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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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U.S. Stock Markets Are At A Crossroads

Crossroads

The US stock markets sure feel inflectiony, at a major juncture. After achieving new all-time record highs, sentiment was euphoric heading into this week. But those latest heights could be a massive triple top that formed over 15 months. Then heavy selling erupted in recent days as the US-China trade war suddenly went hostile. The big US stocks’ just-reported Q1’19 fundamentals will help determine where markets go next.

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 currently 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 38 days since the end of Q1, 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 $24.9t at the end of Q1! 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 major 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 among the largest in the world. This week they reported colossal net assets running $271.9b, $175.1b, and $111.5b respectively! The big SPX companies overwhelmingly drive the entire stock markets.

Q1’19 proved extraordinary, the SPX soaring 13.1% higher in a massive rebound rally after suffering a severe correction largely in Q4. That pummeled this key benchmark stock index 19.8% lower in just 3.1 months, right on the verge of entering a new bear market at -20%. By the end of Q1, fully 5/6ths of those deep losses had been reversed. Did the big US stocks’ fundamental performances support such huge gains?

Corporate-earnings growth was expected to slow dramatically in Q1, stalling out after soaring 20.5% last year. 2018’s four quarters straddled the Tax Cuts and Jobs Act, which became law right when that year dawned. Its centerpiece was slashing the US corporate tax rate from 35% to 21%, which naturally greatly boosted profits from pre-TCJA levels. Q1’19 would be the first quarter with post-TCJA year-over-year comparisons.

Big US stocks’ valuations, where their stock prices are trading relative to their underlying earnings, offer critical clues on what is likely coming next. By late April the epic stock-market bull as measured by the SPX extended to huge 335.4% gains over 10.1 years! That clocked in as the second-largest and first-longest bull in US stock-market history. With the inevitable subsequent bear overdue, valuations really matter.

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 Q1 waned, these American giants alone commanded fully 43.7% of the SPX’s total weighting! Their $10.9t collective market cap exceeded that of the bottom 437 SPX companies. Big US stocks’ importance cannot be overstated. Related: Brazil’s Top Hedge Fund Dives Head First Into Petrobras

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 Q1’19. 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 deep artificial lows 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. Companies 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 Q1’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 we’re also collecting the earnings-per-share data Wall Street loves, it’s 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 Q1’19 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 metric for valuations. Wall Street often intentionally conceals these real P/Es by using the fictional forward P/Es instead, which are literally mere guesses about future profits that often prove far too optimistic.

These are mostly calendar-Q1 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 January instead of March. Oracle uses quarters that end one month before calendar ones, so its results are as of the end of February. Offset reporting ought to be banned.

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. Overall the big US stocks’ Q1’19 results looked pretty mixed, with slight sales growth and strong earnings growth. But these growth rates are really slowing, and valuations remain extreme relative to underlying profits.

(Click to enlarge)

(Click to enlarge)

From the ends of Q1’18 to Q1’19, the S&P 500 rallied 7.3% higher. While solid, that’s not much relative to the extreme euphoria and complacency during this latest earnings season. These stock markets could really be in a massive-triple-top scenario after this record bull run, a menacing bearish omen. The SPX initially peaked at 2872.9 in late January 2018, mere weeks after those record corporate tax cuts went into effect.

Then it quickly plunged 10.2% in 0.4 months, a sharp-yet-shallow-and-short correction. But with overall SPX earnings growth exceeding 20% YoY comparing post-tax-cut quarters to pre-tax-cut ones, this key benchmark clawed back higher and hit 2930.8 in late September 2018. That was merely a 2.0% marginal gain over 7.8 months which saw some of the strongest corporate-profits surges ever from already-high levels.

From there the SPX plummeted 19.8% in 3.1 months in that severe near-bear correction largely in Q4. This trend of slightly-better record highs followed by far-worse selloffs is troubling. By late April 2019 the SPX had stretched to 2945.8, just 2.5% above its initial peak 15.1 months earlier. Such paltry gains in a span with record corporate tax cuts and resulting torrid earnings growth should really give traders pause.

Technically these three major record highs look like a massive triple top. The big US stocks’ Q1 results are critical to supporting or refuting this bearish technical picture. The SPX/SPY top 34 did enjoy superior market-cap appreciation from the ends of Q1’18 to Q1’19, averaging 12.8% gains which ran 1.7x those of the entire SPX. That exacerbated the concentration of capital in the largest SPX stocks, the mega-cap techs.

As Q1 ended, 5 of the 6 largest SPX stocks were Microsoft, Apple, Amazon, Alphabet, and Facebook. Together they accounted for a staggering 15.8% of this flagship index’s entire market cap, closing in on 1/6th! These companies are universally adored by investors, owned by the vast majority of all funds and constantly extolled in glowing terms in the financial media. Investors think mega-cap techs can do no wrong. Related: Warren Buffett Is Betting Big On Energy Stocks

Last summer these incredible businesses were viewed as recession-proof, effectively impregnable. But even if there’s some truth to that, it doesn’t guarantee mega-cap-tech stock prices will weather a stock-market selloff. During that 19.8% SPX correction mostly in Q4, these 5 dominant SPX stocks and another SPX-top-34 tech darling Netflix averaged ugly 33.3% selloffs! They amplified the SPX’s decline by 1.7x.

