Stock market bottoms out when it's darkest
The final result of the election is still some time away, but the Republican red wave seems to be rather weak. At the moment, it seems like they will get a small majority in the House of Representatives and possibly in the Senate. This may have the advantage for the market of making it more difficult to pass on additional stimulus and spending packages. This makes it easier for the central bank to fight inflation. On the other hand, this means that there will be debt ceiling drama next year.
As I pointed out in the last video, stocks tend to rise after the US congressional mid-term elections, as political uncertainty recedes. No matter what the election result. This Reuters graph shows well how the S&P 500 has risen over the last 70 years every time in the 12 months following an election.
Let's talk in this post about how stock markets tend to bottom when it's gloomy. And I'm not referring to the darkness of November, although seasonally it's typical that a real rally that lasts into the spring starts. Let's see then how the earnings season in the US symbolizes a new era. The old winners in the tech sector are struggling, while yesterday's flatliners of banking and energy are shining.
Stock market bottoms out when it's darkest
As the stock market in general falls, the roar of the bears among investors intensifies. There are more negative comments from the media and other investors. Nothing changes sentiment like the share price, and a falling share price turns even a good company into a bad one in the minds of many investors. The media lives on clicks, and people tend to click on apocalyptic news rather than dry reminders of why to be a long-term optimist.
Of course, cheaper stocks offer excellent buying opportunities for long-term investors. As I have often repeated, timing is not critical for successful returns. However, by definition, by hitting close to the bottom, returns are the best and risks are low. When not much is expected from equities, not terribly good things need happen and yet they can still yield a reasonable return for the brave buyer over the holding period.
Stocks tend to bottom out long before other measures of the economy. This is why, paradoxically, the best place to buy is usually when everything seems to be going wrong. Michael Cembalest, JP Morgan's wealth management chief, had some good descriptors on his blog about how the S&P 500 index tends to have bottomed long before the end of the economic and earnings downturn.
There were numerous examples, almost all similar. The deep recession of the late 1950s is a pure example in the sense that there was little economic stimulus. As you can see from the graph, stocks started to fall before the economy or earnings started to cough up. Stocks started to rise in December 1957, while GDP turned around in the spring and results only a year later in December 1958. An investor who would have expected earnings improvements would have had to buy shares at a higher level than the previous peaks.
The same pattern was repeated in the recessions of the 1980s and 1990s, the financial crisis and the COVID crisis. These are good examples of how investors are trying to anticipate the economic turnaround and usually stocks go up on the front foot, even though the news front still looks bad.
However, predicting like this doesn't always hit the mark. For example, in the tech bubble of the 2000s, earnings turned down before stocks and stocks continued to fall for years, even though the recession was mild, and the economy actually grew through the bear market.
Of course, the current direction of the market is a question mark, and the bottoms can only be discerned in hindsight. But it’s reasonably safe to assume that, as is usually the case, stocks will be the first to shoot up and then the macro data will start to ease. Not the other way around. Before that, investors will complain that the rise is not a real one. In general, new bull markets are hated because they aren’t supported by fundamentals or macro developments and investors are mentally prepared for an endless decline with their cash piles.
If there's any metric worth looking at, it's the purchasing managers' indices. They appear to bottom out within a couple of months of the stock market. However, here again, the problem is that it’s impossible to know in advance which reading from the purchasing managers' indices is really the bottom of the bear market.
Stocks can rise on bad news if they are priced in anticipation of even worse news. The safest way to put it is that when there aren’t many expectations loaded into equities, over a 3–5-year horizon, unless the world is completely unhinged, equities should do well. I'm not saying that stocks are super-cheap in the US (blue graph below) in general right now. However, Europe (yellow graph below), where stocks are trading at 11 times their projected earnings, certainly can't be considered expensive. Individual companies have been smashed into the ground with a big sledgehammer, so there are plenty of opportunities for the stock picker.
The earnings period symbolizes a new era
Let’s talk more about those earnings. Let's take a look at how the earnings season went in the US and how the earnings forecasts have developed after it.
In some ways, the past earnings season symbolizes a new era, where the old investor favorites, the mega-techs, are struggling and the previously hated energy and banking sectors are shining.
Of the S&P500 index’ 500 companies almost 90% have already reported their results. 70% of the results have exceeded analysts' expectations, but normally almost 80% of the results exceed the bar that analysts' have ritually lowered before the earnings season. Therefore, one could almost say that the earnings season wasn't even that good.
Indeed, the average price reaction over the period has been negative by around half a percent within a one-day radius, indicating that investors didn’t like the results. Should anyone be interested in this kind of interpretation of short-term reactions, that is.
