The Panic Is on Ice

It's like nothing happened... The latest on inflation, jobs, and earnings... But beware... The Magnificent Seven are turning over... The next stop after 'priced for perfection'... It's all about valuation... Stop wasting money...

The 'panic' is in the rearview for now...

A week ago today, I (Corey McLaughlin) wrote to you with a Digest titled "Panic, Interrupted."

The idea was that anxiety had eased somewhat just a few days after what appeared to be a market panic last Monday. The prices of almost all major asset classes were moving higher, yet market "fear," as measured by the CBOE Volatility Index ("VIX"), was still elevated...

Seven days later, it appears that the market action at the start of last week is even further in the rearview mirror. In a week, the benchmark S&P 500 Index is about 4% higher, the tech-heavy Nasdaq Composite Index is up more than 5%, and the VIX has fallen back below its long-term average to more typical recent levels of around 15.

Whatever sense of panic was in the market 10 days ago is now on ice.

The S&P 500 is within about 2% of its all-time high made on July 16. It's trading above its 50-day moving average, a technical measure of a short-term trend, and well above its longer-term 200-day moving average. And the phrase "carry trade," in reference to the Japanese yen and U.S. dollar, has returned to the recesses of market analysts' vocabulary.

Yet the whole episode – linked to recession fears and a Bank of Japan policy – tells me how sensitive investors can be to a "shock" from anywhere.

At the moment, the focus is back on inflation and jobs...

As I briefly mentioned at the top of yesterday's edition, the latest round of Uncle Sam's inflation data covering July points to continued "disinflation." In other words, prices are still rising, but at a slower pace than the 40-year highs of recent history.

Neither the consumer price index ("CPI") nor the producer price index ("PPI") for last month included any "unwanted" surprises.

The July CPI showed 0.2% monthly growth and was 2.9% higher than a year ago. That's the lowest headline number since March 2021. On Tuesday, PPI showed 0.1% growth for July and 2.2% year over year.

Meanwhile, today brought another round of jobless-claims data. And for the second straight week, the report showed lower numbers than the prior seven days.

In the week ending August 10, 227,000 Americans filed for initial unemployment benefits... below the 234,000 first-time filings from the week before and the 250,000 from the week ending July 27.

It appears the shock of a 4.3% unemployment rate in July reported just on August 2 has already escaped Mr. Market's short-term memory... even though initial jobless claims also remain in a longer-term uptrend since January.

A report today on U.S. retail sales also showed 1% growth in July, though the numbers aren't inflation adjusted.

In any case, due to recession concerns after the July jobs report, federal-funds futures traders had expected the Fed would cut rates by 50 basis points ("bps") at its next policy meeting in September. Yet now, they think the central bank will cut its rate by 25 bps next month.

The odds of a 25-bps cut in September are now near 75% versus less than 50% a week ago when a 50-bps cut was the slight favorite.

So, the market thinks the 'bad news' has gotten 'less bad' since two weeks ago...

Expectations for smaller rate cuts mean less of a concern about the economy than folks previously thought. But as we've said, that doesn't mean the source of the "bad news" has disappeared.

The unemployment rate is rising, and it has been since March, when the rate was 3.8%. As we've written, the Fed historically underestimates how high the unemployment rate can go once it starts moving higher, and typical signals of recession are flashing.

According to the Kobeissi Letter, 2,462 U.S. companies are now under Chapter 11 bankruptcy – the highest number in 13 years and more than double the number from just two years ago.

That said, corporate earnings are strong for now...

All is well if you look at S&P 500 companies' second-quarter earnings results. According to FactSet, companies have reported (or are expected to report) their best quarter in years, on average...

The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report) earnings growth rates for the S&P 500 for [the second quarter of] 2024 is 10.8%. If 10.8% is the actual growth rate for the quarter, it will mark the largest earnings growth rate reported by the index since [the fourth quarter of] 2021 (31.4%)...

The blended year-over-year revenue growth rate for the S&P 500 for the second quarter of 2024 is 5.2%. If this holds, it will mark the largest annual revenue growth rate reported by the index since the fourth quarter of 2022 (5.4%).