No matter how amazing the sales growth among the mega-cap techs, they aren’t only not immune to SPX selloffs but their lofty stock prices make them more vulnerable. Overall the SPX/SPY top 34 companies reported Q1’19 revenues of $969.3b, which was 0.9% YoY higher than the top 34’s in Q1’18. That’s not great performance considering how universally-loved and -owned these companies are among nearly all funds.

Those 6 mega-cap tech stocks did far better, enjoying order-of-magnitude-better revenues growth of 9.9% YoY! Excluding them the rest of the SPX top 34 actually saw total sales slump 1.8% lower YoY, which sure doesn’t sound like a strong economy. If this trend of stalling or slowing revenue growth continues, profits growth will have to start falling sharply in future quarters. Earnings ultimately amplify sales trends.

Even more bearish, Wall Street analysts headed into Q1’19’s earnings season expecting all 500 SPX companies to enjoy 4.7% total revenues growth. But the top 34 that dominate the US stock markets did much worse at 0.9% even with mega-cap techs included. That was definitely a sharp slowdown too, as the SPX top 34 saw 4.2% YoY sales growth in Q4’18. Slowing revenue growth is a real threat to the stock markets.

Remember the SPX surged dramatically in Q1, fueling quite-euphoric sentiment leading into quarter-end. At the same time traders mostly believed that a US-China trade deal would soon be signed, removing the trade-war risks. High tariffs are a serious problem for the gigantic multinational companies leading the SPX, potentially heavily impacting sales. Yet revenue growth was already slowing even before this week!

Trump had twice delayed hiking US tariffs on Chinese imports from 10% to 25%, a good-faith sign giving time for real trade-deal negotiations. But his patience ran out this past Sunday after China backtracked on key previous commitments. So Trump tweeted the current 10% US tariffs on $200b of annual Chinese imports would surge to 25% today, and warned that 25% tariffs were coming “shortly” on another $325b!

China will retaliate as long as high US tariffs remain in effect. That will really retard US sales from top-34 SPX companies in that country. Beloved market-darling Apple is a great example. This second-biggest stock in the S&P 500 did $10.2b or 17.6% of its Q1’19 sales in China! The US-China trade war heating up in a serious way portends even-weaker revenues going forward for the big US stocks dominating the SPX.

The total operating cash flows generated by the top 34 SPX/SPY companies looked like a disaster in Q1, plummeting 64.4% YoY to $67.8b. Thankfully that is heavily skewed by a couple of the major US banks. JPMorgan Chase and Citigroup reported staggering negative OCFs of $80.9b and $37.6b in Q1, due to colossal $123.1b and $30.4b negative changes in trading assets! This seems really confusing to me.

Mega-bank financials are fantastically-complex, and no one can hope to understand them unless deeply immersed in that world. I’ve been a certified public accountant for decades now, spending vast amounts of time buried in 10-Qs and 10-Ks to fuel my stock trading. Yet even with my background and experience I can’t interpret mega-bank results. It seems weird trading assets plummeted in Q1 as the SPX surged sharply.

But rather than getting bogged down in mega-bank arcania that may be impossible to comprehend by outsiders, we can just exclude the four SPX-top-34 mega-banks from our OCF analysis. They include JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup. Without them, the rest of the SPX top 34 reported total OCFs of $163.2b in Q1’19. That was dead-flat ex-banks, up just 0.3% YoY from Q1’18’s OCFs.

So the big US stocks’ operating-cash-flow generation really slowed too in Q1, stalling out compared to hefty 11.5% YoY growth in Q4’18. That’s another sign that the US economy must be slowing despite the red-hot stock markets. That’s ominous and bearish considering the coming headwinds if the trade wars continue and if the stock markets roll over decisively. Future quarters’ business environments won’t be as good.

Earnings were a different story entirely last quarter, soaring dramatically among the SPX/SPY top 34. They totaled $149.8b, surging an enormous 36.1% YoY! But that was skewed way higher by Warren Buffett’s famous Berkshire Hathaway, the biggest SPX stock after the mega-cap techs. BRK reported a monster Q1 profit of $21.7b, compared to a $1.1b loss a year earlier. That accounted for 1/7th of the top 34’s total.

But Berkshire’s epic profits are due to the sharp stock-market rebound rally, not underlying operations. A new accounting rule that Warren Buffett hates and rails against at every opportunity requires unrealized capital gains and losses to be flushed through quarterly profits. Thus when the SPX plunged in Q4’18, BRK reported a colossal $25.4b GAAP loss. That was largely reversed in Q1’19 with its gigantic $21.7b gain.

Excluding the $16.1b of BRK’s Q1 profits that were mark-to-market stock-price gains, the SPX top 34’s total profits grew 21.5% YoY to $133.6b in Q1. That’s still impressive, but it masks some big problems on the corporate-earnings front. Those 6 elite mega-cap tech companies dominating the SPX actually saw their collective Q1 GAAP profits plunge 11.2% YoY! Apple, Alphabet, and Facebook suffered sharp declines.

