The US stock markets are becoming more unstable, fueling mounting anxiety about what’s likely coming. After surging to new all-time-record highs in late July, stocks plunged in a sharp pullback as the US-China trade war escalated. Stock markets’ resiliency in the face of bearish news is partially determined by how companies are faring fundamentally. The big US stocks’ just-reported Q2’19 results illuminate these key indicators.
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 38 days since the end of Q2, 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 $25.8t at the end of Q2! 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 $258.5b, $179.3b, and $115.8b respectively! The big SPX companies overwhelmingly drive the entire stock markets.
Q2’19 proved quite volatile in the US stock markets, leading to increasing unease. The SPX surged 3.9% higher in April, hitting 4 new record closing highs. That capped an unbelievable 25.3% rocketing over just 4.2 months, a crazy move higher. That was driven by extreme Fed dovishness, as it panicked following the SPX’s severe 19.8% near-bear correction that bottomed in late December. Euphoria reigned supreme.
But the big US stocks couldn’t stay at such lofty heights, so the SPX fell on balance through May on the way to a 6.8% pullback by early June. China reneged on major trade commitments it made to the US over a year through 10 rounds of high-level trade talks. So Trump ramped tariffs on a $200b tranche of annual Chinese imports into the US from 10% to 25%. US-China trade-war news was a key market driver in Q2.
That considerable selloff was reversed by a hyper-dovish Fed riding to the rescue. First its chairman said the Fed was ready to start cutting rates again, and later top Fed officials’ collective outlook for future rates shifted from one hike to one cut. The SPX blasted 7.6% higher in a few weeks on that, achieving another new record high in late June. The US-China trade war and Fed jawboning and actions will keep fueling volatility.
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 Q2 waned, these American giants alone commanded fully 44.2% of the SPX’s total weighting! Their $11.4t collective market cap exceeded that of the bottom 439 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 Q2’19. 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. 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 Q2’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 Q2’19 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-Q2 results, but some big US stocks use fiscal quarters offset from normal ones. Walmart, Cisco, and Home Depot have lagging quarters ending one month after calendar ones, so their results here are current to the end of April instead of June. Oracle uses quarters that end one month before calendar ones, so its results are as of the end of May. Such 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’ Q2’19 results looked decent, with modest sales and profits growth. But these growth rates are really slowing, and stock valuations remain near bubble levels relative to underlying earnings.
Over the past 19.3 years, I’ve written 873 of these weekly web essays. None are more challenging than these ones analyzing quarterly results. There’s so much data to collect and analyze, so much work to do. So it wasn’t until Q4’17 results that I took on this Herculean task. Understanding the fundamentals of big US stocks is critical to gaming likely coming stock-market performance, so the hard work is well worth it.
Out of the 7 quarters so far in this essay series, the concentration of capital in the top 34 SPX companies has never been higher. A staggering 44.2% of the market capitalization of all 500 stocks is centralized in just 34 stocks! This compares to 41.7% in Q1’18. It is not healthy for a shrinking pool of market-darling stocks to dominate the entire US markets. That leaves market performance overly dependent on them.
Much of this ominous concentration risk comes from the beloved mega-cap technology companies. The SPX’s top 5 component stocks are Microsoft, Amazon, Apple, Alphabet, and Facebook. They commanded fully 16.2% of the SPX’s entire market cap at the end of Q2, nearly 1/6th! Thus if any one of them gets hit by bad company-specific news, it will help drag the entire stock markets lower intensifying any selling.
One of the cool perks of being a professional speculator and newsletter guy is I get to listen to financial television including CNBC and Bloomberg all day every day. That offers excellent reads on the prevailing sentiment that drives markets. Almost every professional money manager interviewed loves these elite mega-cap techs, including them in their top holdings. They are universally-held and incredibly-crowded trades.
When capital deployed in stocks becomes overly concentrated, that feeds on itself for awhile. Investors deploy capital with money managers based on their performance. If they don’t own these mega-cap techs that investment inflows have driven higher for years, they risk falling behind their peers and losing business. So money managers feel forced to buy the high-flying mega-cap techs even at lofty valuations.
Interestingly these guys try to justify their heavy mega-cap-tech holdings by claiming these stocks are less risky than the broader markets because their businesses are so strong. I can’t count the number of times I’ve heard that mega-cap techs are what to own in case of a recession. That’s total nonsense, as high-flying really-popular stocks have greater downside. The more capital invested, the more potential selling.
