The mega-cap stocks that dominate the US markets have enjoyed an amazing bull run. But February’s first correction in years proved things are changing. With that unnatural low-volatility melt-up behind us, it’s more important than ever to keep leading stocks’ underlying fundamentals in focus. They help investors understand which major American companies are the best buys and when to deploy capital in them.
For some years now, I’ve been doing deep dives into the quarterly financial and operational results in the small contrarian sector of gold and silver miners. While hard and tedious work, this exercise has proven incredibly valuable. With each passing quarter my knowledge of individual companies grows, helping to ferret out miners with superior fundamentals and the greatest upside potential. Traders love the resulting essays.
This successful fundamental-research methodology can be applied to other sectors, and even the stock markets as a whole. And no “sector” is more important to the overall stock markets than the biggest and best American companies. So I’m starting this new essay series to analyze their quarterly results on an ongoing basis. Today’s initial foray starts with their latest results from Q4’17, a critical baseline quarter.
With the new Q1’18 earnings season getting underway, Q4’17’s data is getting stale. Optimally this research would’ve been done 6 weeks or so ago. But it wasn’t until long-lost stock-market volatility finally roared back in February and March that it became abundantly clear big changes are afoot. After that it took time to build our necessary underlying spreadsheets and dive into the big US stocks’ Q4 results.
Going forward it will be easier to analyze and publish new quarters’ results much sooner after those quarters end. But getting Q4’17 baseline data was absolutely essential. That may very well prove the final quarter in one of the most-extraordinary bull markets on record. The flagship S&P 500 stock index had powered 324.6% higher over 8.9 years, making for the third-largest and second-longest US bull on record!
That was also just a hair under the second-largest ranking. 2017 was truly the best of times for the stock markets too. Record-low volatility along with extreme euphoria in anticipation of Republicans’ coming massive corporate tax cuts drove the S&P 500 (SPX) 19.4% higher with nary even a trivial 4%+ pullback. Nearly everyone was convinced this idyllic rally could continue indefinitely, traders were utterly enchanted.
A key real-world side effect of last year’s epic stock-market exuberance was sharply-higher spending by households and corporations alike. Late in major bull markets when everyone is complacent and greedy the wealth effect is very strong. People extrapolate their fat stock gains out into infinity, and ramp their spending accordingly. That drives strong growth in corporate sales and profits, greatly reinforcing the elation.
As a contrarian student of the markets and trader, I wasn’t drinking that Kool-Aid. On 2017’s final trading day I published an essay on the hyper-risky stock markets, explaining why a new bear was long overdue. The valuations of the elite SPX stocks were deep into formal bubble territory, running at average trailing-twelve-month price-to-earnings ratios of 30.7x at the time. That would further balloon to 31.8x by late January!
More importantly, the world’s major central banks were pulling away the punch bowls that had directly fueled that vast orgy of stock-market excess. The Fed was starting to ramp its first-ever quantitative-tightening campaign to begin unwinding long years and trillions of dollars of quantitative-easing money printing. And the European Central Bank was drastically tapering its own QE bond-buying campaign.
This unprecedented tightening following radically-unprecedented QE would literally strangle the stock markets, as I explained in late October. The extreme euphoria drowned out those warnings then, but traders are more receptive now after the SPX’s first 10%+ correction in 2.0 years in early February. All this suggests high odds that Q4’17 will prove the final pre-peaking quarter of that central-bank-goosed bull.
Thus I couldn’t wait for Q1’18 data to start this new essay series, I had to get Q4’17’s baseline data no matter what. The world’s most-important stock index by far is the US S&P 500, which weights America’s biggest and best companies by market capitalization. So not surprisingly the world’s largest and most-important ETF is the SPY SPDR S&P 500 ETF which tracks the SPX. This week it had net assets of $252.4b!
That’s a staggering sum, reflecting the universal popularity of index investing late in major bull markets. Two of the next three largest ETFs also track the S&P 500, the IVV iShares Core S&P 500 ETF at $140.4b and the VOO Vanguard S&P 500 ETF at $87.1b. These dwarf the entire rest of the ETF sector. For comparison, the dominant and popular GLD SPDR Gold Shares gold ETF has net assets of just $37.3b.
Unfortunately my small financial-research company lacks the manpower to analyze all 500 SPX stocks in SPY each quarter. Support our business with enough newsletter subscriptions, and I would gladly hire the people necessary to do it! But for now we’re starting with the top-34 SPY components ranked by market capitalization. That’s an arbitrary number that fits neatly into the tables below, but a commanding sample.
As of the end of Q4’17 on December 29th, these 34 companies accounted for a staggering 41.8% of the total weighting in SPY and the SPX itself! They are the biggest and best American companies that are largely-if-not-totally driving US stock-market fortunes. Whether the SPX rolls over into a new bear market or not will depend on how these elite stocks fare. They are the widely-held mega-cap stocks everyone loves.
