The
mega-cap stocks that dominate the US markets have enjoyed an amazing
bull run. But February’s first correction in years proved things
are changing. With that unnatural low-volatility melt-up behind us,
it’s more important than ever to keep leading stocks’ underlying
fundamentals in focus. They help investors understand which major
American companies are the best buys and when to deploy capital in
them.
For
some years now, I’ve been doing deep dives into the quarterly
financial and operational results in the small contrarian sector of
gold and silver
miners. While hard and tedious work, this exercise has proven
incredibly valuable. With each passing quarter my knowledge of
individual companies grows, helping to ferret out miners with
superior fundamentals and the greatest upside potential. Traders
love the resulting essays.
This
successful fundamental-research methodology can be applied to other
sectors, and even the stock markets as a whole. And no “sector” is
more important to the overall stock markets than the biggest and
best American companies. So I’m starting this new essay series to
analyze their quarterly results on an ongoing basis. Today’s
initial foray starts with their latest results from Q4’17, a
critical baseline quarter.
With
the new Q1’18 earnings season getting underway, Q4’17’s data is
getting stale. Optimally this research would’ve been done 6 weeks
or so ago. But it wasn’t until long-lost stock-market volatility
finally roared back in February and March that it became abundantly
clear big changes are afoot. After that it took time to
build our necessary underlying spreadsheets and dive into the big US
stocks’ Q4 results.
Going forward it will be easier to analyze and publish new quarters’
results much sooner after those quarters end. But getting Q4’17
baseline data was absolutely essential. That may very well prove
the final quarter in one of the most-extraordinary bull markets
on record. The flagship S&P 500 stock index had powered 324.6%
higher over 8.9 years, making for the third-largest and
second-longest US bull on record!
That
was also just a hair under the second-largest ranking. 2017 was
truly the best of times for the stock markets too.
Record-low volatility along with extreme euphoria in anticipation of
Republicans’ coming massive corporate tax cuts drove the S&P 500
(SPX) 19.4% higher with nary even a trivial 4%+ pullback. Nearly
everyone was convinced this idyllic rally could continue
indefinitely, traders were utterly enchanted.
A
key real-world side effect of last year’s epic stock-market
exuberance was sharply-higher spending by households and
corporations alike. Late in major bull markets when everyone is
complacent and greedy the wealth effect is very strong.
People extrapolate their fat stock gains out into infinity, and ramp
their spending accordingly. That drives strong growth in corporate
sales and profits, greatly reinforcing the elation.
As a
contrarian student of the markets and trader, I wasn’t drinking that
Kool-Aid. On 2017’s final trading day I published an essay on the
hyper-risky stock
markets, explaining why a new bear was long overdue. The
valuations of the elite SPX stocks were deep into formal bubble
territory, running at average trailing-twelve-month
price-to-earnings ratios of 30.7x at the time. That would further
balloon to 31.8x by late January!
More
importantly, the world’s major central banks were pulling away the
punch bowls that had directly fueled that vast orgy of stock-market
excess. The Fed was starting to ramp its first-ever
quantitative-tightening campaign to begin unwinding long years
and trillions of dollars of quantitative-easing money
printing. And the European Central Bank was drastically tapering
its own QE bond-buying campaign.
This
unprecedented tightening following radically-unprecedented QE
would literally
strangle the stock markets, as I explained in late October. The
extreme euphoria drowned out those warnings then, but traders are
more receptive now after the SPX’s first 10%+ correction in 2.0
years in early February. All this suggests high odds that Q4’17
will prove the final pre-peaking quarter of that central-bank-goosed
bull.
Thus
I couldn’t wait for Q1’18 data to start this new essay series, I had
to get Q4’17’s baseline data no matter what. The world’s
most-important stock index by far is the US S&P 500, which weights
America’s biggest and best companies by market capitalization. So
not surprisingly the world’s largest and most-important ETF is the
SPY SPDR S&P 500 ETF which tracks the SPX. This week it had net
assets of $252.4b!
