Markets Go Calm: A Lehman Pause or the Real Thing?

Since the March 2020 sellout, the average S&P 500 stock has outperformed the NYSE FANG+ index. “It is only now that investors have fully grasped that [FANGs] shouldn’t be valued as though the pandemic conditions would continue forever.”

“…This incident is very much about mega-cap tech and the premium it deserves over the rest of the market. Looking at the ratio between the S&P 500 Equal Weight Index, in which each stock has a 0.2% weighting regardless of its size, and the standard S&P 500 benchmark, illustrates just how much tech shares weigh down the index when the average stock isn’t doing so badly. The average stock has comfortably beaten the index so far this year. The average S&P 500 stock has now outperformed the NYSE FANG+ index since the nadir of the Covid-19 selloff in March 2020….”

John Authers, “Wile E. Coyote Moment as Tech Goes Off the Cliff,” Bloomberg, October 28, 2022, https://www.bloomberg.com/opinion/articles/2022-10-28/tech-s-fangs-plummet-in-wile-e-coyote-moment-on-earnings?sref=U3dOGIDF

Wile E. Coyote Moment as Tech Goes Off the Cliff

Crash Landing

There is no character in the entire canon of world literature and drama more useful for explaining markets than Wile E. Coyote. In the Roadrunner cartoons, he would run off the edge of a cliff, and continue running into midair. Only once he stopped, looked down, and realized that he was in midair, did he fall. He thus gave the market the invaluable concept of a Wile E. Coyote moment, when investors realize they’ve been running without support for a long time, and prices that should have long since been gradually coming down suddenly collapse.

The laws of physics make what the coyote does impossible. But markets are driven by human nature and crowd psychology. Coyotes can defy gravity for years in the markets — but generally there comes a point when the game is up. And this week has seen the FANGs (the acronym for the huge internet platform groups that originally stood for Facebook, Amazon, Netflix and Google when coined) respond to gravity at last.

Netflix had well-received results last week; but Microsoft Corp., Google-owner Alphabet Inc., Amazon.com Inc. and even Apple Inc. have all this week suffered sharp writedowns, while the treatment meted out to Meta Platforms Inc., the Facebook parent, has been savage. Since Tuesday evening when its results came out, Meta’s stock has been punished horribly for a disappointing revenue forecast, despite Mark Zuckerberg asking for patience given the social-media giant’s growing investments, particularly in the metaverse. The stock has plunged 25% Thursday and 70% year-to-date:

The fall from grace has been staggering. As of Thursday’s close, Meta has underperformed the benchmark S&P 500 since it went public, even excluding dividends. The following graph shows the performance of the social media giant, the benchmark index and the S&P 500 Total Return Index, which is calculated intraday by the S&P based on both price changes and reinvested dividends. For investors who thought they were betting on the next big thing, it won’t be surprising if they are starting to think twice.

Or let’s put that another way. After Thursday’s carnage, Meta trades at just over nine times trailing earnings (having traded as high as 37 times earnings little more than a year ago). The S&P 500 as a whole trades at 18. One of the most exciting growth stocks on the planet, with all its greatest days still ahead of it, is somehow now regarded as so weak that it should only trade at half the market multiple. That kind of judgment is a recognition that Meta should never have been valued so richly in the first place.

Another important way to illustrate the scale of what’s going on involves comparing market capitalizations. The market value of Meta has slipped by $676 billion this year, pushing it out of the world’s top 20 largest companies. At one point it was the fifth-largest in the US, valued at more than $1 trillion, and almost three times the size of the biggest US bricks-and-mortar retailer, Walmart Inc. Now, for the first time since 2015, Meta is smaller than Walmart:

Naturally Meta’s numbers and predictions were disappointing, but its greatest problem was a sudden return by investors to the basics of cash flow and balance sheet analysis. The decline in Meta’s free cash flow drew an apology even from previously ardent backer Jim Cramer on CNBC. And Neil Campling of Mirabaud Equity Research made this telling observation: “For every $1 Apple spends on operating costs, it generates $6.80 in revenue. For every $1 Meta spends on operating costs, it generates $1.17 in revenue.”

