Are Stocks Melting Up? Plus, the Pet Economy Has Legs

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Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Jonathan Golub. He's the chief US equity strategist at Credit Suisse. I asked him whether he thinks the rapid rise in stock prices looks out of control. Is this a melt-up? His answer in a moment. We'll also hear from the CEO of a company whose shares were recently up more than 20% year to date. Kristin Peck runs Zoetis, which makes medicine for animals. It's benefiting from all the attention that those of us who are working from home have been lavishing on our pets. Listening in is our audio producer, Meta. Hi, Meta.

Hey, Jack. I'm really excited about this episode. Lots of animal sound effects.

Oh, right. A lot of opportunities there. Yep.

We're going to have some quacking. We're going to have some barking. I'm gonna say all the animal sounds in Danish.

I can't wait. You know what, drop some barking in the stock part if you're really feeling it. I mean, don't feel like you have to wait. Okay. First, let's look at stocks. Since March 23rd, when US stocks hit their pandemic low point, the S&P 500 has returned about 50%. That's 4 to 5 years' worth of typical returns. Crammed into less than 5 months. And we're now on the cusp of the index hitting an all-time high. That's astonishing considering the state of the economy. I mean, it's showing signs of recovery, but it's nowhere near back to where it was. For example, over the past 3 months, we've added back millions of jobs that were lost during quarantining. But if you look at the past 6 months as a whole, we're still down close to 13 million jobs. That's the biggest decline in records going back more than 80 years. Lately, I hear people talking about whether stocks are in a melt-up. We're in the midst of a liquidity melt-up.

You know, we're kind of unhinged from reality in a little way here, right? The economy is slowing down. It's— we're lurching in and out of COVID yet the tech market makes new highs every day. Tesla's up 10%. That's a classic speculative bubble.

The valuations are now stretched for growth relative to value stocks wider than it was at the peak of the tech bubble. Well, that was the biggest global bubble in history. A melt-up is where stock prices rise too quickly. It's one of those terms like bubble. There's no formal definition that tells you how fast is too fast for prices to be rising, but sometimes you know it when you see it. We've spoken on this podcast before about Zimbabwe and its history of hyperinflation. A stock index there, the Zimbabwe Industrial Index, recently traded at 8 times its level from a year ago. And that's not because of a booming economy. The economy is shrinking. Basic goods there are in short supply. But in June, consumer prices were up 737% from a year earlier. The government has made using foreign currency a punishable offense. Locals with savings would clearly rather pay any price for shares of businesses than leave money sitting in Zimbabwe's currency, so stock prices have soared. The US, of course, is nothing like Zimbabwe. Consumer prices here were up only 1% in July from a year earlier. So is melt-up really the right term for folks to use to describe what's going on here? As with many things now, the matter is made more complicated by election-year politics. President Trump has spoken proudly about the rising stock market.

So I was telling you that the Dow Jones and the S&P 500 are now 50% above the March level. NASDAQ is setting new records. It's already broken the record.

To the president's supporters, a rising stock market is a sign of confidence in his policies. His detractors would probably agree more with how the president himself described the market back in 2016, months before he was elected president.

Believe me, we're in a bubble right now, and the only thing that looks good is the stock market. But if you raise interest rates even a little bit, that's going to come crashing down.

Back then, interest rates were plenty low. The Federal Reserve had its core Fed funds rate at just over 1%, but now the rate is even lower, close to zero. Back then, stock prices looked a little high. The S&P 500 traded at 17 times earnings, but now the index trades at about 26 times earnings. I know that's using this year's earnings estimate, and earnings are depressed this year, but even if we use last year's record earnings The index still trades at close to 21 times earnings. To be honest, I'm not sure whether I find President Trump or candidate Trump more persuasive on stocks now. That's why I stink at politics. Too little certainty about unknowable things. For a fresh perspective on what to make of the market's recent rise, I called Jonathan Golub. Hi, it's Jack Howe from Barron's. How are you?

I'm great, Jack. What's going on?

Jonathan is the chief U.S. equity strategist at Credit Suisse. I jump right to the point and asked him whether U.S. stocks are in a melt-up.

I think that what we need to look at is not the rate of change in the value of stocks. So don't look at the return and ask ourselves a longer-term question, which is what are stocks worth in the environment that we find ourselves in today? And what are the inputs in our process today, which looks dissimilar to what they would've looked like 6 months or a year, you know, ago or something like that. Let's call it pre-crisis. And the biggest change is that the discount rate for stocks has collapsed.

