The
widely-held mega-cap stocks that dominate the US markets are just
wrapping up another blockbuster earnings season. Sales and profits
soared largely due to Republicans’ massive corporate tax cuts.
Still these lofty stock markets are vulnerable to serious downside,
as October’s brutal plunge proved. Such extreme revenue and
earnings growth cannot persist, and valuations remain in dangerous
bubble territory.
Four
times a year publicly-traded companies release treasure troves of
valuable information in the form of quarterly reports. Required by
the US Securities and Exchange Commission, these 10-Qs contain the
best fundamental data available to investors and speculators. They
dispel all the sentimental distortions inevitably surrounding
prevailing stock-price levels, revealing the underlying hard
fundamental realities.
The
deadline for filing 10-Qs for “large accelerated filers” is 40 days
after fiscal quarter-ends. The SEC defines this as companies with
market capitalizations over $700m. That currently includes every
stock in the flagship S&P 500 stock index (SPX), which includes the
biggest and best American companies. The middle of this week marked
38 days since the end of Q3, so almost all the big US stocks have
reported.
The
SPX is the world’s most-important stock index by far, with its
components commanding a staggering collective market cap of $26.1t
at the end of Q3! The vast majority of investors own the big US
stocks of the SPX, as some combination of them are usually the top
holdings of nearly every investment fund. That includes retirement
capital, so the fortunes of the big US stocks are crucial for
Americans’ overall wealth.
The
major ETFs that track the S&P 500 dominate the increasingly-popular
passive-investment strategies as well. The SPY SPDR S&P 500 ETF,
IVV iShares Core S&P 500 ETF, and VOO Vanguard S&P 500 ETF are among
the largest in the world. This week they reported colossal net
assets of $265.5b, $164.9b, and $101.5b respectively! They were
naturally even larger at the end of Q3 before October’s carnage.
Every quarter after earnings season it’s essential to review the big
US stocks’ latest results to see how they’re faring fundamentally.
Their quarterly reports offer the best and latest fundamental data,
and considered as a whole provide many clues on likely near-future
stock-market trends. And since the SPX hit new record highs in late
Q3 before plunging in early Q4, these latest results may prove a
critical inflection point.
While I’d love to analyze all 500 SPX stocks each quarter, my small
financial-research company lacks the manpower. Support our business
with enough newsletter subscriptions, and I’ll hire the people
necessary to do it. For now I’m digging into the top 34 SPX/SPY
components ranked by market cap. That’s simply an arbitrary number
that fits neatly into the tables below, but it happens to be a
dominant sample of the SPX.
At
the end of Q3, these 34 elite American companies alone accounted for
a colossal 43.4% of the total weight of the S&P 500! Their
enormous total market cap of $11.3t equaled that of the bottom 436
SPX companies. So the big US stocks’ importance to the entire stock
markets cannot be overstated. They are the mighty engine driving
overall stock-market performance, dragging everything else along for
the ride.
Every quarter I wade through the 10-Q SEC filings of these top SPX
companies for a ton of fundamental data I dump into a spreadsheet
for analysis. The highlights make it into these tables below. They
start with each company’s symbol, weighting in the SPX and SPY, and
market cap as of the final trading day of Q3’18. That’s followed by
the year-over-year change in each company’s market capitalization, a
key metric.
Major US corporations have been engaged in a wildly-unprecedented
stock-buyback binge ever since the
Fed forced
interest rates to deep artificial lows during 2008’s stock
panic. Thus the appreciation in their share prices also reflects
shrinking shares outstanding. Looking at market-cap changes
instead of just underlying share-price changes effectively
normalizes out stock buybacks, offering purer views of value.
That’s followed by quarterly sales along with their YoY changes.
Top-line revenues are one of the best indicators of businesses’
health. While profits can be easily manipulated quarter-to-quarter
by playing with all kinds of accounting estimates, sales are tougher
to artificially inflate. Ultimately sales growth is necessary for
companies to expand, as bottom-line profits growth driven by
cost-cutting is inherently limited.
Operating cash flows are also important, showing how much capital
companies’ businesses are actually generating. Using cash to make
more cash is a core tenet of capitalism. Unfortunately many
companies are now obscuring quarterly OCFs by reporting them in
year-to-date terms, which lumps in multiple quarters together. So
these tables only include Q3 operating cash flows if specifically
broken out by companies.
