Right now the stock market is trying to figure out what direction it wants to go. We know a few things:
- The S&P 500 dropped about 30% from its February highs to mid-March.
- It recovered about two-thirds of those losses in a little over a month with April being the best month ever for the S&P 500.
- The market is seeing significant volatility during the month of May without a clear direction to the up or down side.
- Most bear markets have a series of downturns and counter-rallies before finding a bottom – see here – but is this time going to be different?
Take a quick look at the S&P 500 chart over the last 30 days to see the recent lack of direction in the stock market:
I cannot say (and not too many people can) whether the stock market is going to be significantly up or down over the next few months. We know the following which leads to significant uncertainty over the coming months:
- The underlying economy is in shambles. The Fed chairman, who has access to more data on the economy than we do, basically said he expects the economy to contract by up to 30% in the second quarter and for unemployment to reach 20% during this time.
- The country is starting to reopen but the degree of reopening varies by state and largely depends on who is your governor. We have no idea how strong the recovery will be from these re-openings because it is unclear how people will react and whether the re-openings will lead to the virus re-emerging. My kids and I went to Home Depot on Saturday and that place was packed. We also took a quick inventory of shopping parking lots and there was a steady trickle of business. The pent-up demand seems to be there but will it last?
- Habits are changing. Companies are figuring out that they can probably do with less office space; some workers are discovering they make more money being unemployed than they do going back to work; people are learning to spend more time at home. How many of these habits stick will determine how quickly the economy recovers and what it looks like after this is all said and done.
- The therapies and vaccines for this virus are being worked on at rapid speed, tons of money is being thrown at them, we are having some promising early results, but even with the resources being applied to find a vaccine it would be hard to imagine a vaccine being available before next year. These things can only move so fast. I worked in this sector for about five years and saw how long it takes to progress drug development (and manufacturing). Most of these early promising results for a vaccine are not the results needed to get a drug approved. The larger phase 2/3 trials are next and that is where a lot of drug candidates fail.
- The Fed has done a lot but it cannot solve the solvency issues coming our way. The Fed is doing its job to make sure money is available to loan at low interest rates to move forward investments and other types of spending. The majority of their tools are already being used to keep financial markets working but they cannot create jobs or keep businesses out of bankruptcy if the economy remains closed or spending does not come back once we are allowed out of our house again or businesses decide not to invest. Congress needs to be responsible for any government assistance to help stimulate the economy.
- Quick and efficient bipartisan legislation to fight the economic damage from the virus and stimulate the economy is not coming anytime soon. Congress took immediate action to prop up the American consumer and small businesses when this all started but any subsequent legislation to help the economy will be less forthcoming. The House passed a version of legislation, the Heroes Act, but it is not going to go anywhere unless significant changes are made by the Senate and accepted by the House. Additional, meaningful, legislation to support the economy seems unlikely in the near-term. We are getting closer to November elections so don’t expect your Congress to continue to act benevolently and in favor of the country.
Okay, so what does that mean? Making a decision on stocks based on the stock market going up or down over the next few quarters seems like a flip of a coin right now. Some legendary investors have come out recently and said the market looks way to expensive compared to how the economy is performing and the risk-reward equation has never been worse for investors holding stocks. However, days like today, with early promising data from a drug vaccine candidate, shows that if some of these questions break in a positive way then we could be in for another stock market run.
What are we to do?
I am taking a longer-term view. I have reshaped my dividend portfolio a bit to favor (1) sectors that will be winners in the next 10 years and (2) the highest quality companies within those sectors. Let’s take Real Estate Investment Trusts (REITs) as an example.
I love REIT stocks. They have seen an average annual return of approximately 9% over the last 15 years (which includes the 2008 Great Recession) and you get cash dividends along the way. Here are some facts on REITs:
- During the financial crisis, most REITs saw significant declines in 2008 and 2009.
- Following the financial crisis, REITs were the top performing asset class in 5 of the next 10 years and performed well during the other years from 2010-2019.
- REITs have not performed well since the COVID-19 crisis. In fact, many REITs are still down 20%-70% and on average REIT stocks are trading at a 25%-30% discount to the value of the assets they hold. How significant the decline is based on the sector.
- REITs tend to do well over time in low interest rate environments. Also, REITs own assets, property, that tend to go up in value when the money supply is increased (think QE and all the money printing that is happening and going to happen over the next few years).
If REITs struggled during the financial crisis, and then saw record growth for the next ten years, and they are struggling now, does that mean pile into these assets right while they are selling at a discount and expect more growth down the road? Yes and no.
This is where understanding the sectors that have long-term momentum behind them matters. There are going to be winners and losers from this crisis and that includes sectors within REITs. This is more so now than during the financial crisis. The average investor can understand long-term trends if they do enough research.
