Category Archives: Equity Market

Crazy Days

I have been somewhat out of the loop on the market over the past 2 months, partly due to work and partly due to a general apathy towards trying to understand the current market reasoning. I am very much in a risk off mode on a personal basis having moved mainly into cash since April to protect YTD gains (and take the hit on YTD losses!). At the end of April, I posted my thoughts about the equity market (with the S&P500 being my proxy for the “equity market”). Since then, the equity market has sea sawed 7% down in May and 7% up June to date, now in sight of new all-time highs. The volatility has primarily centred around the China trade talks and the economic outlook.

With the 10-year US treasury yield now just above 2% compared to around 2.5% at the end of April, clearly market expectations have changed. At its meeting last week, the Fed highlighted an increase in uncertainties to the global economy and stated that “in light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion”. The market is loving the new Powell put rhetoric (he does seem to be overcompensating for the year end 2018 “error”) and some are taking language such aswe will act as needed, including promptly if that’s appropriate” to mean multiple cuts this year, as many as three this year have even been advocated. Equity markets seem to be missing the point that multiple rate cuts will mean the economy has deteriorated rapidly, with a recession a real possibility. Hardly a reason for all time high equity markets!

There’s also the issue of the Fed’s current benchmark rate of 2.25% to 2.5% which is not exactly at normal economic boom levels given it historically has taken cuts of 3-4% to reverse recessionary slowdowns. Powell may be counting on the shock therapy of an early and relatively large cut (50 bps?) as an antidote to any rapid worsening of the trade war with China (or the outbreak of a real war with Iran!). In such an outcome, it is inevitable that talk of QE will re-emerge, providing yet more distortion to this millennium’s crazy brand of monetary policy.

A whole host of other things are bothering me – I highlighted high valuations on the hot business software stocks (here), Slack’s valuation (now over $18 billion. It had $135 million of revenues last quarter!!), a bitcoin rally, the fantasy-land UK conservative party leadership contest (the UK used to lead the world in the quality of its political debate, how did it get to this?), and, last but not least, the Orange One and Iran and well everything else to do with Trump. Sorry, that turned into a bit of a rant.

And so, we come to the G20 meeting of the world’s greatest leaders this week. Maybe it’s my mood but I found myself agreeing with the analysis (here) of Dr Doom himself, known as Nouriel Roubini to his friends. Roubini highlights three possible scenarios on the US China talks – an agreed truce with a negotiated settlement by the end of the year, a full-scale trade & tech & cold war within 6 to 12 months, or no trade deal agreed but a truce whereby tariffs agreed to be capped at 10% to avoid escalation. The third option is in effect a slow-burn trade war or a managed trade escalation.

I would agree with Roubini that either the first (but without the settlement this year) or third options are the most likely as both sides have reasons to avoid a rapid escalation. China needs time to prepare its economy for a prolonged conflict and to see how Trump fairs politically. Trump can portray himself as the John Wayne figure his man-child self longs to be in standing up to China and can pressure the Fed to stimulate the economy from any short-term impacts. Unfortunately, a managed escalation of a trade war is exactly like a managed Brexit. Impossible. You are either in or out. Have a deal or don’t have a deal. Could a grand deal be struck with this G20 meeting proving the turning point? Its possible but unlikely in my view (I’m referring to a real deal, not a fantasy/pretend deal). I hope I’m wrong.

Against this backdrop, forgive my lack of insight into the current collective wisdom of the market but an all-time high equity market makes little sense to me. And that’s me being polite.

Goldilocks Lives

With the S&P500 off its September high and US 10 year yields well over 3% back in October, its crazy to think that just 6 months later the 10-year yield is currently around 2.6% and the S&P500 has just hit new highs. What was all the fuss about! A return to a steady US GDP non-inflationary growth as per the Q1 figures and with Q1 earnings coming in ahead of reduced expectations (with approx. half of the S&P500 reported), one could be tempted to think we have returned to the good old Goldilocks days. My predictions (here) of a rebound off the December lows followed by more volatility in Q1 were well wide of the mark with volatility across major asset classes eerily low as the market hits new highs. My record of been wide of the mark has at least been consistent with this post from January last year calling a premature ending to Goldilocks!