That’s a staggering sum, reflecting the universal popularity of
index investing late in major bull markets. Two of the next three
largest ETFs also track the S&P 500, the IVV iShares Core S&P 500
ETF at $140.4b and the VOO Vanguard S&P 500 ETF at $87.1b. These
dwarf the entire rest of the ETF sector. For comparison, the
dominant and popular GLD SPDR Gold Shares gold ETF has net assets of
just $37.3b.
Unfortunately my small financial-research company lacks the manpower
to analyze all 500 SPX stocks in SPY each quarter. Support our
business with enough newsletter subscriptions, and I would gladly
hire the people necessary to do it! But for now we’re starting with
the top-34 SPY components ranked by market capitalization. That’s
an arbitrary number that fits neatly into the tables below, but a
commanding sample.
As
of the end of Q4’17 on December 29th, these 34 companies accounted
for a staggering 41.8% of the total weighting in SPY and the
SPX itself! They are the biggest and best American companies that
are largely-if-not-totally driving US stock-market fortunes.
Whether the SPX rolls over into a new bear market or not will depend
on how these elite stocks fare. They are the widely-held mega-cap
stocks everyone loves.
Every quarter I’m going to wade through a ton of core fundamental
data on each top-34 SPX company and dump it into a spreadsheet for
analysis. The highlights make it into these tables. They start
with each company’s symbol, weighting in the SPX and SPY, and market
cap as of the final trading day of Q4’17. That’s followed by the
year-over-year change in each company’s market capitalization, a
critical metric.
Major US corporations have been engaged in a wildly-unprecedented
stock-buyback binge ever since the Fed
forced interest
rates to deep artificial lows during 2008’s stock panic. Thus
their share-price appreciation also reflects shrinking shares
outstanding. Looking at market-cap changes instead of just
underlying share-price changes effectively normalizes stock
buybacks. It’s a purer view of company value.
The
next dataset is quarterly sales along with their YoY changes.
Revenues are one of the best indicators of businesses’ health.
While profits can be manipulated quarter-to-quarter by playing with
accounting estimates, sales are mostly set in stone. Ultimately
sales growth is necessary for companies to expand, as earnings
boosts driven by cost-cutting are inherently limited. Sales
declines are bear-market harbingers.
Operating cash flows are also very important, showing how much
capital companies’ businesses are actually generating.
Unfortunately most of these elite big US stocks didn’t break out
Q4’17 OCF, instead lumping it in with full-year financial
statements. While that can still be calculated by subtracting the
Q1 to Q3 OCFs from the annual one, that’s tedious and
time-consuming. Not reporting full Q4 results disrespects
investors.
Next
are the real quarterly earnings that must be reported to the
Securities and Exchange Commission under Generally Accepted
Accounting Principles. Late in bull markets, companies tend to use
fake pro-forma earnings to downplay GAAP results. These are derided
as EBS earnings, Everything but the Bad Stuff! Companies
arbitrarily ignore certain expenses to artificially inflate their
profits, which is very misleading.
While we’re also collecting earnings-per-share data, it’s more
important to consider total profits. Stock buybacks are executed to
drive EPS higher, because the shares-outstanding denominator shrinks
as shares are repurchased. Raw profits are a cleaner measure,
normalizing out stock buybacks’ impacts. When the inevitable bear
market arrives, companies will attempt to mask falling earnings by
emphasizing EPS.
Finally the trailing-twelve-month price-to-earnings ratio is noted.
TTM P/Es look at the last four reported quarters of actual GAAP
results compared to prevailing stock prices. They are the
gold-standard metric for valuations. Wall Street often
intentionally obscures these hard P/Es by using forward P/Es
instead, which are literally mere guesses about future
profits! They have usually proven far too optimistic in the past.
As
expected given last year’s spending-driving stock-market euphoria,
the top SPY/SPX components’ Q4’17 results were generally quite
impressive. Their sales grew strongly, but were still far-outpaced
by their stock-price gains driving valuations sharply higher.
Earnings were heavily distorted due to the impact of Republicans’
big corporate tax cuts passing that quarter, which was fascinating
to analyze.
Not
surprisingly the S&P 500’s top-constituent list was little changed
in 2017. Most of these elite American companies only grew larger.