Next
are the actual hard quarterly earnings that must be reported to the
SEC under Generally Accepted Accounting Principles. Late in bull
markets, companies tend to use fake pro-forma earnings to
downplay real GAAP results. These are derided as EBS earnings,
Everything but the Bad Stuff! Companies often arbitrarily ignore
certain expenses on a pro-forma basis to artificially boost their
profits, which is misleading.
While we’re also collecting the earnings-per-share data Wall Street
loves, it’s more important to consider total profits. Stock
buybacks are executed to manipulate EPS higher, because the
shares-outstanding denominator of its calculation shrinks as shares
are repurchased. Raw profits are a cleaner measure, again
effectively neutralizing the impacts of stock buybacks. They better
reflect underlying business performance.
Finally the trailing-twelve-month price-to-earnings ratios as
of the end of Q3’18 are noted. TTM P/Es look at the last four
reported quarters of actual GAAP profits compared to prevailing
stock prices. They are the gold-standard metric for valuations.
Wall Street often intentionally obscures these hard P/Es by using
the fictional forward P/Es instead, which are literally mere guesses
about future profits that often prove far too optimistic.
These are mostly calendar-Q3 results, but some big US stocks use
fiscal quarters offset from the normal ones. Walmart, Home
Depot, Cisco, and NVIDIA have quarters ending one month after
calendar ones, so their results here are current to the end of July
instead of September. Oracle uses quarters that end one month
before calendar ones, so its results are as of the end of August.
Offset reporting ought to be banned.
Reporting on offset quarters renders companies’ results way less
comparable with the vast majority that report on calendar quarters.
We traders all naturally think in calendar-quarter terms too. As of
the middle of this week, Disney hadn’t yet reported its Q3 results.
That’s when its fiscal year ends, and the larger, more-complex, and
audited 10-K annual reports required by the SEC aren’t due until 60
days after quarter ends.
Stocks with symbols highlighted in blue have newly climbed into the
ranks of the SPX’s top 34 companies over the past year, as investors
bid their stock prices and thus market caps higher. Overall the big
US stocks’ Q3’18 results looked utterly magnificent, with
both revenues and earnings soaring under this new
slashed-corporate-taxes regime. But ominously many valuations
remained at dangerous bubble levels.
From
the end of Q3’17 to Q3’18, the S&P 500 rallied 15.7% higher. These
are certainly strong gains impressive in their own right. But its
elite top 34 component stocks really outperformed, pulling up the
rest of the index. Their market caps blasted an incredible 24.2%
higher YoY on average! Without their outsized gains, the SPX
would’ve been heavily muted at best. Market breadth really
continued to narrow.
Extreme narrowing breadth is a telltale sign of a very-late-stage
bull market. And the main cause was the vast flood of capital into
the market-darling mega tech stocks, which have long dominated the
entire US stock markets. The FANG names are the most famous,
Facebook, Amazon, Netflix, and Alphabet which used to called
Google. Apple and Microsoft also belong in those rarified ranks of
wildly-popular beloved techs.
As
of the end of Q3, AAPL, AMZN, MSFT, GOOGL, and FB were 5 of the 6
largest US stocks in market-cap terms, topping the SPX’s ranks.
They alone accounted for a mind-boggling 16.3% of the weighting of
this entire index! Add in NFLX, and that swells to 17.0%. Just 6
stocks commanding over 1/6th of the S&P 500’s entire
collective market cap is extreme by any measure. This is a grave
risk to the whole markets.
By
late September the SPX had powered 333.2% higher over 9.5 years,
making for the 2nd-largest and 1st-longest stock bull in US
history. The mega techs led the way. Way back in March 2009 when
this monstrous bull was born, MSFT, GOOGL, AAPL, and AMZN clocked in
at 5.4% of the SPX’s entire weighting. FB and NFLX hadn’t yet been
added to the S&P 500 then. So mega techs’ relative footprint
tripled.
Ever
more capital was crowding into fewer and fewer stocks, with fund
managers chasing the winners and increasingly piling into them.
Ignoring their lofty stock prices relative to their underlying
profits, the fundamentals seemed to support that buying frenzy. In
Q3’18 these half-dozen mega techs reported unbelievable average
sales growth of 26.0% YoY! That shouldn’t even be possible
given their colossal sizes.
