Market Commentary: October 30, 2018

Paradigm Financial Advisors

Market Commentary

October 30, 2018

 

Stock Market Volatility:  Market volatility continued today with the Dow Jones Industrial Average closing up 431 points (1.77%) and the S&P 500 ended the trading session up 41.38 points (1.57%).  Last week U.S. equities declined 3.9% and global stock markets also struggled as European stocks fell 4% and Emerging Market stocks were down 3.3%.  Yesterday, stocks initially opened higher but the gains were lost after Bloomberg reported that the U.S. is planning more tariffs on Chinese imports if the meeting at next month’s G20 meeting between President Trump and Chinese President Xi fails. The October sell-off has erased all of the year to date gains in the S&P 500 despite strong economic reports and corporate earnings growth for Q3 coming in at 22%.

As we discussed in our market update last week, investors are concerned about a number of potential risks that could undermine the U.S economy such as the Federal Reserve raising rates too quickly, lower earnings growth in the future, negative consequences of the trade dispute with China, uncertainty in Europe surrounding  BREXIT & the EU’s rejection of Italy’s budget, and potential sanctions against Saudi Arabia after the murder of Jamal Khashoggi.

 

Over the weekend we dug deeper into the market data and it became clear that there are a number of trading related factors that also contributed to the magnitude of the sell-off:

1)  Stop-Loss Orders:  A large volume of trades were triggered by investors having entered Stop-Loss orders on stocks in order to protect their gains.  Stop prices are not guaranteed execution prices. A “stop order” becomes a “market order” when the “stop price” is reached – unless

the investor places a limit on the stop order.  Stop orders can add to selling pressure during volatile market conditions and many investors who enter stop orders end up selling at a price significantly below their expectations.

2) Profit-Taking:  Some active mutual fund managers do not want to risk trailing the indexes so they started taking profits as soon as the market went down two days in a row.

3) VIX Volatility Trading:  Data from the Commodity Futures Trading Commission indicates that during the 30 days prior to the sell-off a large volume of trades were made shorting VIX futures. When stocks started selling off, volatility rose very quickly and institutional investors

who had shorted VIX options had to unwind their trades very quickly which exacerbated the drop in the stock market.

4)  High-Frequency Trading Algorithms: Many of the big Wall Street firms have proprietary trading departments that use “high-frequency trading algorithms” that are designed to increase volatility by adding enormous selling pressure in down markets.   Wall Street’s

proprietary trading departments will likely end up making millions of dollars in October while their clients may end up losing more money than they would have otherwise!  Note:  this is one of the reasons Wall Street firms have spent a large amount of money lobbying against the

proposed Fiduciary Standard because they would have to shut down their proprietary trading departments since it is not in the best interest of their clients.

 

These trading factors contributed to the sell-off over the past few weeks.  The good news is that these factors only impact short term prices.  Long-term stock prices are primarily determined by valuations, future earnings and economic growth forecasts.

 

U.S. Economic Growth Outlook remains Positive: The much anticipated first release of the third quarter 2018 GDP estimate was released on Friday and it showed that GDP grew at an annualized rate of 3.5%.  This was 30 basis points (0.30%) higher than consensus estimates.  This follows second quarter GDP growth of 4.2% and first quarter growth of 2.2%.  This has been the best three-quarter average GDP growth since 2014.  The tax cuts and deregulation have produced higher U.S. economic growth than what economists have been forecasting.  In the third quarter, consumer spending (which accounts for approximately 70% of our economy) rose 4%, government spending on Defense rose by 0.50% and imports rose by 9.1%.

 

Q3 2018 Corporate Earnings RecapAccording to FactSet, as of October 26, 2018, almost half (48%) of the companies in the S&P 500 have reported earnings for the third quarter.

  • 77% of Companies in the S&P 500 have beat analyst’s expectations for EPS Growth.
  • 59% of Companies in the S&P 500 have beat analyst’s estimates on revenue growth.
  • Average earnings per share growth for the S&P 500 is 22.5%.
  • Average revenue growth for the S&P 500 is 7.6%.
  • The companies in the S&P 500 Index are on pace to increase EPS by 22% with 7.2% higher revenues.
  • The bottom up target price among analysts for the S&P 500 over the next 12-months is 3,205.55. This is approximately 20% higher than today’s closing price.

