"A gem cannot be polished without friction, nor a man perfected without trials."
- Seneca
There is no doubt, that investors have been preconditioned to buy the damn dips in the stock market for the last couple years (if not longer!). But in reality, bear markets with rapidly increasing interest rates alter the viability of that strategy just a tad.
Nonetheless, buying those polished gems of companies that rewarded many bull markets for years is a hard habit to give up. After all, the stock market is starting to get cheap on many valuation metrics, specifically on forward P/E. Or is it?
For starters, valuation is always more of an opinion than a fact. Especially when it relates to the earnings component. A company or equity market may look like it's trading at 16x earnings, but if those earnings are 20% lower than expected then the real multiple is north of 20x.
Then, of course, we need to consider the growth component of earnings. For obvious reasons, a company that is growing earnings at 30%+ year is worth a reasonably high multiple. But what if that growth rate gets cut in half for even a year or two? Or, gasp, declines?
In addition to the actual earnings number and the appropriate growth rate, what discount rate should be applied to the earnings and/or cash flow stream? At higher interest rates, any cash flow or earnings stream is worth less when discounted back. Back of the envelope a discount rate that is increased by 2%, means a lower implied value (all else equal) of -~15%.
The point of this isn't to debate the best way to value a stock, but rather to remind you that valuation is a subjective exercise. While a stock or sector can appear cheap, if earnings collapse, the growth rate slows, and the discount rate goes meaningfully higher . . . it will get cheaper. And besides, valuation is never a catalyst.
Consider Facebook as an example. In 2021, $FB did roughly $13.77 per share in earnings. The current estimate for 2022 is $11.63, or -16% lower. In Q1 2022, $FB’s reported EPS was actually down 1-8% Y/Y. Meanwhile, the upcoming quarter is estimated to be down -29% Y/Y . . . what is the right multiple here?
Back to the Global Macro Grind…
If you didn’t know, now you know that economic slowing at the country level will naturally lead to slowing at the company level. On the first point, we had more slowing growth data this morning from the Eurozone:
- Eurozone May Manufacturing PMI declined to 54.5, which is an 18-month low;
- Eurozone May Services PMI declined to 56.3, which is a 2-month low;
- U.K. May Services PMI dropped precipitously to 51.8, versus the prior reading of 58.9; and
- U.K. retailers experienced average sales in May, but the outlook for June is -13% below normal seasonal sales.
Now that is obviously just the major data from this morning, but this is not new. Globally, with very few exceptions, growth is slowing. To the extent that investors are now more worried about growth than interest rates, it is certainly justified given the recent incoming data points.
As is usually the case in these reflexive cycles, confidence is often the leading indicator to economic data. In the chart of the day, we look at U.K. consumer confidence compared to its Services PMI. As you can see, confidence started to decline, likely driven by higher inflation and interest rates, and then PMIs followed suit.
Speaking of consumer sentiment, last week’s Michigan Consumer Confidence clocked in at 59.4. This was the lowest reading in more than a decade. This decline in consumer confidence shouldn’t be a terrible surprise with six straight months of Y/Y declines in real disposable income, which was capped off by -20% Y/Y in March.
To the extent you are waiting for the bottom in economic data or corporate earnings, just remember we are just getting into the most challenging comparisons we’ve literally ever seen on both the top down and bottom-up data. One example is U.S. retail sales, which through the end of the year have comparisons of between +14% and 28% Y/Y. Incidentally, these challenging top line comparisons come while inventories are building . . . specifically $TGT inventory was up +31% Y/Y and $WMT was inventory up +26% Y/Y in the most recent quarter.
This morning $SNAP is providing a bit of a reminder that Q2 corporate reports are also as challenging as they have ever been. Specifically, SP500 Q2 2021 earnings were up +87% Y/Y and revenue was up +25% Y/Y. While consensus estimates are still looking for earnings growth in Q2 2022 for the SP500, it is more likely than not that Sp500 earnings decline Y/Y given these challenging comps.
In conclusion, while there will be a time to buy those unpolished gems of companies . . . that time is probably when we have a sight path to earnings and economic data that is reaccelerating. Said another way: when we are out of #Quad4. But as we all know, any unpolished gem needs some stress to bring back its luster.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 10yr Yield 2.75-3.00% (bullish)
UST 2yr Yield 2.51-2.72% (bullish)
High Yield (HYG) 75.55-77.30 (bearish)
SPX 3 (bearish)
NASDAQ 11,103-11,991 (bearish)
RUT 1 (bearish)
Tech (XLK) 127-138 (bearish)
Utilities (XLU) 70.35-72.97 (bullish)
Shanghai Comp 2 (bearish)
Nikkei 25,726-27,116 (bearish)
DAX 13,458-14,269 (bearish)
VIX 26.30-34.33 (bullish)
USD 101.87-105.38 (bullish)
EUR/USD 1.033-1.072 (bearish)
USD/YEN 127.06-130.96 (bullish)
Oil (WTI) 102.25-115.01 (bullish)
Nat Gas 7.55-9.01 (bullish)
Gold 1 (bullish)
Copper 4.08-4.36 (bearish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
