Let’s try to put together a few events from last week into a coherent (or, if that’s too much to hope, at least a semi-coherent) explanation for where the equity market stands now.
What events, you ask? How about Friday’s report on second quarter GDP growth, and the earnings reports from Facebook (FB) and Amazon (AMZN)–and the market reaction to those pieces of news?
First, we got a report of second quarter GDP growth that certainly wasn’t a surprise, but that is a reminder of the general economic background to the financial markets. The Bureau of Economic Analysis reported its first reading on second quarter U.S. GDP growth at 2.6% year over year. That was below the consensus of 2.8% growth among economists surveyed by Briefing.com. Growth in the first quarter was revised downward to a year over year rate of 1.2% from 1.4%. That puts the average growth for the first half of 2017 at 1.9%.
This rate of growth is slower than for the average economic recovery–if indeed we can still say we’re still in a recovery from the 2007-2008 Global Financial Crisis. But it’s even below the average growth rate for GDP of 2.3% from 2013 to 2106.
So that’s the context for a stock market that keeps churning out record high after record high: Revenue and earnings growth isn’t all that great.
What it’s not? No, it’s not. Check out these numbers on the Standard & Poor’s 500 stock index from FactSet for the recently completed second quarter.
Wall Street analysts, according to FactSet, were projecting year over year revenue growth of 5.2% for the second quarter as of July 24. A big chunk of that comes from the rebounding energy sector. Revenue for that part of the S&P 500 is expected to growth by 17.5% year over year in the quarter. Subtract the energy sector from the S&P picture and Wall Street is forecasting revenue growth of 4.2% for the quarter. Solid but not especially high for a market trading at all time highs. If you subtract inflation, you get about 3% real year over year growth in revenue.
The earnings picture is equally muted. And equally skewed by the performance of just a few sectors. The overall expected year over year rate of earnings growth is 9.1%, according to FactSet. That’s very strong indeed. But again energy plays a huge role in the overall number. Energy sector earnings are pegged to grow at 323% year over year. (That’s what a sector crash will do for the next year’s growth rate.) Without energy, the growth rate for the S&P 500 drops to 6.8%. Solid again, but not spectacular. The technology sector is the second best sector with a projected 12.9% growth. Financials are third at 10.7% year over year earnings growth for the quarter.
These solid but not spectacular revenue and earnings growth rates add up to new record highs for the stock market because of two outside forces. First, there’s the expectation that the Federal Reserve will raise interest rates very, very slowly. Right now the markets are saying, for example, that the Fed is done for 2017 and that there won’t be another interest rate increase until March 2018. Second, the stock market continues to expect that the Trump administration will deliver reduced regulation of the financial and energy sectors, and a big package of tax changes that include lower rates for corporate taxes and some kind of tax holiday that will let companies repatriate earnings now sequestered overseas at a bargain tax rate. If events turn out to prove that the market is wrong on either of these expectations, then I’d expect to see stocks pull back from record highs.
In the meantime, though, and until events prove those expectations wrong (if they do), we’re stuck with an economy that’s growing slowly enough to put a premium in the stock market on revenue and earnings growth. Companies and stocks that can deliver growth well above the background sluggishness will earn premium prices from investors–especially if that higher growth also seems “guaranteed.”
Enter Facebook (FB), Alphabet (GOOG), Amazon (AMZN), Apple (AAPL) Microsoft (MSFT), Nvidia (NVDA), and Netflix (NFLX) to name just the most obviously technology stars of the market in 2017. Overall earnings might be growing at just 6.8% (excluding energy) but at these babies growth was 25% to 50%. Revenue might be growing at 4.2% (excluding energy) for the S&P 500 as whole, but it was racing ahead at 30% or 50% or even 70% at these stocks. And it looked like those higher rates were just about guaranteed too. Or at least the market behaved as if they were as favorable fundamental projections fed into upward price momentum (and momentum money) and then into feedback that made a belief in the “guaranteed” nature of those favorable fundamental projections seem reasonable.
Except that last week cracked that guarantee for some of these stocks. Most spectacularly for Amazon. The company did mange to beat Wall Street expectations on revenue with 24.8% year over year growth in revenue, but it badly missed projections on earnings–by a whopping 99 cents a share. Operating income plunged 51% year over year. In addition the company cut guidance for the third quarter: operating income will range from a loss of $400 million to a profit of $300 million. Wall Street had been expecting $950 million. It turns out that there’s nothing even remotely guaranteed about Amazon’s earnings or growth. The company is about to go into one of its periodic periods of soaring spending on capital investment and on staff that have, in the past, sent earnings down and then down some more. Amazon, the most recent earnings report says, has not left the real world behind and the company needs to invest money–vast amounts of money–to fuel future growth in revenue and, hopefully, in profits.
Coming after a quarterly report from Alphabet in which the company beat Wall Street estimates on earnings and revenue but reported an unexpectedly large increase in an operating expense called cost per click, and ahead of tomorrow’s report from Apple in which the company might reveal a delay in the full production of the new iPhone, Wall Street is re-evaluting its assumptions about the “guaranteed growth rate” for these technology giants. Amazon closed down today another $32.26 a share (or 3.16%) at $987.78 a share. (That puts the shares below the 50-day moving average of $996.)
I say “re-evaluating” because the market hasn’t yet given up on this group–and sent these market leaders into a correction. Facebook did, after all, crush Wall Street expectations when it reported earnings, beating the Wall Street consensus on earnings by 20 cents a share and recording 44% growth in revenue. And because as nervous as the markets may be about Apple, investors and traders won’t have any actual news from Apple until tomorrow (and maybe not then if the company decides to play its cards close to its vest.) And we are coming out of the traditionally weak summer quarter for technology stocks and analysts are starting to look forward to forecasts for the Christmas quarter. This is especially true for Amazon, which isn’t a technology stock as far as the S&P 500 is concerned. How much Amazon do you want to sell ahead of the December quarter?
Still there is no doubt that we’re seeing a worrisome narrowing of the ranks of market leaders. If you were worried before about the ability of the FANG stocks to lead the market to new highs, I doubt that you’ll feel less anxious now that the market is counting on Facebook and Netflix with Amazon and Alphabet (or Google for FANG purposes), for the moment, suffering from uncertainty.
And we are stuck with the big questions about over all economic growth–especially since it looks like the auto sector has peaked–and about the ability of the Trump administration to advance its tax and spending agenda in Washington.
If, as I expect, Apple doesn’t tell the markets much of anything tomorrow, I think we’re looking at an August where stock prices wander without much direction and where worries from outside the market build and increase nervousness.