Stocks continued to turn a mixed performance yesterday reacting to earnings news. It seems this year there have been a lot more meaningful beats and misses, perhaps reflecting uncertain economic times. But some of the volatility has related to a mismatch between expectations and reality.
Let me explain and I will start with Amazon that reported last night and looks like it will open down 7% today. Amazon’s stock has been on an amazing run since the end of the Great Recession, although gains moderated in 2019 even as earnings growth accelerated through the first half of this year. Amazon is among the most admired and most followed stocks on Wall Street. Users love its products and services. For years, the one fly in the ointment has been the willingness of management to forego short term profits as it drives for long term growth. But in recent quarters, as fast as expenses rose, revenues rose faster and profits blew past estimates. When that happens persistently, investors can get complacent and assume revenues would continue to rise and margins expand forever. But on Wall Street, forever doesn’t exist.
In the third quarter, revenue growth for Amazon actually accelerated. It grew 24% after growing 20% the previous quarter. While Amazon Web Service experienced a slight slowdown in growth, it still grew by about 34%, helping to lift the growth rate of the entire company. A movement toward 1-day shipping helped to lift the sales pace of its traditional retail site as well. Thus, on the revenue side, all was good, although a few analysts were slightly upset at the decline in sequential growth at AWS. That’s a bit foolish, however, because the law of large numbers almost guarantees that 35% growth in cloud revenues cannot persist forever.
So far, so good. But the villains this quarter were an accelerated growth in expenses and a mismatch between investor expectations and reality. One day shipping isn’t cheap. Amazon now has 750,000 employees and it needs a lot of warehouse space close to the customer to execute 1-day shipping. The good news is that once the infrastructure is in place and fully developed, Amazon will have a competitive advantage that few, if any, can match. As for AWS, its lead is being challenged by Microsoft, and it must spend more money to protect its position.
There was nothing wrong with the Amazon quarter other than its legion of fans simply got too far out over their skis and blindly thought one-day shipping costs could be absorbed without a profit hitch. None of this should be read as recommendation to buy, hold or sell Amazon’s stock. Even after this morning’s expected decline, it will still sell at 50x or more estimated 2020 earnings. The key to the stock price is a proper forecast of the sustainable rate of revenue growth. I will leave that to Amazon analysts. My point for spending so much time on Amazon this morning is to highlight the mismatch of expectations and reality.
Amazon wasn’t alone this quarter. McDonald’s# shares have suffered a similar fate. Systemwide same-store sales rose almost 6%. In part, those were achieved as a result of steps McDonald’s has taken to employ technology to speed the production and delivery of its products. It has introduced delivery. That isn’t cost-free. Like Amazon, McDonald’s had a short term profit hit as it absorbed the costs of staying ahead. It did it while accelerating sales growth. The decisions by both Amazon and McDonald’s were the right thing to do. But they both came with short term pain that analysts and investors underestimated. So, there was a price adjustment and life will go on.
Conversely, names like Procter & Gamble# and Microsoft# blew well past expectations on higher-than-expected revenue. But the subsequent rise in their respective stock prices were relatively modest (about 2%) and neither moved to new highs. This, in combination with the action in Amazon and McDonalds (just two examples) suggest to me that the market today is pricing in a lot of good news and leaves little margin for error. On the macro side, markets are assuming the tariff trade war has peaked and there will be no new substantive tariffs. It presumes the growth slowdown is over and there will be economic acceleration into 2020. It assumes earnings, which have been flat this year, will rise 5-10% next year. It assumes inflation expectations will remain low and stable. Bonds will trade within a narrow range. So will the dollar. The market today either assumes a Trump reelection or an alternative that will not be economically disruptive.
These are all consensus views and all might happen the way the majority predicts. But as any market strategists has to ask, “if the consensus is wrong, what are the upside and downside possibilities?” To me, there isn’t a whole lot of upside beyond what I just laid out. I don’t see profits accelerating 10% or more next year. I don’t see capital investment surging in front of an election. The risks of wider-than-expected swings in interest rates are real. Profit estimates today seem a bit high for 2020. Who knows what the next election might bring?
For these reasons, I expect stocks to remain within the recent trading range for some time. Given how close we are to record highs, I acknowledge the possibility of a slightly higher all-time high in the near future. But for a real substantive new high to occur, the outlook for cyclical industries (e.g. industrials, oils, retail, etc.) has to improve from what it is today.
At the same time, TINA (there is no alternative) will keep investors anchored in stocks. Why buy an AT&T bond yielding 2% when you can buy the stock paying 5%? Without a recession, and the odds of that are receding every day, there isn’t a case for a major market correction particularly in the November-December timeframe that is seasonally strong for stocks.
The one caveat is that next week the Federal Reserve meets to decide whether to cut interest rates once more. That is almost a certainty. What isn’t a certainty is whether more cuts are to come. The Fed won’t answer that question on Wednesday, but it will discuss what it might take to continue cutting rates. Simplistically, equity markets love low rates because it means higher P/E ratios and higher prices. I think further cuts at this time are unnecessary but my opinion doesn’t count. President Trump will certainly blast the Fed once again and make his rather blunt push for more rate cuts. The Fed will ignore him. But if the post-meeting tone is more hawkish than expected, meaning Mr. Powell suggests the Fed might be done cutting rates for a while unless signs of economic weakness endure, stocks could take a bit of a hit short-term. That would have no long term importance but, once again, it will remind complacent investors that stocks can move in two directions, not just one.
Today, Katy Perry is 35. Since it is World Series time, I will note that Washington outfielder Juan Soto becomes a full-fledged adult today at the age of 21.
James M. Meyer, CFA 610-260-2220