The
US stock markets have surged to all-time-record highs, fueled by
extreme Fed easing. It jawboned about rate cutting, slashed rates,
and birthed a new large-scale Treasury monetization campaign! All
this has left traders hyper-complacent, assuming the upside will
continue indefinitely. But are these lofty stock levels
fundamentally-justified? The big US stocks’ just-reported Q3’19
results illuminate this key question.
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.
The
deadline for filing 10-Qs for “large accelerated filers” is 40 days
after fiscal quarter-ends. The SEC defines this as companies with
market capitalizations over $700m. That easily includes every stock
in the flagship S&P 500 stock index (SPX), which contains the
biggest and best American companies. The middle of this week marked
37 days since the end of Q3, so almost all the big US stocks have
reported.
The
SPX is the world’s most-important stock index by far, with its
components commanding a staggering collective market cap of $26.2t
at the end of Q3! 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 investment fund. That includes retirement
capital, so the fortunes of the big US stocks are crucial for
Americans’ overall wealth.
The
huge 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 the 3
largest ETFs in the world. This week they reported colossal net
assets running $279.7b, $193.3b, and $122.6b respectively! The big
SPX companies overwhelmingly drive the entire stock markets.
Q3’19 was choppy, but the SPX didn’t stray far from record highs.
July saw 8 of them from a big Fed-driven rally. In early June the
Fed chairman started talking rate cuts. That dovishness was
confirmed in mid-June when top Fed officials’ collective outlook for
the rate trajectory shifted from hiking to cutting. The FOMC
delivered at the end of July, cutting by 25 basis points for the
first time since December 2008!
The
SPX surged 2.9% in July alone leading into that cut, hitting those
record closes. But Jerome Powell pooped in traders’ easy-money
punchbowl that day, calling that cut a “midcycle adjustment” and not
“the beginning of a lengthy cutting cycle”. Denied their
perpetual-easing drug, traders revolted to hammer the SPX 6.1% lower
over the next couple weeks. That scared the Fed into backtracking,
leading to more cutting.
The
FOMC cut another 25bp at its next meeting in mid-September, and
Powell’s “midcycle adjustment” turned into 3 25bp cuts in just
3.0 months by the end of October! That and the Fed panicking to
launch its fourth large-scale quantitative-easing campaign to
monetize Treasuries recently pushed the SPX to even more record
highs. But within Q3 proper it averaged 2957.8, the highest ever
witnessed! Traders loved that.
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 a dominant sample of the SPX. As Q3
waned, these American giants alone commanded fully 43.9% of
the SPX’s total weighting! Their $11.5t collective market cap
exceeded that of the bottom 438 SPX companies. Big US stocks’
importance cannot be overstated.
I
wade through the 10-Q or 10-K SEC filings of these top SPX companies
for a ton of fundamental data I feed 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 Q3’19. That’s followed by
the year-over-year change in each company’s market capitalization,
an important metric.
Major US corporations have been engaged in a wildly-unprecedented
stock-buyback binge ever since the
Fed forced
interest rates to the zero lower bound 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 change.
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. Corporations must be
cash-flow-positive to survive and thrive, using their existing
capital to make more cash. Unfortunately many companies now obscure
quarterly OCFs by reporting them in year-to-date terms, lumping
multiple quarters together. So if necessary to get Q3’s OCFs, I
subtracted prior quarters’.
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 I’m also collecting the earnings-per-share data Wall Street
loves, it is 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 Q3’19 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 valuation metric. Wall
Street often intentionally conceals these real P/Es by using
fictional forward P/Es instead, which are literally mere guesses
about future profits that almost always prove too optimistic.
These are mostly calendar-Q3 results, but some big US stocks use
fiscal quarters offset from normal ones. Walmart, Home
Depot, and Cisco have lagging quarters ending one month after
calendar ones, so their results here are current to the end of July
instead of September. Pepsi, Oracle, and Nike report on quarters
ending one month before calendar ones, so their results below are as
of the end of August.
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. The big US stocks reported mixed Q3’19 results overall, with
modest sales growth but shrinking profits. This is a serious
problem with these elite companies still collective trading near
dangerous bubble valuations.
Before we start, these year-over-year comparisons need to be
adjusted slightly. Disney’s fiscal year ends at the end of calendar
Q3. Companies finishing fiscal years have 60 days after
quarter-ends to complete their way-longer, far-more-complex, and
audited 10-K annual reports to file with the SEC. Disney hadn’t
reported anything on Q3’19 yet as of the data cutoff for this essay,
Wednesday’s close. So it is excluded.
The
entire S&P 500 finished Q3’19 up 2.2% from the end of Q3’18. That’s
not much, but remember the SPX collapsed right after that. It
plummeted 19.8% largely in Q4’18 in a severe near-bear correction.