This is all a tad reminiscent of the period of a few weeks in early 2000 when dot-com investors suddenly moved from metrics like “clicks per eyeball” to “burn rate” — an old metric with a new name, referring to how quickly startup companies were burning through their cash flow. Meta has become a vastly more substantial and tangible concern than the entities that evaporated 22 years ago, but the sudden and swift realization that it had been valued far too generously still rings those bells.

The FANGs’ crisis of confidence is all the more interesting because it comes just as bond yields are falling and optimism is growing that central banks will soon relent (of which more below). In fact, the pessimism from Meta, given the company’s sheer size, even overshadowed the positive gross domestic product data Thursday, according to Nicole Webb, SVP and financial adviser at Wealth Enhancement Group. The stock’s slide has had “such a global impact” that it may prompt a broader market recalibration: “I appreciate seeing a slowdown in the mega-cap tech companies. I have always had this thesis that trades don’t grow from the sky. And I think Silicon Valley is showing a bit of its age in that they really ever had to be thoughtful about hiring, layoffs and restructuring.”

She may be right. This incident is very much about mega-cap tech, and the premium it deserves over the rest of the market. Looking at the ratio between the S&P 500 Equal Weight Index, in which each stock has a 0.2% weighting regardless of its size, and the standard S&P 500 benchmark, illustrates just how much tech shares weigh down the index when the average stock isn’t doing so badly. The average stock has comfortably beaten the index so far this year:

Perhaps even more impressively, the average S&P 500 stock has now outperformed the NYSE FANG+ index since the nadir of the Covid-19 selloff in March 2020. For more than a year, investors worked on the assumption that these companies would benefit from the pandemic, which they unquestionably did — but it is only now that investors have fully grasped that they shouldn’t be valued as though the pandemic conditions would continue for ever:

Strategically, Webb suggests that the selloff could offer a good point to enter tech again, although tactically it appears to be a good time to stay in the bricks-and-mortar stocks that are reviving at present. Today’s defensive trades are more about existing in a lower-growth environment for a time, which will create a more sustainable market “and gives us a launching pad to the next wave of growth.”

For Anthony Saglimbene, chief market strategist at Ameriprise Financial, what’s happening is simply the divergence between the old economy and the new economy.

Old economy stocks, he said, comprise those that are value-based, which typically perform better due to their stable earning streams. This is where investors are gravitating now, especially since they are less sensitive to rate increases. The new economy, on the other hand, include high-growth tech names that are prone to fears of rising interest rates, since many of them are valued based on their projected profits far into the future. And as the Fed forges on with its most aggressive tightening monetary policy in decades, the future profits of tech firms will be worth far less.

Unfortunately for the tech sector, the bad news continued at the end of the day, when it was the turn of Amazon.com Inc. to feel the market’s wrath in after-hours trading. Its third-quarter earnings were above prior expectations, but a particularly sanguine warning that the coming holiday season isn’t going to be a good one for sales prompted investor flight. The stock plummeted 20% at one point in extended trading.

The numbers involved are vast. The price at which Amazon’s shares came to rest implied a fall of $159 billion in market cap. This would leave it in the club of trillion-dollar companies, but only just, at $1.02 trillion. This seems like quite a reckoning, as the tech companies fall coyote-like toward the canyon floor. But to Saglimbene, who is overweight tech, the headwinds are only temporary until interest rates find their equilibrium.

For now, other parts of the market are enjoying a boost — companies that warmly fill tummies, bring us to exciting places, and entertain us with endless movies. To Webb, it’s simply a matter of everyone getting their time, as companies that were hurt by the pandemic return to normal: “McDonalds is such a great story in the psyche of the consumer as is Chipotle as is Boeing… When you think about the world today, kids are back in school so it’s not surprising Netflix has new subscribers again. Well now we are back to the school year, winter is coming. Everyone is back to normal activity. Return to normalcy will prevail the trade.”