Some commentators are bullish on more upside for the market on the improved economic and earnings figures and cite comparisons to similar 20% drops and recoveries in 1998 and 2011. The graph below shows the comparisons, with 2 other 20% drops (although 1957 and 1990 were during recessions).

click to enlarge

As to what happens next, I have no idea. Some say at 17 times forward earnings; the market is not too expensive, and a wall of money will fuel this FOMO (fear of missing out) rally. Although the positive narrative from Q1 earnings will likely dictate short term trends, the market just feels like it has gotten ahead of itself to me and I feel comfortable taking some money off the table. As the graph below of monthly moves greater than +/- 3% shows, volatility is never that far away.

click to enlarge

A return to economic and earnings growth also raises the question of how long the Fed can remain ultra-accommodative. The arguments on raising rates and debts levels are all very déjà vu! For the moment however, unless the China trade talks fall apart, all looks surprisingly rosy.

There are always concerns. Bank of America recently highlighted that over the past five years, US firms have paid out $3.3 trillion in dividends and bought back $2.7 trillion of their own shares ($800 billion in 2018 alone) whilst taking on $2.5 trillion of new debt. The buybacks are responsible for 30% of earnings growth according to Bank of America (20% in 2018). The need to pay down this debt was a focus for many firms in the stock market rout. Bank of America predict further upside in equities to the summer before a pullback in Q3. The ever-excellent John Authers (ex-FT columnist now with Bloomberg) had an insightful article on corporate debt in March.

According to a recent report from Euler Hermes, the non-bank leveraged loan market is flattering the overall US corporate debt profile and corporate spreads are likely under estimating risk. This report from Moodys suggests that high leverage is offset by ample coverage of net interest expense. In this report, S&P estimate that “the proportion of companies having aggressive or highly leveraged financial risk has risen slightly to 61% (compared to 2009)”. Regulators also remain concerned about debt levels, particularly leveraged loans as per this recent report. The size of the leveraged loan market globally is estimated around $1.5 trillion, with the Bank of England estimates shown below.

click to enlarge

According to Ron Temple of Lazard Asset Management the “deterioration in underwriting standards for leveraged loans is increasingly worrisome” and the graph below shows the increased leverage in the market which combined with lax terms (approx. 80% are covenant lite loans) are a red flag in the event of any downturn.

click to enlarge

The buoyant private equity market is a testament to the joys of leverage, with recent PE raisings hitting records and an estimated $1.3 trillion of undeployed capital as of March. In this recent FT article, Jonathan Lavine of Bain Capital warned that private equity groups are taking on too much debt in the competition to win deals (the Bain 2019 market report is well worth a read).

Still, these are all things to worry about in times of stress. As of now, let’s enjoy Goldilocks return and keep dancing. Carefully mind you, it is late and we don’t want to wake those bears.

Flying High

As the S&P 500 grapples around the 2,800 mark, it has achieved an impressive 12% year to date gain. A pause or a pull-back whilst macro events like Brexit and the US-China trade talks are resolved are a possibility given the near 17 forward PE. I thought it would be worthwhile looking at some of the high flyers in the market to search for value.

I selected a group of 12 stocks that have increased by 25% on average since the beginning of the year. The list is dominated by business software firms that are squarely in the SaaS, cloud and AI hype. Firms like ServiceNow (NOW), Workday (WDAY), Tableau Software (DATA), Splunk (SPLK), Adobe (ADBE), Salesforce (CRM), Palo Alto Networks (PANW) and the smaller Altair Engineering (ALTR). Others included in my sample are Square (SQ), Paypal (PYPL), VMWare (VMW) and my old friend Nvidia (NVDA).

Using data from Yahoo Finance, I compared each of the firm’s valuation, based upon today’s close, using their 2019 projected PE against their PEGs, using projected EPS growth for the next 3 years. The results are below.

click to enlarge

These are not cheap stocks (a PEG at or below 1 is considered undervalued). As per this FT article, the CEO of ServiceNow John Donahoe summed up the market’s love of some of these stocks by saying “investors value, first and foremost, growth”. By any measure, “value” in that quote is an understatement. I have never been good at playing hyped stocks, I just can’t get my head around these valuations. I do think it indicates that the market has got ahead of itself in its love of growth. I am going to focus on the two most “reasonably” valued stocks on a PEG basis in the graph above – Nvidia and Altair – by running my own numbers (I always distrust consensus figures).

I have posted on my journey with Nvidia previously, most recently here in November after their first revenue warning. Amazingly, even after a second big revenue warning in January from ongoing inventory and crypto-mining headwinds, the stock recovered from the 130’s into the 150’s before again trading into the 160’s in recent weeks following the Mellanox merger announcement. NVDA purchased Mellanox, an admired data centre equipment maker, at 25 times 2018 earnings (which seems reasonable given Mellanox is growing revenues at 25%).

