Stocks had another very strong week, building on the strength exhibited in October. A favorable CPI report on Thursday sparked a huge rally, lifting the Dow by 3% and the NASDAQ by 6%. There were some distortions in the numbers that amplified the reduction in the pace of inflation, but clearly, we have seen the peak. While there will be one more CPI report before the FOMC concludes its December meeting, the odds now strongly favor that rate increases will continue at a reduced rate over the next few meetings and could stop sooner than previously expected. That’s music to equity investors’ ears.
Getting inflation from 8% to 5% will be a lot easier than getting it from 5% to 2%. To finish the job, some slack must be restored to the labor market. Any inflation dove still must acknowledge that the labor market remains overheated. There is no way that inflation will find its way down to 2% with almost two job openings for every unemployed worker. Labor participation rates are not going to return to pre-Covid levels simply because of demographics. In an aging nation, there will persistently be more workers leaving the workforce than entering. That means even more slack may be necessary than previously anticipated.
This doesn’t mean that the Fed is wrong to ease pressure on the brakes. No one said that inflation must return to 2% in 2023; it just must be on the right path. If the Fed Funds rate ends up somewhere between 4% and 5%, there will be ample pressure to deter excess borrowing. “Free” money, which we experienced for most of the past 10 years, instigated a lot of mistakes. Last week we saw that in the crypto market. While I still see no intrinsic value to Bitcoin or any other crypto currency, what was startling about last week is that the failure of one of the largest crypto exchanges came about against such an obvious background of nefarious behavior all through the industry. In the traditional banking world, banks pay interest on deposits for the funds which they then lend at a higher rate to borrowers. The spread between their lending and borrowing costs is their profit. The crypto exchanges aren’t banks. They don’t lend money. Their only profit comes from trading. Meanwhile they pay 5-20% to investors who leave their crypto tokens under their custody. Does the math work? Personally, I don’t see how. Hundreds of billions of dollars have already been lost either through theft or some variant of a Ponzi scheme as we saw last week with FTX. It isn’t just retail speculators getting hosed. Huge institutions became victims as well. This is what happens when money is free. Free money supports frivolous investments.
Back to inflation and the economy. The question all year has been whether there will be a soft landing or a recession. I will define a soft landing for my purposes as an economy growing plus or minus 1%. If there is to be a soft landing, the only way that happens is for labor force growth to disappear, meaning monthly net employment growth close to zero for an extended period. That doesn’t sound very appealing, but it is the only non-recessionary way to put slack back into the labor market. The alternative is a recession, which would create the slack quicker. Either works. Good companies can manage around a flat economy, but not all can.
That takes me to the big news of the past few weeks. Third quarter earnings season was generally OK. Growth was near zero overall, not bad for an economy growing at an anemic pace, facing very strong currency translation headwinds, and 8% inflation. Generally, companies with pricing power did much better than companies without.
There was one pocket that suffered greatly, those growth companies whose managements believed that they could grow forever at rates substantially faster than the overall economy. When Google#, Amazon#, and Meta Platforms# were growing revenues at 20% per year or more, they produced prodigious cash flows that could support any number of new investments. Some fed new businesses that grew themselves, such as YouTube, Amazon Web Services, and Instagram. Others either didn’t work (does anyone carry an Amazon phone?) or couldn’t be monetized. But when growth slows, continuing to spend at a super rapid pace crushes earnings. The most obvious example of this was the recent earnings report from Meta Platforms. Mark Zuckerberg wants to spend close to $30 billion per year to build out his version of the metaverse, whatever that might be. Investors responded by knocking 25%+ off the value of his company’s shares in one day. Alexa can tell me the weather, the traffic and tell me a joke, but it is costing Amazon $5 billion per year for that privilege.
Amazon’s core business is marvelous as long as costs are matched up to revenues. Ditto at Meta. Facebook itself may not be growing subscribers, but it is still one of the two best digital advertising platforms around. Instagram is growing and Reels is taking off. Core businesses are sound. They may not be growing at 20%+ anymore, but no one expected that.
Look at Apple#. It is growing smartphone sales in a mid-single digit range as consumers trade up to the best performance phones. It is growing services a bit faster. CEO Tim Cook has always had his focus on the bottom line, on cash flow. Substantively, it grows at the same topline pace as Meta or Alphabet, but its stock sells at a much higher multiple. Apple will take its moonshots, but it does so in a careful way.
When McDonald’s# launches a new product or feature (e.g., a new cooking system), it does it in one or two markets first. When Disney# decides to go all in on streaming, it spends with abandon. It gets its subscribers (that’s the good news), but it loses almost twice as much as expected (Ugh!). Disney’s strength has always been creating new heroes and platforms. Whether it be Elsa from Frozen or the Black Panther, the new creations feed content everywhere, from cruise ships to television. Streaming isn’t a product, it’s a platform. A good manager has a roadmap to bring revenues and expenses in line.
So, what did we hear last week? Finally, the big guys are getting the message. Finally! Meta is making huge workforce cuts. Disney is doing the same while raising streaming rates and introducing ads to its channels. Alphabet is making cuts. Seasoned managements at long time blue chip companies already knew the playbook. That’s why so many of them had good earnings and good stock performance in the third quarter. In the tech world, both Apple and Microsoft said months ago that they were trimming staff or implementing hiring freezes.
For Meta and Amazon, the good news is that they have the balance sheets and the cash flow to return to steady growth faster than overall GDP. For others that lack the balance sheet, failure to match spending to revenue and cash flow will greatly impede growth.
For the past few weeks, I have noted the market’s rotation from big tech to the rest of the market. That process is now fairly complete. We saw big bounces, for instance, in names like Microsoft and the semi stocks last week. No need to rotate further if the leaders still have life and the laggards are starting to get economic religion.
Where do we go from here? My math is simple. Acknowledging the momentum of the market and seasonal influences, multiplying 17.5 times $230 for S&P earnings next year, I get a valuation close to where markets are today. I find both 17.5x and $230 as optimistic targets. Therefore, I find it hard to recommend chasing the current rally unless one believes inflation will return to 2% much quicker than I do, or that earnings in 2023 will be significantly higher than they will be in 2022. That certainly won’t happen if there is a recession. The one big positive is the falling value of the dollar, down more than 5% from its peak, but still well above year ago levels. A falling dollar reduces the foreign exchange trade winds, but it also will help to boost the price of commodities prices in dollars (e.g., oil) and increase the price of American exports. Bottom line; it’s too late to chase. At the moment I see few bargains. We are still in the transition phase of our economy, which means there is still opportunity for downside news. Just as investors were too skeptical a month ago, it isn’t time to get too euphoric now.
Today, Curt Schilling is 56. Condoleezza Rice is 68. King Charles turns 74.
James M. Meyer, CFA 610-260-2220