Usually mega-cap tech stocks are the profits engine driving the entire SPX higher. If these market-darling companies that are universally-loved and -held struggled with earnings growth in Q1, what does that say about profits going forward? And again profits can be manipulated quarter-to-quarter by playing with all kinds of accounting estimates. So if anything corporate profits are overstated instead of understated.

One of Wall Street’s great farces is the game of comparing quarterly results to expectations instead of what they were in the comparable quarter a year earlier. Mighty Apple is a great example, reporting after the close on April 30th. Its Q1 earnings per share and sales of $2.47 and $58.0b came in ahead of Wall Street expectations of $2.37 and $57.5b. So Apple’s stock surged 4.9% the next day on those “great results”.

But that expectations bar had been lowered dramatically, which is the only reason Apple beat. On an absolute year-over-year basis compared to Q1’18, Q1’19 saw sales drop 5.1%, OCFs plummet 26.3%, and earnings plunge 16.4% YoY! That was quite weak, and couldn’t be considered good by any honest measure. In this recent Q1 earnings season, the fake expectations game obscured plenty of real weakness.

Yet overall SPX-top-34 profits growth still remained strong, with companies suffering drops offset by other companies seeing big jumps. But earnings can’t be considered in isolation, they are only relevant relative to underlying stock prices. Imagine you own a rental house and someone offers you $1000 a month to move in. The reasonableness of that earnings stream is totally dependent on the value of your property.

If your house is worth $100k, $1k a month looks great. But if it’s worth $1m, $1k a month is terrible. The profits anything generates are only measurable relative to the capital invested in that asset. The classic trailing-twelve-month price-to-earnings ratios show how expensive stock prices are relative to underlying corporate profits. Big SPX-top-34 earnings growth isn’t bullish if overall profits are low compared to stock prices.

At the end of Q1’19 proper before these Q1 results were reported, the SPX/SPY top 34 component stocks averaged TTM P/Es of 30.4x. That is definitely improving compared to the prior four quarters’ trend of 46.0x, 53.4x, 49.0x, and 39.7x. But 30.4x is still dangerously high absolutely. Over the past century-and-a-quarter or so, fair value for the US stock markets was 14x. Double that at 28x is where bubble territory begins.

So the big US stocks were literally trading at bubble valuations exiting Q1! Their stock prices were far too high relative to their underlying earnings production compared to almost all of US stock-market history. And this wasn’t just a mega-cap-tech-stock thing, with these elite companies often being bid to really-high valuations compared to other sectors. The 6 mega-cap techs we’ve discussed indeed averaged a crazy 52.0x.

But the other 28 top-34-SPX companies remained very expensive near bubble territory even excluding the tech giants, averaging 25.8x! Even the strong Q1’19 earnings growth didn’t help much. At the end of April as those Q1 results started to work into TTM P/E calculations, the SPX top 34 averaged a slightly-higher P/E of 31.0x. Literal bubble valuations with stock markets trading near all-time record highs are ominous.

Just last Friday when the SPX closed right at its highest levels in history, I wrote a contrarian essay on these “Dangerous Stock Markets”. It explained how high valuations kill bull markets, summoning bears that 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.

The SPX’s last couple bears that awoke and ravaged due to high valuations pummeled the SPX 49.1% lower in 2.6 years leading into October 2002, and 56.8% lower over 1.4 years leading into March 2009! Seeing big US stocks’ prices cut in half or worse is common and expected in major bear markets. And there’s a decent chance the current bubble valuations in US stock markets will soon look even more extreme.

Over the past several calendar years, earnings growth among all 500 SPX companies ran 9.3%, 16.2%, and 20.5%. This year even Wall Street analysts expect it to be flat at best. And if corporate revenues actually start shrinking due to mounting trade wars or rolling-over stock markets damaging confidence and spending, profits will amplify that downside. Declining SPX profits will proportionally boost valuations.

If the big US stocks’ fundamentals deteriorate, the overdue bear reckoning after this monster bull is even more certain. 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.

Gold investment demand surges as stock markets weaken, as we got a taste of in December. While the SPX plunged 9.2%, 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 30% higher fueling a massive 182% gold-stock upleg!

The bottom line is the big US stocks’ Q1’19 results were pretty mixed despite the surging stock markets. Revenues and operating cash flows only grew slightly, which were sharp slowdowns from big surges in previous quarters. While earnings somehow defied sales to soar dramatically again, that disconnect can’t persist. A slowdown looked to be underway even before the US-China trade war flared much hotter this week.

Even the surging corporate profits weren’t enough to rescue super-expensive stock markets from extreme bubble valuations. They are what spawn major bear markets, which are necessary to maul stock prices long enough for valuations to mean revert lower. Make no mistake, these overvalued stock markets are still an accident waiting to happen. Stock investors should diversify, adding substantial gold allocations.

By Adam Hamilton

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