The US stock markets have surged to all-time-record highs, fueled by extreme Fed easing. It jawboned about rate cutting, slashed rates, and birthed a new large-scale Treasury monetization campaign! All this has left traders hyper-complacent, assuming the upside will continue indefinitely. But are these lofty stock levels fundamentally-justified? The big US stocks’ just-reported Q3’19 results illuminate this key question.
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 easily 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 37 days since the end of Q3, 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 $26.2t at the end of Q3! 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 huge 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 the 3 largest ETFs in the world. This week they reported colossal net assets running $279.7b, $193.3b, and $122.6b respectively! The big SPX companies overwhelmingly drive the entire stock markets.
Q3’19 was choppy, but the SPX didn’t stray far from record highs. July saw 8 of them from a big Fed-driven rally. In early June the Fed chairman started talking rate cuts. That dovishness was confirmed in mid-June when top Fed officials’ collective outlook for the rate trajectory shifted from hiking to cutting. The FOMC delivered at the end of July, cutting by 25 basis points for the first time since December 2008!
The SPX surged 2.9% in July alone leading into that cut, hitting those record closes. But Jerome Powell pooped in traders’ easy-money punchbowl that day, calling that cut a “midcycle adjustment” and not “the beginning of a lengthy cutting cycle”. Denied their perpetual-easing drug, traders revolted to hammer the SPX 6.1% lower over the next couple weeks. That scared the Fed into backtracking, leading to more cutting.
The FOMC cut another 25bp at its next meeting in mid-September, and Powell’s “midcycle adjustment” turned into 3 25bp cuts in just 3.0 months by the end of October! That and the Fed panicking to launch its fourth large-scale quantitative-easing campaign to monetize Treasuries recently pushed the SPX to even more record highs. But within Q3 proper it averaged 2957.8, the highest ever witnessed! Traders loved that.
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 Q3 waned, these American giants alone commanded fully 43.9% of the SPX’s total weighting! Their $11.5t collective market cap exceeded that of the bottom 438 SPX companies. Big US stocks’ importance cannot be overstated.
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 Q3’19. 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 the zero lower bound 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. Corporations 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 Q3’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 I’m also collecting the earnings-per-share data Wall Street loves, it is 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 Q3’19 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 valuation metric. Wall Street often intentionally conceals these real P/Es by using fictional forward P/Es instead, which are literally mere guesses about future profits that almost always prove too optimistic.
These are mostly calendar-Q3 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 July instead of September. Pepsi, Oracle, and Nike report on quarters ending one month before calendar ones, so their results below are as of the end of August.
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. The big US stocks reported mixed Q3’19 results overall, with modest sales growth but shrinking profits. This is a serious problem with these elite companies still collective trading near dangerous bubble valuations.
Before we start, these year-over-year comparisons need to be adjusted slightly. Disney’s fiscal year ends at the end of calendar Q3. Companies finishing fiscal years have 60 days after quarter-ends to complete their way-longer, far-more-complex, and audited 10-K annual reports to file with the SEC. Disney hadn’t reported anything on Q3’19 yet as of the data cutoff for this essay, Wednesday’s close. So it is excluded.
The entire S&P 500 finished Q3’19 up 2.2% from the end of Q3’18. That’s not much, but remember the SPX collapsed right after that. It plummeted 19.8% largely in Q4’18 in a severe near-bear correction. That was driven by Fed tightening, its since-abandoned quantitative-tightening campaign ramping up to full speed and the Fed’s 9th rate hike of its also-forsaken normalization. Marginal new highs after that are a big deal.
The top 34 SPX companies’ collective market capitalizations grew by 1.3% YoY to $11,490.6b as of the end of Q3. Ex-Disney, their total revenues climbed a healthy 2.4% YoY to $1002.3b. Sales growth at their massive scales is always impressive. But all of that came in 3 of the 4 market-dominating mega-cap tech stocks, Microsoft, Amazon, and Alphabet. Their total revenues soared an incredible 20.2% higher YoY!