Now, discount rate is a simple term for a complex explanation of a simple thing, whether a stock or other asset is a good deal. Basically, the price investors are willing to pay for an investment depends a lot on what they could get on a different investment that carries virtually no risk and whether they're being fairly compensated for the risk of this investment. When Jonathan says the discount rate has collapsed, he means two things have come down a lot. One is interest rates. The 10-year Treasury started the year yielding 1.9%, but it recently yielded closer to 0.6%. The other thing is worry over risk, and we can measure that by looking at how much more risky bonds yield than Treasuries. That's called the credit spread. Credit spreads widened a lot during the early days of the pandemic when investors feared many companies would fall into financial distress. Then credit spreads came back down once it became clear that the Federal Reserve was willing to act very aggressively to buy risky bonds. Even junk bonds, to counteract investor panic, and that Congress was willing to spend to make up for lost economic activity. Any pets out there see where I'm going with this? Thank you, Meta. Put it all together, and saying the discount rate for stocks has collapsed means investors are drawn to stocks because bonds look worse and because risk seems contained. That helps explain the disconnect between stocks and the economy. Here's Jonathan.

If you look at all of those realities and then say, how is it possible that the market can be basically at peak levels? You would say that that's insane. It doesn't make any sense. And then on the other hand, what you have is really tremendous confidence that the government has an almost unlimited wallet to be able to make sure that the damage from this is mitigated.

There's another factor that helps explain why stocks have done so well. Thriving tech companies like Apple, Microsoft, Alphabet, Amazon, and Facebook make up a growing portion of the S&P 500 index.

Something in the ballpark of 23% of the market is made up of 5 tech names. That are extraordinarily successful. So they're not doing well in their stock performance because speculative money is going in there and there's a speculative frenzy. They're literally out-earning everybody else around them.

I'm not sure whether all that tech dominance makes me feel better or worse about the rising stock market, but it means indexes don't give the full picture of corporate America, to say nothing of the economy.

Now, if you look at the average company in the S&P, it's not recovered. If you look at value stocks, not recovered. Small cap, not recovered. Non-US, not recovered. And so if you look at Nasdaq, you really do get a skewed view of the world that as opposed to one where you say, what is the average company doing, which is not nearly as healthy.

So we have this small group of privileged companies that are growing their earnings quickly. Most of the market is not growing its earnings nearly as fast. But how long will it take for the index as a whole to get back to last year's record level of earnings? The consensus view on Wall Street is that companies will set a new record on earnings next year. Jonathan thinks it might take a little longer.

Our work says that it's probably going to be longer, something closer to 2.5 to 3 years. If we go back to every recession going back to 1937, It's taken on average 2.5 years to get back to peak earnings. So, that's average. And yet, if you take a look at the last, let's say, the financial crisis, it took over 4 years to get back on earnings. If you look at the 2001-2002 recession, it took over 3 years. So, if we were to get back to peak earnings in 2 years, we will have had tens of millions of people lose their jobs. This would've been a quicker recovery than anything we've seen in 30 years. It just seems like it's gonna take a little bit longer.

Okay, so Jonathan doesn't see a melt-up. He sees a stock market where prices can be explained by the backdrop of low interest rates and aggressive intervention by policymakers and by the presence of a handful of thriving tech giants. But does that mean stocks are still an okay deal? Or should a typical investor with 60% in stocks and 40% in bonds consider selling stocks. Jonathan says stick with stocks, but that it might not be easy if you struggle like me to hold back your inner cheapskate. Jonathan says he expects stock prices to remain high relative to earnings. The long-term average price level for the U.S. stock market, it's around 15 times earnings. Earlier I said that stocks recently traded at 26 times earnings, Jonathan says they might stay that expensive for the foreseeable future, and that if so, investors will have to accept that if they want to be in stocks.

So I think for the next decade, we're going to live with stock multiples in the mid-20s, even though that seems historically very, very high. And that is going to be really uncomfortable for professional investors because if the economy is weaker, We may have 3 or 4% earnings growth, and yet we could have a 25 stock multiple, and people are going to say that's crazy.

People will say that. I'm saying it now. Prices look crazy, but I'm not selling out of stocks. My rough plan is to keep saving, stay diversified, and whine about valuations to anyone who'll listen. Let's talk about the pet economy. I got a dog last year. Meta, you've seen a picture of my dog, right? Ginger?

