I'm Worried About This ONE THING

Written By Briton Ryle

Posted September 26, 2018

I’m worried. Now, I’m not quite ready to stand on a street corner shouting, “Repent! The end is nigh!” through a megaphone. But the hairs on the back of my neck are starting to get a little frisky…

And it’s because of an earnings report from a couple weeks ago…

It may be nothing, a “temporary glitch” kind of thing that’ll work itself out over the next few months. Or it could be the first warning shot over the bow of this incredibly resilient bull market, a canary in the coalmine.

This isn’t a tease. I’m gonna tell you exactly what’s bugging me, and probably in greater detail than anyone wants. That’s just how my brain works. But first, a couple observations about the nature of bull markets. 

A bull market can be summed up in three words: It’s all good. Bull markets make optimists of us all.

Just look at the reaction to Trump going nuclear on tariffs. He’s now put tariffs on ~$250 billon in Chinese goods, is threatening $267 billion more, China nixed negotiation talks, Alibaba’s Jack Ma cancelled his plans to invest in the U.S., consumer prices are likely to rise… and what has the market’s response been?

“It’s All Good.” — Sincerely, The Market

Stocks have barely blinked. This tells us in no uncertain terms that investors are not worried about bad news. All they see is the virtuous cycle of employment gains → higher wages → higher spending → higher corporate profits → higher stock prices. 

No doubt this has been the correct mindset for 10 years. And let the record show that while I have raised concerns to my Wealth Advisory subscribers from time to time, my main message has been consistent: Buy U.S. stocks. (Yeah, every year or so, the talking heads say, “Oh, it’s time to buy European stocks, or emerging market stocks.” I have said no to that thesis every time. Stick with the global growth engine, the U.S.)

In bull markets, a good portion of the gains you see come from what’s called “multiple expansion.” What that means is that stocks simply get more expensive based on valuation ratios, like the price-to-earnings (P/E) ratio. Think of a P/E ratio as telling you how long it would take the earnings of a company to pay off a loan to buy that company. If a P/E is 10, it will take you 10 years to pay off the loan and own the company outright. When P/E ratios get to 30, 35, it starts to look a little silly.

Thirty-five years is a long time. Will the company’s products still be relevant? Will earnings keep growing? Will the economy still be good? It should be obvious that with more time, you get more uncertainty.

But bull markets don’t think like that. Multiple expansion is just the bull market way of saying things are so good, there’s no way they get bad anytime soon. It’s a matter of confidence: Investors pay more for stocks because they are confident earnings will continue to rise. 

And that’s usually what happens in bull markets. Things like earnings, economic reports, and job growth tend to surprise to the upside during bull markets. We’ve mostly seen that for the last 10 years…

During bear markets, it’s the opposite. It seems like everything surprises to the downside. And investors have a very hard time changing their mindset from bullish optimism. They say, “Oh, that manufacturing survey will get better next time.” And it comes in worse.

Buy the Dip?

OK, now that I got all that out of the way, here’s what’s bugging me: Micron Technology (NASDAQ: MU). 

Micron makes flash memory (DRAM and NAND). And these chips appear in just about every connected device made today. So, yeah, it’s been a fantastic few years for Micron. Earnings beats, raised guidance, price target hikes, the works. Micron’s had that virtuous cycle going…

Analysts have price targets that range between $68 and $110. The stock is currently trading for $44 and change. Looks like a nice 50% gain just to get to that low target, right? Hold your horses.

In its recent earnings report, Micron said gross margins would fall from 61% to a range of 57–60%. That doesn’t sound terrible. And it may not be. But I’m not buying this dip…

Chips are called cyclical because supply will increase when there’s demand and strong pricing. That is happening now. Micron has added capacity, and so have its two competitors, Samsung and Hynix. It’s weighing on prices. Plus, Micron said “inventory adjustments” at some companies are also affecting gross margins. I read “inventory adjustments” to mean “we have plenty.” And finally, Micron said tariff issues were in play. 

So we have memory prices falling due to oversupply, weakening demand, and a yuge macro wildcard. 

Now, Apple’s got a new phone coming soon. Demand may turn out to be just fine. After all, sales in the U.S. and Europe are very stable and pretty easy to predict. But Apple is very dependent on Asian iPhone sales for growth. Especially China. You see where I’m going with this…

If there are any bumps in the road for iPhone sales, Micron’s bad news is gonna get worse. And if investors get a hint that the chip cycle has peaked, oh boy, will this get ugly fast. 

Because we’ve got interest rates headed higher. We’ve got banks trading like crap lately. We’ve got oil prices headed higher. And the Dow Transportation Index (DJT) has been diverging from the Industrials. (Dow theory says the Transports are supposed to make new highs along with the Industrials to conform to a bull market.)

Yes, it’s early. All these negatives are just emerging in the last week or so. I am NOT selling everything because the end is nigh. Maybe it is, maybe it isn’t. Because, as I said before, news tends to get better in bull markets. And GDP numbers this quarter are gonna look really good. 

Still, I’m seeing enough warning signs to go to DEFCON 2 (not sure exactly what DEFCON 2 is, but I’m hoping it means something like being on high alert).

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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