By Adam Hamilton – Re-Blogged From Silver Phoenix
The mega-cap stocks that dominate the US markets are just finishing another monster earnings season. It wasn’t just profits that soared under Republicans’ big corporate tax cuts, but sales surged too. That’s no mean feat for massive mature companies, but sustained growth at this torrid pace is impossible. So peak-earnings fears continue to mount while valuations shoot even higher into dangerous bubble territory.
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 contain the best fundamental data available to investors and speculators. They dispel all the sentimental distortions inevitably surrounding prevailing stock-price levels, revealing the 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 single stock in the flagship S&P 500 stock index, which includes the biggest and best American companies. As Q2’18 ended, the smallest SPX stock had a market cap of $4.1b which was 1/225th the size of leader Apple.
The middle of this week marked 39 days since the end of calendar Q2, so almost all of the big US stocks of the S&P 500 have reported. The exceptions are companies running fiscal quarters out of sync with calendar quarters. Walmart, Home Depot, Cisco, and NVIDIA have fiscal quarters ending a month after calendar ones, so their “Q2” results weren’t out yet as of this Wednesday. They’ll arrive in coming weeks.
The S&P 500 (SPX) is the world’s most-important stock index by far, weighting the best US companies by market capitalization. So not surprisingly the world’s largest and most-important ETF is the SPY SPDR S&P 500 ETF which tracks the SPX. This week it had huge net assets of $271.3b! The IVV iShares Core S&P 500 ETF and VOO Vanguard S&P 500 ETF also track the SPX with $155.9b and $96.6b of net assets.
The vast majority of investors own the big US stocks of the SPX, as they are the top holdings of nearly all investment funds. So if you are in the US markets at all, including with retirement capital, the fortunes of the big US stocks are very important for your overall wealth. Thus once a quarter after earnings season it’s essential to check in to see how they are faring fundamentally. Their results also portend stock-price trends.
Unfortunately my small financial-research company lacks the manpower to analyze all 500 SPX stocks in SPY each quarter. Support our business with enough newsletter subscriptions, and I would gladly hire the people necessary to do it. For now we’re digging into the top 34 SPX/SPY components ranked by market capitalization. That’s an arbitrary number that fits neatly into the tables below, and a dominant sample.
As of the end of Q2’18 on June 29th, these 34 companies accounted for a staggering 42.6% of the total weighting in SPY and the SPX itself! These are the mightiest of American companies, the widely-held mega-cap stocks everyone knows and loves. For comparison, it took the bottom 431 SPX companies to match its top 34 stocks’ weighting! The entire stock markets greatly depend on how the big US stocks are doing.
Every quarter I wade through the 10-Q SEC filings of these top SPX companies for a ton of fundamental data I dump 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 Q2’18. That’s followed by the year-over-year change in each company’s market capitalization, a critical 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 changes. 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 earnings growth driven by cost-cutting is inherently limited.
Operating cash flows are also important, showing how much capital companies’ businesses are actually generating. Using cash to make more cash is a core tenet of capitalism. Unfortunately most companies are now obscuring quarterly OCFs by reporting them in year-to-date terms, which lumps in multiple quarters together. So these tables only include Q2 operating cash flows if specifically broken out by companies.
Next are the actual hard quarterly earnings that must be reported to the SEC under Generally Accepted Accounting Principles. Late in bull markets, companies tend to use fake pro-forma earnings to downplay real GAAP results. These are derided as EBS earnings, Everything but the Bad Stuff! Companies often arbitrarily ignore certain expenses on a pro-forma basis to artificially boost their profits, which is very misleading.
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 ratio as of the end of Q2’18 is 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 obscures these hard P/Es by using the fictional forward P/Es instead, which are literally mere guesses about future profits that often prove far too optimistic.
Not surprisingly in the second quarter under this new slashed-corporate-taxes regime, many of the mega-cap US stocks reported spectacular Q2’18 results. For the most part sales, OCFs, and earnings surged dramatically. The big problem is such blistering tax-cut-driven growth rates are impossible to sustain for long at the vast scales these huge companies operate at. Downside risks are serious with bubble valuations.
The elite market-darling mega tech stocks continue to dominate the US stock markets. Most famous are the FANG names, Facebook, Amazon, Netflix, and Alphabet which used to be called Google. Apple and Microsoft should be added to those rarified beloved ranks. Together these half-dozen companies alone accounted for nearly 1/6th of the SPX’s entire market cap! That’s an incredible concentration of capital.