Yeah, I've seen a picture.

She's very cute. Yeah, I got her from the pound. I mean, I went down there, I gave them whatever it was, $250, $300, they gave me a puppy. But I think if you get a dog from the pound, people say you rescued the dog, right? Am I entitled to say that I rescued a dog?

I think so.

And if I rescued a dog, I guess that kind of makes me a hero, right?

I think you're pushing it a little.

Okay. All right, well, I got a dog anyhow. And I had a dog growing up, but these days there's this elaborate moral framework surrounding pet ownership, and if you make a misstep, you can really draw scorn in a hurry. When I got my puppy, She's a lab mix. I stopped at the pet shop on the way home and I said to the clerk, "Hey, do you have any Milk Bones?" And it was like the scene in an old western where the piano player stops playing and everyone turns to look. He goes, "Uh, we don't use those anymore." And he handed me something called a Bully Stick. He said, "This is what I recommend." I don't know what made me sniff it like a fine cigar, but then he told me what part of the bull a Bully Stick is made from and I feel like I haven't been able to unsniff it since. My wife buys the dog food now, and from what I can tell, all dog snacks these days are horrifying animal parts. The other day I reached into a paper bag on the top of the fridge and I felt what I thought was the last of a batch of homemade tortilla chips. It was a pig's ear. I think I'm off chips for a while. People spend a lot more on pets than I remember. When I was a kid, we fed our dog a knockoff of a popular dog food at the time called Gainesburgers. It was shaped like hamburger patties, only it didn't need refrigeration. Now my wife says Ginger is on a raw food diet. The food takes up like half a shelf in my refrigerator. I looked at one of the cartons and the first ingredient was organic chicken. The price worked out to about $5 a pound. I'm pretty sure that's more than the chicken I eat costs. My wife says she adds a little quinoa and kale for fiber. I don't know how much that stuff costs. The pet business is booming even during the pandemic. A stock index called the FactSet Pet Care Index is up 26% so far this year. That includes not just food makers but also pet healthcare companies. This past week, Ginger went to the vet for shots. The bill was $228. Anyhow, I read a report from ProShares which has an exchange-traded fund that tracks the Pet Care Index. The ticker is PAWZ, that's P-A-W-Z. The report said that in a survey, almost 3/4 of pet owners said that having a pet was helping to reduce their stress during the pandemic. Only 15% said current economic conditions had made them spend less on their pets, while 21% said they're spending more. Most said they're spending the same. Meanwhile, pet adoptions are up. To learn more about the state of the pet economy, I spoke recently with Kristin Peck, who runs Zoetis, a big maker of pet medicines. Hi, Kristin, it's Jack Howell from Barron's.

How are you?

Hey, Jack, how are you?

Doing well, thanks. Zoetis went public in 2013. It was spun off from the drug giant Pfizer. Kristin has been with the company since the spinoff, but became chief just this year. Zoetis makes about half its money from treatments for pets and the rest from treatments for livestock. In the company's most recent quarterly report, revenue for the pet business was up while the livestock business was down. I asked Kristin first about what she was seeing in the pet business.

Maybe 50 years ago your dog was in your backyard, you probably gave it a certain level of care, then your dog moved into your house, you gave it more care, and now it sits on your bed. So we said once the dog got to your bed, you're going to pay a lot more attention, and now you're home 24/7 with that dog or that cat. So I do think that's a lot of it is people are noticing more things about their pets, but they're also adopting more pets. You know, we're really grateful that the shelters are, you know, almost empty across the country. People are looking for companionship.

New products contributed to revenue growth during the quarter. One of these is called Simparica Trio. It combines a flea, tick, and heartworm medicine in a monthly chewable that makes it easy for dog owners to stick with their regimens. Kristin also says dermatology products sold well, and that dogs can get atopic dermatitis, or what people call eczema.

I certainly had two dogs who had it, and you know, it sure drives your dog crazy because they scratch and they lick, lick, lick. It is quite frustrating. So we came out with the first product for it a few years ago called Apoquel, and followed up with a monoclonal antibody, which is a biologic, so an injectable. That lasts longer and has, you know, great efficacy.

Monoclonal antibodies. Regeneron is in that business. We've had their CEO on this podcast. It turns out that Zoetis has a research agreement with Regeneron. Now, Kristin says that looking beyond the pandemic, the long-term outlook for pet healthcare is strong, in part because pets might be substituting for babies.