More telling still was the judgment of Louis Navellier, a veteran growth investor who has cheered fast-growing tech stocks in the past, and has made a fortune by looking at growth prospects rather than valuations. He pointed out that Meta’s spending on the metaverse would likely have a long payback, and that the Dow Jones Industrial Average was still up for the day thanks to strong numbers from McDonald’s Corp. and a range of other old-world names that earn their money from making things and selling them to people, including Honeywell International Inc., Caterpillar Inc., Boeing Co. and Merck & Co. Inc. Amid the bloodbath for tech companies, McDonald’s shares have somehow managed to rise slightly for the year so far.

Navellier suggests that assumptions about tech that have survived for the best part of a quarter century are at last being revised: “Consider that both Microsoft and ExxonMobil are currently generating roughly the same amount of free cash flow yet Exxon has a market value of only 25% of Microsoft. If the economy continues to slow as the Fed intends, the leadership that tech has enjoyed for many years may be brought back down to earth by valuation adjustments.”

And as the Wile E. Coyote moment demonstrates, now that those valuations are at last being examined critically, not even the prospect of lower interest rates can keep the FANGs levitating.

Cruise Path to a Soft Landing (???)

While the FANGs made a crash landing, the top-down macro world is providing much news that investors had been hoping to hear. The European Central Bank met and hiked rates by 75 basis points as expected, but President Christine Lagarde signaled very clearly in her press conference (which you can see here) that we should expect the rate of increases to slow down from now on. Previously, the ECB had alerted that it expected to raise rates at “the next several meetings.” Now, under questioning, Lagarde was much more hedged: “Our sense is that we have already made significant progress, as I said. We are not done yet. There is more ground to cover, and the question of what that pace will be — what will be the magnitude of future rates — will be determined meeting by meeting and will be data dependent.”

That had an immediate impact on the implicit path of interest rates projected by the overnight index swaps market. Expectations had risen sharply over the summer, but Lagarde’s words helped cut projected rates for next year by 25 basis points:

This isn’t a “pivot” toward lower rates. Lagarde said inflation was “far too high, and will stay high for a while,” and predicted an economic slowdown, but it’s plainly a deceleration and it makes it that much easier for the Federal Reserve also to start paving the way to slow its pace during next week’s meeting. It also weakened the euro, which had just exceeded parity to the dollar for the first time in a month.

Shortly after, US GDP numbers for the third quarter were released, and were almost perfectly “Goldilocks” (not too hot, not too cold) as far as the market is concerned. GDP is growing, but consumption is slowing, a combination that should allow some kind of “soft landing.” Bond yields did reduce, with the 10-year Treasury yield dropping below 4% for the first time in two weeks, but not in a way that saved the stock market from a tough day.

One reason for this is that the third quarter’s GDP number of 2.6% is already well in the past. Friday’s release of Personal Consumption Expenditure inflation data, the Fed’s favorite measure and within days of a monetary policy decision, promises to be far more important. Expectations for PCE are widely dispersed, but everyone thinks that they will show a rise. If the number comes in at the bottom of the range of expectations, that could have a much powerful effect on bond yields:

Friday also brings the employment cost index, which comes out only quarterly and is closely monitored by the Fed for any sign of an incipient wage-price spiral. That could have a major impact on the central bank’s flight path from here. Tom Hainlin, national investment strategist at US Bank Wealth Management, said by phone: “Is it a shallow glide lower? Is it a big stair step lower in terms of the outlook for 2023? That’s still unknown. GDP was backward looking. It’s not really going to be a key driver of the market. That employment cost number is going to be a key driver.”

As the FANGs continue their crash landing, there are still hopes of a soft landing for the bond market. That could yet translate into one for the stock market as well, as some ludicrous valuations are corrected, and capital diverts to some places that have been starved of it but could use it. The readjustment from the pandemic seems to be over — but bonds and tech stocks are reassessing assumptions that have stood for a couple of decades or more. This is tricky to engineer. The path to a safe landing might exist, but it’s a perilous one.