- Stellar second quarter earnings results from Apple, Facebook and Microsoft were not well-received by traders.
- Slowing revenue growth forecasts and company-specific issues like chip shortages were among reasons for the big tech stock selloff.
- These trillion-dollar companies have as much as doubled their earnings growth over the past two years and remain in dominant positions, but a fundamental market question underlies the investment concern: just how good will post-pandemic growth be?
If you are an Apple shareholder who wondered after last week's stellar earnings report why the value of your stock holding was going down rather than up, the reason given — that chip shortages will weigh on the short-term outlook — may not seem good enough. For a trader looking at every short-term opportunity to move portfolio money to where the next quick buck is likely to be, it doesn't take more than that "sell on the news" headline. Longer-term investors, though, might want to consider a recent fact about the company and negative headlines: Apple has overcome pretty much every short-term "sell" headline in recent years on its way to being a $2-trillion-plus company.
Trump's trade war with China? No problem. The surprise decision to stop offering iPhone unit guidance? Much ado about nothing as the iPhone super-cycle came along anyway. As for the global semiconductor chip shortage now being cited by Apple, it might be wise to keep in mind that Apple has a long history of being pretty conservative with its outlook — formal earnings guidance still has not returned. And one more thing: Tim Cook was elevated to the CEO post after Steve Jobs based on his mastery of global logistics.
"Let's face it, if Apple has any trouble getting chips, then every other company on the planet will have 10x those problems," said Nick Colas, co-founder of DataTrek Research. "If you're really worried about chip supply, you want to own Apple because it is first in line at every chip fab."
But there is a bigger question relevant to Apple and the rest of the market: Just how strong is the next leg of growth for the market going to be?
The immediate outlook for the market doesn't necessarily scream buy-on-the-dip after the big tech sell-on-the-news, according to Colas. Seasonality is an immediate risk, with market history showing the early August period to be a volatile one for the VIX volatility index.
"It's a valid trading question, where to go for the trading dollar in August," Colas said.
Short-term trading versus longer-term investing
Since 1990, the early August period has been one into which the VIX peaks. Part of the reason is the lighter volumes in the market during the summer. "It's a trough for liquidity, when people are on vacation ... a lower number of people trading and more volatility any news item will carry. I am telling clients to be careful," he said.
On Wednesday through Friday of last week, the S&P 500 trading volume was below its 30-day average.
For the short-term trader, a rotation away from the large-cap leaders into small-cap represented by the Russell 2000, which Colas described as being "way oversold" since its torrid hot streak in early 2021, could make sense. "Small-caps went parabolic through March and April and have not worked since because they got so far ahead," he said.
That makes them, at least statistically, based on 100-day trailing returns, cheap right now.
But for investors not playing the market for a quick trade, Colas says the post-earnings disappointing trades from Apple, Facebook and Microsoft shouldn't weigh too heavily. Amazon was the outlier in actually missing revenue expectations rather than posting a big beat, making a selloff on the news a "fair" reaction, according to Colas.
Big tech stocks were really bid up into Q2 reports
It's also important to remember that the big beats from the rest of big tech were already embedded in most of the stocks as they had a strong June and July based on the market guessing right — that Q2 earnings would be stellar. "The market was bidding up the names into the quarter. The market sniffed out the surprise and they all occurred, and when you see stocks all rally into a quarterly earnings, it's just hard to sustain that. That is 'sell on the news' unless there is a tremendous amount of good news and guidance," Colas said. "That's normal capital markets behavior."
He goes back to one important data point in assessing the strength of these companies: they have doubled their earnings power in the past two years. "Which is astounding," he said. And that gives him more comfort in the longer-term picture. "I don't see any change. Big tech is still the place to be."
He cited two reasons.
Even as these companies have doubled earnings growth, he doesn't think they are anywhere near peak earnings. "It's just a much higher base to build on."
Second, these companies have definitive advantages in industries and don't directly compete against each other in a zero-sum game i many areas of strength.
