The view from 20,000 feet
I typically don’t love bold proclamations about what the market will do, First off, we should all try and be a bit more humble since we don’t and can’t know anything with certainty unless we are doing something illegal. But I do like to try and help investors see if market conditions are ripe for rallies or selloffs. For example, coming into September, I wrote that I was a bit worried about the Nasdaq because of the stretched valuations of many tech stocks. The Nasdaq did in fact pull back almost 1% while the other indices raced ahead, but that did not stop companies like AMZN and AAPL from staying close to highs after selling off the first half of the month. So where are we now?
The Nasdaq (QQQ) is off its highs, but its valuation is still very stretched. The Composite Index is trading at 22.7 times NTM earnings – very close to two recent peaks including the one in January. Historically, the Index does well in October, logging a gain of .9% on average over the last ten years. So which will win out? Too expensive? Wants to make new highs? Or seasonally strong?
The SPX (SPY) is off its highs as well, but without a particularly stretched valuation. It has moved back up to 17.3 times NTM – off its recent high of 19 times back in January. It, too, historically moves up .9% in October.
Finally the DJIA (DIA) is also off its highs and is not stretched from a valuation perspective as well (16.3 times versus 18.6 times earlier this year). And it typically performs even better with a 1.3% gain on average over the last 10 years in November.
OK so the zoomed out view looks decent – all 3 indices are off their highs, all 3 tend to do well in October, and only the Nasdaq stands out as expensive.
Will exogenous factors start to take their toll?
So rates are up again. Tariffs have just taken hold. The Democrats seem to have a good chance at winning back the House of Representatives (Senate seems less likely). Inflation is present at the very least. And most other world markets are acting pretty poorly. Let’s start with the election year returns in October for 2002, 2006, 2010, and 2014. They were, in that order, +8.6%, +3.2%, +3.7%, and +2.3%. So at least for now, take out the election concern. And frankly, most other “macro” events end up getting ignored. Really, investors want to see accelerating earnings growth – period. Usually the rest is just noise. But that brings me to my last point.
Valuation bifurcation and the earnings cliff
These two factors should ultimately drive stock prices as earnings kicks in 2/3’s of the way into October. Right now in the market, we have the winners really winning, and the losers, not so much. They are really stuck in the mud. Earnings’ time has a good chance of kicking these companies heading in different directions back toward the middle.
Some of you may know that we recommended selling/avoiding FFIV in late August. It has a ludicrous valuation for the growth and is just floating along. Right now, you would be paying about 19x 2019 earnings for 7% EPS growth – and no dividend. You may think that’s a bad pick now, but look at CTAS. We said nearly the same thing about it in August. They beat earnings by 7.5% – and numbers went up by .08 for next year as well, BUT since then, the stock has fallen 7%. Why? Point number 2- the earnings cliff. Cintas is expected to grow earnings by 32% this year, but next year that growth falls to 13%. And right now you are still paying 25.5 times for that privilege. Sorry – no thanks. That, I fear, is going to happen a lot this earnings season.
However, we will hopefully have the earnings valley happen as well. One of our picks, FSLR, SHOULD go from -80% growth this quarter to earning .87 (vs. a loss last year) next quarter with catalysts in 2019.
The point is look carefully at valuations of stocks – they are in kind of momentum (on the expensive and the cheap sides) holding pattern until earnings – then things will likely change. And then be very cautious about growth into 2019. As of now, it ain’t what its cracked up to be in many cases – and the cliff is going to get a lot of stocks – soon.
Contradicting myself in conclusion
OK – I do try to make predictions – maybe not broad sweeping ones. Feels like we enter October feeling pretty good – historically no election worries, a seasonally good month, tariffs not hit yet, a “good”economy and not many stocks reporting. But then, here come the numbers, stocks start looking expensive, election fallout fears mount, tariffs start to affect prices, and October looks like the opposite of March – in like a lamb, out like a lion. Either way, just watch your stocks – lots of opportunities are coming our way, one way or another.
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