Stocks fell once again on Friday although a late afternoon rally reduced the losses. Despite a weak stock market last week, and a weak end to October, interest rates on both 10-year and 30-year Treasuries rose. Energy prices continued to weaken and the oil sector was one of the worst performers. Also losing ground, both absolutely and relatively, were the high-flying tech stocks.
Apple#, Facebook#, Alphabet#, and Amazon all reported earnings after the close on Thursday. All had good to excellent results, beating analyst forecasts. Yet only Alphabet shares rose on Friday. Facebook and Amazon were leaders to the downside. I often suggest you watch the reaction to earnings, not the earnings themselves. The fact that the tech leaders had stalled in recent weeks and saw losses accelerate on Friday suggests what is happening is more centered on valuation than earnings fundamentals. In bull markets, enthusiasm can get ahead of reality. Indeed, at the end, euphoria replaces enthusiasm. I am not suggesting that we are at or even past the end. But valuations in many of the tech leaders are stretched. Historically, investors have used Price/Earnings as a marker to judge valuation. These stocks have been more successful and growing faster than the average company. The stock market as a whole is selling at 20-21 times forward earnings estimates. That assumes no Covid-19 relapse. More on that in a moment. Thus, it is logical that they sell at some sort of premium. But when the P/E gets to be 50, 60 or even 100, investors who pay any attention to valuation start scratching their heads. Newer upstarts that became cult favorites like Zoom, Peloton, and Snowflake sell at even higher prices. P/E no longer can be used as a valuation guide. In some cases, there aren’t any earnings, at least not yet.
Back in the 1998-2000 Internet bubble, analysts started to use discounted cash flow models more to justify high valuations. Since many of the hot Internet names weren’t earning any money, they: (1) speculated when they would begin to earn money (sometimes several years down the road), (2) then presumed massive ongoing growth rates, and (3) finally assigned a terminal value that made no sense. If this didn’t come up with a valuation that pointed to even higher prices, they simply left out early years of losses, converting a discounted cash flow model into a fractured fairy tale. Exactly one Internet wannabe of the 1990s ended up being a home run; Amazon. The rest either faded away, went bankrupt, or got acquired.
It can be argued that today’s generation of young growth companies is vastly superior to those of 1998-2000. Fair point. Many have been incubated as private companies for a long time. They didn’t come public until proven. Once again, fair point. But valuation still matters. Today, investors are still conjuring up P/E alternatives to justify valuation. If X is selling at 50x earnings, then Y deserves to sell at 60x. That presumes, of course, that X is valued properly. If 100 times earnings is a lot, 15 times sales sounds less threatening. Since when did we start valuing a company on revenues?
I have no idea whether 10 years from now Zoom is going to be THE way we conference call or that Peloton will dominate the home exercise market with a family of superior products. But maybe Microsoft# and Apple will incorporate video conferencing into their suite of products and Zoom fades like AOL did two decades ago. As for Peloton, today spinning is extremely popular. Will it remain that way when the pandemic fades? Home exercise equipment has been around for decades. Can Peloton endure? I will leave it to others to decide. My only point is that any valuation model for Zoom or Peloton, or any of the other emerging startups has to be taken at face value. No one knows the answers and all models have a component of garbage-in, garbage-out within their composition. If Zoom is the next Amazon, it will be worth even more someday. But when a stock sells at the lofty valuation of the current cult favorites, the risks of being wrong increase while the ultimate rewards, if proven right, decrease.
The same argument applies to bigger companies like Tesla and Amazon. I have less doubt of their ultimate success. But ask yourself this question, keeping in mind the law of large numbers. In 5-10 years, what will Amazon and Tesla be earning? Apply a 20 P/E to that number. Why 20? Because normal is about 15 and a decade from now, even if they remain superior, they will not be growing 2-3 times faster than the entire economy. The math simply doesn’t work unless you want to assume that Amazon has 50%+ share of the retail market or that Tesla is selling 20% of the cars delivered worldwide.
Valuation matters and it appears that investors are starting to get that message. Futures point higher this morning and these stocks will rebound. But the rate of gain over the past 12-24 months isn’t going to be replicated indefinitely.
Speaking of the market, that brings me back to the two immediate concerns, Covid-19 and the election. In Europe, disease spikes have caused France, Germany, the U.K. and Switzerland to reinvoke partial lockdowns. So far, despite rising virus counts, the same hasn’t happened here. Is Europe simply 2-4 weeks ahead of us, or is Europe simply the epicenter of the pandemic? So far, hospitalization and death rates have not moved up as fast as virus counts, but they are climbing both in Europe and here. No one wants to resume quarantines or even take a few steps backwards. But that could change if hospitals get overwhelmed. The last couple of days offers signs of improvement but weekend data is always fuzzy at best. If the improvement lasts, stocks will rebound, but if not, the next few weeks will remain volatile.
As for the election, both candidates spent the weekend trying to energize their respective bases. Mr. Trump’s rallies have certainly been larger and his campaign is more energized as we rush to the close. Both sides seem to be focused on getting their bases out to vote, rather than trying to reach any undecideds that are left (are there any?). Trump seems to be gaining some support among minorities, but the virus spike may be costing him support among worried seniors given the way he continues to trivialize the virus. There remains a big split among voters, and several battleground states are still too close to call. What isn’t too close to call is the consensus that wants this election campaign to be over. We may not know the final result tomorrow night, but we will know a lot more than we know today.
“Friends” actor David Schwimmer is 54 today. What could be more upsetting than watching one more day of any 24/7 news channel? Being forced to watch a replay of last night’s Eagles-Dallas game.
James M. Meyer, CFA 610-260-2220