Stocks fell once again although a sharp afternoon rally reduced the damage. Still, the NASDAQ fell another 2.4% after a prominent social media company lowered earnings guidance just a month after it previously offered a somber outlook. As a group, social media and related companies depend on advertising for revenue. With the economy slowing and competition increasing, the combination proved to be another dagger in the hearts of speculators. Separately Lyft, one of the leading ride sharing companies, reined in its outlook and said it would have to reduce overhead as a result. Finally, it was announced that April new home sales fell by the largest amount since 2013. High mortgage rates, a wet and cool April, and overall softening demand combined to wreck havoc. All in all, it was another day when the news simply was worse than declining expectations. Stocks won’t bottom until expectations and future reality come more into line.
But all is not as terrible as I just painted. Housing activity is still well above its 5-year average. There are few signs that real GDP is in decline. There are emerging signs that inflation has peaked. Gasoline futures are down more than $0.25 per gallon. That should show up at the pump before too long. Retailers from Amazon# to Wal-Mart to Target all find themselves with too many workers and too much inventory. The cure for too much inventory is lower prices. Freight costs are falling. Small business executives are as downbeat as they have been in years. That suggests the JOLTS survey of new job openings will start to show declines before too long and the Fed has only begun to raise rates. Two 50-basis point increases are planned for June and July. The goal has been to get the Federal Funds rate to about 3% before year end. With signs of economic slowing already evident, that target could prove to be too high.
One shouldn’t read too much into April data. It’s just one month, a cool and damp one at that. In some surveys, May looks a little better. It will probably take 3-4 months to get a clearer picture. Until then the market’s mood swings will continue to be volatile, but there have been no signs of panic, the sort of capitulation that marks market bottoms. What we have started to see over the past month, however, is a rapid increase in selling by retail investors. Normally, that happens much closer to the end of a bear market than the beginning.
All this suggests we might be in the later innings of this savage decline, but it doesn’t mean the correction or bear market is over. For that to happen, we need to see signs of an economic bottom in the coming months, and we must see an end to the purge of excess speculation.
I mentioned Lyft briefly earlier. The stock was down over 15% on the news. Its largest competitor, Uber, was down close to 10%. Both traded at all time lows. Yet Uber still has 41 analysts with a Buy rating, 4 who say hold and none who say sell, at least in writing. The economic model of these ride sharing companies simply doesn’t work. Today, prices to use Uber or Lyft are significantly higher than using a conventional cab and both still lose money. Drivers want more money. Fuel costs more. There is nothing to differentiate one ride sharing company from the other besides price. I offer this as an example, but the public market over the past several years has been littered with exciting stories filled with lots of promise and no earnings. Many of these stocks are now down well over 50%. Before all is said and done, they will need to fall 90% or more.
While the newbies struggle to survive, the giants who grew up earlier this century are starting to mature. Amazon’s retail business is suddenly growing only a little faster than retail in general. Netflix# is losing subscribers in the U.S. as we leave our couches and get back to work. The ad-free subscription model may have to be modified. Facebook is losing users to edgier sites like Tik Tok. New iPhone sales are barely growing. Call it maturity or the law of large numbers. Whatever. It is happening as the market reprices growth. Lower multiples and lower growth make a bad combination. The five largest companies in the S&P 500, all tech firms, are showing signs of maturity. All are now down more than the S&P 500 overall and give little hint that lows have been set. Yesterday both Amazon and Alphabet# set new 52-week lows.
Yet, there have been few safe havens in this market. Most are defensive in nature. Consumer staples, selected REITs, utilities, and large drug companies all share two traits. They are relatively unaffected by moderate changes in overall economic growth rates, and they pay large dividends that grow slowly but steadily over time. Current dividend yields of 2-4% compete favorably with bond returns.
Lest anyone forget, the theoretical price of a stock is the present value of future cash flows. I said cash flows, not revenues. Look at the oil patch. Companies like Chevron sell at record highs. Yet oil prices were much higher in 2008. Younger companies that started as wildcat drillers first sought to maximize production whatever the cost. Wall Street screamed that it wanted earnings more than revenues. The companies listened and cut spending. Revenue growth slowed but cash flow skyrocketed. Needless to say, they have been this year’s darlings of Wall Street.
Slow growth isn’t a bad thing. If you are a big retailer, you don’t have to open a bunch of new stores. Instead, getting more business from existing stores, or developing another revenue channel like online sales will yield more profits and prodigious cash flow. In a market like this, the formula is to be less dependent on the overall economy, focus on cash flow, and return money to your owners (shareholders) consistently. Whenever the bear market ends, I suspect investors willing to step back in will chase rising cash flows before they chase sexy stories with unproven earnings models.
Amid the carnage in the stock market, bond yields have retreated a bit. Perhaps that reflects a flight to safety. Perhaps it is a judgment that the Fed won’t have to raise interest rates as high as previously anticipated. Probably a combination of both. Whatever the cause, it creates a more solid valuation floor for equity investors. A near-term key will be the ability of stocks to hold above last Friday’s intraday low. The NASDAQ set a new low yesterday, but the S&P 500 and Dow have held. While I think, ultimately, that those lows will be broken by all indices, there are improving reasons (e.g., lower bond yields, a slower growth economy) to think many sectors of the market can find some footing. Valuations are close to normal, but in a bear market, stocks must be compellingly cheap for a bottom to be set. That is likely months away. Until then, the near-term strategy is to hunker down, reduce risk and prepare for brighter times ahead.
When markets go from euphoria to capitulation, the recovery doesn’t begin with speculative leaders of the past regaining control. Rather returning investors will likely be risk averse and focus on predictability, cashflow and safe returns. Growth investors will be looking for reasonably priced names whose growth will accelerate for the next several years, not the old favorites in decline. When similar speculative purges occurred, many of the leaders before the decline regain the leadership mantel. Some will; most won’t. As investors, one always must look forward.
Today, Mike Myers is 59. Frank Oz is 78. For those who aren’t familiar with Mr. Oz, he is a puppeteer who is the voice behind such legends as Miss Piggy, Cookie Monster and Yoda.
James M. Meyer, CFA 610-260-2220