Every quarter I’m going to wade through a ton of core fundamental data on each top-34 SPX company and dump it into a spreadsheet for analysis. The highlights make it into these tables. They start with each company’s symbol, weighting in the SPX and SPY, and market cap as of the final trading day of Q4’17. That’s followed by the year-over-year change in each company’s market capitalization, a critical metric.
Major US corporations have been engaged in a wildly-unprecedented stock-buyback binge ever since the Fed forced interest rates to deep artificial lows during 2008’s stock panic. Thus their share-price appreciation also reflects shrinking shares outstanding. Looking at market-cap changes instead of just underlying share-price changes effectively normalizes stock buybacks. It’s a purer view of company value.
The next data set is quarterly sales along with their YoY changes. Revenues are one of the best indicators of businesses’ health. While profits can be manipulated quarter-to-quarter by playing with accounting estimates, sales are mostly set in stone. Ultimately sales growth is necessary for companies to expand, as earnings boosts driven by cost-cutting are inherently limited. Sales declines are bear-market harbingers.
Operating cash flows are also very important, showing how much capital companies’ businesses are actually generating. Unfortunately most of these elite big US stocks didn’t break out Q4’17 OCF, instead lumping it in with full-year financial statements. While that can still be calculated by subtracting the Q1 to Q3 OCFs from the annual one, that’s tedious and time-consuming. Not reporting full Q4 results disrespects investors.
Next are the real quarterly earnings that must be reported to the Securities and Exchange Commission under Generally Accepted Accounting Principles. Late in bull markets, companies tend to use fake pro-forma earnings to downplay GAAP results. These are derided as EBS earnings, Everything but the Bad Stuff! Companies arbitrarily ignore certain expenses to artificially inflate their profits, which is very misleading.
While we’re also collecting earnings-per-share data, it’s more important to consider total profits. Stock buybacks are executed to drive EPS higher, because the shares-outstanding denominator shrinks as shares are repurchased. Raw profits are a cleaner measure, normalizing out stock buybacks’ impacts. When the inevitable bear market arrives, companies will attempt to mask falling earnings by emphasizing EPS.
Finally the trailing-twelve-month price-to-earnings ratio is noted. TTM P/Es look at the last four reported quarters of actual GAAP results compared to prevailing stock prices. They are the gold-standard metric for valuations. Wall Street often intentionally obscures these hard P/Es by using forward P/Es instead, which are literally mere guesses about future profits! They have usually proven far too optimistic in the past.
As expected given last year’s spending-driving stock-market euphoria, the top SPY/SPX components’ Q4’17 results were generally quite impressive. Their sales grew strongly, but were still far-outpaced by their stock-price gains driving valuations sharply higher. Earnings were heavily distorted due to the impact of Republicans’ big corporate tax cuts passing that quarter, which was fascinating to analyze.
Not surprisingly the S&P 500’s top-constituent list was little changed in 2017. Most of these elite American companies only grew larger. Three stocks did claw their way into the top 34 since Q4’16, their symbols are highlighted in blue above. Boeing is a high-priced Dow 30 stock, which has skyrocketed on better business prospects driving the Dow higher. Its market cap soared an astounding 85% higher last year!
Any company with YoY market-cap gains over 19% beat the overall SPX last year, while any company below that lagged it. These top-34 US stocks saw average market-cap gains of 29%, well ahead of that average. One of the telltale characteristics of bull-market tops is gains concentrate in fewer and fewer stocks. The well-known shrinking-business problems of GE and IBM forced them just out of the top 34 last year.
With 500 stocks in the S&P 500, it’s still amazing and damning that 41.8% of this entire index’s market cap is concentrated in just 34 big US stocks! At the end of Q4’17, investors had $10.2t of wealth tied up in these elite companies. That extreme concentration is a double-edged sword, because bear markets often inflict downside damage on individual stocks in proportion to their upsides seen in the preceding bulls.
Ominously the universally-adored and -owned mega-cap tech stocks were dominating the SPX at the end of 2017. Apple, Alphabet, Microsoft, Amazon, and Facebook all had staggering market caps in excess of a half-trillion dollars each. These 1% of SPX stocks weighed in at a colossal 13.8% of index weight! Their average TTM P/E was 61.7x, more than double the 28x classical bubble threshold. That’s super risky!
One reason investors have been willing to pay such high premiums for the tech market darlings is their astounding sales growth. While the top-34 SPX companies together averaged still-impressive 11% sales growth from Q4’16 to Q4’17, the top 5 tech stocks trounced that at 28%! The rest of these top-34 SPY components reporting Q4 sales averaged about a quarter of that at 7.7%. So these tech stocks look invincible.
