- Martin Sosnoff
Punditry’s Big Picture Flub Analysts Whiff On Big Tech
Still too much residual bullishness in our market setting. Nobody seriously questions whether the Big Board deserves to sell at 20 times earnings. Tech houses selling at 2 times the market’s valuation are dangerous properties. The penalty for being wrong-footed used to be a 10% markdown. Currently, as in Netflix we are talking haircuts of 30% to 40%. A bullish analysts’ consensus does disappear overnight. “Hey, guys, we no longer have an opinion, you’re on your own.”
Current corrections in commodity plays like aluminum, steel and copper follow enormous run-ups, past 12 to 18 months. Alcoa corrected over 25% past couple of weeks. Freeport-McMoRan has faded along with U.S. Steel.
Does anyone but me remember how tech went out of fashion in 1973 - ‘74? The market traded at 18.4 times earnings during 1972. Not radically different than valuation in 2000 or even today. Premiums for growth stocks ranged up to 4 times the S&P 500 Index, but not for long. The 1973 - ‘74 recession collapsed earnings for Polaroid, Xerox, Avon Products and Eastman Kodak. They never came back. The future rested in small regional discount retailers like Walmart. Microsoft was still a private company.
Morgan Guaranty’s investment construct centered on growth stocks at whatever price-earnings ratio extant. Only after Morgan’s portfolio self-destructed did everyone realize that the life of a growthie could be as short as 5 years. I look at profit margins as a leading indicator. When the return on capital fades, it’s the beginning of the end. That’s what happened by the end of 2021.
My central point on this chart is analysts and money managers periodically get caught up in euphoric rationalizations of valuation. At its peak in 2000, Yahoo sold at 100 times revenues and Cisco Systems at 100 times forward 12-months’ earnings power. Amazon corrected 90% from its high in 2000, but still sold at 3 times revenues. Most tech houses, including Microsoft kept payrolls low by issuing massive options to key employees.
My unequivocal rule of thumb is never pay more than 2 times the growth rate for anything. It will keep you from much heartache. You’ll make the most money buying stocks at 1 times their growth rate. To do so you gotta be early in a growth stock’s development. This is a sometimes thing. I discovered cell phone technology early on and found Xerox on its introduction of the 914 Copier on Wall Street.
Currently, I believe recovery in airline profitability is at hand, so I own a bunch of American Airlines. Its 6 1/2% coupon convertible issued a year ago is ahead 40%. I didn’t buy enough to brag so much and it’s a short-maturity piece of paper.
When I charted growth vs. value indices over a 14-year period starting in 2000, there was enormous variance, year-to-year. But, strangely, the rate of return for both indices came out the same. I believe today growth is too rich, but so are a bunch of industrial sectors like railroads, autos, steel, aluminum and copper.
The tech collapse in 2001 insured that value stocks would outperform for several years. Because growth stocks are so risky currently, we could be in for a comparable outperformance for value stocks. Consider how they just took apart Netflix.
The risk being overweighted in value paper is you become saddled with dead paper for a long time, because you believe it’s too cheap to discard. Then, the wolf scratches at your door: General Motors’ insolvency or the stupidity of banks in the mortgage paper meltdown of 2008 - ‘09. Brokerage houses like Lehman Brothers fell off my screen and Merrill Lynch was merged into Bank of America. I remember buying Bank of America’s preferred stock at $5 - a $25 par issue. Same goes for Chrysler’s preferred in the deep recession of 1973 - ‘74. Never underestimate pervading stupidity.
In the spring of 2009, the entire stock market sold at book value and 10 times earnings. I licked my chops, plunged into the frigid waters and never looked up. Currently, our major investment houses rationalize as pretty attractive a market that sells at 2 times book value and 20 times forward 12 months’ projected earnings.
Lemme take apart a typically bullish client investment strategy letter: Corporate earnings grow by 8%.
This is from an earlier projection of 12%. GDP grows 3%. The FRB tightens only 1.75% points. S&P target is 4,700 to 4,800, presently 4,164. Earnings grow 8%. Target range for S&P lowered to 4,700 - 4,800 from 4,950. Total return is lowered to 1% from 6% for the year! Punditry can tickle you to death.
You would think that the Street at the least would keep on top of a major industrial’s earnings power like General Electric. But, analysts badly missed their numbers and the market took GE out to be shot, down over 10% intraday.
How do wealth managers deal with client restiveness in an ongoing bear market? The answer is forecast often. If wrong, change gradually but not overnight. Clients never receive a communication that the market is treacherous so we’re selling you down to a minimal risk construct. After all, 10-year Treasuries sell to yield 2% which is pretty much what we expected, but unlikely to spike from here. (Probably wrong.)
Chances of a recession put at just 15% over the next 12 months, they say. Our economy can grow around 3.5%. This is pretty much trendline growth in a normal setting. Many wealth managers see just a 20% probability of a recession developing next 12 months. But economists like Larry Summers see recession at a 50% or better chance.
My sense is few if any wealth managers subscribe to the 50% to 60% recession forecast. They don’t project more than 100 basis points of tightening from the FRB. Most forecasts of economic growth range around 3% next 12 months. Therefore, they claim, it’s too early to exit the stock market. Wealth managers are looking for 10% earnings growth this year, yet individual investor surveys come out bearish.
To summarize the bullish forecast, the U.S. economic expansion remains intact. The Fed won’t panic. Covid-19 will be manageable and oil quotes settle down some.
In financial markets you are what you do. I’ve cut back equity exposure from 100% to below 60%. Hate the bond market. Too much complacency on inflation. Stronger FRB policy initiatives convey risk spreads widening between Treasuries and high-yield paper. Stay away from both.
In the background, I hear my grandmother chanting “Nobody promised you a rose garden, sonny boy.”