Bubble, Broaden, Break
Published On: August 7, 2017
Written by: Ben Atwater and Matt Malick
As equity markets continue their ascent, we consider what will happen next – more of the same; out-of-favor stocks begin participating; or a stall in gains.
Stocks are expensive with the trailing price-to-earnings (P/E) ratio of the Standard and Poor’s 500 stock index at almost 24 times realized earnings and over 18 times estimated earnings over the next year. Given this backdrop, surprise events or even investors reinterpreting the environment could cause a quick and substantial price adjustment.
If stocks don’t break anytime soon (momentum is a powerful force in markets), then we could see a continuation of leadership from technology stocks or we could see other, less expensive, stocks begin to outperform.
Information technology is the largest sector in the S&P 500 with a weighting of 22.3% of the index, while the average trailing P/E for stocks in the sector is 37 times. The so-called FAANG stocks – Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Google (GOOG) – have spurred about 50% of the Nasdaq 100 Index’s gains this year. Of the ten largest stocks in the S&P 500 index, the five biggest weights are technology stocks (four out of five are FAANG stocks).
Tech leadership is not exclusive to the United States. The Morgan Stanley Capital International Emerging Markets Index has its own tech cohort – the SATT stocks, Samsung, Alibaba, Tecent Holdings Ltd., and Taiwan Semiconductor Manufacturing Co. – which have accounted for approximately 32% of that index’s gains.
Technology stocks are booming because broader economic growth is anemic. Since the Time of Shedding and Cold Rocks ended in January 2009, U.S. Gross Domestic Product (GDP) growth has averaged 2.1% per year versus the post-World War II average of 3.22% per year. Without macro growth, investors have been seeking growth within sectors and specific stocks.
From the election through the end of 2016, investors were willing to buy more economically sensitive areas like financials, industrials, and materials resulting in a change of market leadership in November and December. This move was powerful but short-lived. When we flipped the calendar to 2017, tech (and “growth stocks” more generally) reasserted market leadership. Year-to-date through June 30th, the Russell 1000 Growth Index outperformed the Russell 1000 Growth index by 9.3%.
This occurred as economic reality again set in and first quarter GDP registered a meager 1.4%. After a disappointing three months, the Federal Reserve Bank of Atlanta’s GDP Now estimate in mid-April for second quarter GDP was over 4%, but as the second quarter matured, observers’ hopes dwindled. The GDP Now estimate for 2Q 2017 is presently down to 2.6%.
When economic growth is low, investors will overpay for companies that are defying the odds with quickly rising revenues. Unfortunately, this isn’t sustainable. The economy needs to improve and market leadership needs to broaden.
For one, we must see broader participation from financial stocks. Reality dictates that bank lending is the lubricant of business, which drives American economic activity. If banks aren’t doing well no amount of Facebook user growth, Netflix new subscribers or Amazon Prime memberships will create lasting prosperity. The estimated P/E ratio for the financial services sector is 12. With the economy stalled, this sector is cheap.
Other sectors like basic materials, energy and consumer cyclical stocks could also catch a bid in a healthier environment. Investors want hard data suggesting authentic reflation (of which we have yet to see any).
Within many of these neglected sectors, investors need to start noticing certain stock-specific bargains to broaden market leadership. Ever-expanding tech valuations can only carry the stock market so far.
Take, for example, names like Wal-Mart (WMT), Target (TGT) and Intel (INTC) as compared to Amazon (AMZN). Of course, Amazon is a miraculous company that deserves a premium valuation. However, it is a fairytale to think that Amazon can flip a switch and become highly profitable while remaining highly innovative and rapidly growing its top-line revenue. An AMZN for which investors will eventually demand large and consistent profits is far different than the AMZN investors adore today.
Amazon has been a public company for two decades and it has a cumulative profit of $5.7 billion, whereas Wal-Mart registered profit of $14 billion in 2016 alone. In a similar vein, although Target’s trailing 12-month profit of $2.786 billion slightly outpaced Amazon’s $2.582 billion figure, AMZN’s market capitalization is over 16 times that of TGT.
The Amazon retail business makes virtually no money but their web services (cloud) business is profitable and also growing. Intel has a cloud business too (data centers), which has substantially better margins than its personal computer business and INTC derives more revenue ($4.67 billion) from their cloud business than AMZN does ($3.53 billion).
Although Amazon has had extraordinary revenue growth and has been managed to near perfection, there are fair comparisons to Wal-Mart and Target’s retail businesses and Intel’s cloud operations. Our broader point is that if investors come to appreciate inexpensive stocks like WMT, TGT and INTC, not for their growth, but for their profits, cash flows, dividends and their stability, it would broaden leadership.
A rising market that continues to bubble-up could have a shorter life and a more violent death. A market that broadens could supply this bull market with an even longer life before it breaks, perhaps years from now.
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