People often having fewer children globally, they're investing more in the pets, whether that's depending on geography, a dog or a cat. The macro trends are strong. And what you've seen with Zoetis is we've been growing faster than the market because of our innovation and a number of new products that I spoke about, but the macro drivers for just the companion animal market are very strong.

Zoetis shares, ticker ZTS, have multiplied 6 times in price since the IPO 7 years ago. They trade at an ambitious 45 times this year's earnings forecast. Wall Street expects earnings to grow at double-digit percentages in each of the next 2 years. Not every part of the business is thriving at the moment. Zoetis' livestock division has been hurt by disruption in how people eat because of the pandemic. Fewer steaks at restaurants, more chicken at home. The supply chain has had to adjust. Here's Kristin.

We run in the U.S. a very efficient food supply. So when you move to packing capacity from 100% to 95%, you back up animals, and it was very challenging for our customers. And, you know, in animals that live a long time that, you know, are really large, like, you know, cattle or pigs, it's gonna take a while to work through that inventory.

What's interesting is that Zoetis makes most of its livestock money outside the U.S., and revenues there grew. I asked Kristin about all the new meatless burgers I keep hearing about. Veggie burgers used to look and taste like satan falafels. The new ones like Impossible Burger and Beyond Burger could almost pass for meat if you're eating them in a hurry, which is how I eat burgers. I'm not a convert, but I wonder if meatless burgers could cut into the livestock business. Unlikely, says Kristin.

I think that, you know, the trend obviously for a lot of people trying and experimenting with some of these new alternative proteins, it's growing fast, but it's still very small. And the macro trends that you reference, which is a growing middle class, certainly if you look around the world, people will be eating and drinking more protein, milk, et cetera. So if you look at the projections over the next 10 to 20 years for protein growth, it's 1 to 2%. So we don't see that as a significant headwind for us in our livestock business. Livestock has traditionally in animal health grown around 5%. It's certainly been a little less in the last year or two, but we expect with innovation and hopefully the end of COVID it returns to those levels.

Meta, do we have a listener question that will shock and amaze and inform and delight in that order, if we can?

Yeah, no pressure, but we do have a question on so-called SPACs from a listener in California.

Let's hear it.

Hey, Jack, this is Chip from San Ramon, California.

I've been a fan of your podcast since day one. I have a question regarding the special acquisition vehicle that Bill Ackman just IPO'd. Can you educate us exactly on how that works? Great question, Chip. SPAC, that's S-P-A-C, stands for Special Purpose Acquisition Company. Picture going into a restaurant and saying, I don't know what to order, but I've heard good things about the chef. Just have him or her cook me up something yummy. You might get a delightful surprise. You hopefully won't get blue cheese ice cream with a cod liver oil drizzle, but you might get something you're not crazy about. With SPACs, investors buy into a stock offering for a cash-filled shell company with the understanding that it will soon buy a yet unnamed private company. SPAC offerings are booming this year. They're outpacing regular initial public offerings. You mentioned Bill Ackman. He's a hedge fund investor who launched the biggest ever SPAC in July called Pershing Square Tontine Holdings. Barron's spoke with Ackman recently for a cover story. He said, "We're a unicorn looking to marry another unicorn." That's another way of saying he wants to buy a large, fast-growing, privately held company. So why are SPACs popular? I think some investors who might not be able to get in on a hot initial public offering like the idea of getting in on the ground floor with a SPAC, even if they don't know what it is they're getting in on the ground floor of. I think private companies looking at a rocky stock market, if they want to go public, sometimes like the idea of doing that by selling to a SPAC. It means that they don't have to take the chance of running an initial public offering on their own and having it turn into an embarrassing flop, which sometimes happens. But mostly I think investors are interested in SPACs now for the same reason that they're interested in a lot of things. They're going up. For example, there have been wild price gains for SPACs that bought the electric truck maker Nikola and the bookmaker DraftKings earlier this year. That generates excitement for future SPACs and it keeps money flowing, and ultra-low interest rates don't hurt. If your question is, should you buy a SPAC, Chip, my answer is only if you're looking for a little financial adventure in your life, but not as a core strategy for your portfolio. I like steak and I like Spam, but I don't like ordering a meat to be named later. Thank you, Chip, for sending in your question, and everyone, please keep the questions coming. Just tape on your phone Use the voice memo app. Send it in an email to jack.hough@barons.com. Thank you for listening. Meta Lutzhaft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhough. H-O-U-G-H. See you next week.

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