The Market Imitating Art

November 3, 2022

By Ellen Hazen, CFA®, Chief Market Strategist

November 3, 2022

 

October Takeaways:

  • Inflation eased a touch, with September’s reading of 8.2% slightly below August’s 8.3% and down from the June peak of 9.1%
  • Although there was no Federal Reserve meeting, Fed officials’ speeches indicate that they plan to continue to increase interest rates throughout 2022 and at least into early 2023
  • Unemployment remains very low at 3.5%, matching the 40-year pre-pandemic low
  • Q3 preliminary GDP was announced, at +2.6%, an acceleration from negative GDP in each of Q1 (-1.6%) and Q2 (-0.6%)
  • Just over half of S&P500 companies have reported Q3 earnings. Average revenue growth has been over 11%, while earnings growth has been below 2%. Seventy-one percent of these companies have reported earnings higher than consensus estimates, which is lower than the long-term historical average of 77%
  • US Growth stocks struggled, with the Russell 1000 Growth Index (+5.8%) underperforming the Russell 1000 Value Index (+10.3%) by nearly 4.5%

We expect inflation to continue to moderate, as energy prices have come down from peak levels.

We expect earnings estimates for 2023 to continue to decline, as companies give more detailed guidance on their earnings calls.

What We Are Watching for in November:

  • Most of the rest of the S&P500 companies will report Q3 2022 earnings. We expect to see continued negative operating leverage as companies face higher costs that they are not fully able to pass along to customers
  • The Federal Reserve raised interest rates by another 0.75% at the November 2 meeting
  • October jobs data will be reported on November 4. We expect the labor market to remain strong

 

“Happy families are all alike; every unhappy family is unhappy in its own way.”  -Leo Tolstoy

Tolstoy said this about human families, but the comparison to the stock market is particularly apt this year. Large tech stocks – which for years were one big happy family characterized by both high growth and soaring share prices – have each succumbed to a weaker economy in their own way.

Since the middle of the last decade, the so-called FAANG stocks – Facebook (now Meta), Amazon, Apple, Netflix, and Google (now Alphabet), later extended to include Microsoft – tended to move together. The correlations between those companies and the Nasdaq 100 averaged 78% over the five years before 2022. They were all considered high-quality growth stocks, and it seemed they were “one-decision stocks”: buy once (and do not sell). Even during the pandemic years, they were viewed as both pandemic-resistant and pandemic beneficiaries. An equal-weighted portfolio of the six of them increased by an average of 33% per year over the five years before 2022, nearly twice the S&P500 average return of 18%. These stocks were all alike, as they say.

Not All Stocks Are Alike Any More

The fissures in tech stock dominance that began to show earlier this year widened into crevasses during the October reporting season. Recall that in April of 2022, Netflix declined by 35% in a single day after reporting the first subscriber loss in a decade, followed shortly by Amazon with a 14% single-day decline after reporting disappointing earnings and issuing lower-than-expected forward guidance. Microsoft and Apple, on the other hand, performed in line with the market back in the Q1 reporting season, as they acknowledged slowing growth but did not expect meaningful negative impact to their businesses.

What has happened? The slowing economy has exposed or highlighted the weaknesses inherent in each company’s business model. During the happy times, investors could – and by and large, did – ignore these idiosyncratic weaknesses. Now that conditions are not as rosy, companies must make individually customized decisions about how to respond.

We could call this TANGO – There Are No Good Options – for many companies in this environment

 

Companies Are Responding to the Environment

Stepping back, the biggest takeaway from the overall Q3 2022 earnings reporting season is that costs are rising faster than revenue. This has been true across nearly all sectors within the S&P500: Consumer Staples, Materials, Healthcare, Financials, Communications, and Utilities all reported earnings growth below revenue growth. The only exceptions have been Consumer Discretionary, Industrials, and Energy. In all, revenue has grown 11% while earnings have grown 2%.

As the economy has continued to slow and inflation has continued well above the Fed’s long-term target, companies now face the difficult choice of whether to preserve profit margins by cutting headcount or to hold on to employees and face the wrath of the stock market. In prior recessions, companies generally chose the former – but in prior recessions, unemployment was not at a 40-year low. Then, companies were comfortable letting employees go, with the idea they could easily ramp hiring when business improved. Today, some companies are opting instead to retain employees and take the unavoidable margin hit. We could call this TANGO – There Are No Good Options – for many companies in this environment. We saw what Meta chose to do. In the most recent quarter, Meta’s operating margin plummeted from 45% a year ago to 21%, and it told analysts it expects operating expenses to increase by at least $11 billion next year.

In some cases, companies did report positive operating leverage, but the problems showed up elsewhere in the financials. In Q3, Amazon reported earnings growth of 19%, higher than revenue growth of 15%, but receivables from third-party sellers ballooned by 26%, as the third-party sellers are getting squeezed by the economy. Amazon, like other companies, cannot escape this economic environment.

Multiples of High-Growth Stocks Have Declined

Many investors have questioned the valuations of these companies for years. After $3.7 trillion in lost market capitalization (see Forward 12 months P/E ratio chart below), multiples have compressed and many of these former high-flyers trade at reasonable valuations. The Market Capitalization chart at bottom shows forward price-to-earnings ratios for a number or the big-cap tech stocks and for a few broader market averages.

 

Company-By-Company Evaluation Is Necessary

So, does this mean we should throw up our hands and sell stocks? Or just buy them now that multiples are down? Not so fast. The market is, rationally, now distinguishing amongst corporate business models in a way that it did not for many years. Alphabet and Meta are driven by advertising, so stock behavior is more closely attuned to the outlook for ad spend growth. Amazon has always had thin margins (Amazon Web Services excepted), so now the stock is behaving more akin to a traditional retailer, and the market is paying increased attention to working capital components like inventory and receivables. Netflix is pivoting its business model to include a lower-cost, advertising-driven tier. Many of these companies have enviable free cash flow and return on invested capital profiles that will create value for shareholders over time. It’s time to recognize that we are all, every one of us, unique. The market was wrong to ever believe otherwise.

 

Disclosures

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