This highlights the extreme narrowing breadth behind this very-late-stage bull market. At the month-end just before Trump’s election victory in early November 2016, these same tech giants weighed in at 12.3% of the SPX weighting compared to 16.4% today. And if you go all the way back to this bull’s birth month of March 2009, MSFT, GOOGL, AAPL, and AMZN weighed in at 5.4%. FB and NFLX weren’t yet in the SPX.
Ever more capital is crowding into fewer and fewer stocks as fund managers chase the biggest winners and increasingly pile into them. And these 6 elite mega techs’ Q2’18 results show why they are widely adored. Their revenues rocketed 30.3% YoY on average, more than doubling the 14.0% growth in this entire top-34 list! Excluding these techs, the rest of the top 34 only grew their sales by 10.0% or a third as much.
That vast outperformance is reflected in their market-cap gains too, which again normalize out all the big stock buybacks. Overall these top SPY companies’ values surged 23.5% higher YoY, nearly doubling the 12.2% SPX gain from the ends of Q2’17 to Q2’18. But these top 6 tech stocks’ stellar average gains of 57.5% YoY dwarfed the rest of the top 34’s 16.2% annual appreciation! These stocks are loved for good reason.
The same is true on the profits front, with AAPL, AMZN, GOOGL, MSFT, FB, and NFLX trouncing the rest of these biggest US stocks. These 6 tech giants saw staggering average earnings growth of 289.1% YoY, compared to 30.9% for the rest of the top 34. That former number is heavily skewed by Amazon’s results though, as its profits skyrocketed an astounding 1186% from $197m in Q2’17 to $2534m in Q2’18.
Netflix had a similar enormous 484% YoY gain in earnings from a super-low level. Interestingly the rest of these big 6 tech stocks saw average growth of just 16.0% YoY, only about half that of the rest of the top 34. That proves the enormous surge in mega-cap-tech stock prices over this past year wasn’t driven by earnings as bulls often claim. Stock-price appreciation has far outstretched profits growth, an ominous sign.
In conservative hard trailing-twelve-month price-to-earnings-ratio terms, the big-6 tech giants sported an incredible average P/E of 107.3x earnings exiting Q2! That is deep into formal stock-bubble territory over 28x, which is itself double the century-and-a-quarter average fair value of 14x in the US stock markets. Again AMZN and NFLX are skewing this way higher though, with their insane 214.8x and 263.9x P/E ratios.
P/Es are the annual ratio of prevailing stock-price levels to underlying profits. So they can be viewed as the number of years it would take a company to earn back the price new investors today are paying for it. A stock bought at 200x earnings would take 200 years to merely recoup its purchase price through profits, assuming no growth of course. Buying at these heights is crazy given humans’ relatively-short investing lifespan.
Assuming people start investing young at 25 years old and retire at 65, that gives them about 40 years of prime investing time. So buying any stock above 40x implies a time horizon well beyond what anyone actually has. And provocatively even excluding the crazy P/Es of Amazon and Netflix, the rest of these big 6 tech stocks still average extremely-high 41.2x P/Es. And ominously that is right in line with market averages.
Without those elite tech leaders, the rest of these top 34 SPY stocks had average TTM P/Es of 41.0x when they exited Q2. History has proven countless times that buying stocks near such extreme bubble valuations has soon led to massive losses in the subsequent bear markets that always follow bulls. So these stock markets are extraordinarily risky at these valuations, truly an accident waiting to happen.
When stocks are exceedingly overvalued, the downside risks are radically greater than upside potential. After everyone is effectively all-in one of these universally-held mega tech stocks, there aren’t enough new buyers left to drive them higher no matter how good news happens to be. And these investors who bought in high and late can quickly become herd sellers when some bad news inevitably comes to pass.
Q2’18’s earnings season has already proven this in spades despite the extreme euphoria surrounding the stock markets and elite tech stocks in particular. Fully 3 of the 4 beloved FANG stocks showed just how overbought stocks react to news. The recent price action in Amazon, Netflix, and Facebook following their Q2 results is a serious cautionary tale for investors convinced mega tech stocks can rally indefinitely.
Everyone loves Amazon, but it is priced far beyond perfection. Its stock skyrocketed 75% YoY to leave Q2 with that ludicrous P/E of 214.8x. When any stock gets so radically overbought and overvalued, it has a tough time moving materially higher no matter what happens. Normally stocks shoot higher on blowout quarterly results as new investors flood into the strong company. But Amazon couldn’t find many buyers.