But such fast sales growth is unsustainable given their massive sizes, and likely to reverse with the stock markets. Everyone loves Apple’s products, but they are expensive. iPhones and iPads last years with no need to upgrade, and major upgrades are few and far between anyway with those technologies maturing. So the upgrade cycles Apple desperately needs to drive its massive sales are lengthening considerably.
As the stock markets’ wealth effect reverses to negative in the next bear market, odds are Americans will keep their iPhones longer before buying new ones. These are sizable expenses relative to median US household incomes. Amazon might be able to better weather a stock-market storm, depending on how much of the stuff Americans order from it is necessary versus discretionary. Its bear sales trends will be interesting.
Alphabet, Microsoft, and Facebook rely heavily on business spending. The coming huge tax cuts made 2017 a banner year for business confidence, leading to giant leaps in spending on online advertising as well as back-office data services. When the next recession comes accompanying the stock bear, much of that euphoric business spending will wither and reverse. So mega-cap-tech sales growth ahead isn’t so rosy.
I was very dismayed to find only 13 of these biggest-and-best American companies bothered reporting their Q4 operating cash flows to their investors. These companies have effectively infinite accounting resources, yet their Q4 breakouts from full-year results were terrible. Even the gold miners with their wildly-varying accounting and home countries did way better. So there’s not enough Q4 OCFs to bother analyzing.
Thankfully that won’t be the case in Q1s to Q3s, where every one of these elite stocks will dutifully report their quarterly operating cash flows. In the gold-mining space, sometimes companies choosing to obscure their OCFs want to hide poor performance. I don’t think that’s the case in these top SPX/SPY companies given their strong sales growth. But I’m shocked they don’t consider shareholders worthy of this key data.
The biggest surprises for me in this first foray into big US stocks’ quarterly results came on the earnings front. As expected given all the spending-inducing stock euphoria last year, overall profits of these top-34 SPY components grew to $112.2b in Q4. That made for average YoY gains of 137%, certainly sounding phenomenal. But that was just one quarter, not the entire year. So valuations didn’t decline on that.
The dominant reason the stock markets soared in 2017 was the coming massive corporate tax cuts. All year long there was great anticipation of them becoming law. The actual Tax Cuts and Jobs Act of 2017 bill was introduced in early November, passed the House in mid-November, passed the Senate in early December, and then was passed again in its reconciled version in both Congress chambers in mid-December.
Trump signed it into law and made it official on December 22nd, 2017. This whole process surrounding the actual bill began and ended in Q4. Its flagship provision was slashing the US corporate tax rate from 35% to 21%. This was a huge cut despite many offsetting business deductions and credits also being eliminated. It was probably the biggest change in US corporate taxation in history, a huge shift to adjust to.
For large publicly-traded companies, the SEC requires formal 10-K annual reports after fiscal year-ends to be filed by 60 days after quarter-ends. So American companies only had about 9 weeks to analyze the impact of the TCJA on their businesses before reporting Q4’17. Fully 33 of these top 34 companies in the SPX reported TCJA adjustments to their Q4’17 profits. Apple was the only company not breaking it out.
These adjustments’ profits impacts had an enormous range, from a colossal $29.1b boost to Berkshire Hathaway’s Q4 profits to a gargantuan $22.0b hit on Citigroup’s! So nearly all these Q4 GAAP profits are somewhat-to-heavily distorted by one-time impacts of those corporate tax cuts. Most of the really-big profits and really-big losses above are the result of these TCJA adjustments and not business operations.
In reading through all these 10-Ks and 10-Qs, there were generally two major tax-cut drivers impacting profits. The first was deferred tax assets and liabilities. These are very complicated, but basically US companies either overpaid or underpaid their taxes in individual years due to various accounting rules. The differences become DTAs or DTLs, which reduce or increase future years’ tax burdens for these companies.
But when the corporate tax rate was drastically slashed from 35% to 21%, all of a sudden both DTAs and DTLs were worth much less going forward. DTAs shielded less future profits at lower tax rates, while DTLs would have lower future tax payments. Different industries and businesses had wildly-different deferred taxes on their books. The second provision driving the adjustments was a one-time repatriation tax.
Because the US corporate tax rate had been so obnoxiously high relative to the rest of the world for so long, major companies played accounting games recognizing earnings in other countries. This stacked up to trillions of dollars held overseas. The TCJA imposed a one-time repatriation tax assuming that this cash was being sent back to the US whether that was true or not, which was a big cost for some companies.