In particular, the energy sector exceeded analysts' consensus expectations. Both Exxon and Chevron made record or near-record profits, supported by high oil and gas prices. The companies are currently returning billions to shareholders in the form of share buybacks, as the sector has become quite disciplined in terms of investment.
Everyone in the industry remembers the situation in the mid-2010s, when high oil prices tempted the industry to over-invest, which collapsed oil prices. Of course, the discipline of companies in this sector is somewhat problematic if one hopes that fuel prices will fall.
Both oil giants are trading at about ten times their earnings, which doesn't seem like much. However, it's worth remembering how cyclical the energy sector is and how difficult it is to generate high returns on capital for a long time because of the capital intensity of the sector. This graph shows Exxon and Chevron's wildly fluctuating return on capital employed over the past 30 years.
By contrast, tech giants were floundering. Costs and investments are spiraling out of control, especially at Alphabet (Google) and Meta (Facebook). It's hard to tell from Google what the tens of thousands of new recruits are doing there, but Facebook is lighting up money at Zuckerberg's asocial metaverse altar like no tomorrow. At the same time, earnings growth has practically stopped. The company announced yesterday that it would terminate 13% of its employees, meaning just over 11,000 will leave.
E-commerce and cloud service giant Amazon is struggling with inflation. The higher-quality tech giant, Microsoft, also sees a slight slowdown in Azure's growth in the future. Only Apple exceeded analysts' expectations by a clear margin, but on the other hand, the company cut production volumes for the new iPhone model a while ago. However, China's COVID shutdowns were cited as the reason and according to the company, demand is healthy.
This somewhat busy graph shows how Alphabet, Amazon, Meta and Microsoft's EPS forecasts for 2022-2024 have evolved. They have been cut back as growth slows.
Among the Big Five, Amazon, Meta and Alphabet in particular got a boost during the COVID pandemic that hasn’t been sustainable. This graph, inspired by investment writer Heikki Keskiväli, shows the quarterly operating profit performance of the five tech giants over the past five years, indexed by quarter. As you can see from the graph, Amazon and Alphabet's profits quadrupled and tripled from the beginning of 2018 in the run-up to the pandemic, but now the trend is reversed. Only Apple and Microsoft seem to be steadily marching forward.
The weak performance is also reflected in stock prices Since the beginning of the year, energy stocks have returned almost 70%. Indeed, there is always a bull market somewhere. Bank stocks have fallen by around 20% on the back of the recession fears despite earnings boosted by rising interest rates. However, tech stocks as measured by the Nasdaq-100 index have fallen by more than 30% since the beginning of the year.
Naturally, this doesn’t mean that it’s a good idea to jump on board energy stocks at peak prices and sell off the ugly techs in your portfolio. Energy stocks have a history of rallying up last in the hot phase of the cycle.
The technology sector is on average first class in terms of profitability, whereas the energy sector not so much on average in the long run as returns on capital fluctuate wildly with energy prices. But, if you believe in a longer inflationary cycle where energy prices stay high and interest rates at least don't come down, banks and energy are not the craziest diversification in the portfolio.
On the other hand, the technology sector may now provide tasty options as investors are traumatized by the blows of the past year. The services of Google and Amazon or Microsoft are unlikely to leave the center of our lives. In the past, Google has seen its costs sprawl, until it gets its act together again. Perhaps of that bunch, Meta is not my cup of tea, because the company's money-burning shows no sign of stopping and it's the most prone to disruption, even though it owns excellent assets like Instagram and WhatsApp.
Behind these mega-techs are hundreds of smaller, fast-growing tech companies.
This graph shows the forward-looking P/E of the Nasdaq-100 index in the 2000s. In practice, tech stocks are trading back at where they were years before the COVID pandemic bubble. They have been cheaper in the past, but if interest rates don’t rise much more, this sector shouldn’t be overlooked either. It is, after all, where most companies are capable of strong and profitable growth, although it’s always difficult to assess technological competitive advantages.
Let's take another quick look at how the earnings forecasts have developed since the earnings season. The S&P 500's EPS forecasts for both the next 12 months and the next few years have effectively been falling for some time. Until recently, earnings per share were supposed to be $270 in 2024, but now that has slipped to $255 and there is no end in sight.
Earnings are therefore expected to continue to grow, but at an ever-slower pace. In real terms, therefore, results in practice start to fall when inflation exceeds nominal earnings growth. I looked at the earnings forecasts by sector and mainly the earnings forecasts for energy companies continue to improve. In other sectors, earnings growth expectations have been cut and are being cut more aggressively.
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