Troublingly the rest of the top 34 ex-Disney saw their total revenues slump a slight 0.0%. So all the top-line revenue growth among elite American companies came in just a few tech giants. If the US economy was booming as record-high stock markets imply, the rest of these market-leading companies would also be seeing higher sales. Even mighty Apple has seen its revenue growth flag, with iPhone demand saturated.
That bifurcation between mega-cap tech and everything else was even more pronounced in operating-cash-flow-generation terms. Overall these top 34 saw their total OCFs collapse a stunning 23.6% YoY to $188.9b! That was despite MSFT, AMZN, and GOOGL actually growing their OCFs by 4.9% YoY. But the rest of the top 34 without Disney suffered a shocking 28.3% YoY decline in total operating cash flows!
Traders universally believe these are the best of times, deep into a record US economic expansion with record-high stock markets. But the rising tide of economic growth lifts all boats, not just a handful. If the vast majority of elite American companies are struggling to boost revenues and falling way behind in OCF generation, what’s going to happen in the next recession? The Fed can’t delay that inevitable reckoning forever.
The hard-GAAP-earnings front revealed another serious crack in the euphoric everything-is-awesome narrative fueled by record-high stock markets. Overall SPX-top-34 profits in Q3’19 without Disney fell 2.6% YoY to $148.9b. That trio of mega-cap techs actually dragged down that average, falling 4.9% YoY despite their torrid sales growth. The rest of the top 34 ex-Disney saw corporate earnings slide 2.2% from Q3’18.
The big US stocks’ overall Q3’19 results certainly look like these elite companies are teetering on the very edge of entering an earnings recession. That has incredibly-bearish implications given the lofty prevailing valuations. Companies are doing their damnedest to mask that their profits look to have peaked and are rolling over. They’ve massively stepped up their manipulative stock-buyback campaigns to obscure profits.
Consider some examples. Database and cloud-computing giant Oracle earned $2137m in net income in its latest fiscal quarter ending August 31st. That was down a considerable 5.7% YoY. Yet in earnings-per-share terms which is all companies report now, Q3’19 EPS of $0.64 climbed a strong 10.3% over the Q3’18 results! There were no unusual income-statement items distorting those results in either of these quarters.
Despite earning that $2137m, ORCL spent a staggering $5005m during that quarter buying back its own stock! It and other elite US companies are magically conjuring rising EPS from falling absolute profits with enormous stock buybacks. Oracle certainly isn’t alone. Home Depot’s actual earnings slumped 0.8% YoY in its latest quarter, yet it still reported strong 3.9% EPS growth. Merck came in at -2.5% and +1.4%.
The deception inherent in artificially goosing EPS growth through stock buybacks isn’t even the primary issue here. Way more important for the stock-market outlook is why absolute earnings are falling with everything so favorable. And how near-bubble priced-for-perfection valuations are very unforgiving of any earnings weakness. The record-high stock markets’ already-flimsy fundamental underpinning is rotting.
Based on the FOMC’s actions, what the Fed does and when, a strong-if-not-ironclad case can be made that all it cares about is stock-market fortunes. Remember just 10.6 months ago in mid-December the Fed raised rates for the 9th time in that hastily-abandoned hiking cycle. The SPX plummeted 7.7% in just 4 trading days on that, and was staring into the vicious jaws of a long-delayed bear. So the Fed panicked.
The day of that 9th rate hike, top Fed officials were predicting 3 more rate hikes including 2 more in 2019! Yet the FOMC did a colossal about-face since, actually cutting 3 times in 3 months this year. The reason things changed so radically on that SPX near-bear correction is the wealth effect. Americans spend more when stock markets are high, boosting confidence. And consumer spending drives over 2/3rds of the US economy.
So top Fed officials know the overdue stock bear their extreme easing has so far warded off is going to drag the US into a severe recession. As the SPX itself falls 20%, 30%, even 50%, Americans will grow scared and pull in their horns. And 50% losses are par for the course in major bears inevitably following major bulls. The last two SPX bears ending in October 2002 and March 2009 saw 49.1% and 56.8% losses!