These companies have grown earnings so much because the pandemic changed consumption patterns, made us all even more tech-centric, and the market made a lot of money betting on that playing out exactly as it did. But now the big question for big tech isn't about its dominance being threatened — though multiple antitrust battles loom — it is just figuring out how much more room they have to keep the earnings growth rate going higher.
"Tell me what you would pay for a company with a 30% return on investment and structural growth of 10% to 15%, and can do it for a decade? What is the multiple? Is it 30 times or 40 times? I have no idea," Colas said, "but I know it's not 20 times."
Post peak-pandemic growth and peak earnings
Apple was an example from this group of concerns about price-to-earnings multiples. It lagged the rest of the tech giants for years, seen as a hardware vendor and weighed down by that market view until the services business soared through the pandemic and the $2 trillion market cap was given to the company. And again this year, it was "the one oddball laggard," in Colas's words, as its year-to-date return into earnings was roughly 10% versus roughly 30% for Facebook and Microsoft.
Apple trailed the S&P 500, too, ahead of the earnings. One reason: it sucked so much demand forward investors are rightly concerned posting good earnings comps will get harder. But, Colas said, that might also mean it has the most room left to go up, even in the short-term as a new iPhone launches in the fall and back-to-school boosts spending on consumer tech.
The broader global growth story the entire stock market is tied to isn't a lock. In fact, amid the panic over inflation earlier this year and expectations that the 10-year Treasury yield would go higher, it did the opposite. "The market totally understood growth had peaked in Q1 and started trending down at the end of the quarter," Colas said.
The rate story was wrong, but slower economic growth is now higher up on the list of investor concerns for a U.S. market where P/E ratios are high. Big tech represents 23% of S&P 500 and that means whatever the market next decides about its lofty valuations will weigh on U.S. stocks overall.
But investors don't have that many great choices globally. With the situation in China between the government and its leading companies resulting in massive losses in recent weeks, there might be trading opportunities, but emerging markets are no place to be for anything but a trade. And even if there is potential opportunity in other international plays like European financials, it is going to take time for rates to move in a direction that benefits those stocks.
"What's left? It's U.S. and the top of the cap table," Colas said. "That's what you need to own. Still back to the same names."
Looking at sector weightings back to the 1970s and through the 1990s, he says there has never been a time when five companies had more weighting. "It's just 5 names, and it's not like when Exxon was at its peak in the S&P. That was a commodity play. These companies have huge barriers to entry and very high structural returns."
Even with those advantages, trying to figure out what their earnings power will be post-pandemic, or at least as the world transitions from the worst of the pandemic to the lingering effects, is the bigger issue for big tech.
"What is a fair growth rate for 2022? That is hard," Colas said.
For Alphabet — the only among the big tech names to report last week which rose after its earnings — and for Facebook, which reiterated a prior warning of slowing revenue growth, there is the cyclical nature of advertising market to rely on, and that has not changed all that much in recent decades. Apple, though, is a harder one, because even as it has made progress moving past the iPhone story and building its services business into a huge driver of growth, so much hardware demand was pulled forward.
For Amazon, Colas noted that e-commerce's share of demand when from 17% to 24% in Q2 2020, and then back down to 20%. And every percentage point in that band has huge leverage over Amazon's business model — in fact, he pointed to it as a reason why Amazon had been "stuck in that band" for nine months before it rallied into earnings. From October 2020 to June of this year Amazon had bounced around but didn't get bid up like the other names until the pre-earnings run. Year-to-date after its earnings fall, the stock is barely holding onto a gain, just under 3%.
What just occurred in all of these stocks was a peaking into earnings, but it's nowhere near peak earnings for these companies, Colas said. The concept of peak earnings, which has been a concern for investors, implies there is a point in the cycle when a company shows its highest earnings growth in absolute terms. "That's what peak earnings are about, and no big tech company is near peak earnings on an absolute basis," Colas said. "Because they continue to grow and their amount of earnings leverage is massive."
That is more likely to be a buy on the future after the sell on the news has worn off.