That was driven by Fed tightening, its since-abandoned
quantitative-tightening campaign ramping up to full speed and
the Fed’s 9th
rate hike of its also-forsaken normalization. Marginal new
highs after that are a big deal.
The
top 34 SPX companies’ collective market capitalizations grew by 1.3%
YoY to $11,490.6b as of the end of Q3. Ex-Disney, their total
revenues climbed a healthy 2.4% YoY to $1002.3b. Sales growth at
their massive scales is always impressive. But all of that
came in 3 of the 4 market-dominating mega-cap tech stocks,
Microsoft, Amazon, and Alphabet. Their total revenues soared an
incredible 20.2% higher YoY!
Troublingly the rest of the top 34 ex-Disney saw their total
revenues slump a slight 0.0%. So all the top-line revenue growth
among elite American companies came in just a few tech giants.
If the US economy was booming as record-high stock markets imply,
the rest of these market-leading companies would also be seeing
higher sales. Even mighty Apple has seen its revenue growth flag,
with iPhone demand saturated.
That
bifurcation between mega-cap tech and everything else was even more
pronounced in operating-cash-flow-generation terms. Overall these
top 34 saw their total OCFs collapse a stunning 23.6% YoY to
$188.9b! That was despite MSFT, AMZN, and GOOGL actually growing
their OCFs by 4.9% YoY. But the rest of the top 34 without Disney
suffered a shocking 28.3% YoY decline in total operating cash
flows!
Traders universally believe these are the best of times, deep into a
record US economic expansion with record-high stock markets. But
the rising tide of economic growth lifts all boats, not just a
handful. If the vast majority of elite American companies are
struggling to boost revenues and falling way behind in OCF
generation, what’s going to happen in the next recession? The Fed
can’t delay that inevitable reckoning forever.
The
hard-GAAP-earnings front revealed another serious crack in the
euphoric everything-is-awesome narrative fueled by record-high stock
markets. Overall SPX-top-34 profits in Q3’19 without Disney fell
2.6% YoY to $148.9b. That trio of mega-cap techs actually dragged
down that average, falling 4.9% YoY despite their torrid sales
growth. The rest of the top 34 ex-Disney saw corporate earnings
slide 2.2% from Q3’18.
The
big US stocks’ overall Q3’19 results certainly look like these elite
companies are teetering on the very edge of entering an earnings
recession. That has incredibly-bearish implications given the
lofty prevailing valuations. Companies are doing their damnedest to
mask that their profits look to have peaked and are rolling over.
They’ve massively stepped up their manipulative stock-buyback
campaigns to obscure profits.
Consider some examples. Database and cloud-computing giant Oracle
earned $2137m in net income in its latest fiscal quarter ending
August 31st. That was down a considerable 5.7% YoY. Yet in
earnings-per-share terms which is all companies report now, Q3’19
EPS of $0.64 climbed a strong 10.3% over the Q3’18 results!
There were no unusual income-statement items distorting those
results in either of these quarters.
Despite earning that $2137m, ORCL spent a staggering $5005m during
that quarter buying back its own stock! It and other elite US
companies are magically conjuring rising EPS from falling
absolute profits with enormous stock buybacks. Oracle certainly
isn’t alone. Home Depot’s actual earnings slumped 0.8% YoY in its
latest quarter, yet it still reported strong 3.9% EPS growth. Merck
came in at -2.5% and +1.4%.
The
deception inherent in artificially goosing EPS growth through stock
buybacks isn’t even the primary issue here. Way more important for
the stock-market outlook is why absolute earnings are falling
with everything so favorable. And how near-bubble
priced-for-perfection valuations are very unforgiving of any
earnings weakness. The record-high stock markets’ already-flimsy
fundamental underpinning is rotting.
Based on the FOMC’s actions, what the Fed does and when, a
strong-if-not-ironclad case can be made that all it cares about is
stock-market fortunes. Remember just 10.6 months ago in
mid-December the Fed raised rates for the 9th time in that
hastily-abandoned hiking cycle. The SPX plummeted 7.7% in just 4
trading days on that, and was staring into the vicious jaws of a
long-delayed bear. So the Fed panicked.
The
day of that 9th rate hike, top Fed officials were predicting 3
more rate hikes including 2 more in 2019! Yet the FOMC did a
colossal about-face since, actually cutting 3 times in 3 months this
year. The reason things changed so radically on that SPX near-bear
correction is the wealth effect. Americans spend more when stock
markets are high, boosting confidence. And consumer spending drives
over 2/3rds of the US economy.