Ten of the 11 major S&P 500 sectors have reported year-over-year quarterly revenue growth so far, led by tech and energy. Materials is the only sector reporting an annual decline in second-quarter revenues.

But beware...

As FactSet's John Butters put it at the end of a research note published yesterday...

It should be noted that analysts are currently projecting (year-over-year) revenue growth for the next five quarters for the S&P 500. For Q3 2024 through Q3 2025, the current estimates for revenue growth are 4.9%, 5.4%, 5.8%, 5.8%, and 6.2%.

In other words, Wall Street expectations for the next year or so are for about the same or better growth than companies are showing right now. They're certainly not "pricing in" a recession, or even a significant slowdown of any kind.

That goes double for shares of certain companies...

Like the "Magnificent Seven," for instance... That's Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla.

Shares of these seven companies reached highs last month, then dropped double digits before rebounding somewhat lately (except for Alphabet).

But check out this analysis and chart that our Dr. David "Doc" Eifrig shared in his free Health & Wealth Bulletin yesterday. These mega-cap stocks are turning over when it comes to net income growth...

Market bulls frequently argue that Big Tech stocks are still worth buying because they have wide profit margins... They are so profitable that they deserve a higher valuation than the average S&P 500 stock. And that's true, to a degree.

But we're starting to see the profit gap between mega-cap tech stocks and the rest of the market shrink. Take a look...

While the S&P 500 is actually seeing net income growth, as reflected in this quarter's earnings report, the story for mega-cap tech stocks is changing...

This was one of the big points of our "emergency briefing" last week featuring Doc, Stansberry Research founder Porter Stansberry, Stansberry's Investment Advisory lead editor Whitney Tilson, and our Director of Research Matt Weinschenk.

One not to buy...

Last month, in his Income Intelligence newsletter, Doc focused specifically on Nvidia and wrote bluntly, "Do not buy Nvidia (NVDA) today." He explained several reasons why...

They included the fact that people likely already own shares of Nvidia – and more than they might think – simply by owning the S&P 500. Indeed, the top 10 U.S. stocks by market cap now represent roughly 36% of the S&P 500 Index.

Nvidia has been one of the companies that has helped the "market" push higher since this current bull run started in October 2022.

The chip designer, which essentially has monopoly-like pricing power right now in cutting-edge chips linked to artificial intelligence, represents about 7% of the S&P 500.

Doc also made the case that investing in Nvidia isn't just a bet on the company right now but also on the bull market continuing. He said that it's part of textbook "bubble" behavior in AI – and noted the company will undoubtedly face more competition than it does now...

But what I want to highlight is Doc's nuts-and-bolts analysis of Nvidia's valuation... because it speaks to the risks in the stock price and the market today, with the major U.S. indexes still near all-time highs even as signs of possible recession are easily found.

There's only one way to go from 'priced for perfection'...

As Doc wrote, "Nvidia is an incredible business – perhaps one of the best we've ever seen."

The company dominates the market for graphics processing units ("GPUs"), and its trailing 12-month revenue is $79 billion, up from $26 billion in 2023.

The company made $39 billion in free cash flow ("FCF") over the last 12 months. That's more than ExxonMobil (XOM) and Berkshire Hathaway (BRK-B) rake in... and more than double what Walmart (WMT) earns.

But as Doc said...

Even if a business is near perfect, its stock should trade at a reasonable price relative to its sales, earnings, and other metrics... And Nvidia trades at absurd valuations.

Today, it trades for 39 times sales – the most expensive multiple in the S&P 500.

It also trades for 81 times FCF. That's "only" the 23rd-most expensive, though that's because some companies have very low cash flow. It's the most expensive in the S&P 500 when looking at companies with FCF greater than $2 billion.

The valuation of a stock gives you an idea of investors' expectations for future business. A high valuation means the market is counting on huge growth in the future...

We know that Nvidia is extremely profitable. However, at a market cap of $3.2 trillion, investors expect a lot from the company.

