'Below the hood, there are signs of trouble'... 'Narrowing participation' and pricey valuations... A record-breaking quarter at Apple... Why the stock is still dirt-cheap today...
We begin today's Digest with another note of caution...
As we've noted recently, we're cautiously bullish today. We believe we're in the "final innings" of this long bull market, and the biggest gains often come toward the end.
But we're beginning to see more and more signs that the market is getting a little "frothy" – especially here in the U.S. – and at least a short-term correction could be coming.
After declining in June, the broad U.S. markets – as measured by the S&P 500 and the Nasdaq Composite Index – have rallied to new all-time highs again. But as the Wall Street Journal reported yesterday, the rally may not be as healthy as it appears...
The stock market has rebounded in July, but fewer stocks are leading the charge. The Nasdaq 100 index – comprised of the 100 largest stocks listed on the Nasdaq – is up 10.3% this year. In July alone, it has gained 6.7%.
But below the hood, there are signs of trouble. More than half of the index's gain this year is due to three stocks that also happen to be among the largest by market capitalization: Apple, Google, and Amazon, according to Mike O'Rourke, chief market strategist at JonesTrading. Throw in biotechnology company Gilead Sciences, Facebook, and Netflix, and the figure rises to 80%.
"You look underneath the surface and breadth is not nearly as robust as it used to be," said Willie Delwiche, investment strategist at Robert W. Baird. "What you're seeing is narrowing participation." The fact that fewer stocks are joining the rally is a sign of investor unease, Mr. O'Rourke said. Prior market peaks – including the 2000 top – were accompanied by a similar pattern of a shrinking handful of large-cap stocks pulling ahead, he said.
In a separate article today, the Journal noted the market could also be getting more expensive than many investors realize...
Most folks are familiar with the price-to-earnings (P/E) ratio. This is simply the market price per share of a stock (or stock index) divided by the annual earnings per share of that stock. In other words, if a stock were trading at $100 per share and had annual earnings of $5 per share, its price to earnings ratio would be 20.
Today the S&P 500 is trading at about 18.5 times its companies' earnings. This is a little above its long-term average of 15.7, but not exactly "expensive." For example, the S&P 500 traded at a price-to-earnings ratio of 29 at the market top in 2000.
But according to some investors, this may not be the best measure to use today. From the article...
Some market watchers point out that earnings per share can be massaged, through buybacks or cost cutting measures, making the metric less effective. These people say price/sales is a more appropriate predictor of market froth and it's flashing red right now.
"Earnings in many respects are in the eye of the beholder," said Jack Ablin, chief investment officer at BMO Private Bank. "Revenues aren't."
According to the article, the current price-to-sales (P/S) ratio for the S&P 500 is 1.86. This is 26% above the median value over the past 22 years. The last time the ratio was higher was in 2000. More from the article...
Since the end of the financial crisis, sales growth has mostly failed to keep up with the increases in earnings. For years, this divergence has sparked concern. Investors fretted that the fragile economic recovery wouldn't fully take hold until revenue began to rise.
That trend should continue to play out as S&P 500 companies report second-quarter earnings. FactSet forecasts that profits for companies in the index will contract 3.7%, while revenue should fall 4%. If revenue does decline, it will mark the first time since 2009 that revenue has fallen in two consecutive quarters.
Mr. Ablin said he is mostly unimpressed by the earnings beats. "(Revenues) are mostly organic," said Mr. Ablin. "Reported earnings per share are as organic as a box of Twinkies."
Still, these indicators don't mean U.S. stocks can't continue higher.
So while we always recommend avoiding extremely overvalued assets, our general stance remains the same...
Stay long, and put new money to work in good values (and select speculations, if appropriate)... but keep your "catastrophe-prevention plan" in place, just in case.
Returning to market-leader Apple (AAPL), the blue-chip consumer-products giant reported earnings on Tuesday after the market close... and investors panicked...
The company announced record third-quarter results. Sales were up 33% and earnings were up 45% from the same period of 2014. In the last 12 months, Apple has generated nearly $225 billion in sales over the last 12 months... more than $50 billion in earnings... $70 billion-plus in free cash flow (up 39% from 2014)... and now sits on a cash pile of more than $200 billion (enough to pay off its debt almost four times).
And yet investors were unimpressed...
They focused on the fact that Apple "only" sold 35% more iPhones and "only" made 59% more revenues in the third quarter compared with the same period of 2014. Shares opened down nearly 7% yesterday before closing down 4.2%.
