We are interrupting our series on the Political Economy to address concerns voiced by clients about the recent decline in the Mega-cap NASDAQ stocks.
“What’s happening with my portfolio?”
Just a few short weeks ago, many market watchers reported that this market could not be stopped. Many believed the boom in technology stocks was destined to continue as the new shelter-in-place economy favored high-growth companies that benefit from a work force that works remotely. Even so, periodic profit-taking is to be expected on Wall Street—and the market was due for a breather after a great run: The S&P 500 Index and the Nasdaq Composite had enjoyed five straight weeks of advances prior to the Labor Day weekend.
In fact, the Nasdaq Composite hit an all-time high on Tuesday, September 2, 2020. Yet, it was a handful of companies, including Amazon, Apple, Alphabet (Google), Facebook, Microsoft, and Tesla that drove this achievement, representing nearly 49% of the value of the Nasdaq 100. Overall, the Nasdaq Composite was trading at its highest price-to-earnings ratio (P/E) since 2004, courtesy of these superstars. Market exuberance for these companies drove their valuations higher and higher, making their “P” (price) out-of-whack with their earnings estimates, the “E” part of the ratio. On September 8, 2020, the day after the Labor Day holiday, a price correction began.
Some time ago we explained that the market was being carried by a small number of companies that had become significantly overvalued. We explained that every company’s stock price ultimately corrects to reflect the value of the future earnings of that company. To further assist in explaining this concept, we will examine the valuation of the most valuable company on the planet: Apple.
Between September 2008 and September 2019, Apple shares traded in a P/E range between approximately 10 on the low side and 18 on the high side. Translation: During that 11-year period, $1 of Apple earnings generated a stock value of between $10 and $18 per share. On September 1, 2020, the P/E of Apple was approximately 40. Translation: $1 of Apple earnings created a stock value of $40 per share. In the most recent quarter, Apple had earnings per share of $3.28 resulting in a September 1, 2020 price of approximately $134. Today, just 12 days later, the P/E ratio has come down to 34 and the share price to $112. If Apple were to trade back to a P/E ratio of 18, the stock would be trading at a price of $59—47% below the current value!
Why a correction? Why now?
There are a host of factors influencing investor psychology. For example, Amazon has benefitted enormously from consumer behavior during the pandemic—as evidenced by its stock price, hitting as high as $3,552 on Tuesday, September 2. As of Friday, September 9, however, Amazon’s stock price closed at $3,116, down 12% from the peak. This decline may be attributed to nothing more than profit-taking. It may be attributed to sellers recognizing that more people are getting out-and-about and returning to their prior way of shopping. It may be attributable to recent speculation about a coronavirus vaccine being available before the close of the year. In essence, perhaps, this price correction can be attributed to returning to a more “normal” way of life. If so, one would expect that Amazon would experience some sales declines as shoppers return to their pre-pandemic behavior.
With volatility increasing, stock traders seek economic data from a variety of sources. A primary source of information is the Federal Reserve’s Beige Book, which is published eight times a year, in advance of its Open Market Committee meetings at which monetary policy is discussed and established. The most recent edition of the Beige Book was released on September 2nd, making it a likely contributor to the market correction.
A summary of surveys taken in each of the Fed’s twelve districts, the Beige Book contains crucial anecdotal feedback from leaders in businesses, nonprofits, and educational institutions. It is intended as a complement—not a replacement—for the quantitative statistical data on employment, unemployment, personal income, retail sales, and real estate markets that are used to analyze regional and national economic conditions. Jerome Powell, chairman of the Federal Reserve, delivered a preview of the Beige Book findings on September 4: “The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern. Many find it counterintuitive that the Fed would want to push up inflation. After all, stable and low inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes. However, inflation that is persistently too low can pose serious risks to the economy.”
Without saying it, it is clear that Mr. Powell is wary of deflation, the cause of the Great Depression.
This sobering dose of reality is emblematic of what we have been communicating to clients since the end of March: There is an underlying disconnect between Wall Street and Main Street. We have been purposeful in our writings to explain that there are periods of time during which Wall Street valuations and Main Street economic activity become disconnected. When the Federal Reserve floods the economy with money, that cash often finds its way into the financial markets. When the Washington politicians dole out trillions of dollars of “stimulus” money, that cash can also find its way into the financial markets. Excess cash flowing into the markets often creates an upside bias with stretched valuations. That condition can persist for an extended, but not infinite, period of time.
Clearly, this matters.
At PWA Wealth Management, we regularly communicate our understanding of economic and market activities so that you can better understand our investment choices and planning recommendations. During the pandemic, investment criteria has become more stringent, more selective. The good news is there are investments with solid value propositions—and PWA is studying and evaluating these opportunities on your behalf. We are working diligently to identify, assess, and exploit responsive and responsible investment strategies for our clients. Ultimately, our efforts are aligned with your goals, timelines, and risk appetite, as reflected in a personalized Goal Policy Statement (GPS).
Thank you for your continued confidence.
Joseph A. Scarpo
Founder & CEO