October has been a very frustrating month for investors as the market seems to be reacting irrationally by ignoring strong economic reports and not rewarding companies that have posted strong earnings growth.  Typically, when a company beats earnings estimates their stock moves up immediately but that has not been the case in Q3 for most companies.

 

The Chart below shows the average one-day stock price change for the companies that have reported results thus far in Q3 (solid column) compared to the change in stock price after Q2 earnings reports (shaded column).

 

Chart Comparing Stock Price Changes after Q2 vs Q3 Earnings Reports

 

Recap of Earnings Results from Last Week:

 

Amazon reported another quarter of record profit Thursday, fueled by the growth of online shopping and its cloud-computing service, but revenue grew less than Wall Street analysts expected.  For years, Amazon has  posted razor thin quarterly profits because it has been spending most of its earnings on building warehouses and making other investments to continue growing sales.   However, Amazon’s earnings are improving dramatically due to Amazon’s Cloud Computing business.  Just one year ago, Amazon reported profit of just $256 million but then last week Amazon posted third-quarter profit of $2.88 billion, its fourth straight quarter profit above $1 billion.  Amazon’s Revenue rose 29 percent to $56.58 billion in Q3 – which was slightly below analyst’s expectations of $57.05 billion.  Amazon reported earnings per share of $5.75, beating the $3.29 per share analyst expected.  Amazon gave guidance for the fourth quarter, which includes Christmas shopping season, in the range of $66.5 billion to $72.5 billion, which is slightly lower than the $73.8 billion Analysts had been expecting.

 

Google (Alphabet) posted earnings that were 25% higher than analyst’s estimates.  Google reported a net profit of $9.19 billion in Q3 and earnings per share of $13.06 – significantly above the $10.42 EPS that analysts expected.  Alphabet Q3 revenue was $33.7 billion, up 21% year-over-year but slightly lower than Wall Street’s consensus estimates of $34.04 billion.  Google’s hardware sales were down somewhat in Q3 but they anticipate significant growth going forward with the launch the new Google Pixel 3 smartphones and other products in Q4.  Google ad revenue climbed 20%, to $28.95 billion for the third quarter, and operating income rose 10.6%, to $9.49 billion.  Google ended the quarter with $106.4 billion in cash and equivalents and marketable securities, and $3.99 billion in long-term debt.

 

Netflix’s third-quarter revenue rose 34% year-over-year, to almost $4 billion, and net income was up 130% to $481 million. Revenue growth was fueled by a 25% increase in average paid streaming memberships, along with an 8% increase in average pricing. Netflix began raising its monthly prices in November 2017, and the increase helped Netflix post an impressive increase in revenue in the third quarter.  Netflix’s profit margins rose by 6% from the prior year to 28.8%.  Quarterly EPS rose to $0.89 from $0.29 in the same period last year, which was $0.21 or 31% higher than analyst’s consensus estimates.  Netflix grew subscribers by 22% in the third quarter.  They added 1.09 million new subscribers in the U.S. and 5.87 million international net streaming members in the quarter and now has 137 million total streaming subscribers. Management currently expects 1.8 million net additional U.S. streaming subscribers in Q4 2018. The company is also forecasting a continued ramp in international streaming net adds to 7.6 million.   The market has still sold Netflix stock off over overblown fears that the costs will continue to rise as the company plans to continue to spend heavily on creating new content.