Three stocks did claw their way into the top 34 since Q4’16, their
symbols are highlighted in blue above. Boeing is a high-priced Dow
30 stock, which has skyrocketed on better business prospects driving
the Dow higher. Its market cap soared an astounding 85% higher last
year!
Any
company with YoY market-cap gains over 19% beat the overall SPX last
year, while any company below that lagged it. These top-34 US
stocks saw average market-cap gains of 29%, well ahead of that
average. One of the telltale characteristics of bull-market tops is
gains concentrate in fewer and fewer stocks. The well-known
shrinking-business problems of GE and IBM forced them just out of
the top 34 last year.
With
500 stocks in the S&P 500, it’s still amazing and damning that 41.8%
of this entire index’s market cap is concentrated in just 34 big US
stocks! At the end of Q4’17, investors had $10.2t of wealth tied up
in these elite companies. That extreme concentration is a
double-edged sword, because bear markets often inflict downside
damage on individual stocks in proportion to their upsides seen in
the preceding bulls.
Ominously the universally-adored and -owned mega-cap tech stocks
were dominating the SPX at the end of 2017. Apple, Alphabet,
Microsoft, Amazon, and Facebook all had staggering market caps in
excess of a half-trillion dollars each. These 1% of SPX stocks
weighed in at a colossal 13.8% of index weight! Their average TTM
P/E was 61.7x, more than double the 28x classical bubble threshold.
That’s super risky!
One
reason investors have been willing to pay such high premiums for the
tech market darlings is their astounding sales growth. While the
top-34 SPX companies together averaged still-impressive 11% sales
growth from Q4’16 to Q4’17, the top 5 tech stocks trounced that at
28%! The rest of these top-34 SPY components reporting Q4 sales
averaged about a quarter of that at 7.7%. So these tech stocks look
invincible.
But
such fast sales growth is unsustainable given their massive sizes,
and likely to reverse with the stock markets. Everyone loves
Apple’s products, but they are expensive. iPhones and iPads last
years with no need to upgrade, and major upgrades are few and far
between anyway with those technologies maturing. So the upgrade
cycles Apple desperately needs to drive its massive sales are
lengthening considerably.
As
the stock markets’ wealth effect reverses to negative in the next
bear market, odds are Americans will keep their iPhones longer
before buying new ones. These are sizable expenses relative to
median US household incomes. Amazon might be able to better weather
a stock-market storm, depending on how much of the stuff Americans
order from it is necessary versus discretionary. Its bear sales
trends will be interesting.
Alphabet, Microsoft, and Facebook rely heavily on business
spending. The coming huge tax cuts made 2017 a banner year for
business confidence, leading to giant leaps in spending on online
advertising as well as back-office data services. When the next
recession comes accompanying the stock bear, much of that euphoric
business spending will wither and reverse. So mega-cap-tech sales
growth ahead isn’t so rosy.
I
was very dismayed to find only 13 of these biggest-and-best American
companies bothered reporting their Q4 operating cash flows to their
investors. These companies have effectively infinite accounting
resources, yet their Q4 breakouts from full-year results were
terrible. Even
the gold miners with their wildly-varying accounting and home
countries did way better. So there’s not enough Q4 OCFs to bother
analyzing.
Thankfully that won’t be the case in Q1s to Q3s, where every one of
these elite stocks will dutifully report their quarterly operating
cash flows. In the gold-mining space, sometimes companies choosing
to obscure their OCFs want to hide poor performance. I don’t think
that’s the case in these top SPX/SPY companies given their strong
sales growth. But I’m shocked they don’t consider shareholders
worthy of this key data.
The
biggest surprises for me in this first foray into big US stocks’
quarterly results came on the earnings front. As expected given all
the spending-inducing stock euphoria last year, overall profits of
these top-34 SPY components grew to $112.2b in Q4. That made for
average YoY gains of 137%, certainly sounding phenomenal. But that
was just one quarter, not the entire year. So valuations didn’t
decline on that.
