A sloppy Friday followed three strong sessions last week. Interest rates fell. Stocks were impacted by weak earnings from Snap and a poor revenue report from Twitter that raised fears that Internet advertising growth rates may be slowing more than expected. While last week was the first full week of earnings reports, this week is when almost half of S&P companies will report including all the top companies by market capitalization.
To date, weak earnings from names like Netflix and DH Horton, a major homebuilder, elicited positive reactions from investors, a sign that the anticipated bad news was already priced in. That’s exactly what one looks for at a market bottom. In addition, lower long-term rates pushed high multiple stocks higher. Stocks have rallied 5-10% since the June lows. Is this simply a bear market bounce or the bottom of the market? It’s too early to call. From an optimistic viewpoint, a lot of pessimism was priced in. The earnings reports I just alluded to support that. While the Fed isn’t likely to raise the Federal Funds rate a full percentage point when it concludes its two-day FOMC meeting this Wednesday, as some expected after the June CPI report, it is still likely to elevate rates to something well over 3% before the end of the year and possibly higher early in 2023. That should be the end, at least as the market sees events unfolding today. Since stocks look 6-9 months ahead, that means investors can see the worst and, perhaps, start looking beyond the bottom. There is also a school of thought that says inflation will recede rapidly once the slowdown triggered by rising rates really kicks in and supply chains become unclogged. Not only will commodity prices continue to tumble, but labor slack will appear, and shelter costs (i.e., rents) will start to decline.
There is another more pessimistic view. Earnings have held up well. While unemployment claims have started to rise, they are far from elevated. Companies still complain they can’t fulfill orders for a lack of qualified workers, particularly in the summertime amid another Covid surge. Simply look at the airline industry. It is short pilots while airports are short everything from TSA workers to baggage handlers to air traffic controllers. The only solution is to cut back on the number of flights. Economically, that ‘s hardly a satisfactory answer. Car dealer lots still lack adequate inventory. Store shelves are not fully stocked and workers still quit because of better alternatives. While housing prices are rolling over, rents are not. It took years of monetary easing and Congressional largesse to get inflation where it is today. A few months of higher interest rates won’t be enough to cure the problem.
The outcome of this yin and yang isn’t likely to be settled for a few months. Are we in for a soft landing or is a mild recession already priced in? Or will it require a steeper downturn to not only beat inflation but to keep it in the 2-3% range for years to come? I suspect it will take one more quarter of earnings reports, coming in October, to solidify that answer. What investors will be looking for is not just a nominal drop in the CPI through the fall, but real evidence that there is sufficient slack coming that will allow the Fed to loosen its reins on monetary policy. The Fed still runs the risk of overtightening. Some look at that predicament and predict it will be cutting rates during the second half of 2023. The impact of higher rates takes many months for the full impact to be felt. That makes the task of finding the proper balance that much more difficult.
With that said, I want to shift and look within the S&P 500. The top 5 S&P 500 stocks are Apple#, Microsoft#, Alphabet#, Tesla and Amazon#. By market cap, these five stocks comprise almost a quarter of the index’s value. All but Tesla will report this week (Tesla already reported). The four tech names are experiencing some deterioration of growth. All are slowing their hiring. Some are laying off workers. All have market caps of $1 trillion or more. They are great companies, but except for Tesla, are facing maturity. The laws of large numbers apply. These were companies that were born, in their present form (Apple didn’t become a growth company until the iPod emerged), more or less, at the turn of the century. Again, Tesla is the exception. None will grow at the same rate over the next decade that they grew over the last decade. At some point, several may grow no faster than the average S&P 500 company. Past S&P 500 giants from Exxon to IBM to Cisco# demonstrate the weight that sheer size has on future growth. Over the past decade, owning these top companies in the S&P 500 was a winning strategy. We may get serious hints as they report this week whether owning them over the next decade will be as effective.
I don’t want to get into the micro details of second quarter earnings, but anyone can see that worldwide smartphone sales now mirror GDP growth. Online retailing may no longer be gaining market share at the expense of traditional stores. If I back out buying online and picking up at a store, the growth rate shrinks further. Advertising is not a growth business, but online adverting has been for decades. Online, a merchant can target its ads directly to individuals. They know from your search and buying patterns, your likely age, income, location and wish lists. On TV the options are more vague. Ditto for magazines and newspapers, but that switch has been going on for decades. Meanwhile social media has become more crowded with new entrants all chasing the same ad dollars. It is no longer a tale of rising tides lifting all boats.
In 2000, the top 5 companies in the S&P 500 were Microsoft, Cisco, Exxon, GE, and Intel. They accounted for 18% of the Index’s value. Of the 5, only Microsoft remains. It has stayed because it pivoted from a Windows-centric PC company to a focused enterprise business centered on the explosive growth of cloud computing. Three, Cisco, Intel, and GE, sell for less than their 2000 peaks twenty years later. GE is down more than 75%.
Today’s behemoths can all pivot successfully. Apple has done it several times successfully and is trying once again with a service-based model. Amazon built AWS to support its own logistics and look what happened. All great companies pivot, but not all succeed. Between 2016 and 2021, the top 5 S&P companies rose by 244% while the S&P itself was rising 41%. There is no guarantee that today’s giants must follow the path created by Cisco, Intel and GE, but to expect them to outperform the average by 5-fold over the next five years sounds a bit crazy.
At the beginning of bull markets, or even during sharp bear market rallies, investors revert quickly to what worked in the past. Some of that is familiarity. They want in, they don’t know what to buy, so they buy what they are most comfortable with. But in the end, fundamentals always matter. They take over. I have little doubt that all the current leaders will become larger companies in the future, but that isn’t the whole story. Cisco and Intel have continued to grow, but their stock prices haven’t. Their stock prices in 2000 were predicting far faster growth than occurred.
Thus, when Microsoft, Amazon, Apple, and Alphabet report this week, the real questions to ask are (1) what future growth rate is logical, and (2) do their stock prices jive with that forecast? Last quarter, names like Amazon, Netflix and Alphabet got crushed due to the mismatch between forward looking growth and built-in expectations. Today, expectations have been lowered. Have they been lowered enough? We’ll know soon.
The next logical question is who will be tomorrow’s leaders? In 2000, there were no smartphones. Amazon was just beginning to grow beyond books. There was no such thing as cloud computing. Search existed but the dominant participants were names like Yahoo and Lycos, not Google. Many of the giants 20 years from now haven’t even been born yet. Most will have some technology base. New ways will be found to take advantage of artificial intelligence and big data. Cars will be more electric and more autonomous. Some of the great companies of tomorrow do exist today. Tesla is certainly a controversial name with a bright future, but it won’t have the electric vehicle market to itself. Happy hunting,
Today, Matt LeBlanc is 55. Country music legend and Grand Ole Opry host Roy Acuff is 89.
James M. Meyer, CFA 610-260-2220