Stocks continued to rise in the wake of a favorable CPI report on Wednesday. The gist is that the economy continues to chug along, inflation is slowing, and the Fed may be near the end of its credit tightening cycle. After briefly crossing the 4% yield level, 10-year Treasuries are now back below 3.8%. Two-year notes, which crossed 5% as the Fed was touting at least two more rate increases, are back below 4.65%. Lower yields mean higher stock prices. The prime beneficiaries are growth stocks, as not only do lower yields lead to higher prices, they also lead to widening P/E spreads between slow and fast-growing companies.
There is nothing like momentum, at least in the short-term, when it comes to stock prices. For many months, stocks were stuck in a 3800-4200 S&P 500 trading range. When they finally broke through in June, stocks surged. Bulls celebrated. Bears, caught on the wrong side of the trade, capitulated. Quant investors using trading algorithms piled on. Short sellers or those using futures bets, reversed course. It has been a great six weeks. How long can this continue? As I often note, in the short-term, emotion trumps reality. The emotion today is decidedly bullish. While a mild recession could happen over the coming several months, at the moment the fear of missing out is trumping any fundamental concerns.
Earnings season is getting started. Yesterday we heard from Pepsico# and Delta. I noted Wednesday that a key to this earnings season was a focus on profit margins. They have been falling recently, testimony to the ill effects of inflation and, in particular, the higher cost of labor. Both Pepsico and Delta beat forecasts and raised guidance. Their investors were rewarded. In the case of Pepsico, stronger than expected sales helped, but so did its investments in standardization and automation. Delta obviously benefited from a surge in travel. There is no better cure for margin pressure than higher than expected revenue. It also benefited from lower jet fuel costs. But Delta is a cyclical company. Airline fares are already trending lower, a sign that lower prices will be needed this fall to keep planes full. How long will the travel surge last? As noted in Wednesday’s Comment, there is still excess money sloshing around that was doled out during the pandemic. But that excess is being whittled down. We’ll see.
This morning, we have already heard from JPMorgan Chase# and United Healthcare#. Unlike Pepsico and Delta, these two companies are in industries with headwinds. For JPMorgan, the banking industry has suffered from an inverted yield curve, rising loan loss exposure (although still historically low), and lower demand for credit. At the same time JPM has benefited from the flow of money from local and regional banks to the big national banks, a flight to safety accelerated by some prominent bank failures. When the pot was stirred and the results revealed, investors appeared to like what JPM had to say. Hopefully the glow will remain after this morning’s conference call.
United Healthcare (UNH) is a different story. It is best of breed but the breed is under attack. It is a large health insurer getting more involved in health care management. Congress loves to pick on health care companies blaming them for inflation. The reality is that drug price inflation is and has been below national inflation averages for some time. But it is easy for politicians to scold the providers of health care because some drugs and some procedures are very expensive. In addition, a new concern arose recently when UNH noted that hospital activity and surgical procedures were increasing. That would put pressure on the medical cost ratio of its huge insurance operation. Investors have to question whether the surge is a temporary event due to Covid-related deferrals or there has been a fundamental increase in demand for procedures. Some even blame the increase on pickleball, the fastest growing sport in America. While pickleball’s growth is causing some increase in injuries that require medical attention, it is hard to believe that it is changing long-term healthcare demand. In any case, UNH’s stock is up this morning. While the fears persist, they don’t appear to be as bad as first feared.
That’s only four stocks. But there is a message already two days into earnings season. The winners (PEP and DAL) keep rising, suggesting all the good news isn’t completely priced in yet. What you don’t want to see are stock prices falling in the wake of very good news. Conversely, JPM and UNH doing well suggests fears might be overblown. Good managements know how to deal with issues and pivot around the problems.
This doesn’t mean stocks will continue to surge during earnings season. The four companies I just mentioned all have excellent management teams. That isn’t universally true. For some, problems are more overwhelming. Disney# announced Wednesday that CEO Bob Iger’s contract was extended for two more years. While that may have been reason to celebrate, it was an acknowledgement by Iger and Disney’s Board that its problems are more deeply rooted and will take longer to solve. If you want a roadmap for Disney, look no further than GE which went through a tormented decade or more before bringing in Larry Culp, a proven CEO from outside. GE was hemorrhaging everywhere from its financial underpinnings, to its huge power generation business. Culp spun off businesses and sold others. As he nears the end of a multi-year restructuring whereby the remainder of GE will be focused on aircraft engines, the company’s shareholders are finally being rewarded. Iger, likewise, faces multiple issues. At its core is Disney’s creative abilities whether it be Mickey Mouse, the cast of Frozen, or the gang from Star Wars. These creations feed the growth of theme parks, merchandise, and streaming product. Industry changes are also disrupting it distribution patterns. Linear TV (ABC and ESPN) is losing share to streaming. Disney’s streaming products are losing billions. But all problems are solvable. Over time, ESPN will become a streaming product moving away from cable. Streaming losses will start to fall meaningfully. When Iger was last CEO, Disney had a market share of close to 50% in theatrical gross revenues in the U.S. It is way down today. That can and will be fixed. All this will take time, which is why his contract was extended. With that said, he is facing new challengers. Companies like Apple# and Amazon# are bidding for sports rights. Cable’s demise is accelerating. It took years for GE to regain investor interest. It will take time for Disney as well.
Thus, earnings season is going to present lots of surprises, good and bad. The focus will remain on profitability. Covid-19 changed the world we live in. We work more from home. Technology has also changed how we live. We go to movies less and stream from home or wherever our laptops and smartphones take us. Many now get their news on social media. No more Walter Cronkite. Those living in cities have ditched the car and rely on Uber. Artificial Intelligence is about to change how we live and act again. Before Covid, China was set to take over world economic leadership. Now it is saddled with lower growth, a declining population, 20% youth unemployment, and economic isolation as distrust between China and the U.S. deepens. India and Saudi Arabia want to fill the void but both have their own issues and, combined, their GDPs are less than 25% of China’s.
Change means we have to monitor our investments more carefully. What worked three years ago may not work tomorrow. Here are a few keys to keep in mind as you review your portfolio.
1. You buy stocks offensively and bonds defensively. If a company isn’t growing, its stock price has no reason to go up.
2. Good companies persistently gain market share. That means others have to lose market share. If you are invested in a company losing market share, ask yourself why?
3. Good companies find ways to protect margins. They invest in automation. They shed losing businesses. Profit margins won’t go up indefinitely but they are key to good performance.
4. Mediocre companies stand still and whine about outside influences negatively impacting their businesses. Good companies pivot. Look at how GE has pivoted as noted earlier. Where would Microsoft# be today if it was still focused on Windows and PC applications. Sometimes the pivots are more subtle. Dick’s Sporting Goods constantly reconfigures stores to reflect surges up and down in sports interests. Apple may not sell a lot more phones year-over-year, but it will make more money from each phone user via services from ApplePay to data storage to music.
5. Look further ahead than you think you should. Not years and years ahead, but maybe 1-2. I often note during earnings season that today’s blowout results are next year’s tough comparison. Is the surge sustainable or the start of something really big? If stocks price in expectations 6-9 months ahead, meaning today’s stock price is reflecting what is expected around year end or soon thereafter, then a year from now, a stock should be reflecting the state of affairs at the end of 2024. While that picture is always going to be somewhat hazy, getting the general direction right is important. If you aren’t thinking about the end of 2024, I guarantee you good management teams are.
Thus, earnings season is off to a good start. But one can’t judge the next three weeks by the performance of a handful of companies. It should be interesting times.
Today, actress Jane Lynch is 63.
James M. Meyer, CFA 610-260-2220