The Importance of Being Apple
Do you remember when this correction started? And more importantly, do you remember which was the first domino to fall? The S&P 500 peaked on October 4, 2018. But it was an 800+ down day for the Dow Industrials on Tuesday, October 10, that signaled something serious might be in the works...
After that big decline, the debate really started to rage about whether the trade war with China was to blame or if the Fed was pushing interest rates higher too fast.
If you think about it, trade wars have been a headline issue for a year now. And the end of the Fed's easy money policies has been worrying investors a good bit longer than that...
Why did these two items all of sudden break the market's back?
It's because of Apple.
You see, it was right around that early October period that Apple began cutting component orders with its suppliers for the holiday season. This was a sign: Apple was lowering its expectations for sales in the critical fourth quarter.
Now, one company doesn't make or break the global economy. We've seen Apple cut orders with suppliers before. And we've seen Apple miss sales number before, too. But it's been a while since we've seen a 40% decline for Apple shares...
And it's because we have a wicked combination where macro factors (trade and interest rates) are pressuring corporate earnings. That's the formula for a big decline.
The last time Apple dropped like this was back in 2015. Shares fell around 30%, from $130 to around $90. And as it happens, there are some similarities between then and now. 2015 was the year of the "earnings recession." Corporate profits were shrinking a little.
But the U.S. economy was still posting those weak growth numbers we were so accustomed to, around 2%. And employment gains were steady. Rates weren't moving higher yet. Nobody was talking trade war...
In bull markets, surprises are to the upside. Companies beat earnings, employment numbers come in better than expected. Economic numbers surprise to upside. That's why you see what's called "multiple expansion" in bull markets. Multiple expansion is a way of saying stocks get more expensive in bull markets. Valuation multiples — like price-to-earnings and price-to-book ratios — get bigger because earnings numbers and economic numbers get bigger.
It's an expectations thing. I heard someone say expectations are just preplanned disappointments. Wise words...
In bear markets and corrections, the opposite dynamic comes into play. Things start surprising in a bad way. Way back in October, analysts already had earnings growth coming in at just 5%. We've already gotten a high-profile earnings warning from FedEx (NYSE: FDX). Ford, GM, Delta — they've warned, too.
Don't forget what the chairman of the White House Council of Economic Advisers said last week: “It’s not going to be just Apple... There are a heck of a lot of U.S. companies that have sales in China that are going to be watching their earnings being downgraded next year until we get a deal with China.”
As things now stand, 2019 earnings are likely to come in lower than that 5% estimate.
PRO TIP: When you see a company that hasn't issued any downward revisions to its earnings, do not think of it as an island of strength. Instead, think of these companies as the ones that are vulnerable to lowering their estimates and getting some kind of Apple- or FedEx-like beat-down (both stocks dropped over 10% after warning).
Now, what does that mean? What are you supposed to do with that information?
I have some ideas...
Let's start with the observation that stocks have been selling off for three solid months. As a result, we have this chart:
Stocks are now cheaper than they've been in five years. And they're much more in line with historical norms. These are good things. However, these forward P/E ratios are based on — that's right — expectations (forward P/E measures stock prices based on earnings estimates for the next 12 months). So the possibility that the current forward P/E ratio is still out of whack is absolutely real.
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What About Those Other Vulnerabilities?
Glad you asked. And at the risk of sounding like I don't know what's ahead, I have to tell you I don't know what's ahead. But again, I have some ideas...
Just a couple paragraphs ago, I said, "As things now stand, 2019 earnings are likely to come in lower than that 5% estimate."
So the question is: Is this the way things will stand for the remainder of 2019?
As it happens, the first problem — the Fed and rate hikes — might already be resolved. Hence the big rally on Friday.
Now we just need a resolution to this stupid trade war. (And so you know, I say it's stupid because the U.S. has not spelled out specifically what we want from China. I'm in favor of playing tough with China; there's stuff happening that is not OK. But you gotta have specific conditions to end the trade war.)
A U.S. delegation meets with China starting today. And now that the biggest company in the world (Apple) has basically said the trade war is a problem, the pressure has really ramped up to get a deal done.
As my man Jason Stutman said over the weekend, it's probably time for a nibble on Apple and that tasty forward P/E of 10. I think Twitter (NYSE: TWTR) deserves a look, too. And there's likely some upside for biotech now that Celgene got bought out last week and a stock I first told you about when it was $70 — LOXO Oncology (NASDAQ: LOXO) — went today for about $230 a share.
The upside potential for stocks if a deal does get done this week looks pretty good.
Until next time,
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 also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.
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