 

Intel posted third quarter earnings of $1.40 per share on an 18.7% year-over-year jump in revenue to $19.16 billion, both of which also beat analyst’s estimates.  Intel also posted higher than expected guidance for the fourth quarter of 2018. Intel said that they expect fourth quarter earnings of $1.22 per share and fourth quarter revenue to be roughly $19.00 billion. Intel now expects full year 2018 earnings of $4.53 per share, which is significantly higher than previous guidance for earnings between $3.94 per share and $4.36 per share.  Intel said it expects revenue to reach $71.20 billion for full fiscal year 2018, which is also higher than their previous forecast for sales between $68.50 billion and $70.50 billion.  Intel generated record revenue in all of their business segments and their operating margin rose by 5% to 39.7%, the strongest level in more than a decade.  Business Computing sales grew 16.0% year-over-year to $10.20 billion while operating income jumped 26.0% to $4.50 billion.  Personal/Desktop computer sales increased 9.0% and notebook/laptop computer sales rose 13.0%. The average selling price of desktop processors increased 10.0% while the average selling price of notebook CPUs grew 4.0%.  Data Center revenue jumped 26.0% to $6.10 billion while operating income spiked 37.0% to $3.10 billion.  Cloud revenue grew 50.0% while unit volumes grew 15.0%. Intel’s average selling prices increased 10.0%.  INTC is currently trading at a P/E of 9.7, based on 2019 forecasted earnings per share, which is a 35% DISCOUNT to 5-year median for semiconductor companies.

 

Peak Earnings Fears are Overblown:  Despite the fact that 77% of companies have reported better than expected earnings, investors seem to believe that the combination of additional tariffs, a stronger dollar, and rising material costs may signal that corporate earnings have reached a peak.  We think worries over peak earnings are overblown because it  assumes that every company and sector are all the same and it fails to recognize that companies in various sectors of the market are at very different stages in their growth cycles.   There are a number of industries that have experienced very little growth over the past decade, such as energy, machinery, infrastructure, health care, biotechnology, transportation, robotics & artificial intelligence, etc. that are in the early stages of a long-term growth trend.  Companies are forecasting double digit earnings growth in 2019 and they do not expect any significant deterioration in profit margins.  As additional earnings reports come in this week, hopefully investors will stop reacting to the noise and focus on the data that shows corporate earnings are not going to fall off of a cliff anytime soon!

 

The Federal Reserve May Change its Plans for Raising Interest Rates:  In September the Federal Reserve raised rates by another .25% to 2.25% and they raised some concerns by removing the word “accommodative” from their comments describing their stance on monetary policy.   After the meeting, Chairman Powell tried to relieve these concerns by saying “the change does not signal any change in the likely path of policy” and he also said, “it is a sign that policy is proceeding in line with our expectations.”   In our opinion the Fed needs to reconsider their plans and postpone the December rate hike because inflation is well contained and higher interest rates will have a negative impact on home and auto sales.  The Federal Reserve has said repeatedly that they do not want to jeopardize the economic recovery by raising rates too aggressively.  A number of Federal Reserve officials will be giving speeches over the next few weeks and we expect to hear them start walking back their comments about the timing of raising interest rates prior to the next meeting of the Federal Reserve Board on December 18th & 19th.


Important announcements this week
:

 

  • Earnings: Apple, Facebook, Berkshire Hathaway, Coca-Cola (KO), General Electric (GE), Starbucks (SBUX) and Pfizer (PFE). Chevron (CVX) and Exxon Mobil (XOM) all release earnings this week.

 

  • The October jobs report will be released on Friday and it is expected to improve over September’s hurricane-dampened figure of 134,000 to 193,000. The unemployment rate is expected to remain at 3.7% and wage inflation as measured by average hourly earnings is expected to stabilize at 2.8% year-over-year.

 

Conclusion:  The market seems to be ignoring the fact that U.S. companies are posting fantastic earnings and their balance sheets are the strongest they have been in decades.  The investors that have sold equities during this recent volatility are making irrational investment decisions based on short term noise.  Disciplined investors focus on the data – not the noise and they take advantage of the buying opportunities that have been created by the short term selling.   We believe that the selling has been overdone and the market should get some support from the earnings reports and economic data over the next few weeks.

 

PFA’s Investment Committee:

Jim Reding                          Bob Spindel

Ryan Powers                     Brad Combs

Matt Schaller                    Matt Kellerman