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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Have Markets Abandoned Fundamentals?

Markets Fundamentals

Stock-market volatility has exploded on COVID-19 fears, shattering the Fed’s QE4-fueled levitation. The resulting stunning sentiment shift has left investors and speculators wondering where these wild markets are heading. This is an important time to check the latest fundamentals underlying the big US stocks that dominate market action. They just finished reporting their Q4’19 results, which illuminate their valuations.

Recent weeks’ stock-market swings have been huge, driven by mounting worries about the economic fallout from the COVID-19 pandemic. For 6 weeks I’ve covered this virus’s daily progression in depth in our subscription newsletters, including many troubling reports out of China that the media ignored. Before this selloff, I recommended long-volatility and short-stock-market trades that surged to big realized gains up to +145%.

By last Friday, the flagship US S&P 500 had plummeted 12.8% in just 7 trading days! That made for its fastest formal-correction selloff over 10% ever. In that same short time frame, the leading VIX fear gauge skyrocketed 179.1% higher on close to 40.1. COVID-19 is virulent and dangerous, super-infective with a mortality rate believed to be running 20x to 40x that of the seasonal flu! Traders really need to study it.

In times of elevated market fear, understanding major stocks’ fundamentals is more important than ever. Because their latest reporting quarter was last year’s final one, the deadline for releasing 10-K annual results to the SEC was 60 days after quarter-end. These full-year reports are larger, more complex, and must be audited by independent CPAs. So many of these crucial 10-Ks were finally released just last week.

The biggest and best US companies are the big stocks in that S&P 500 index, or SPX. As nearly every fund’s top holdings are some combination of them, they are owned by the vast majority of all investors. SPX index funds are wildly popular, led by the mammoth SPY SPDR S&P 500 ETF, IVV iShares Core S&P 500 ETF, and VOO Vanguard S&P 500 ETF. These behemoths have sucked in epic amounts of capital.

As of the middle of this week, their net assets ran $279.4b, $204.2b, and $133.3b! Going through all 500 10-Ks of the 500 SPX stocks is way beyond the bandwidth of my small research company, so after every quarter we delve into the top 34. That’s simply an arbitrary number that fits neatly into the tables below, and a commanding sample. As Q4’19 ended, these stocks accounted for fully 44.3% of the entire SPX’s weighting!

Their colossal total $12.6t market cap is as large as the bottom 441 SPX companies’ combined. The big US stocks’ importance to the markets and portfolios cannot be overstated, they lead the rest of the stocks up and down. And given the wild stock-market swings over the past year or so, these latest Q4’19 results just reported are more important than usual. The market action since Q4’18 has truly been extraordinary.

As that quarter dawned, the Fed ramped its quantitative-tightening campaign to full-speed. That pushed the SPX to plummet 19.8% in just 3.1 months almost all in Q4’18, nearing the new-bear-market threshold. That terrified Fed officials into making its biggest policy course change ever. During 2019 they prematurely killed QT years early, shifted their rate outlook from hiking to cutting, and slashed rates 3 times in 3 months!

All these dovish actions directly goosed stock markets, but the coup de grace was the Fed launching QE4 in mid-October and running large-scale Treasury monetizations ever since. All that unprecedented and extreme easing catapulted the SPX an astounding 28.9% higher in 2019! The big US stocks’ newest Q4’19 results compared to Q4’18’s illuminate whether that massive Fed-fueled stock-market surge was justified.

The tables below include key fundamental data from these elite US companies as Q4’19 ended. The top 34 stocks’ symbols are followed by their weightings within the SPX and SPY and market capitalizations. The absolute year-over-year changes in these market caps from the ends of Q4’18 to Q4’19 are noted. This is a purer measure of value than stock-price changes, since it effectively normalizes out stock buybacks.

That’s followed by quarterly revenues, operating cash flows, and hard GAAP profits reported to the SEC, along with their YoY changes. Finally trailing-twelve-month price-to-earnings ratios are noted. A handful of these companies report on fiscal quarters offset from calendar ones. In those cases we included the latest-available quarterly data. Symbols highlighted in blue newly climbed into the ranks of the SPX’s top 34.

This latest fundamental data from the big US stocks was both impressive and concerning. While they enjoyed sizable revenues growth and huge profits growth, their valuations collectively remain way up near formal bubble territory. That helps explain why they plunged so hard on the growing COVID-19 pandemic fears. When stocks are richly-priced relative to underlying earnings, they are far less resilient to selloffs.

