The
widely-held mega-cap stocks that dominate the US markets recently
finished reporting their Q4’18 financial results. Because the tenor
of stock markets changed radically last quarter, this latest
earnings season is more important than usual. An extreme monster
bull market suddenly rolled over into a severe near-bear correction
in Q4. How major corporations fared offers insights into whether a
young bear is upon us.
Four
times a year publicly-traded companies release treasure troves of
valuable information in the form of quarterly reports. Required by
the US Securities and Exchange Commission, these 10-Qs and 10-Ks
contain the best fundamental data available to traders. They dispel
all the sentiment distortions inevitably surrounding prevailing
stock-price levels, revealing corporations’ underlying hard
fundamental realities.
While 10-Qs with filing deadlines of 40 days after quarter-ends are
required for normal quarters, 10-K annual reports are instead
mandated after quarters ending fiscal years. Most big companies
logically run their accounting on calendar years, so they issue
10-Ks after Q4s. Since these annual reports are larger and must
be audited by independent CPAs, their filing deadlines are
extended to 60 days after quarter-ends.
So
the 10-K filing season just wrapped up last Friday, revealing how
the biggest and best US companies were doing in Q4’18. They are the
stocks of the flagship S&P 500 stock index (SPX). At the end of Q4
they commanded a gigantic collective market capitalization of
$22.2t! The vast majority of investors own the big US stocks of the
SPX, as some combination of them are usually the top holdings of
nearly every fund.
The
major ETFs that track the S&P 500 dominate the increasingly-popular
passive-investment strategies as well. The SPY SPDR S&P 500 ETF,
IVV iShares Core S&P 500 ETF, and VOO Vanguard S&P 500 ETF are among
the largest in the world. This week they reported colossal net
assets running $262.4b, $160.5b, and $103.2b respectively! Overall
stock-market fortunes are totally dependent on big US stocks.
Q4’18 proved extraordinary. Leading into it, the SPX hit a dazzling
all-time record high in late September about a week before Q4
arrived. That extended an extreme monster stock bull to 333.2%
gains over 9.5 years, the 2nd-largest and 1st-longest in all of US
stock-market history! But as I warned days after that euphoric
peaking, the Fed’s unprecedented quantitative-tightening campaign
would finally
ramp to full speed in Q4.
Stock markets artificially inflated by $3625b of Fed QE over 6.7
years couldn’t react well to Fed QT finally starting to unwind that
epic monetary inflation. With QT hitting $50b per month starting in
Q4, the stock markets indeed wilted. Over the next 3.1 months into
Christmas Eve, the SPX plummeted 19.8%! That was right on the verge
of a new bear market at -20%. The SPX suffered its worst December
since 1931, -9.2%.
That
sure looked like a
young bear market,
really freaking out traders. But since those deep and ominous lows,
the SPX has soared 19.3% at best in a massive rally! That has
reversed nearly 4/5ths of the total correction losses largely
suffered in Q4. This looked and acted like a classic bear-market
rally, rocketing higher to eradicate fear and restore universal
complacency. New-bear worries have shriveled to nothing.
Given Q4’18’s colossal stock-market inflection and subsequent huge
rebound, whether the SPX narrowly evaded the overdue-bear bullet or
not is supremely important. Bear markets exist for one reason, to
maul overvalued stocks back down below historic fair-value levels.
So how the major US corporations actually fared last quarter, how
large their earnings were compared to their stock prices, offers
essential bull-bear clues.
Every quarter I analyze the top 34 SPX/SPY component stocks ranked
by market cap. This is just an arbitrary number that fits neatly
into the tables below, but is a dominant sample of the SPX. At the
end of Q4, these American giants alone commanded fully 43.7%
of the SPX’s total weight! Their $9.7t collective market cap
exceeded that of the bottom 437 SPX companies. Big US stocks’
importance cannot be overstated.
I
wade through the 10-K or 10-Q SEC filings of these top SPX companies
for a ton of fundamental data I dump into a spreadsheet for
analysis. The highlights make it into these tables below. They
start with each company’s symbol, weighting in the SPX and SPY, and
market cap as of the final trading day of Q4’18. That’s followed by
the year-over-year change in each company’s market capitalization, a
key 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 the appreciation in their share prices also reflects
shrinking shares outstanding. Looking at market-cap changes
instead of just underlying share-price changes effectively
normalizes out stock buybacks, offering purer views of value.