NVDA’s recent quarterly results were not only worrying for its near 50% sequential decline in gaming but also for the 14% sequential decline in its data centre business, its second largest segment which was growing strongly. Despite management’s assertion that the gaming segment’s quarterly run rate is $1.4 billion (Q4 was below $1 billion), I am struggling to match analyst revenue estimates for FY2020 and FY2021. The most optimistic figures that I can get to (pre-Mellanox), assuming the crypto-mining boom is removed from the trend, is $10.3 billion and $12.8 billion for FY2020 and FY2021, 8% and 4% less than the consensus (pre-Mellanox), as below.

click to enlarge

Based upon management’s guidance on expenses (it is impressive that nearly 9,500 of their 13,300 employees are engaged in R&D), on the Mellanox deal closing in calendar year Q3 2019, and on 15 million shares repurchased each year, my estimates for EPS for FY2020 and FY2021 are $5.00 and $7.77 respectively (this FY2020 EPS figure is below analyst estimates which exclude any Mellanox contribution). At today’s share price that’s a PE of 33 and 21 for their FY2020 and FY2021. That may look reasonable enough, given the valuations above, for a combined business that will likely grow at 20%+ in the years thereafter. However, NVDA is a firm that has just missed its quarterly numbers by over 30% and it should be treated with a degree of “show me the money”. I think the consensus figures for FY2020 on NVDA are too optimistic so I shall watch NVDA’s progress with interest from the sidelines.

Altair Engineering (ALTR) is not the usual hyped firm. ALTR provide an integrated suite of multi-disciplinary computer aided engineering software that optimizes design performance across various disciplines which recently purchased an AI firm called Datawatch. ALTR is led by the impressive James Scapa and have built a highly specialised platform with significant growth potential. The revenue projections for the firm, including Datawatch and another acquisition SimSolid, with 2018 and prior on an ASC 605 basis and 2019 on an ASC 606 basis are below. The reason for the relatively flat Q/Q is the conversion of the Datawatch business to a SaaS basis and integration into the Altair platforms.

click to enlarge

For 2019 through 2021, my estimates for EPS are $0.62, $0.81 and $1.17 respectively (2019 and 2020 figures are over 10% higher than consensus). At the current share price of $38.32, that’s PE ratios of 63, 47, and 33. A rich valuation indeed. And therein lies the problem with high growth stocks. ALTR is a fantastic firm but its valuation is not. Another one for the watchlist.

A naughty or nice 2019?

They say if you keep making the same prediction, at some stage it will come true. Well, my 2018 post a year ago on the return of volatility eventually proved prescient (I made the same prediction for 2017!). Besides the equity markets (multiple posts with the latest one here), the non-company specific topics covered in this blog in 2018 ranged from the telecom sector (here), insurance (here, here, and here), climate change (here and here), to my own favourite posts on artificial intelligence (here, here and here).

The most popular post (by far thanks to a repost by InsuranceLinked)) this year was on the Lloyds’ of London market (here) and I again undertake to try to post more on insurance specific topics in 2019. My company specific posts in 2018 centered on CenturyLink (CTL), Apple (AAPL), PaddyPowerBetfair (PPB.L), and Nvidia (NVDA). Given that I am now on the side-lines on all these names, except CTL, until their operating results justify my estimate of fair value and the market direction is clearer, I hope to widen the range of firms I will post on in 2019, time permitting. Although this blog is primarily a means of trying to clarify my own thoughts on various topics by means of a public diary of sorts, it is gratifying to see that I got the highest number of views and visitors in 2018. I am most grateful to you, dear reader, for that.

In terms of predictions for the 2019 equity markets, the graph below shows the latest targets from market analysts. Given the volatility in Q4 2018, it is unsurprising that the range of estimates for 2019 is wider than previously. At the beginning of 2018, the consensus EPS estimate for the S&P500 was $146.00 with an average multiple just below 20. Current 2018 estimates of $157.00 resulted in a multiple of 16 for the year end S&P500 number. The drop from 20 to 16 illustrates the level of uncertainty in the current market

click to enlarge

For 2019, the consensus EPS estimate is (currently) $171.00 with an average 2019 year-end target of 2,900 implying a 17 multiple. Given that this EPS estimate of 9% growth includes sectors such as energy with an assumed healthy 10% EPS growth projection despite the oil price drop, it’s probable that this EPS estimate will come down during the upcoming earnings season as firms err on the conservative side for their 2019 projections.