That
trounced the good 8.3% annual revenue growth seen in the rest of the
top 34, making the mega-tech love affair seem righteous. Overall
these big US stocks saw average sales growth of 11.5% YoY, which was
skewed higher by the mega techs. I’ve seen countless fund managers
on CNBC arguing that these stocks’ extreme revenue growth justifies
buying them at any price. But it isn’t sustainable at such a
torrid pace.
The
math itself is damning. At 25% annual growth, sales would double
every 3 years or so. And these 6 beloved mega techs are already
huge, with average Q3 revenues of $33.3b! They can’t keep doubling
and doubling without gobbling up the entire US economy, which
obviously can’t happen. I also suspect their crazy sales growth is
a function of euphoric spending driven by record stock
markets and corporate tax cuts.
This
has fueled epic levels of optimism about the future, and thus
abnormally-outsized levels of spending from both individuals and
businesses in recent years. That’s greatly goosed sales across the
entire stock markets. But once these stock markets inevitably roll
over, euphoria will fade forcing spending to quickly mean revert
lower. Much of this buying binge was financed by enormous new
borrowing as well, a big problem.
With
interest rates inexorably rising as the Fed keeps hiking, both
consumers and corporations will lose their desire and ability to
keep piling on new debt. That will weigh on spending, and slow it
significantly if they start diverting some income to pay down their
increasingly-expensive debt. That portends far-slower
corporate-sales growth or even shrinkage ahead, killing the
sentiment-driven anomaly of 25%+ in mega techs.
Unfortunately half of these big US stocks didn’t break out their Q3
operating cash flows, instead lumping them into year-to-date
numbers. While Q3 can be backed out by subtracting their Q2 YTD
numbers, I left the non-reported OCFs blank in these tables. But of
the 17 of these elite companies reporting them in Q3, the average
growth was 20.6% YoY. The 5 mega techs ex-Netflix did way better
averaging +43.5%!
Earnings naturally amplify sales trends, leveraging any growth. So
with big US stocks’ revenues surging on the unbridled optimism from
record-high stock markets and big corporate tax cuts, profits
should’ve soared in Q3. And they did, with breathtaking annual
growth averaging 53.8% in these elite companies! That is
again being widely used to justify buying mega tech stocks at any
price, ignoring their valuations.
Interestingly the bifurcation between those half-dozen
market-darling tech stocks and the rest of the SPX top 34 was much
narrower than in sales. The mega techs’ earnings rocketed up 64.5%
YoY on average, a stupendous gain. Yet the rest of the top 34
weren’t far behind averaging 51.7% YoY. That’s mere 1.2x
outperformance by the mega techs, compared to 3.1x in sales growth.
Why didn’t their earnings grow more?
But
that 51.7% for the rest of the top 34 is skewed. Warren Buffett’s
famous Berkshire Hathaway, which is the largest non-technology stock
in the SPX, reported a gargantuan $18.5b profit in Q3 soaring 356%
YoY! But nearly 4/5ths of that resulted from investment gains which
aren’t normal earnings. Ex-BRK, the rest of the top 34 outside of
those half-dozen mega techs had average profits growth of 39.0% YoY
in Q3.
That
raises the mega techs’ outperformance to 1.7x, which remains way
short of their 3.1x sales growth. They only grew profits 64.5% on
26.0% sales growth, while the rest of the top 34 saw profits rise
51.7% on mere 8.3% revenue upside! That makes it look like the mega
techs are getting less efficient. Perhaps hubris has set in with
their sky-high stock prices and universal popularity, leading to
excessive expenses.
But
the serious downside risks to mega techs and thus the entire stock
markets come from their bubble valuations. Over the past
century and a quarter or so, fair value for the US stock markets has
averaged about
14x earnings. That is reasonable and makes sense, as it implies
a 7.1% long-term rate of return before dividends. Dangerous bubble
territory begins at 28x, when stocks are twice as expensive as
normal.
As
Q3’18 ended just off all-time-record SPX highs, those 6 mega tech
stocks averaged scary TTM P/Es of 80.2x! In other words, investors
buying their stocks then would expect to wait fully 80 years before
they earned back that price paid assuming no earnings growth.