That’s followed by quarterly sales along with their YoY changes.
Top-line revenues are one of the best indicators of businesses’
health. While profits can be easily manipulated quarter to quarter
by playing with all kinds of accounting estimates, sales are tougher
to artificially inflate. Ultimately sales growth is necessary for
companies to expand, as bottom-line profits growth driven by
cost-cutting is inherently limited.
Operating cash flows are also important, showing how much capital
companies’ businesses are actually generating. Using cash to make
more cash is a core tenet of capitalism. Unfortunately many
companies are now obscuring quarterly OCFs by reporting them in
year-to-date terms, lumping in multiple quarters together. So the
Q4’18 OCFs shown are mostly calculated by subtracting Q3’18 YTD OCFs
from full-year ones.
Next
are the actual hard quarterly earnings that must be reported to the
SEC under Generally Accepted Accounting Principles. Lamentably
companies now tend to use fake pro-forma earnings to downplay
real GAAP results. These are derided as EBS profits, Everything but
the Bad Stuff! Certain expenses are simply ignored on a pro-forma
basis to artificially inflate reported corporate profits, often
misleading traders.
While we’re also collecting the earnings-per-share data Wall Street
loves, it’s more important to consider total profits. Stock
buybacks are executed to manipulate EPS higher, because the
shares-outstanding denominator of its calculation shrinks as shares
are repurchased. Raw profits are a cleaner measure, again
effectively neutralizing the impacts of stock buybacks. They better
reflect underlying business performance.
Finally the trailing-twelve-month price-to-earnings ratios as
of the end of Q4’18 are noted. TTM P/Es look at the last four
reported quarters of actual GAAP profits compared to prevailing
stock prices. They are the gold-standard metric for valuations.
Wall Street often intentionally conceals these hard P/Es by using
the fictional forward P/Es instead, which are literally mere guesses
about future profits that often prove far too optimistic.
These are mostly calendar-Q4 results, but some big US stocks use
fiscal quarters offset from normal ones. Walmart, Home
Depot, and Cisco have quarters ending one month after calendar ones,
so their results here are current to the end of January instead of
December. Oracle uses quarters that end one month before calendar
ones, so its results are as of the end of November. Offset
reporting ought to be banned.
Reporting on offset quarters renders companies’ results way less
comparable with the vast majority that report on calendar quarters.
We traders all naturally think in calendar-quarter terms too.
Decades ago there were valid business reasons to run on offset
fiscal quarters. But today’s sophisticated accounting systems that
are largely automated running in real-time eliminate all excuses for
not reporting normally.
Stocks with symbols highlighted in blue have newly climbed into the
ranks of the SPX’s top 34 companies over the past year, as investors
bid up their stock prices and thus market caps relative to their
peers. Overall the big US stocks’ Q4’18 results looked impressive,
with good sales and profits growth. But that masks a sharp
slowdown from prior quarters that will be exacerbated as the
corporate-tax-cut transition year ends.
2018
was a banner year for corporate earnings because of Republicans’
massive corporate tax cuts. The Tax Cuts and Jobs Act was signed
into law on December 22nd, 2017 to go into effect on January 1st,
2018. Its centerpiece was slashing the US corporate tax rate from
35% to 21%, which naturally boosted reported profits. But 2018’s
four quarters were the only ones that would experience anomalous
TCJA growth.
Q4’18 was the last quarter comparing year-over-year growth between a
pre-TCJA quarter and post-TCJA quarter. That major discontinuity
distorted corporate-earnings growth. Profits soared last year not
just because companies were doing better, but because they were
paying taxes at much-lower rates. But starting in Q1’19, that TCJA-transition
boost is gone forever. Normal same-tax-regime YoY comparisons will
return.
But
before we get to all-important corporate earnings and resulting
valuations, let’s work our way through these tables. Thanks to the
SPX’s brutal 14.0% plunge in Q4, this leading broad-market stock
index lost 6.2% last year. The biggest and best US companies fared
a little better, with the collective market cap of the top 34
sliding 5.2% YoY. These elite corporations had average market-cap
losses running 3.6% YoY.