The
dominant reason the stock markets soared in 2017 was the coming
massive corporate tax cuts. All year long there was great
anticipation of them becoming law. The actual Tax Cuts and Jobs Act
of 2017 bill was introduced in early November, passed the House in
mid-November, passed the Senate in early December, and then was
passed again in its reconciled version in both Congress chambers in
mid-December.
Trump signed it into law and made it official on December 22nd,
2017. This whole process surrounding the actual bill began and
ended in Q4. Its flagship provision was slashing the US corporate
tax rate from 35% to 21%. This was a huge cut despite many
offsetting business deductions and credits also being eliminated.
It was probably the biggest change in US corporate taxation in
history, a huge shift to adjust to.
For
large publicly-traded companies, the SEC requires formal 10-K annual
reports after fiscal year-ends to be filed by 60 days after
quarter-ends. So American companies only had about 9 weeks to
analyze the impact of the TCJA on their businesses before reporting
Q4’17. Fully 33 of these top 34 companies in the SPX reported TCJA
adjustments to their Q4’17 profits. Apple was the only company not
breaking it out.
These adjustments’ profits impacts had an enormous range, from a
colossal $29.1b boost to Berkshire Hathaway’s Q4 profits to a
gargantuan $22.0b hit on Citigroup’s! So nearly all these Q4 GAAP
profits are somewhat-to-heavily distorted by one-time impacts of
those corporate tax cuts. Most of the really-big profits and
really-big losses above are the result of these TCJA adjustments
and not business operations.
In
reading through all these 10-Ks and 10-Qs, there were generally two
major tax-cut drivers impacting profits. The first was deferred tax
assets and liabilities. These are very complicated, but basically
US companies either overpaid or underpaid their taxes in individual
years due to various accounting rules. The differences become DTAs
or DTLs, which reduce or increase future years’ tax burdens for
these companies.
But
when the corporate tax rate was drastically slashed from 35% to 21%,
all of a sudden both DTAs and DTLs were worth much less going
forward. DTAs shielded less future profits at lower tax rates,
while DTLs would have lower future tax payments. Different
industries and businesses had wildly-different deferred taxes on
their books. The second provision driving the adjustments was a
one-time repatriation tax.
Because the US corporate tax rate had been so obnoxiously high
relative to the rest of the world for so long, major companies
played accounting games recognizing earnings in other countries.
This stacked up to trillions of dollars held overseas. The TCJA
imposed a one-time repatriation tax assuming that this cash was
being sent back to the US whether that was true or not, which was a
big cost for some companies.
So
these Q4’17 profits numbers are very distorted by these one-time
TCJA adjustments flushed through income statements. I gathered all
these with the rest of the data, and expected a big overall impact
on their collective profits. The absolute value of all of them
together for these top-34 US stocks was a truly-staggering
$209.2b in Q4’17! That dwarfed the actual reported GAAP profits
running $112.2b that quarter.
Thus
I watched the running total with great interest as I waded through
the quarterlies. I expected to see corporate profits greatly
overstated by the TCJA adjustments. But much to my surprise, the
net of all of these positive and negative profits impacts was merely
+$2.7b. That’s just 2.4% of the total earnings of these top-34 big
US stocks, essentially a wash. Will the corporate tax cuts
be less valuable than expected?
While the old statutory corporate rate was 35%, many companies are
using schemes and loopholes to pay far less. Many of those were
closed to get to 21%. If the positive impact of lower corporate
taxes is smaller going forward than Wall Street joyously expects, it
will have a big adverse psychological impact. If profits don’t
balloon dramatically as forecast, valuations are going to get even
more dangerously extreme.
While individual top SPX companies’ profits won’t be comparable with
those big TCJA adjustments, they will be collectively with
the overall flat impact. If the $112.2b of Q4’17 GAAP profits
earned by these top 34 US companies is annualized, it implies
$448.9b of earnings on a $10.2t collective market cap. That equates
to a 22.7x overall P/E for these big US stocks at the end of one of
the best corporate-profits years ever.