Apple lost nearly $32 billion in market cap yesterday. To put that in perspective, only 150 of the companies in the S&P 500 have market caps of $32 billion or more. In other words, Apple's market value fell more in one day than 70% of the stocks in the S&P 500 have to lose at all.
But DailyWealth Trader co-editors Brian Hunt and Ben Morris aren't worried. As they told subscribers yesterday...
Apple is one of the best businesses in the world. It controls more than 50% of the global market for mobile phones (by sales)... and about 30% of the market for personal computers (including tablets). And because of its strong brand name and leading technologies, it enjoys thick, 23% profit margins.
In addition, Apple's shares are dirt-cheap today on two key valuation metrics – the EV/EBITDA and EV/FCF ratios, which compare Apple's market value to its earnings and cash flows. As Brian and Ben explained...
Even though Apple's share price has risen 238% (from $37 to $125), shares are cheaper today than they were five years ago. Apple isn't just cheap relative to its five-year history. It's cheap relative to other stocks in the market today...
Apple is at least 37% cheaper than the average tech stock today and at least 45% cheaper than the benchmark S&P 500 Index. Yet Apple is a far stronger company than the average company included in these indexes. We suggest using the pullback as an opportunity to "trade for income."
If you're looking for new investment opportunities here in the U.S., we believe you can add Apple to the relatively short list of "good values" to consider today, along with stocks like discount retailer Wal-Mart, oil giant Chevron, and Big Tech firm IBM.
New 52-week highs (as of 7/22/15): Chubb (CB), Cempra (CEMP), PNC Financial Warrants (PNC.WS), Scorpio Tankers (STNG), short position in Suncor Energy (SU), and short position in Viacom (VIAB).
In today's mailbag, another comment on the economy, more on storing cash and precious metals, and Stansberry Resource Report analyst Brian Weepie answers a question about China's gold. Send your thoughts to feedback@stansberryresearch.com.
"Hi my name is Daniel Hansson, (a recent subscriber) I am an owner operator of a semi in the platform division, I see business investment at a very low pace, and this year has returned to a bear market in transports, if nothings moving to market, or to infrastructure nothing is selling, if nothing is selling, or being built to sell something, the economy is bad, and believe me this year is a repeat of 2009 levels of activity, I'm just waiting for the other shoe to drop!. Yea yea yea I've invested in gold, and other things of value, and I'm holding an inverese etf much to the contrary of what I see others doing. I'm just waiting to see how long people will continue to "pay no attention to the man behind the curtain", (wizard of OZ) – Paid-up subscriber Daniel Hansson
"It may be cliché, but wrapping a large sum of cash in foil and storing it in the freezer works quite well, too." – Paid-up subscriber Anthony A.
I feel rather uneasy about storing precious metals and/or dollars outside of the US. Bad as things are getting here it could end up worse somewhere else especially in Central and South America where governments can change overnight. Unless you have your own plane or sea-going boat it would be difficult maybe even impossible to take possession of your precious metals and money accounts. And whose to say our government and other countries wouldn't halt all travel coming in and going out. I like to keep those precious items close to me. Same goes for overseas real estate. It could be easily confiscated. My parents homeland was invaded by the Soviets after WWII and their homes and lands were confiscated. It seems that to escape the tentacles of greedy governments one has to be either a vagabond, own nothing that's tied down, or be super rich." – Anonymous
"China just reported that it has far less gold holdings then what was expected. Why on earth would this cause the price of gold to drop? I mean, if we woke up one morning and it was reported that E.T. stole half the U.S. corn crop... the price would go up of course... right? So how is it possible... when a huge stash of gold that was expected to be there... turns out to not really be there... cause the price of gold to fall? Wanted some thoughts regarding this." – Paid-up subscriber Dave Routh
Weepie comment: China is a key driver of global gold demand. Its government last reported 1,054 metric tons in gold reserves in 2009. The market expected the number would be much higher today... likely in excess of 3,000 metric tons. So when it was announced to be 1,658, the market was underwhelmed.
The reported number is a negative for the gold price because it suggests China has actually acquired much less gold than expected. In other words, if the reported number is correct, there is more gold available than previously thought.
In the case of your corn crop analogy, it's actually like E.T. added 50% to the U.S. corn crop. In that case – like this one – the price would fall. Of course, that's assuming China is telling the truth...
Regards,
Justin Brill
Baltimore, Maryland
July 23, 2015
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