The concentration of capital among the top US stocks is incredible. The 5 biggest companies in the SPX exiting 2019 were the usual market-darling mega-cap techs everyone loves. Apple, Microsoft, Alphabet, Amazon, and Facebook are universally heavily owned. They are among the top holdings of nearly every fund. As capital floods into stock-index ETFs, a proportionally-large share buoys these tech behemoths.

Together these Big Five tech giants commanded a stunning 17.4% of the entire SPX’s weighting at the end of Q4’19! That’s super-high and risky, letting this handful of companies wield outsized influence on the entire stock markets’ fortunes. For comparison just three years earlier in Q4’16 when I started this research thread, these same companies weighed in at 11.5%. They are gobbling up the SPX like Pac-Man!

Contrarians who believe stock-market bull-bear cycles still exist despite extreme interventionism by the world’s biggest central banks marvel at the Big Five’s popularity. How can almost everyone be willing to follow the herd to pile into the same few stocks? Don’t they understand the great risks inherent in such a strategy? Popular stocks that rise disproportionally to the markets in uplegs amplify downside in selloffs.

In 2019 the top 34 SPX stocks averaged hefty 26.8% gains in their market caps, which is slightly below the overall S&P 500’s huge 28.9% gain last year. Yet these Big Five tech stocks’ popularity and growing share of index capital commanded catapulted them to far-greater 47.6% average gains! That compares to just 23.2% for the rest of the top 34. Investors and speculators love chasing winners, allocating more to them.

But surprisingly techs’ outsized downside has been fairly muted. Between February 19th and 28th, the SPX again plummeted 12.8% from QE4-fueled all-time-record highs. The Big Five’s average losses over that span were just 13.2%, pretty much in line with the broader markets! And back in Q4’18’s SPX near-bear severe correction of 19.8%, the Big Five fell 24.8% on average. That’s just 1.25x the overall index drop.

So despite their outsized bull-market gains, so far they haven’t suffered similar outsized losses in both big and sharp bull-market corrections. That could certainly change during the next bear market, but traders’ fanatical faith in these tech giants is understandable. They are boosting the entire stock markets, and crazily enough their fundamentals somewhat justify such outperformance! Their results are far superior.

In Q4’19, the top 34 SPX companies’ revenues collectively grew 3.6% year-over-year. That isn’t much, but sales growth from already-large bases is hard to achieve. Yet the top-line revenues growth Apple, Microsoft, Alphabet, Amazon, and Facebook put on the scoreboard totaled an enormous 15.5% YoY despite their massive sizes! The rest of the top 34 were comparatively poor, adding up to 0.1% shrinkage.

In my line of work as a speculator and newsletter writer, I’m blessed to be able to watch the markets all day every day. Hardly a day goes by when CNBC and Bloomberg don’t have multiple experts extolling the virtues of the Big Five tech giants. They argue that despite being crowded trades, that’s where all the revenue growth is. It is amazing these huge mature companies have expanded at the rates they’ve clocked.

This is true on the operating-cash-flow-generation front too. Overall the top 34 SPX companies’ total OCFs skyrocketed 84.8% higher YoY, which is incredible. The problem is that is wildly distorted by the four mega-bank stocks among the biggest US companies. These are JPMorgan, Bank of America, Wells Fargo, and Citigroup. Their financial reporting is mind-bogglingly complex, all but impossible to understand.

I started my career as an auditor for a Big Six CPA firm, and have kept my CPA license current and active since 1997. I’ve spent decades wading through 10-Qs and 10-Ks both as an auditor and a speculator, which I find very interesting. Yet even with my experience I can’t begin to comprehend the mega-banks’ financials. Their operating cash flows in particular are so volatile they aren’t reported on earnings news releases!

They literally vary by tens of billions of dollars from quarter to quarter, somewhat dependent on stock-market fortunes and trading. Consider the biggest US bank, JPMorgan. In Q3’19 it reported year-to-date OCFs of -$77.0b, which sounds apocalyptically bad. But by Q4’19, those OCFs had skyrocketed $83.1b to +$6.0b YTD! Stuff like this is why Wall Street SPX data is often presented without financial stocks.