If revenues and earnings growth among the biggest and best US companies are already flagging even with record-high stock markets, imagine how they will collapse when consumer spending wanes. Weaker sales and profits are problematic for stock prices anytime, but much more so now given the sky-high valuations spawned by the Fed’s extreme easing. The elite top-34 SPX companies are trading near bubble levels!
Over the past century-and-a-quarter or so, stock-market valuations as measured by trailing-twelve-month price-to-earnings ratios have averaged about 14x earnings. That’s historical fair value. Double that at 28x is formal bubble territory, which virtually guarantees a severe bear will follow. As of the end of Q3’19, these 34 elite big US stocks commanding 43.9% of the SPX’s market cap reported average TTM P/Es of 25.9x!
That is perilously close to 28x, dangerously-expensive. These stellar valuations prove the Fed-sparked and -fueled monster 30.9% SPX surge since late December’s near-bear low wasn’t justified by underlying corporate profits. It was entirely a sentiment thing, pure greed as the flow of traders’ easy-money drugs resumed in a big way. Ominously weakening earnings will force prevailing valuations even higher from here!
With lower profits in price-to-earnings ratios’ denominators, valuations will climb if stock prices remain flat. So today’s near-bubble valuations could easily become bubble valuations in coming quarters, multiplying the downside risks in the stock markets. And that earnings-stock-prices loop can easily become a vicious circle. The less consumers spend, the more profits decline. The more earnings fall, the more stocks sell off.
And due to the wealth effect, the farther stocks fall the less consumers are comfortable spending. This all feeds on itself, eventually snowballing into a severe recession or even a depression. That’s what the Fed is so scared of. The next bear market is going to bring this whole Fed-conjured illusion of easy-money prosperity crashing down, with dire political implications for the Fed’s independence if it is rightly blamed.
Again Q3’19 was the best of times for stock markets. The SPX rallied to a bunch of new all-time closing highs, making for its highest average quarter ever. Straddling Q3 the FOMC stunningly reversed its future rate bias from hiking to cutting, made 3 rate cuts in 3 months, injected vast amounts of new money trying to stabilize malfunctioning overnight-funding markets, and launched QE4! That makes for epic easing.
If the big US stocks’ earnings couldn’t grow in even these extremes, and sales were flat outside of a few mega-cap techs, the SPX is in a world of trouble. A stock-selloff-driven recession will hammer market-darling techs too, as their businesses are heavily dependent on other businesses spending. As corporate sales and profits deteriorate, companies will reduce spending on advertising and cloud services to cut costs.
Excessive valuations after long bulls always eventually spawn proportional bear markets. And we are way overdue for the next one. At its latest all-time-record high earlier this week, this current monster SPX bull up 355.0% in 10.7 years ranks as the 2nd-largest and 1st-longest in all of US stock-market history! This Fed-amped secular uptrend can’t persist near bubble valuations as corporate earnings roll over to shrinkage.
Bear markets 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. Seeing big US stocks’ prices cut in half or worse is common and expected in major bear markets. And odds are the current near-bubble valuations in US stock markets will soon look even more extreme.
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. When stock markets weaken its investment demand surges, which happened last December as the SPX sold off hard.
While the SPX plunged 9.2% that month, 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 up 30% fueling a massive 182% gold-stock upleg! Investors are even more interested in gold now after its decisive bull breakout in late June.
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The bottom line is the big US stocks’ just-reported Q3’19 results certainly don’t justify these record-high stock prices. Revenue growth mostly stalled out last quarter, while earnings declined. That happened with the best stock-market levels ever witnessed, and incredibly-extreme Fed easing. Stock prices were stretched so far beyond underlying earnings that elite American companies are trading near bubble valuations.
This is a precarious situation at best, and dangerous at worst. The hyper-easy Fed is running low on stock-market-goosing ammunition, with only 6 rate cuts left between here and zero. Can these lofty, expensive stock markets keep levitating without the Fed? Probably not with corporate fundamentals deteriorating even when everything is awesome. A valuation mean reversion lower, or bear market, is coming.
Published by Adam Hamilton of Zeal LLC Specialising in stock-market speculation and investment from a contrarian perspective. This material has been prepared for general information purposes and must not be construed as investment advice.