Image Source: Pravine Chester
It’s no secret that investors have been disappointed with returns across the equity market in 2015, and this week has not made the unrest any easier to deal with. Money managers across the globe will be looking at a short-term chart of the S&P 500 (SPY), observing that the broad US index has finally broken down from a critical multi-month base, and many will look to “lighten up” on some of their equity positions that they have been reluctantly “letting run” for months.
It is no surprise to us why Netflix (NFLX) was one of the market’s worst performers in Thursday’s trading session. The company is trading at nearly 500 times earnings (not a typo), and the low end of our fair value range is still roughly half of its closing price. Subscribers across the media landscape aren’t paying for content like they used to, something we uncovered in Disney’s (DIS) recent outlook, and media stocks, while generally overvalued, may be hinting that consumer spending could disappoint in coming periods.
Investors are looking to take some profits, and here are three reasons why de-risking may be a prudent idea:
1) We’ve yet to feel the full impact of China’s collapsing stock market. China’s (FXI) economy may be entering a new and lower trajectory of expansion as it navigates the aftermath of the collapse in its stock market during the past few months. We outlined here that very few companies levered to the country have been spared tangible, fundamental pain, and we received news today that, according to Gartner, total smartphone sales in China dropped for the first time in history (-4% on a year-over-year basis).
We’re not taking the impact of the shrinking wealth effect from plummeting Chinese shares lightly. Consumers in the country are hurting. From gaming stocks [LVS, WYNN, MGM] and luxury stocks [CFRUY, LVMHF] to auto makers [GM, VLKAY, F] and Internet giants [BABA, BIDU] and mining giants [BHP, RIO, GLEN] and beyond, we’re waiting for the other shoe to drop (read: downward guidance revisions).
Worse, the Chinese government, despite its best efforts, does not seem to have control of the situation. The country’s equity markets continue to trade wildly, despite ongoing interventionism, and we don’t expect this to change. With greater uncertainty, capital outflows may accelerate.
2) Energy bellwethers continue to model $70+ crude oil prices. Many executive teams across the energy space are still holding on to yesterday. Despite the myriad capital spending cuts across the energy complex as project NPVs dry up, some have yet to face the music and update their budgets for ~$40 per-barrel crude oil pricing, which is the current reality.
We wrote here how the globe is drowning in crude oil, with OPEC engaged in a fierce pricing war against US shale domestics and US field production still the highest since the 1980s, or earlier. Weekly petroleum data recently revealed that crude oil inventories haven’t been this high for this time of year in 80 years. The glut of oversupply is only part of the story though. As currencies around the world weaken relative to the US dollar, the dollar-denominated black-liquid commodity may face ongoing pressure. The devaluation of the Chinese yuan is only the most recent event, as the US dollar has strengthened nearly 20% against a basket of currencies since July of last year. Multi-nationals have been feeling the pain of currency headwinds for some time.
The bias to crude oil prices, in our view, is lower than today’s levels, and investors continue to ignore that it has only been 17 years since crude oil prices were ~$12 per barrel. OPEC is producing to put most US independents out of business, and while full-cycle costs have been estimated at ~$40/boe, the marginal cost of bringing one barrel of oil equivalent to the surface is less than $14 today. Credit spreads have “blown out” across the energy space, implying higher probabilities of default, and bankers are looking to cut further losses on debt paper, if they can.
Even the perceived “safe” dividends of oil giants such as Chevron (CVX) and ConocoPhillips (COP) may be tested, as both are burning through free cash as they pile up more and more debt. Projects that had been profitable just a few months ago are no longer, and charges in the hundreds of millions have already been reported. These two bellwethers were removed from the Dividend Growth Newsletter portfolio some time ago with their hefty gains intact. In just a little over a year, ConocoPhillips has witnessed its shares fall from the mid-$80s to under $50.
3) Broader market valuations matter. We learn time and time again why valuations matter. The stocks that get hit the hardest during times like these are the ones that have moved “too far too fast,” and we’re seeing many across the traditional “momentum” arena take some big hits. Netflix, for one, but Twitter (TWTR) and Facebook (FB) also are under pressure. The iShares Nasdaq Biotechnology ETF (IBB) shed more than 4% Thursday, as investors take profits on the group’s phenomenal run these past few years. “Hard-to-value” equities often feel the most pain when market uncertainty increases. We’d put Twitter in the “impossible-to-value” camp.
But the broader equity market is not cheap either. On the basis of FactSet’s S&P 500 forward earnings estimate of $127.40, as of August 6, the broader S&P 500 index is still trading at 16 times earnings, above both its 5-year and 10-year averages. Investors may be forgetting that the US equity markets have essentially tripled since the March 2009 panic bottom, and a modest 15%-20% “correction” from all-time highs wouldn’t be unusual. The dividend-growth heavy consumer staples and healthcare sectors may not be completely spared from the sell-off either.
We’re not panicking, as we’ve been prepared for some time for whatever the market may throw at us. Both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio have been sitting on 30% cash, waiting for some of the “air” to come out of the frothy US markets. We’re not quite ready to add protection to the portfolios, but we’ll be looking to opportunistically lighten up on some of our outsize weightings. No sector was spared in trading on Thursday, as even the utilities shed ground. The bias, at least in the near term, is to the downside.