So these Q4’17 profits numbers are very distorted by these one-time TCJA adjustments flushed through income statements. I gathered all these with the rest of the data, and expected a big overall impact on their collective profits. The absolute value of all of them together for these top-34 US stocks was a truly-staggering $209.2b in Q4’17! That dwarfed the actual reported GAAP profits running $112.2b that quarter.
Thus I watched the running total with great interest as I waded through the quarterlies. I expected to see corporate profits greatly overstated by the TCJA adjustments. But much to my surprise, the net of all of these positive and negative profits impacts was merely +$2.7b. That’s just 2.4% of the total earnings of these top-34 big US stocks, essentially a wash. Will the corporate tax cuts be less valuable than expected?
While the old statutory corporate rate was 35%, many companies are using schemes and loopholes to pay far less. Many of those were closed to get to 21%. If the positive impact of lower corporate taxes is smaller going forward than Wall Street joyously expects, it will have a big adverse psychological impact. If profits don’t balloon dramatically as forecast, valuations are going to get even more dangerously extreme.
While individual top SPX companies’ profits won’t be comparable with those big TCJA adjustments, they will be collectively with the overall flat impact. If the $112.2b of Q4’17 GAAP profits earned by these top 34 US companies is annualized, it implies $448.9b of earnings on a $10.2t collective market cap. That equates to a 22.7x overall P/E for these big US stocks at the end of one of the best corporate-profits years ever.
That’s not in bubble territory, but still very expensive after such a big and long bull. But not aggregated these top stocks look way more overvalued. Their average TTM P/Es, which didn’t yet include Q4’17 earnings at the end of December, ran way up at 30.6x. That’s still above that 28x bubble threshold. But Amazon is an insane outlier at 190.2x earnings. Ex-Amazon, that top-SPY-stocks average drops to 25.8x.
That’s still frighteningly high. The whole purpose of bear markets following long bull markets is to drag stock prices down and sideways long enough for earnings to catch up with lofty stock prices. Bears don’t end until overall stock-market P/E ratios collapse back down to 7x to 10x earnings! That implies the US stock markets face getting at least cut in half, which is typical in major bear markets. That’s serious downside.
Ominously most of this past year’s incredible stock-price appreciation in these elite companies wasn’t driven by earnings growth. The average jump in their market capitalizations from the end of Q4’16 to the end of Q4’17 was 29%. In this same span their TTM P/E ratios climbed an average of 25%. Thus these top SPY companies’ earnings barely grew during all of last year despite all the record-high-stocks euphoria!
The hard data proves that’s true. In Q4’16, these same 34 big US stocks collectively earned $110.4b. That only rose 1.7% YoY to $112.2b in Q4’17. Yet their total market caps still blasted 26.9% higher! This proves one of the greatest stock-market years on record didn’t drive any meaningful earnings growth in Q4, which tends to be the best quarter of the year on holiday spending. Fundamentals didn’t improve.
Last year’s extreme stock-market melt-up to dazzling new all-time highs was purely a sentiment thing, not at all fueled by GAAP earnings growth. 2017’s big gains were built on sand. Psychology is a fleeting capricious thing that will absolutely mean revert back to neutral and overshoot to bearish. And when that happens, the profits won’t be there to keep these elite market-darling stocks from getting mauled by the bear.
Despite the recent mild correction, these stock markets remain exceedingly overvalued and dangerous. The big US stocks’ Q4’17 fundamentals prove corporate earnings remain far too low to justify such high stock prices. That’s terrifying in 2018 where the Fed and ECB will collectively remove $950b of liquidity compared to last year! Regardless of valuations, this alone would plunge these stock markets into a new bear.
Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming central-bank-tightening-triggered valuation mean reversion in the form of a major new stock bear. Cash is king in bear markets, as its buying power grows. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half-price!
SPY put options can also be used to hedge downside risks. They are still relatively cheap now with complacency rampant, but their prices will surge quickly when stocks start selling off materially again. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.
Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early that year. If the stock markets indeed roll over into a new bear in 2018, gold’s coming gains should be much greater. And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains. Gold stocks skyrocketed 182% higher in 2016’s first half!
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The bottom line is the big US stocks’ latest quarterly results are concerning. Despite a perfect year for the stock markets, and boundless optimism fueled by hopes for big tax cuts soon, corporate profits were largely flat in Q4. If the biggest and best American companies can’t grow earnings substantially even in that ideal environment, how will they fare when these stock markets inevitably roll over into a long-overdue bear?
And the initial massive-corporate-tax-cut impact on corporate profits was effectively a wash. What if the slashed corporate tax rate doesn’t yield the expected earnings windfall in 2018? This risk coupled with slowing sales as stock markets weaken is incredibly bearish. Especially with the biggest and best US stocks everyone loves and owns still trading near or above bubble valuations as central banks greatly tighten.
Adam Hamilton, CPA
April 13, 2018
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