Those 5 elite mega-cap tech stocks dominating the SPX saw their total OCFs surge 18.7% YoY, strong growth. Meanwhile the rest of the top 34 excluding those four mega-banks reported aggregate OCFs that slumped 2.7% YoY. The bifurcation between mega-cap-tech growth and the rest of the markets is just massive. While these beloved market darlings are still very overvalued, their fundamentals improve fast.

Although many professional investors are nervous about the concentration of capital in the Big Five tech stocks, that’s where the fundamental growth has been. Their performances on all kinds of metrics are just dominating the rest of the markets. That’s true on the earnings front as well, even ignoring all the adjusted-earnings nonsense and focusing on hard profits per Generally Accepted Accounting Principles.

Overall SPX-top-34 profits skyrocketed an astounding 49.1% higher YoY in Q4’19, which defies belief. Interestingly that is wildly skewed by the largest big US company after the mega-cap techs, the famed Warren Buffett’s Berkshire Hathaway. It is a colossal investment holding company, owning a wide variety of companies across different industries. Every quarter its investments must be marked to market prices.

Buffett hates this GAAP rule that flushes changes in investment portfolios through net income, he rails against it every chance he gets! With the SPX soaring 28.9% higher in 2019 on that extreme Fed easing, fully 89% of Berkshire’s full-year profits came from investment gains. In Q4’19 in particular, $24.7b of its $29.2b in accounting earnings came from rising investments! Those certainly aren’t normal operating profits.

And back in Q4’18 when the SPX mostly plunged 19.8% in that near-bear severe correction, Berkshire had to dump $28.1b of investment losses through its earnings. So the SPX-top-34 total profits comparison from Q4’18 to Q4’19 includes $52.8b of unrealized investment swings through Buffett’s giant company! These colossal veers must be excluded to get a better picture of how big US stocks’ profitability is faring.

Those elite Big Five mega-cap tech stocks saw their GAAP profits surge 16.8% YoY in Q4’19, incredible growth given their massive sizes. Yet the rest of the top 34 excluding Berkshire’s huge investment gains and losses saw their total earnings fall a sizable 8.3% YoY! Without the market-darling tech giants, the earnings picture for the rest of the big US stocks is quite weak. That’s a serious problem for these stock markets.

Exiting Q4’19 and into the first half of Q1’20, stock prices were super-high. Between the Fed launching its QE4 Treasury monetizations in mid-October and mid-February, the SPX achieved an incredible 35 new all-time-record closing highs! By mid-February the Fed’s balance sheet had ballooned 11.2% over just 5.5 months. Its QE4 Treasury buying was running at a monthly pace exceeding $80b, way over the $60b target!

Before hyper-complacent American stock traders realized COVID-19 is no mere bad flu, the SPX had surged 17.0% in the 4.4 months QE4 was underway! That left stock prices exceedingly high, which is evident in price-to-earnings ratios. Even exiting Q4’19 with only about 70% of the SPX’s total QE4 gains in, the top 34 US stocks averaged trailing-twelve-month P/Es of 27.5x. That’s perilously high by historical standards. Related: Market Takes Deep Breath After Fed Cut, Biden Win

Over the last century and a quarter or so, fair value has averaged around 14x earnings. Double that at 28x is where stock-market bubbles begin, and that’s right where the top stocks’ valuations were running! And that’s where the Big Five tech giants were vulnerable, with average P/Es way up at a nosebleed 39.5x compared to 25.5x for the rest of the top 34! In Q4’18 these elite tech stocks averaged a similar 39.3x.

Thus their big market-leading earnings growth was insufficient to offset their huge stock-price appreciation over this past year. The mega-cap techs’ lofty valuations make them particularly vulnerable to the next bear market. The whole purpose of bears that eventually follow bulls is to force stock prices sideways to lower long enough for earnings to catch up with stock prices to lower valuations. That still needs to happen.

With the Fed’s massive QE4 Treasury monetizations still injecting vast amounts of liquidity into markets, it’s hard to imagine a long-overdue stock bear getting underway. The stock markets surged dramatically under QE1, QE2, QE3, and now QE4. The Fed is fighting a stock bear with everything it has got, as evident in its shocking emergency 50-basis-point rate cut this week! The stock-market wealth effect is too powerful.