So
top Fed officials know the overdue stock bear their extreme easing
has so far warded off is going to drag the US into a severe
recession. As the SPX itself falls 20%, 30%, even 50%, Americans
will grow scared and pull in their horns. And 50% losses are par
for the course in major bears inevitably following major bulls. The
last two SPX bears ending in October 2002 and March 2009 saw 49.1%
and 56.8% losses!
If
revenues and earnings growth among the biggest and best US companies
are already flagging even with record-high stock markets, imagine
how they will collapse when consumer spending wanes. Weaker sales
and profits are problematic for stock prices anytime, but much more
so now given the sky-high valuations spawned by the Fed’s extreme
easing. The elite top-34 SPX companies are trading near bubble
levels!
Over
the past century-and-a-quarter or so, stock-market valuations as
measured by trailing-twelve-month price-to-earnings ratios have
averaged about 14x earnings. That’s historical fair value. Double
that at 28x is formal bubble territory, which virtually guarantees a
severe bear will follow. As of the end of Q3’19, these 34 elite big
US stocks commanding 43.9% of the SPX’s market cap reported average
TTM P/Es of 25.9x!
That
is perilously close to 28x, dangerously-expensive. These stellar
valuations prove the Fed-sparked and -fueled monster 30.9% SPX surge
since late December’s near-bear low wasn’t justified by
underlying corporate profits. It was entirely a sentiment thing,
pure greed as the flow of traders’ easy-money drugs resumed in a big
way. Ominously weakening earnings will force prevailing valuations
even higher from here!
With
lower profits in price-to-earnings ratios’ denominators,
valuations will climb if stock prices remain flat. So today’s
near-bubble valuations could easily become bubble valuations in
coming quarters, multiplying the downside risks in the stock
markets. And that earnings-stock-prices loop can easily become a
vicious circle. The less consumers spend, the more profits
decline. The more earnings fall, the more stocks sell off.
And
due to the wealth effect, the farther stocks fall the less consumers
are comfortable spending. This all feeds on itself, eventually
snowballing into a severe recession or even a depression.
That’s what the Fed is so scared of. The next bear market is going
to bring this whole Fed-conjured illusion of easy-money prosperity
crashing down, with dire political implications for the Fed’s
independence if it is rightly blamed.
Again Q3’19 was the best of times for stock markets. The SPX
rallied to a bunch of new all-time closing highs, making for its
highest average quarter ever. Straddling Q3 the FOMC stunningly
reversed its future rate bias from hiking to cutting, made 3 rate
cuts in 3 months, injected vast amounts of new money trying to
stabilize malfunctioning overnight-funding markets, and launched
QE4! That makes for epic easing.
If
the big US stocks’ earnings couldn’t grow in even these extremes,
and sales were flat outside of a few mega-cap techs, the SPX is in a
world of trouble. A stock-selloff-driven recession will hammer
market-darling techs too, as their businesses are heavily dependent
on other businesses spending. As corporate sales and profits
deteriorate, companies will reduce spending on advertising and cloud
services to cut costs.
Excessive valuations after long bulls always eventually spawn
proportional bear markets. And we are way overdue for the next
one. At its latest all-time-record high earlier this week, this
current monster SPX bull up 355.0% in 10.7 years ranks as the
2nd-largest and 1st-longest in all of US stock-market history! This
Fed-amped secular uptrend can’t persist near bubble valuations as
corporate earnings roll over to shrinkage.
Bear
markets are necessary to maul stock prices sideways to lower long
enough for profits to catch up with lofty stock prices.
These fearsome beasts are nothing to be trifled with, yet
complacent traders mock them. Seeing big US stocks’ prices cut
in half or worse is common and expected in major bear markets.
And odds are the current near-bubble valuations in US stock markets
will soon look even more extreme.
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. When stock markets
weaken its
investment demand surges, which happened last December as the
SPX sold off hard.
While the SPX plunged 9.2% that month, 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 up 30% fueling a massive 182%
gold-stock upleg! Investors are even more interested in gold now
after its
decisive bull breakout in late June.
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The
bottom line is the big US stocks’ just-reported Q3’19 results
certainly don’t justify these record-high stock prices. Revenue
growth mostly stalled out last quarter, while earnings declined.
That happened with the best stock-market levels ever witnessed, and
incredibly-extreme Fed easing. Stock prices were stretched so far
beyond underlying earnings that elite American companies are trading
near bubble valuations.
This
is a precarious situation at best, and dangerous at worst. The
hyper-easy Fed is running low on stock-market-goosing ammunition,
with only 6 rate cuts left between here and zero. Can these lofty,
expensive stock markets keep levitating without the Fed? Probably
not with corporate fundamentals deteriorating even when everything
is awesome. A valuation mean reversion lower, or bear market, is
coming. | 