That
certainly isn’t calamitous, but the deceleration is
neck-snapping! In the prior four quarters starting in Q4’17, the
SPX’s top 34 components saw enormous average YoY market-cap gains of
29.2%, 14.6%, 23.5%, and 24.2%. Make no mistake, Q4’18 saw a
massive and ominous stock-market inflection. The severe near-bear
correction’s selling pressure was even heavier in smaller SPX stocks
below the top 34.
That
pushed the top 34’s share of the SPX’s total weighting to 43.7%, a
big increase from Q4’17’s 41.8%. The more capital concentrated in
fewer stocks, the riskier the entire stock markets become. Big down
days driven by company-specific news in highly-weighted individual
stocks can drag down the entire stock markets. A great example
occurred in mighty Apple just after Q4 ended, when it warned on weak
Q4 sales.
For
years Apple had been the largest US stock by market cap, commanding
the highest ranking in the SPX and SPY. Just after 2019’s first
trading day closed, Apple cut its Q4 revenue guidance by 7.7% from
its own midpoint given 2 months earlier. The next day AAPL stock
collapsed by 10.0%, which pummeled the entire SPX 2.5% lower in its
worst loss so far this year. When a top US stock sneezes, markets
catch a cold.
Falling stock markets exert a strong negative wealth effect.
Both consumers and corporations get scared as stocks suffer big and
fast drops, so they pull in their horns on spending. That left all
kinds of economic data covering parts of Q4 weaker than expected,
sometimes shockingly so. Lower spending weighs on corporate
revenues, as fewer people buy less goods and services. Would the
top 34’s Q4’18 sales reflect this?
On
the surface these biggest-and-best US companies looked immune.
Their total Q4 sales of $1051.6b still climbed an impressive 4.2%
YoY in the stock markets’ worst quarter since Q3’11. These
companies averaged big sales growth of 7.4% YoY, which was
surprisingly robust given the stock-market carnage. Yet even that
good top-line growth still reflects a major slowdown for the
top 34 from the past year’s pace.
In
the preceding four quarters, the SPX’s top 34 component stocks
averaged YoY revenues growth way up at 10.8%, 14.0%, 14.0%, and
11.5%. So Q4’s was a serious deceleration, which may be an ominous
portent for 2019. Q4’s revenues growth may be overstated too.
Nearly 2/3rds of the SPX’s spending-sapping Q4 plunge came in
December alone, after much of the surge in holiday shopping was
already over.
If
big US companies’ sales growth continues slowing or even starts
shrinking in 2019, corporate-profits growth will collapse. While
Q1’19’s earnings season doesn’t start for another 5 weeks or so,
plenty of companies have warned that they see revenues slowing
much more than Wall Street expected. If Q4’18 was indeed a
major stock-market trend change from bull to bear, corporate results
will continue deteriorating.
The
mega-cap companies dominating the SPX and American investors’
portfolios also enjoyed strong operating-cash-flow-generation growth
in Q4. Their collective OCFs surged 11.5% YoY to $195.8b.
Individual companies enjoyed average OCF gains of 10.8% YoY. That
looks great on the surface, but just like sales it represents a
sharp slowdown from huge YoY OCF growth seen in the prior four
quarters.
Starting in Q4’17 the SPX top 34’s operating cash flows averaged
growth of 17.0%, 52.5%, 30.3%, and 20.6% YoY. So Q4’18’s
still-strong OCF growth actually decelerated by almost 2/3rds from
the precedent of the prior year. That was the prevailing theme of
Q4’18 results, good numbers but already slowing fast from the rest
of 2018’s even though last quarter had easy annual comparisons
across those corporate tax cuts.
Actual corporate profits among these elite US companies are critical
to prevailing valuations. The price-to-earnings ratio is the
classic measure of how expensive stock prices are. It simply
divides companies’ current stock prices by their total earnings per
share over the last four reported quarters. So profits are really
the only corporate results that matter for valuations, making
their growth trends the most important of all.