During that severe near-bear correction where the SPX plummeted 19.8% largely in Q4’18, these top 5 SPX stocks amplified that by 1.3x with a 24.8% average drop. When the SPX pulled back 6.8% mostly in May, MSFT, AMZN, AAPL, GOOGL, and FB averaged big 12.5% declines nearly doubling the SPX’s retreat! And during the sharp 6.0% SPX pullback since late July, their average fall of 7.8% again leveraged it 1.3x.
The serious risks of too much capital in too few stocks aside, the big US stocks as a group enjoyed a solid Q2 fundamentally. Their collective revenues grew 2.7% year-over-year to $978.8b. Much of this was concentrated in those 5 mega-cap tech stocks, which averaged amazing 16.0% top-line growth compared to just 4.4% for the rest of the top 34 SPX stocks. Money managers use this to rationalize being overweight.
These elite tech market-darlings are certainly not recession-proof, despite the euphoria surrounding them. Recessions are often triggered by stock bear markets, which generate enough fear to scare both consumers and businesses into pulling in their horns and spending less. That is likely to lead to falling sales for all 5 of these mega-cap techs, which will hammer their prices sharply lower sucking in the SPX.
Businesses will cut back on their information-technology spending if they are worried about their own sales, hurting the fast-growing cloud-computing sides of Amazon, Microsoft, and Google. Companies will also cut back on their marketing spends if their own perceived prospects dim sufficiently, leading to lower revenues for Google, Facebook, and even Amazon. These high-flying stocks will really suffer in a bear market.
On the consumer side, the sales of Apple’s expensive products will plunge dramatically when consumers get worried about their own futures. They will keep their existing iPhones and iPads longer, extending the critical upgrade cycle. And most of the endless stuff Amazon sells is discretionary not essential, so those purchases will be cut back when people feel financially stressed. The top SPX stocks aren’t immune to a slowdown.
In Q2’19 these top 34 SPX and SPY stocks saw operating-cash-flow generation soar 17.0% YoY to $144.8b. Again those 5 mega-cap techs led the way, with 21.0% average growth compared to 12.9% for the rest. But these market-darling tech companies benefit heavily from the great optimism spawned by record-high stock markets. That convinces both companies and consumers to heavily buy their offerings.
The GAAP-earnings front was more interesting, with these big US stocks’ total profits up just 4.2% YoY to $140.5b in Q2’19. These were dragged down by a couple notable losses, including Procter & Gamble writing down $8.3b in a massive goodwill-impairment charge. That was an admission this company paid far too much for its Gillette shaving business, as men are shaving less and increasingly using cheaper razors.
Then Boeing suffered an ugly $3.4b loss from operations due to its ill-fated 737 MAX airplane. This is a 1960s-era airframe that was upgraded with engines far larger than ever intended in order to maximize fuel efficiency. But these wouldn’t fit under the wings, so they were mounted forward and higher. That screwed up this airplane’s center of gravity and aerodynamics, requiring computer assistance to keep flying.
Either this inherently-unstable flawed design or software bugs caused two horrific crashes killing 346 people. So the entire 737 MAX fleet was grounded, and that airplane was supposed to generate about a third of Boeing’s revenue over the next 5 years! So this company is in a world of hurt until well after this airplane is cleared to fly again. Overall SPX-top-34 profits would’ve been even higher without these losses.
While 4.2% profits growth sounds good, it is still slowing sharply. Overall SPX corporate-earnings growth rocketed 20.5% higher in 2018 largely thanks to the Tax Cuts and Jobs Act. Its centerpiece slashed the US corporate tax rate from 35% to 21%, which went effective as last year dawned. 2018’s four quarters were the only ones comparing pre- and post-TCJA earnings. This year the comparisons are all post-tax-cut.
Thanks to the stock markets’ massive corporate-tax-cut rally in 2017 and 2018, and sharp rebound on the Fed’s radical shift to dovishness earlier this year, valuations remain dangerously high. They are still up near historical bubble levels heralding new bear markets. So low-single-digit earnings growth, with the threat of actual shrinkage in future quarters, isn’t likely to be enough to support these lofty stock prices for long.
Before we get to valuations though, there’s more to consider on the big US stocks’ earnings. One of the main reasons corporations engage in stock buybacks is to artificially boost their reported earnings per share. That masks what their underlying overall GAAP profits are doing, lulling traders into complacency. Some of the companies among these top 34 had yawning gulfs between earnings per share and total profits!
