe that Bristol's been forced to buy Celgene (CELG) , a move that I like, but others have remained quite skeptical about.
The stock has been pretty non-stop, up from $73 in April of last year to $87 a couple of weeks ago. It just dropped ten bucks in two days. Ten bucks! It repealed about half of its gain!
Now, let's look at what happened here. First, did anything happen at Merck? No. Nothing. Nada.
When we think about drugs, we have to think about pricing. Did any politician of either party have anything new to say about pricing? Nope -- all quiet on the pricing front.
So then, what caused the downturn? As best as we can tell, it's a rotation -- a rotation out of companies that do well in an economy going from strength to weakness and poorly in an economy traveling from weakness to strength.
What coincided with the hideous decline in the stock? The weaker non-farm payroll number last week, the one that made it clear that the Fed has room to cut rates again, without looking weak. What happens when rates get cut? The economy gets stronger. What do you do with the stock of a company that does well in weak or strong environments? You sell it, because you want shares in a company that will surprise to the upside when the economy gets better. That sure is not Merck.
Obviously, Merck's Keytruda has about the least amount of price sensitivity imaginable, a life-saving drug doesn't get used less if the economy is weaker or stronger.
So, Merck? Sell, sell, sell.
Now, though, let's go back to the concept of emotion. Merck's stock was in free fall this morning, at one point down $4.5. I think that's because there are people who owned the stock and they panicked, believing that there has to be something very wrong at the company.
I always say no one ever made a dime by panicking, and Merck is a terrific example of that. You know why? Because in the span of two days, Merck went from a somewhat expensive growth stock to an inexpensive stock with a high dividend, almost 3%. Given Merck's strong balance sheet and the paltry 2.18% 30-year treasury, that's an easy choice, especially as every year for multiple years I expect Keytruda to keep growing. It's a bond with upside!
So, buyers came in and stabilized the stock and a bottom was formed. I fully expect that bottom to hold, and if it doesn't, this stock just keeps getting cheaper and cheaper vs. its 30-year treasury, unless interest rates move up dramatically, something I do not expect to happen. That's where I could be wrong -- that and a potential election of U.S. Sen. Elizabeth Warren, an early leader in the polls, although Joe "Status Quo" Biden represents a safety net for drug pricing.
Now this process doesn't work for some of the more expensive growth stocks. The stock of Estee Lauder Companies (EL) , for example, the best of the consumer-packaged goods stocks, got slammed for no reason whatsoever, save that it got too expensive vs. its own history. Same exact story with Mastercard (MA) and Visa (V) , these companies are the best of the best of financial technology, or fin tech; that's technology that grows with or without a strong economy. They are financial momentum stocks, loved by investors who need to show they own something in the financial sector, because it's a big part of the S&P 500, but they don't want the risk of declining earnings or earnings that are made by buybacks and fees offset by a lack of loan growth or loans that aren't that profitable.
On the other hand, investors are itching for something that fits the new image of a stock that could gain when the economy grows in a more robust fashion. A stock, for instance, like that of Citigroup (C) , the cheapest of all banks on a price, nine-times earnings with a 3% yield.
How powerful is this rotation?
At the same time that Citigroup's stock is soaring, Citi is actually telling a story of declining trading in fixed income, commodities, currency and equities. Do you know how much Citi's stock would have fallen if we weren't in the midst of one of the most violent rotations I have ever seen - a rotation with ever-so-higher interest rates that can be extrapolated one day into a stronger economy? The stock just flew up 10%. I think it would have fallen 10%, if it weren't for the rotation.
Finally there is the tale of two retailers: Macy's (M) and Costco (COST) . The former is thought to be performing quite badly, so badly that if something doesn't change soon, like an economy that accelerates enough that shoppers actually return to the mall -- as if that's what it would take for customers to retreat to brick and mortar behemoths -- it might have to cut its bountiful, almost 9% yield. A price-to-earnings multiple of six-times gives you a lot of comfort if things are getting better. The latter, with its incredible revenue stream that comes from cardholders, a stream that's impervious to downturns, and amazingly consistent same-store sales, gives you comfort only if the economy is doing nothing or actually weakening, because who wants to pay an astronomical 35-times earnings, if things could get better fast.
Now, what do you do at home with all of this to-ing and fro-ing?
I think it's all about getting a chance to get in, not to get out. If a stock is down enough, like was the case with Merck Tuesday morning, that's your chance to buy. If a stock rallies to the point of absurdity relative to its own history, as was the case with Merck before the fall, as well as with Mastercard and Costco, you have permission to trim, but only if you can't handle a hammering.
Otherwise, you know what really matters? The quality of the company, not the price of the stock. Merck, Costco, Mastercard, they are the best of the best. Citi and Macy's? They are cheap, but perhaps deservedly so.