The bears point to building pressures on top-line growth and on record profit margins. The golden boy of the moment, Michael Wilson of Morgan Stanley, calls the current 2019 EPS estimates “lofty”. The bulls point to the newly established (as of last Friday) Powell Put and the likely resolution of the US-China trade spat (because both sides need it). I am still dubious on a significant or timely relaxation of global quantitative tightening and don’t feel particularly inclined to bet money on the Orange One’s negotiating prowess with China. My guess is the Chinese will give enough for a fudge but not enough to satisfy Trump’s narcissistic need (and political need?) for a visible outright victory. The NAFTA negotiations and his stance on the Wall show outcomes bear little relation to the rhetoric of the man. These issues will be the story of 2019. Plus Brexit of course (or as I suspect the lack thereof).

Until we get further insight from the Q4 earnings calls, my current base assumption of 4% EPS growth to $164 with a multiple of 15 to 16 implies the S&P500 will be range bound around current levels of 2,400 – 2,600. Hopefully with less big moves up or down!

Historically, a non-recessionary bear market lasts on average 7 months according to Ed Clissold of Ned Davis Research (see their 2019 report here). According to Bank of America, since 1950 the S&P 500 has endured 11 retreats of 12% or more in prolonged bull markets with these corrections lasting 8 months on average. The exhibit below suggests that such corrections only take 5 months to recover peak to trough.

click to enlarge

To get a feel for the possible direction of the S&P500 over 2019, I looked at the historical path of the index over 300 trading days after a peak for 4 non-recessionary and 4 recessionary periods (remember recessions are usually declared after they have begun), as below.

Note: These graphs have been subsequently updated for the S&P500 close to the 18th January 2019. 

click to enlarges&p500 q42018 drop compared to 4 nonrecession drops in 1962 1987 1998 & 2015 updated

 

click to enlarges&p500 q42018 drop compared to 4 recession drops in 1957 1974 1990 & 2000 updated

 

I will leave it to you, dear reader, to decide which path represents the most likely one for 2019. It is interesting that the 1957 track most closely matches the moves to date  (Ed: as per the date of the post, obviously not after that date!) but history rarely exactly rhymes. I have no idea whether 2019 will be naughty or nice for equity investors. I can predict with 100% certainty that it will not be dull….

Given that Brightwater’s pure Alpha fund has reportingly returned an impressive 14.6% for 2018 net of fees, I will leave the last word to Ray Dalio, who has featured regularly in this blog in 2018, as per his recent article (which I highly recommend):

Typically at this phase of the short-term debt cycle (which is where we are now), the prices of the hottest stocks and other equity-like assets that do well when growth is strong (e.g., private equity and real estate) decline and corporate credit spreads and credit risks start to rise. Typically, that happens in the areas that have had the biggest debt growth, especially if that happens in the largely unregulated shadow banking system (i.e., the non-bank lending system). In the last cycle, it was in the mortgage debt market. In this cycle, it has been in corporate and government debt markets.

When the cracks start to appear, both those problems that one can anticipate and those that one can’t start to appear, so it is especially important to identify them quickly and stay one step ahead of them.

So, it appears to me that we are in the late stages of both the short-term and long-term debt cycles. In other words, a) we are in the late-cycle phase of the short-term debt cycle when profit and earnings growth are still strong and the tightening of credit is causing asset prices to decline, and b) we are in the late-cycle phase of the long-term debt cycle when asset prices and economies are sensitive to tightenings and when central banks don’t have much power to ease credit.

A very happy and healthy 2019 to all.

Apple Crush

The news just keeps getting worse for Apple (AAPL) with all the negative rumours being confirmed by the top-line warning announced last night. In my last post on AAPL, I ruminated that the stock could fall as low as $160. Well, it was trading below that figure prior to last night’s warning and it looks set to possibly test $140 today. The only bright side of the announcement is that it quantifies the bad news which is the first step towards reaching a bottom. The enviable round of analyst downgrades means the next few weeks will likely be choppy for both AAPL and the market.

In the interim, I quickly revised some numbers in my model, as below.

click to enlarge

Based upon my historical forward multiples excluding cash, whilst reverting to a straight average multiple of 9 compared to an increasing multiple (that was in another era now!), my new estimate of how low AAPL can go is $115 per share, a near 30% drop from last night’s close.

click to enlarge

Whether I will be a buyer around the $120 level will depend upon what the overall market is doing. Best to wait on the side-lines for this drama to unfold.