When Americans’ stock-market wealth plunges in bears, they naturally get depressed and really curtail spending. That slows down the entire US economy, plunging it into a recession at best. I suspect the top Fed officials actually fear a depression next time around, which is why they desperately try to short-circuit every material stock-market selloff. Stock markets have grown too big relative to the underlying economy.

Their near-bubble valuations leave them vulnerable, which makes this COVID-19 pandemic such a stellar wildcard risk. Regardless of how dangerous that virus really proves, people are justifiably scared of contracting it. That caused the entire country of China to all but shut down, and it still hasn’t come fully back online despite Beijing pushing hard to force people back to work. COVID-19’s economic impact is big.

As it spreads around the world, people are avoiding spending that may expose them. This is hitting travel industries like airlines, hotels, cruise ships, and conventions really hard. Local industries like restaurants, movie theaters, and sports events face massive losses of revenues too if people decide to stay home more. These kinds of family-preservation behaviors to avoid COVID-19 exposure will weigh on corporate earnings.

Examples are already legion. The SPX’s biggest company and most-important American stock at the end of Q4’19 was mighty Apple. It has major supply-chain problems, with Chinese factories that manufacture its products stopping operations for weeks and still not running at normal capacity. Apple is increasingly having trouble meeting demand, and its P/E ratio already soared 87% YoY to 24.5x which is very high for it.

Many other SPX-top-34 companies source goods from China, including Amazon and Walmart. Disney is in a world of hurt if families decide it isn’t worth the infection risks to visit the theme parks. Boeing has really struggled with that whole 737 MAX fiasco, but imagine how its future looks if Americans decide to fly less in years ahead. The implications of COVID-19 for the US economy and thus corporate earnings are huge.

If the big US companies’ total profits take a hit on COVID-19 fears, which seems unavoidable, it is going to force valuations even higher into dangerous bubble territory! The Fed’s QE4 and rate cuts may be able to stave off a normalization for some time, but not forever. So downside risks remain considerable in these still-lofty super-overvalued stock markets. The beloved mega-cap techs won’t be immune to any selloff.

If big US stocks’ Q4’19 results showed fundamentals leaving them closer to 14x-earnings fair value, the potential selling would be much more modest. But trading twice that high near 28x bubble territory really amplifies the risks. The Fed’s vast QE4 liquidity injections mitigate that as long as they’re underway, but COVID-19’s spending-curtailing impacts catapult them way back up. We need to remain wary about these markets.

This latest monster stock bull artificially goosed by the Fed’s ZIRP, QE1, QE2, QE3, and now QE4 is the second-largest and first-longest in US history at epic 400.5% gains over 11.0 years! At some point it has to give way to the overdue next bear, which will maul valuations back down to reasonable levels. No one knows when that will awaken, but it is inevitable at some point regardless of the Fed’s endless machinations. Related: New Study Equates Luxury Cars With Low Self-Esteem

Stock bears aren’t to be trifled with! The SPX plummeted 56.8% over 1.4 years in the last one ending in March 2009, obliterating naive buy-and-hold investors! And the bear before that wasn’t much better, with a 49.1% SPX plunge over 2.6 years into October 2002. The higher big US stocks’ valuations, the greater the odds the next bear will begin soon. The COVID-19 economic slowdown will likely accelerate that timeframe.

Since the Fed can’t artificially stave off the long-overdue bear forever, it’s essential to cultivate excellent contrarian intelligence sources. That’s our specialty at Zeal. After decades studying the markets and trading, we really walk the contrarian walk. We buy low when few others will, so we can later sell high when few others can. We can help you both understand these markets and prosper in them, even during bears.

The bottom line is the big US stocks’ just-reported Q4’19 results certainly don’t justify their near-bubble valuations. All the revenues and earnings growth was concentrated in a handful of mega-cap tech stocks. The rest of these elite companies dominating the stock markets saw flat sales and declining profits, which is an ominous omen. That was despite a full year of the most extreme easing the Fed has ever undertaken!

And last quarter COVID-19 wasn’t even identified yet. That’s a game changer for the economy and stock markets unlike anything I’ve seen in my lifetime. Avoiding exposure to that deadly pathogen necessitates reduced spending, which will further weaken corporate profits. Sooner or later that adverse economic impact will overpower QE4 Treasury monetizations. So these super-overvalued stock markets remain very risky.

By Adam Hamilton

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