The Losers with Uncertainty Regarding Their Future
Retail properties: Retail properties were getting smacked around by e-commerce before this pandemic started and they are getting annihilated by it now. Retail tenants are filing for bankruptcy seemingly every day and anchor tenants (think Macy’s, Nordstroms, Neiman Marcus) that were once investment grade tenants are going to be gone or severely injured from this experience. New rules around seating capacity, etc. for restaurants and theatres, which may be long-term, are going to drive down profits for those retail tenants and in turn those tenants will require a change in the rent they pay. The best retail REIT operators, think Simon Property Group, kept their malls profitable by turning malls into areas to gather, eat, see a movie, and perhaps do some shopping. They had large tenants in restaurants, move theaters, and brand name retailers. It is unclear whether that model works going forward and if it does not what does a mall have to offer over e-commerce? There is no easy recovery for retail REITs and in 10 years they are likely long-term losers. There may be some niche plays with “essential” stand-alone retail (think shopping centers with a large grocery store) but even these shopping centers will see a lot of their smaller tenants default and go bankrupt over the next year. It will take time to rebuild those missing tenants.
Senior housing: There was an oversupply of senior housing before this crisis hit and now no one wants to put their grandparents in these places. Stigma associated with these properties is likely to last for a while but long-term demographics (meaning an increasing number of seniors) could help the sector recover in the long run. It could take years though and it is in no way a guaranteed winner over the next few years.
Hospitality: Hotel stock prices are perhaps performing the worst but they will also likely significantly recover after a vaccine is available. Business travel may go down but people want to travel in some capacity. The question is how long will the suffering of hotels endure? It could be 1 year, it could be three years, we are not sure but it should happen at some point. If you invest in this space you want to pick the company with the strongest balance sheet to survive the worst-case scenario. There could be clear losers in this space.
The key here is none of these sectors have clear momentum on their side even when the pandemic is over.
The Question Marks
Office: There was also a lot of office space and vacancy rates were increasing before the pandemic hit. This sector is a wild card because if major companies have significant swaths of their employees begin to permanently work from home then office vacancies will rise further and office rents and profits will fall. High-rise offices, with a model that has everyone going up and down a few elevators, may need to re-work things such as how to get to your office which will not be easy. This sector, although the stocks have been beaten down, has a lot of question marks swirling around it.
Multi-Family: I am investing in multi-family so I think it will be a winner. If anything, stay-at-home orders have made people value their homes even more and the last thing people want to do right now is move or get kicked out of their place. April and May rent collections have remained surprisingly high and it will be interesting to see how many people continue to pay their rents if the economy continues to struggle mightily. Moratorium on evictions won’t last forever and I think renters do not want to be on the eviction list when evictions are allowed again. However, the wild card is how state governments react to this crisis in the long-run when it comes to landlords and their ability to raise rents. There is a growing cry for putting rent controls in place and this could be part of the solution proffered by tenant friendly states to deal with the longer-term affordable housing issue. If large markets like San Francisco, Los Angeles and New York use this crisis as an opportunity to build in rent controls then these REIT stocks may not see the rebound you would otherwise expect to see from them. No rent increases means slowing profitability for these REIT stocks.
The key here is these sectors may not have their momentum on their side due to potential changes caused by this pandemic.
The Clear Winners: REITs that Support Technology
This crisis has accelerated e-commerce and the need for reliable technology. It has also shown that technology companies perform well in both a pre and post pandemic environment. When it comes to REITs, the long-term winners are clear:
The Cell Towers: 5G is coming and it will need cell towers to support its growth. The cell tower stocks have not suffered like many other REIT stocks but they have still seen a 15%-20% drop in price. Most experts are expecting the transition to 5G to be a 10 year process which basically means these tower stocks are supporting an inevitable shift that will see at least a decade of growth. There are three to four cell tower stocks to choose from but all of them should benefit from the strong sector growth over the next decade. My favorite is American Tower (AMT) – you should review its financial filings to get a better understanding of what it owns and what it does.
The Data Centers: A data center is a facility that centralizes shared IT operations and equipment for the purposes of storing, processing, and disseminating data. With technology being the clear winner of the post-pandemic world it will continue to need growing infrastructure to store, process and disseminate the growing amount of digital data this world creates. Data centers should benefit immensely over time from this long-term trend towards technology and data. The pandemic has only accelerated people’s adaption of technology in their daily lives and data center REITs will benefit from it. Check out Digital Realty (DRL) to better understand these data center REITs.
Industrial Warehouses Supporting E-Commerce: It seems like an Amazon, DHL, or postal truck is dropping off a package in my neighborhood every fifteen minutes. Guess what? Amazon and other e-commerce companies need super-efficient logistical operations to get those products to people in short periods of time. That’s where REITS that own industrial warehouses that support these logistical supply chains come into play. The growth in this sector has been happening for a while but it should be a growing sector for years to come. These industrial REITs have seen 10-15% discounts due to COVID but so far their rent collections have not been impacted and the long-term trends support a robust and growing sector for these companies. Take a look at Prologis (PLD) as an example of this type of REIT.
It is really hard to predict what is going to happen over the next few months when it comes to the market. Also, for some industries, like office properties for REITs, it is hard to predict how they will be negatively impacted from behavioral changes brought on by this pandemic. However, for some industries it is clear there is a long-term upward trend that has been accelerated by COVID-19. Picking long-term winners seems a lot easier to do right now if you think about the bigger trends facing this world.