After the close on July 26th Amazon reported a monster blowout Q2. Its earnings per share of $5.07 was more than double analysts’ estimate of $2.50! Revenues, operating cash flows, and profits rocketed up an astounding 39.3%, 93.5%, and 1186.3% YoY. AMZN’s revenue guidance for Q3 at a midpoint running $55.8b also hit the low end of Wall Street expectations. Any normal stock would soar the next day on all that.
But while Amazon stock mustered a decent 4.0% gain at best the next day, that faded to a mere +0.5% close. AMZN was priced for perfection, so not even one of its best quarters ever was enough to bring in more buyers. Everyone already owns it, so who is left to deploy new capital? AMZN slumped 1.7% over the next several trading days, though it has since recovered to new record highs with the strong stock markets.
Netflix was the best-performing large US stock over the past year, skyrocketing 162% higher between the ends of Q2’17 to Q2’18! It had an absurd TTM P/E of 263.9x leaving Q2, more extreme than Amazon’s. But man, investors love Netflix with a quasi-religious fervor and believe it can do no wrong at any price. So Wall Street was eagerly anticipating NFLX’s Q2 results that came out after the close back on July 16th.
And they were really darned good. EPS of $0.85 beat the expectations of $0.79. On an absolute basis, sales and profits soared 40.3% and 484.3% YoY! Netflix did report negative operating cash flows, but it has been burning cash forever so that was no surprise. Yet despite these strong results this priced-for-perfection market-darling stock plunged 13%ish in after-hours trading! Good news wasn’t good enough.
Investors weren’t happy because subscriber growth was slowing. NFLX reported 5.2m net new streaming subscriptions in Q2, below the 6.3m expected and 7.4m in Q1. Netflix itself had provided earlier guidance of 1.2m US adds, but the actual was way short at 0.7m. So NFLX stock plummeted as much as 14.1% the next trading day before rebounding to a still-ugly -5.2% close. It couldn’t rally on great Q2 financial results.
And universally-held big stocks not responding favorably to quarterly results can quickly damage traders’ euphoric enthusiasm for them. The selling in Netflix’s stock gradually cascaded following that big hit on Q2 results. Over the next couple weeks, NFLX dropped 16.4% from its close just before that Q2 earnings release! The mega tech stocks aren’t invincible, and are very risky trading so high with everyone all-in.
With the possible exception of mighty Apple, Facebook was widely considered the least risky of the elite tech stocks as Q2 ended. Its 32.5x P/E was almost low by mega-tech standards, only bested by the 17.9x of Apple which is in a league of its own. FB reported after the close on July 25th, and shared great results led by a modest EPS beat of $1.74 compared to $1.72 expected. But the absolute gains were really big.
Facebook’s sales, operating cash flows, and profits soared 41.9%, 17.5%, and 31.1% YoY! That top-line revenue growth in particular was huge, nearly the best out of all these top 34 SPY stocks. And FB’s profits were growing so fast that it was the only elite mega-tech stock to see its TTM P/E actually decline YoY, retreating 14.2%. So FB looked much safer fundamentally than the other FANG stocks dominating the SPX.
But Facebook’s stock effectively crashed in after-hours trading immediately after those Q2 results, falling as much as 24%! The reason? It guided to slowing sales growth in Q3 and Q4 in the high single digits. FB was obviously priced for perfection and universally owned too, leaving nothing but herd sellers when anything finally disappointed. The next day FB stock plummeted a catastrophic 19.0%, stunning investors.
That wiped out an inconceivable $119.4b in market capitalization! That was the worst ever seen in one day by any single company in US stock-market history. More than ever investors and speculators need to realize that their beloved FANG stocks along with MSFT and AAPL aren’t magically exempt from serious selloffs. When any stocks are way overbought and wildly overvalued, it’s only a matter of time until selling hits.
Without these mega tech stocks, the US stock markets never would’ve gotten anywhere close to their current near-record heights. The flood of investment capital into Netflix over this past year was so huge it catapulted that company well into the ranks of the top 34. Its symbol is highlighted in light blue, along with a few other stocks, because it is new in the SPX’s top 34 in Q2. Outsized tech gains can’t happen forever.