As Doc explained, the life cycle of a company and its multiples follows a standard pattern if the company sticks around long enough to be successful...

A young, fast-growing company sports a high multiple. That multiple decreases as the company matures, but the rising earnings and the lower multiple can still combine to deliver positive returns for investors.

Again, Nvidia trades for about 39 times sales. A mature company trades for much less. The S&P 500, for instance, has an average multiple of 3 times sales.

But let's give Nvidia some more room... After all, it's a highly profitable company, and high margins justify a higher multiple on sales.

We think that Apple (AAPL) – a massive, profitable, and mature tech company with big advantages over its competitors – makes for a good comparison.

Apple trades for 9.4 times sales. If Nvidia were to trade at that multiple today, it would need to generate $320 billion in sales, per year, to justify its current $3.2 trillion market cap.

That's growth of five times over from here.

That's a stretch, Doc said...

He continued...

And that's only enough to justify the current market cap. Even if the company hits those expectations, someone buying Nvidia today wouldn't see any return. That would just validate the stock's current price.

If Nvidia traded at 3 times sales, like the standard company in the S&P 500, it would need to crack more than $1 trillion in sales per year. How can its customers even amass that much to pay for GPUs?

You can use just about any metric to gauge a stock's valuation. In the table below, we used sales, earnings, and cash flow to compare Nvidia's valuation against Apple's and the S&P 500's...

Nvidia is priced for perfection. Any hiccup in investor predictions that Nvidia will rule the world could send the stock down – and fast.

Doc published his analysis in his July 18 issue of Income Intelligence... Nvidia shares traded around $121 on that day, then they fell by nearly 20% to around $99 last Wednesday before rebounding back past that level.

The stock – and the market – aren't out of the "downside risk" woods quite yet.

Don't short, don't buy...

This doesn't mean you should necessarily short Nvidia, but Doc says you shouldn't be buying shares at current valuations either...

When stocks detach from reality, they can stay that way for a long time. Nvidia could easily rise another 50% or more if it can deliver on its next few earnings reports (scheduled for August 23 and November 21).

While a 50% gain doesn't seem that high in light of Nvidia's recent performance, keep in mind that such a move would take Nvidia up to a $4.8 trillion valuation. We've got to be approaching a ceiling here.

Nvidia could also fall 50% or more. When the dot-com bubble burst, even real, world-dominating businesses fell by 90% or more... simply because valuations and hype had pushed them too far.

The fear there is that so many investors already have so much exposure to Nvidia that it will wipe out a lot of wealth.

It's in your pension. It's in your index funds. And it's in the accounts of retail investors who've seen Nvidia's returns and decided to dabble in the stock market. The crash will be painful.

What's more, Doc predicts that when stocks fall, shares of Nvidia "will be the hardest hit in your hard-hit portfolio."

Be warned... The same goes for the other "magnificent" mega-cap tech companies.

As Doc told his readers yesterday: "Stop wasting your money on overvalued tech stocks."

New 52-week highs (as of 8/14/24): AbbVie (ABBV), Agnico Eagle Mines (AEM), Brown & Brown (BRO), CBOE Global Markets (CBOE), Direxion Daily Real Estate Bull 3X Shares (DRN), Fair Isaac (FICO), Fidelity National Financial (FNF), Intercontinental Exchange (ICE), Intuitive Surgical (ISRG), Kellanova (K), Lockheed Martin (LMT), Cheniere Energy (LNG), Altria (MO), Motorola Solutions (MSI), Nuveen California Quality Municipal Income Fund (NAC), Northrop Grumman (NOC), Novartis (NVS), Skeena Resources (SKE), Veralto (VLTO), Viper Energy (VNOM), Consumer Staples Select Sector SPDR Fund (XLP), and Health Care Select Sector SPDR Fund (XLV).

A quiet mailbag today. As always, send your comments and questions to feedback@stansberryresearch.com.

All the best,

Corey McLaughlin
Bethany Beach, Delaware
August 15, 2024