Interestingly the top 34 SPX components’ total GAAP profits
actually shrunk 1.4% YoY to $110.6b in Q4! That doesn’t make
sense given their total revenues growth of 4.2%, which earnings
should’ve amplified. But a couple big factors played into that
surprising decline. After the Tax Cuts and Jobs Act was passed near
the end of 2017, companies had to make huge adjustments to overpaid
or underpaid taxes on their books.
These are called deferred tax assets and liabilities, which would
suddenly be valued very differently under the new corporate-tax
rules. So as I
analyzed last year, the top 34 SPX companies ran a staggering
$209.2b of TCJA adjustments through their earnings in Q4’17! Thus
that earlier comparable quarter to Q4’18 was a mess in GAAP-earnings
terms. Q4’17 was probably the most-distorted quarter in SPX
history.
But
with about half those one-time TCJA adjustments resulting in profits
gains and half in losses, the net impact to overall SPX-top-34
earnings in Q4’17 was essentially a wash at +$2.7b. That
merely boosted overall Q4’17 profits by 2.5%. A far-more-important
factor in Q4’18’s YoY earnings decline came from a single company,
Warren Buffett’s Berkshire Hathaway. It was the 5th-largest SPX
component as 2018 ended.
BRK
suffered a catastrophic $25.4b GAAP loss last quarter! That was
almost entirely due to the sharp stock-market decline, which
hammered Berkshire’s gigantic investment portfolio lower. It
suffered $27.6b of non-cash losses that now have to be run through
quarterly earnings. A new accounting rule now requires that
unrealized capital gains and losses must be flushed through the
bottom line, really irritating Buffett.
In
BRK’s 2018 annual report he wrote “As I emphasized in the 2017
annual report, neither Berkshire’s Vice Chairman, Charlie Munger,
nor I believe that rule to be sensible. Rather, both of us have
consistently thought that at Berkshire this mark-to-market change
would produce what I described as “wild and capricious swings in our
bottom line.” ...
Wide swings in our
quarterly GAAP earnings will inevitably continue.”
“That’s because our huge equity portfolio – valued at nearly $173
billion at the end of 2018 – will often experience one-day price
fluctuations of $2 billion or more, all of which the new rule says
must be dropped immediately to our bottom line. ... Our advice?
Focus on operating earnings, paying little attention to gains or
losses of any variety.” Berkshire’s operating earnings were $5.7b
in Q4’18, soaring 71.4% YoY!
If
BRK’s epic unrealized capital loss is ignored, total SPX-top-34
earnings would’ve surged 23.2% YoY in Q4’18. On average these top
34 SPX companies reporting profits in both Q4’17 and Q4’18 averaged
similar 27.8% YoY gains. But the same sharp-deceleration story seen
in revenues and OCFs also applies here. The previous four quarters
saw far-stronger average growth of 137.0%, 45.9%, 44.5%, and 53.8%
YoY!
The
massive swings in Berkshire’s enormous investment portfolio are
going to distort overall corporate profits in all future quarters
with significant SPX gains or losses. We’ll have to watch that
going forward, and adjust for it if necessary. But overall
corporate profits will be much cleaner in coming years with the TCJA
transition year of 2018 behind us. Apples-to-apples comparisons
will once again become the norm.
The
major slowdown in big US companies’ revenues, operating cash
flows, and earnings growth in Q4’18 is certainly ominous.
Especially since the majority of the SPX’s plunge last quarter came
relatively late in December. But the most-important thing for
attempting to divine whether that monster bull remains alive and
well having merely suffered a severe correction, or a young bear is
underway, is how valuations look.
These top 34 SPX companies that earned GAAP profits over the past
four quarters averaged trailing-twelve-month price-to-earnings
ratios way up at 39.7x as Q4 ended! That’s 29.4% above Q4’17’s
average a year earlier, and well into dangerous bubble territory.
Over the past
century-and-a-quarter or so, US stock markets have averaged 14x
earnings which is fair value. Twice that at 28x is where bubble
territory begins.
Despite remaining scary-high, big US companies’ average valuations
did moderate considerably in Q4. The prior four quarters saw the
SPX top 34’s average TTM P/Es run 30.6x, 46.0x, 53.4x, and 49.0x.