The main culprits were the top 4 mega-cap US banks, JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup. Their financial reporting is mind-bogglingly complex, and full of estimates that allow them to actively manipulate their reported earnings per share. Wall Street loves the big financial stocks, which are often the most-important sector after mega-cap tech for coloring sentiment for the entire stock markets.
JPM’s EPS soared 22.5% YoY in Q2 despite total GAAP earnings only up 10.5%. BAC looked similar at 17.2% EPS growth versus 8.3% overall profits growth. WFC saw earnings per share soar 33.7% YoY despite overall earnings only rising 19.7%. And C’s 19.0% EPS surge literally tripled its 6.3% growth in hard GAAP profits! Something is really wrong here and highly misleading, eventually the truth will catch up.
Some big non-financial stocks also had magical earnings-per-share growth far outstripping underlying corporate-profits growth. Cisco’s EPS rocketed 25.0% higher despite mere 13.1% growth in the bottom-line profits on its income statement. Sooner or later there has to be a reckoning between earnings per share and actual profits, even if huge stock buybacks persist. These key profits measures have to converge.
Wall Street analysts have grown adept at using misdirection to blind investors to the adverse trends in earnings growth. Mighty Apple was a key case in point recently, reporting its Q2’19 results after the close on July 30th. This was heralded as a big beat, with EPS of $2.18 on revenues of $53.8b both exceeding expectations of $2.10 and $53.4b. By those metrics it looked like Apple was thriving, so its stock shot higher.
In after-hours trading it was up 4%+, and by the middle of the next day this monster-market-cap stock had rocketed 6.0% higher! The problem was comparing those Q2 results to estimates is totally deceptive. The analysts always lowball their guesses to ensure companies beat, stoking euphoria and complacency. But all that really matters is companies’ absolute profits and sales growth compared to their year-earlier quarters.
In hard year-over-year terms, Apple’s Q2’19 sales only eked out a 1.0% gain. That was pathetic relative to its other 4 mega-cap-tech peers, which averaged 19.7%. And Apple’s Q2’19 GAAP earnings actually plunged 12.8% YoY from Q2’18! So what Wall Street dishonestly spun into a great quarter was in reality a weaker one. Eventually stock prices have to reflect underlying fundamentals, not perma-bull propaganda.
Ominously stock prices remain dangerously high relative to their underlying corporate earnings. The big US stocks averaged trailing-twelve-month price-to-earnings ratios way up at 27.5x as Q2’19 wrapped up. That is just shy of the historical bubble threshold above 28x! So the current earnings picture over the past 4 quarters certainly doesn’t justify such lofty stock prices. That greatly amplifies market downside risk.
These chronic overvaluations aren’t just concentrated in those top 5 mega-cap tech stocks, which sported 36.2x average P/Es. The rest of the top 34 were still near bubble territory averaging 25.9x. Trading at such high valuations, these stock markets are an accident waiting to happen. It’s only a matter of time until the next bear market arrives. It could be spawned by the mounting US-China trade war, or weaker profits.
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.
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 in late July, this current monster SPX bull up 347.3% in 10.4 years ranked as the 2nd-largest and 1st-longest in all of US stock-market history! This powerful secular uptrend can’t persist near bubble valuations as corporate-earnings growth stalls or even reverses.
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. 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 near-bubble valuations in US stock markets will soon look even more extreme. If the big US stocks’ fundamentals deteriorate, the overdue bear reckoning after this monster bull is even more certain. So big US stocks’ coming Q3’19 and Q4’19 results could prove pivotal if they’re weak.
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 in 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! Gold’s awesome decisive bull breakout in late June is already attracting traders back.
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The bottom line is big US stocks’ latest fundamentals from Q2’19’s earnings season were decent. These elite companies enjoyed modest sales and earnings growth. But that masked serious and mounting risks. Investment capital is increasingly concentrating in the beloved mega-cap technology stocks, leaving stock markets overly dependent on their fortunes. Any slowing from them will drag the entire stock markets lower.
More ominously big US stocks’ valuations remain way up near dangerous bubble territory. Their earnings aren’t justifying their lofty stock prices. The resulting downside risks are exacerbated with profits growth really slowing, and threatening to stall out entirely or even shrink in coming quarters. This is a potently-bearish situation, even before any bad news like further escalation in the US-China trade war hits stocks.
Adam Hamilton, CPA
August 9, 2019
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