Interestingly I found something else in their quarterly reports I haven’t yet seen discussed elsewhere. The total debt of these top 6 mega tech stocks soared an average of 36.5% higher YoY! That is way beyond the rest of the top 34 excluding the giant banks which have very-different balance sheets. Those other 18 top-34 SPY companies saw total debt only climb 6.0% YoY. Mega-tech debt is rocketing at 6.1x that rate!
While the elite tech stocks do have huge cash hoards, their spiraling debt is ominous. With the Fed deep into its latest rate-hike cycle, the carrying costs of debt are rising fast. With each passing month and each bond companies’ roll over, their interest expenses increase. At best those will cut into their profits, which will push their nosebleed P/Es even higher. They will have to slow debt growth and eventually pay back much.
We are talking huge amounts, $588.2b of total debt across Apple, Amazon, Google, Microsoft, Facebook, and Netflix alone! The main reason most of these companies are ramping their debt so fast is to finance massive stock buybacks propelling their share prices higher. They will have to really slow or even stop their huge buyback campaigns if their total debt or the carrying costs on it grow too large, a serious threat now.
These top 34 SPX stocks collectively had an extreme average trailing-twelve-month price-to-earnings ratio of 53.4x leaving Q2! That is nearly double historical bubble levels, exceedingly dangerous. There are far-higher odds the next major move in these hyper-expensive stock markets will be down rather than up. The next couple quarters face very different psychology and monetary winds than this rallying past year.
In both Q3 and Q4 last year, traders were ecstatic over the Republicans’ record corporate tax cuts that were excitingly nearing. In Q1 and Q2 this year, traders were dazzled by the incredible profits growth largely driven by sharply-lower taxes. While that will continue to some extent in Q3 and Q4 this year, the initial exuberance has mostly run its course. Big US stocks are facing tougher comparables going forward.
But the real threat to these bubblicious extreme stock markets is the Fed’s young quantitative-tightening campaign. It started imperceptibly in Q4’17 to begin unwinding the staggering $3625b of quantitative-easing money printing the Fed unleashed over 6.7 years starting in late 2008. Total QT in Q4’17 was just $30b. But it grew to another $60b in Q1’18 and then another $90b in Q2’18. And it is still getting bigger.
In this current Q3’18, another $120b of QE is going to be wiped out by QT. And finally in Q4’18, this new Fed QT will hit its terminal speed of $150b per quarter. That’s expected to last for some time. If the Fed merely wants to reverse just half of its extreme QE, it will have to run QT at that full-speed $50b-per-month pace for fully 2.5 years. That extreme monetary-destruction headwind is unprecedented in world history.
Today’s enormous stock bull grew so extreme because the Fed’s epic QE levitated stock markets, driving their valuations to nosebleed heights. What Fed QE giveth, Fed QT taketh away. At the same time the European Central Bank is tapering its own colossal QE campaign to nothing too. Between the Fed and ECB alone, 2018 will see $900b less central-bank liquidity than 2017! That’s certainly going to leave a mark.
The odds are very high that a major new bear market is awakening. Stock markets inexorably levitated by long years of extreme central-bank easing now face record tightening as that easing finally starts to be unwound. Thanks to that extreme QE as well as the Fed’s radically-unprecedented 7-year-long zero-interest-rate policy, this SPX bull extended to a monster 324.6% gain over 8.9 years as of its late-January peak!
That is nearly the second-largest and easily the second-longest stock bull in all of US history. Stock bulls always eventually peak in extreme euphoria, and then give way to subsequent proportional bears. With today’s valuations so deep into dangerous bubble territory, not even blowout earnings will be enough to keep stocks from sliding. Normal bear markets after normal bulls often maul stock markets down 50% off highs!
And after this epic QE-fueled largely-artificial monster stock bull, the inevitable bear to come is very likely to prove much bigger and meaner than normal. If the Fed’s QT doesn’t spawn it, peak earnings will. The past year’s extreme growth rates in sales and profits at the largest US companies from already-high base levels aren’t sustainable mathematically. Traders will freak out when they see growth slow or even reverse.
Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming central-bank-tightening-triggered valuation mean reversion in the form of a major new stock bear. Cash is king in bear markets, as its buying power grows. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half-price!
SPY put options can also be used to hedge downside risks. They are still relatively cheap now with complacency rampant, but their prices will surge quickly when stocks start selling off materially again. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.
Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early that year. If the stock markets indeed roll over into a new bear soon, gold’s coming gains should be much greater. And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains. Gold stocks skyrocketed 182% higher in 2016’s first half!
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