So the severe near-bear correction definitely did some real work in
mauling valuations down. And the P/Es in these tables are as of the
end of Q4, which of course didn’t yet reflect the solid YoY growth
in Q4 earnings.
By
the end of February the top 34 SPX companies’ average TTM P/Es had
further dropped to 26.4x, still very expensive but no longer bubble
levels. That includes these Q4 results and is even despite the
SPX’s powerful rebound rally out of late December’s near-bear lows.
So the situation today is nowhere near as dire as at the end of
Q4’18 on the valuation front. But that doesn’t mean stock markets
are out of the woods.
Bear
markets exist because stocks get too expensive leading into the ends
of preceding bulls. At 14x fair value it takes 14 years for a
company to earn back the price investors are paying for it. The
reciprocal of that is a 7.1% return, which is mutually beneficial
for both investors with surplus capital and companies that need it.
Once extreme bubble valuations birth bear markets, they don’t
hibernate until stocks are cheap.
Throughout all of 2018 the US stock markets were trading at
extreme bubble
valuations. Then in Q4 that severe 19.8% correction hammered
the SPX to the verge of formal bear territory. The rebound since
has all the hallmarks of a massive bear-market rally. Wall Street’s
oft-cited belief that Q4’s plunge was more than enough to restore
balance to these stock markets isn’t credible. Bears don’t stop
with stocks still expensive!
Historical bear markets after major bulls nearly always maul
prevailing US-stock-market valuations back down to cheap levels at
7x to 10x earnings in TTM P/E terms. With the top US stocks
averaging 39.7x as Q4 waned and 26.4x at the end of February, the
valuation-mean-reversion work still has a long way to go. It is
certainly not safe to assume no bear is coming until the SPX trades
under 14x, which is far lower.
The
SPX soared 11.1% YTD by the end of February, hitting 2784.5. Merely
to get to fair value at 14x earnings, not even overshoot to the
downside, the SPX has to fall to 1476.6! That’s another 46.7% under
this week’s levels! And if corporate earnings actually start
retreating this year, the SPX downside targets will fall
proportionally. Big bears are
normal and
inevitable after big bulls, as I explained in depth in late
December.
Nearly a decade of Fed-QE-goosed bull market has left traders
forgetting how dangerous bears are. The SPX’s last two bears were a
49.1% decline over 2.6 years ending in October 2002, and a 56.8%
plunge in 1.4 years climaxing in a stock panic to a March 2009 low!
With the big US stocks sporting extreme bubble valuations all of
last year, and still near bubble valuations now, it’s hard to
believe we aren’t in a young bear.
If
that proves true, investors need to lighten up on their stock-heavy
portfolios, or at least put stop losses in place. Cash is king in
bear markets, since its buying power grows. Investors who hold cash
during a 50% bear market can double their holdings at the bottom by
buying back their stocks at half-price. But cash doesn’t appreciate
in value like gold, which actually grows wealth during major
stock-market bears.
Gold
investment demand
surges as stock markets weaken, as we got a taste of in
December. While the SPX plunged 9.2%, gold rallied 4.9% as
investors flocked back. The gold miners’ stocks which
leverage gold’s
gains fared even better, with their leading index surging 10.7%
higher. The last time a major SPX selloff awakened gold in the
first half of 2016, it soared 30% higher fueling a massive 182%
gold-stock upleg!
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The
bottom line is big US stocks’ Q4’18 results looked impressive on the
surface. Good annual growth in sales, operating cash flows, and
even earnings excluding Berkshire’s huge mark-to-market losses
appeared to buck Q4’s major stock-market selloff. But these growth
rates all suffered sharp decelerations from those seen in preceding
quarters, suggesting a slowdown is underway. That’s a real problem
for stock markets.
Valuations remain dangerously high, deep into bubble territory at
the end of Q4. And even after the Q4 earnings were included by late
February, near-bubble valuations persisted. That means the likely
bear has barely started its stock-price-mauling work to mean revert
expensive valuations. On top of that, 2018’s anomalous
corporate-tax-cut-transition growth rates are history. All this
will continue to pressure stock prices. |