That’s ludicrously expensive, wildly unjustified fundamentally.
Even after years of massive sales and profits growth, tech earnings
remain way too small.
They
still haven’t caught up with the blistering stock-price appreciation
driven by investors concentrating their buying in this handful of
beloved stocks. Ominously that’s the whole purpose of bear markets,
to force stock prices to trade sideways to lower for long enough for
profits to catch up with bull-market stock-price gains. At 80x
earnings almost tripling that bubble threshold, mega techs
are an accident waiting to happen.
But
this latest dire tech bubble isn’t unique. The rest of the SPX’s
top 34 big US stocks averaged TTM P/Es of 41.8x as of the end of
Q3! That’s also deep into bubble territory, valuations
signaling bulls are highly likely to roll over into new bears to
gradually normalize the extreme pricing anomalies. While it’s true
that higher-growth companies should command stock-price premiums,
these valuations are far too rich.
I’ve
been warning about the risks of the increasing capital
concentrations in the mega techs pushing the markets higher for some
time. My last essay on
big US stocks’
Q2’18 fundamentals published in mid-August discussed this
extensively. I used real-world examples of what happened to their
stock prices after great Q2 results to show how vulnerable
they were. While no one believed it then, October changed
everything.
Between the last euphoric S&P 500 record high on September 20th and
the latest oversold bottom on October 29th, the SPX plunged 9.9%!
That was a big and sharp pullback, just shy of the 10%+ needed to
qualify as a correction. As feared, it was capital flight from the
market-darling mega techs that led the SPX down. I explained
what caused the daily action play-by-play last month in our
new monthly
newsletter.
With
their enormous sales and profits growth, many fund managers and
analysts had believed the mega techs would provide safe harbors in
any market storm. But their extreme bubble valuations were so high
that didn’t work during that recent 5-week stock-market plunge.
AAPL, AMZN, MSFT, GOOGL, FB, and NFLX led the way lower, falling by
3.5%, 20.9%, 5.8%, 13.2%, 14.4%, and 22.0% during that exact span.
That
averages out to 13.3% mega-tech losses, or 1.3x the SPX’s. But that
really understates the carnage in these market-darling stocks, as
they started sliding earlier and eventually dragged down the
markets as a whole. On that late-October day the SPX bottomed 9.9%
under its record high, these elite stocks had plunged 8.5%, 24.5%,
7.5%, 19.5%, 34.7%, and 32.0% from their own 52-week highs. That
averages 21.1%!
So
despite their far-superior sales and profits growth, and their
beloved and universally-owned status, the mega techs effectively
outpaced the SPX’s selloff to date by over 2.1x! Make no
mistake here, the higher any stock’s price relative to its
underlying earnings the more downside it faces during any material
stock-market selling. Valuations trump all, with high-flying
momentum stocks getting hammered the worst in bears.
And
despite October’s sharp pullback, not much valuation progress was
made. At the end of September these top 34 SPX stocks had average
TTM P/Es of 49.0x, exceedingly high. Then the SPX plunged 6.9% in
October, making for its worst month since February 2009 after the
first full-blown US stock panic in a century. But at the end of
last month after that plunge, the top 34 SPX stocks still averaged
a 42.2x P/E.
That
only moderated 13.9% last month, remaining in dangerous extreme
bubble territory far above that 14x long-term average. And unlike
late September’s number, late October’s included most of these big
blowout Q3’18 earnings from these top US companies! Bear markets
inevitably follow bull markets, and ultimately drive stocks sideways
to lower until earnings grow enough to force market P/Es down to
7x to 10x.
So
October’s sharp pullback was likely the opening salvo in a
long-overdue
major bear market. Although these extreme late-bull valuations
will be its primary driver, several other factors will add to the
downside pressure in coming months. That debt-fueled spending binge
fueled by stock-market euphoria will wane. Major stock-market
selloffs quickly gut ebullient psychology, leading to consumers and
businesses pulling in horns.
That
means much-slower revenue and earnings growth ahead for the big US
stocks. At some point their profits will even start shrinking,
which will push valuations higher again. The more stock markets
fall, the worse collective sentiment gets. The more worried people
feel, the less they spend. Thus big US stocks’ fundamentals
deteriorate, exacerbating fears and fueling more selling. This is a
classic bear-market vicious circle.