That’s not in bubble territory, but
still very
expensive after such a big and long bull. But not aggregated
these top stocks look way more overvalued. Their average TTM P/Es,
which didn’t yet include Q4’17 earnings at the end of December, ran
way up at 30.6x. That’s still above that 28x bubble threshold. But
Amazon is an insane outlier at 190.2x earnings. Ex-Amazon, that
top-SPY-stocks average drops to 25.8x.
That’s still frighteningly high. The whole purpose of bear markets
following long bull markets is to drag stock prices down and
sideways long enough for earnings to catch up with lofty stock
prices. Bears don’t end until overall stock-market P/E ratios
collapse back down to 7x to 10x earnings! That implies the US stock
markets face getting at least cut in half, which is typical
in major bear
markets. That’s serious downside.
Ominously most of this past year’s incredible stock-price
appreciation in these elite companies wasn’t driven by earnings
growth. The average jump in their market capitalizations from the
end of Q4’16 to the end of Q4’17 was 29%. In this same span their
TTM P/E ratios climbed an average of 25%. Thus these top SPY
companies’ earnings barely grew during all of last year
despite all the record-high-stocks euphoria!
The
hard data proves that’s true. In Q4’16, these same 34 big US stocks
collectively earned $110.4b. That only rose 1.7% YoY to $112.2b in
Q4’17. Yet their total market caps still blasted 26.9% higher!
This proves one of the greatest stock-market years on record
didn’t drive any meaningful earnings growth in Q4, which tends
to be the best quarter of the year on holiday spending.
Fundamentals didn’t improve.
Last
year’s extreme stock-market melt-up to dazzling new all-time highs
was purely a sentiment thing, not at all fueled by GAAP
earnings growth. 2017’s big gains were built on sand. Psychology
is a fleeting capricious thing that will absolutely mean revert back
to neutral and overshoot to bearish. And when that happens, the
profits won’t be there to keep these elite market-darling stocks
from getting mauled by the bear.
Despite the recent mild correction, these stock markets remain
exceedingly overvalued and dangerous. The big US stocks’ Q4’17
fundamentals prove corporate earnings remain far too low to justify
such high stock prices. That’s terrifying in 2018 where the Fed and
ECB will collectively
remove $950b of
liquidity compared to last year! Regardless of valuations, this
alone would plunge these stock markets into a new bear.
Investors really
need to lighten up on their stock-heavy portfolios, or put stop
losses in place, to protect themselves from the coming
central-bank-tightening-triggered valuation mean reversion in
the form of a major new stock bear. Cash is king in bear markets,
as its buying power grows. Investors who hold cash during a 50%
bear market can double their stock holdings at the bottom by buying
back their stocks at half-price!
SPY put options
can also be used to hedge downside risks.
They are still relatively cheap now with complacency rampant, but
their prices will surge quickly when stocks start selling off
materially again. Even better than cash and SPY puts is
gold, the anti-stock trade. Gold is a rare asset that tends to move
counter to stock markets, leading to
soaring
investment demand for portfolio diversification
when stocks fall.
Gold surged nearly
30% higher in the first half of 2016 in a new bull run that was
initially sparked by the last major correction in stock markets
early that year. If the stock markets indeed roll over into a new
bear in 2018, gold’s coming gains should be much greater. And they
will be dwarfed by those of the best gold miners’ stocks, whose
profits leverage
gold’s gains. Gold stocks skyrocketed 182% higher in 2016’s
first half!
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The
bottom line is the big US stocks’ latest quarterly results are
concerning. Despite a perfect year for the stock markets, and
boundless optimism fueled by hopes for big tax cuts soon, corporate
profits were largely flat in Q4. If the biggest and best American
companies can’t grow earnings substantially even in that ideal
environment, how will they fare when these stock markets inevitably
roll over into a long-overdue bear?
And
the initial massive-corporate-tax-cut impact on corporate profits
was effectively a wash. What if the slashed corporate tax rate
doesn’t yield the expected earnings windfall in 2018? This risk
coupled with slowing sales as stock markets weaken is incredibly
bearish. Especially with the biggest and best US stocks everyone
loves and owns still trading near or above bubble valuations as
central banks greatly tighten. |