U.S. equities suffered a second day of slaughter. After last Friday’s 500 point fall in the Dow-Jones average, the index lost an additional 500 points today. Every sector in the S&P 500 and every stock in the Dow Jones Industrial Average declined.
The small-cap Russell 2000 index lost 2.5%, for a peak-to-trough decline of 21%. A bear market in the Russell, as I noted yesterday, is an ill omen for US economic growth.
This remains a “Murder on the Orient Express” market. Like the solution to Agatha Christie’s murder mystery, everybody did it: Donald Trump with his trade war, Robert Mueller with his inquisition against Donald Trump, Jerome Powell with his uncertain monetary policy, Theresa May (no “dog’s Brexit” puns, please), and so forth.
We’ve hated this market of late and advised investors to sell. Emerging markets in general and China, in particular, did better than US stocks, but that’s small consolation. Today’s ill wind blew nobody good but owners of government bonds.
There are lots of political reasons for the market to plunge, but there is also an important vulnerability: Most of the profitability among US corporations is concentrated in a very small number of names. The chart below shows the cumulative contribution of the most profitable names to the overall return on equity in the S&P 500. First, I multiply each member’s weight in the index by its return on equity. Then I add up the cumulative sum of the biggest names. The results are instructive.
Home Depot, the most profitable name in the S&P 500, by itself accounts for 17% of the total return on equity in the index. Add in Apple, and the two of them together account for 23%. Add Verizon, and the sum rises to 26%. Add Amazon, and we get to 29%. Microsoft brings us to 32%, and so forth.
The US stock market looks cheap by historical standards. Its price earnings is just above 15x according to the Bloomberg consensus of analysts, or around 17% on a backward-looking basis.
But aggregates are deceptive. When you buy the S&P, you aren’t buying an aggregate; you are buying individual stocks that add up to an aggregate. To believe in this market you have to believe that giant retailers like Home Depot, tech giants like Apple and Amazon, consumer staples giants like Johnson and Johnson or Proctor and Gamble, and financial megafirms like Mastercard will continue to earn outsized profits.
In a nutshell, you have to believe that the dominant monopolies of the past decade will last a while longer.
Seventeen dominant firms account for half the return on equity of the index. That gives you seventeen reasons to stay away from it.
Home Depot is a great company, but it won’t sustain its present return on equity of 300%. It’s down 20% from its peak. It looks like a falling knife.
Apple isn’t cool anymore. Huawei is eating not only its lunch, but its canapés at the high end of the Chinese market. It has no substitute for its highly-profitable but declining handset business. At just 12.5 times estimated future earnings, it looks dirt cheap (and net of its huge cash hoard, it’s even cheaper). But there’s no urgent reason to buy it, and it has a lot of vulnerability.
Verizon is more like a bond than a stock. It pays a 4.3% dividend, and trades at a modest 12.5 times future earnings. The trouble is that mobile phone rates are falling (the cheapest competitor to Verizon offers basic service for free), and the monopoly may not be sustainable.
Amazon is a transformational market leader, but I think it’s worth $1,200 on a good day, not the $1,540 price it traded at today. That’s because the present price assumes a revenue growth rate in the high 20%’s (Amazon has low margins but tries to make it up on the volume). The trouble, as I pointed out Oct. 24 in this space, is that this growth assumption would put Amazon’s sales at around 13% of US GDP in ten years, which seems nearly impossible. More modest prospects and pricing seem in order.
Microsoft keeps coming back from the dead, like Freddie Kruger, and reasserting its monopoly in the PC world. It has held up better than most of the tech world, down just 10% from the peak. I can’t think of an urgent reason to sell it, but there is no doubt something will occur to me.
UPS is next on the list of big contributors to index ROE. It’s down 27% from its January peak because Amazon will start competing against it in the package delivery business, and also because the company underestimated its capital investment needs. A battle of the titans between Amazon, UPS and FedEx will be good for consumers, but for investors maybe not so much.
These are great companies that established de facto monopolies that drove a great equity market boom. All monopolies fade, and some of them are fading fast.
“A Tech War, Not a Trade War”
Former CIA Acting Director Michael Morell picked up a theme we warned of yesterday, in a Washington Post Op-Ed. The issue comes down to Washington’s unwillingness to allow a Chinese company to dominate a crucial industry.
“There may not be an end to this technological cold war anytime soon, but it is vital for our national security that we not cede the field. It is also vital that we win the battle for 5G. To do that, we need not only sound economic and technological policies but also the best statesmanship, diplomacy, intelligence and law enforcement,” Morell wrote.
Corporate profitability has depended on a global supply chain characterized by continuous technological improvements and falling costs. Rip the global supply chain apart and future profitability is incalculable for a large number of industries. This remains a risk to equity valuations.
Washington is less concerned about what technology Huawei might have stolen in the past, and more concerned about its evident technological advantage in game-changing 5G applications.
Nowhere to hide from the bear
Some of the worst-performing sectors in today’s US market were the supposed safest. Utilities fell 3.2%, more than the overall market, and real estate investment trusts fell by just over 3%. The sectors usually trade like bond substitutes.
The long bond rose 22/32nds in today’s trading, but bond-like stocks underperformed the overall market. There are a number of reasons for this reversal. The first is that equity funds are flooded with redemptions and must sell safe stocks along with risky ones. The second is that investors have noticed that real estate isn’t exactly risk free. The worst performers among REITs were shopping-mall owners.