And
Wall Street analysts don’t care about absolute sales and profits as
much as growth. And that is on the verge of plummeting on a
year-over-year basis. Republicans’ massive corporate tax cuts went
live at the dawn of 2018. Thus the quarterly comparisons in Q1, Q2,
Q3, and maybe Q4 this year will look amazing. Profits soared
largely because the US corporate tax rate was drastically slashed
from 35% to 21%.
But
these 4 quarters of 2018 are the only ones comparing
post-tax-cut profits with pre-tax-cut ones! So once Q1’19 and
future quarters roll around, the comparables get far harder since
the tax cuts are already in place. So no matter what else happens,
earnings growth is going to collapse in 2019 and beyond after this
year’s one-time corporate-tax-cut boost passes. This year’s extreme
growth is a unique anomaly.
Finally the Fed’s
quantitative-tightening campaign to start unwinding its $3.6t of
QE money creation over 6.7 years just hit full speed in Q4’18. QT
is going to erase $50b per month of QE-conjured capital going
forward! Merely to unwind half of that epic QE, this
terminal-velocity QT will have to run for 30 months. That is an
unprecedented and staggering headwind for stock markets and probably
the entire US economy.
So
while the big US stocks’ Q3’18 fundamentals were indeed spectacular,
this is likely as good as things will get in this
very-late-stage bull. While Q4’18’s results will also benefit from
the corporate tax cuts, the
Q4’17 ones were
distorted by lots of big charges and gains being flushed through
income statements as companies prepared for the new tax regime. So
Q4 is unlikely to enjoy the incredible growth seen in Q3.
After this epic QE-fueled largely-artificial monster stock bull, the
inevitable bear to come is very likely to prove much bigger and
meaner than normal. If the Fed’s QT doesn’t spawn it, cycle peak
earnings will. The past year’s extreme growth rates in sales and
profits at the largest US companies from already-high base levels
aren’t sustainable mathematically. Traders will freak out when
they see growth slow or even reverse.
Investors really
need to lighten up on their stock-heavy portfolios, or put stop
losses in place, to protect themselves from the coming
central-bank-tightening-triggered valuation mean reversion in
the form of a major new stock bear. Cash is king in bear markets,
as its buying power grows. Investors who hold cash during a 50%
bear market can double their stock holdings at the bottom by buying
back their stocks at half-price!
SPY put options
can also be used to
hedge downside risks, as October proved. We had recommended a
couple SPY puts trades in our newsletters, deployed in August when
stock-market euphoria remained extreme. We exited them in late
October after the SPX got oversold for hefty 124% and 108% realized
gains! SPY puts soar during major stock selloffs, and can be added
after sharp rallies out of oversold levels.
Gold
and the stocks of its miners are even better than cash and SPY puts
during stock bears. Gold is a rare asset that tends to move
counter to stock markets, which leads to
soaring
investment demand to prudently diversify stock-heavy portfolios
when stock markets fall. Gold surged 30% higher in essentially the
first half of 2016 in a new bull run initially sparked by a pair of
major corrections in the SPX, a great upleg.
Imagine how gold will thrive in the long-overdue next bear market in
stocks, when pretty much everything else is burning. It’s the only
radically-unloved and wildly-undervalued asset class left today.
And the gold miners’ stocks leverage gold’s gains. They skyrocketed
182% higher in that first half of 2016 when gold was bid up by
American stock investors’ flight capital. Gold stocks are
the last cheap
sector in these markets!
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The
bottom line is the big US stocks dominating the S&P 500 just
reported blowout Q3 results. Sales and profits both soared
dramatically, boosted by stock-euphoria-driven spending and those
big corporate tax cuts. Yet despite surging earnings, valuations
still remained deep into dangerous bubble territory since stock
prices were so darned high. Downside risks abound as October’s
sharp selloff menacingly proved.
Too
much capital is concentrated in the market-darling mega techs, which
led the way down. And all that selling has still barely dented the
extreme valuations rampant in these lofty stock markets. So a new
bear remains highly probable. Corporate fundamentals are set to
deteriorate rapidly as spending fades, the one-off tax-cut boost
rolls past, and the Fed’s QT destroys colossal amounts of capital.
Protect your wealth! |