After the cascading decline of year-to-date, the market indexes are down 10 percent in terms of the Dow Jones Industrial Averages, 13 percent for the Standard & Poor’s 500, and 23 percent for the NASDAQ Over-the-Counter Market. Relatively recent market participants ask the question: what is going on?
What is going on is the ebb and flow of a liquid market whose overall value is based on the most recent transaction. This is hard for some to grasp. If there were, say, 100 million shares of a firm’s stock outstanding, and the most recent trade is down a dollar from the previous day, the firm’s market value declines by a hundred million dollars. If we further assume that one million shares were traded that day, then the million shares traded imposes its value on the 99 million that did not.
If this sounds crazy, add a second point: some people take market values seriously. In fact, some people even assume that the value imposed by the market is always “right”. If a stock that sold last summer for $100 is now $50 per share, there must be rational reasons for it being so; same for the stock that was $50 last summer and is now $100. If this were not so, the prices would not have moved. Out of this line of thinking we have the concept of markets as “efficient” in the sense that they reflect all data about a security at that point in time.
Last week’s performance of Netflix was especially insightful. The stock fell 20 percent in a day due to reporting its first negative subscriber growth in a decade. The stock, which had been selling for $700 a share as recently as last fall, can now be had for $204. When Netflix was $700 a share, its Price/Earnings ratio (P/E for short) was about 70. It is now about 20. The ratio for the overall market is 17.
A stock with a P/E ratio over four times the overall market should grow four times faster than the overall market, not just this year but every year thereafter. Netflix’s revenues are projected to be $35 billion this year, up around 10 percent. Four times overall growth was not to be. Earnings growth estimates for this year for the overall market are about 15 percent. Netflix’s earnings would have to gain 60+ percent to justify its December price – hard to do when revenues are growing 10 percent per year.
Netflix was one of the FAANG stocks, which were “disruptors” who would justify their price by relegating old line companies to the dust bin of history. Of the others– Metaverse (nee Facebook), Amazon, Apple, and Alphabet (nee Google)—only Apple has not collapsed, and it almost always had the lowest P/E ratio of the group.
Like all hot concepts, the FAANG stocks fed on cheap and easy money. Covid-19 further helped them, as they catered to those who were trying to minimize social interaction. As Covid-19 subsided, people returned to their more social ways. In the case of Netflix, the number of streaming services increased faster than the population demanding them. As inflation caused cutbacks among customers needing funds for more basic items, some streaming services were cut back. Netflix evidently was among them.
The impact of FAANG stocks on some index funds this past decade has been material. An S&P Index fund could hold as much as 20 percent of its assets in these five companies. This was not a judgment call. The stocks comprised 20 percent of the relevant universe, so the computers that were programmed to mimic the indexes bought. Now that the stocks make up a smaller share of the market, index funds are buying less. This only accelerates their decline. What was once a virtuous circle of outperformance leading to greater purchases by indexes becomes a vicious circle as fewer investment dollars go to the stocks that had gone down more than the index.
All this suggests that what we are witnessing is not so much a large-scale decline in stocks as a temporary changing of leadership. A sector like energy, which disappointed investors as recently as 2019, is up 57 percent in the last year. Consumer staples are up almost 11 percent. Utilities are up 7.6 percent.
History teaches us that the leadership in one market stands a less than one-in-five chance of leading the next upwards move. As interest rates rise there will be more pressure for companies to both pay and increase dividends. Technology companies, due to their internal demands for capital, are not well suited for this environment.
As for markets being “efficient”: tell that to the Netflix investor who purchased stock at $700/share last year. What markets measure is the popularity of an investment, usually in the context of some investment concept. Like fashion, popularity in stocks change. The trick is to research and know what is being bought so that your stock does not wind up on the remainder table.
There is a school of thought that posits that every recession begins with a stock market decline. While that may be true, not every stock market decline results in a recession. This fact causes all kinds of confusion among investors. Many head for the exits when they should be taking a look at other sectors.
There is still over $1 trillion in savings from Covid-19 that has not been spent. As the environment becomes more normal, expect large scale demand for vacation spending and all the things done pre-Covid-19 that have not been done thereafter. International travel is still a bit problematic, but domestic holidays will be in strong demand.
In a similar vein, the slow but sure increases in the supplying of semiconductor chips to manufacturing will help the sales of everything from cars to gadgets. Average prices should come down, as makers will have enough chips to build lower cost versions of what is being sold now.
Interest rates are continuing to climb. As rates get over the inflation rate, expect them to moderate and level off.
Interest rates above the inflation rate will reward savers for the first time in over a decade. This is important, as the economic recovery has been carried on the backs of savers who received little or nothing for their savings.
There are rumors afoot of a 75-basis point increase in Federal Reserve rate in June and July. This is hard to contemplate, especially with the bond buying program also set to reverse. It could be the rumor was started to make a 50-basis point increase seem moderate by comparison.
Inflation is set to moderate. Currently running over 7 percent, it is expected to moderate to 3 to 4 percent by year’s end. While still high by recent standards, it is less of a factor than previously.
Factors driving inflation are the cost of housing, weather-related food inflation, and challenges in getting imported goods delivered. Some of these factors will get better, others will have to wait until 2023 to be addressed. At some point inflation will reduce demand in the categories it affects.
The Stock Market
Stocks in general are having a rough go of it. This is the result of changing internal dynamics, as previously stated. Once new leadership is established the market should again find its footing.
The question is: how fast will the market recover and what will its projected trajectory be like? Given its rich valuation, we could see several years of low overall returns while different sectors jockey for leadership. This will emphasize stocks and sectors over a broad index. An index fund will let you buy the market. The question is, do you want to?
Warren M. Barnett, CFA
April 27, 2022
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