Stock Selloff May Not End Until This ‘Final Shoe’ Drops

I’ve talked breathlessly about the demolition in growth stocks and, more broadly, the demise of the so-called “duration infatuation” trade that defined the post-GFC era and swelled the collective market cap of US mega-tech shares to the size of several large countries’ economies.

The rapid rise in real yields in 2022 was the last straw — the tipping point beyond which the best tech companies were no longer immune to a disease that began to infect “hyper-growth” names last year, but largely spared the titans until the Fed pivoted decisively hawkish.

Part of any constructive thesis for US stocks going forward is the idea that the de-rating which accompanied the surge in real yields and the attendant underperformance from the stocks that matter most at the benchmark level (and also for hedge funds), is mostly done. After all, a benchmark dominated by a handful of companies will have a hard time rising if those companies continue to struggle.

You’ll note that the FAAMG cohort plus Tesla and Nvidia have given back all their collective gains since 2021 (simple figure above, from Goldman).

But maybe we’re missing the bigger picture. What if we should be measuring from pre-pandemic levels when it comes to assessing whether index heavyweights have fallen enough to justify calling a bottom?

There’s some good news on that score. Facebook has obviously erased all of its pandemic gains. Amazon is essentially flat from pre-COVID levels, and Visa is in the same boat.

However, panning out to the top 25 stocks, which together comprise 40% of index market cap, one comes away less convinced that we’re close to a real bottom. The figure (below) makes the point.

“If we are going to see an index level consolidation back into the 3000’s, the top 25 names will likely have to do the heavy lifting,” Morgan Stanley’s Mike Wilson said Monday.

There’s quite a bit of nuance to be had here, and Wilson went into considerable detail, but my point in presenting the truncated version is to contextualize it via i) the contention that America’s tech titans and other heavy-lifters have fallen “enough,” and ii) the broader discussion about the Fed’s efforts to lean on inflation by bleeding demand through the wealth effect channel.

Recall Zoltan Pozsar:

At 3,500 [on the S&P], we would have lost all of the post-pandemic gains in market wealth, but that level for stocks still feels like a put option, just with a lower strike price. At 2,500, we would lose not only all of the post-pandemic gains, but would eat into some of the pre-pandemic gains too. And if something indeed happened to the supply of labor post-pandemic (and some of that is wealth related), then to cool price pressures, maybe a pre-pandemic wealth level is appropriate indeed.

He was being deliberately provocative (increasingly his modus operandi, it would seem), but the questions he raised are good ones.

On Monday, Morgan’s Wilson reminded investors that “the largest S&P 500 weights have outperformed the most during the COVID era.”

“One could say that the market has worked efficiently with the largest and most stable companies acting the most defensively within the index,” he went on to say. “However, this potentially presents a downside scenario as well where these stocks could be the final shoe to drop before we exit the current bear market.”

To be sure, there’s a good argument to be made that at least when it comes to mega-cap tech, that shoe has already fallen. Just ask equity hedge funds, for whom the rout in FAAMG names was a very expensive headache.

But if the Fed’s unspoken goal is to undo the wealth “overshoot” they helped engineer post-pandemic, there’s still a lot of work to be done. And, as the table (above) makes clear, the usual suspects (including and especially Tesla) could still shed a lot of market cap without eating away at pre-pandemic levels.


Speak your mind

This site uses Akismet to reduce spam. Learn how your comment data is processed.

4 thoughts on “Stock Selloff May Not End Until This ‘Final Shoe’ Drops

  1. Over the weekend, I saw a couple of notes regarding softness in the Hamptons summer rental market. I presume that market is a good “seasonal proxy” for overall Hedge Fund performance. Maybe Joe and J-Pow can cite this as progress in their battle against inflation ?

    1. Possible explanation for that lies in foreign vacationing. The Hampton crowd might be sick of the hamptons after the last 2 summers.

  2. The biggest US companies (SP500) benefited greatly from the pandemic, enjoying high demand, constrained supply of goods and labor, and large injections of fiscal and monetary stimulus. Revenue growth got a boost on surging demand and rapid price increases; while costs increased, pricing power and fixed cost leverage still drove a large lift in profit margins.

    For the SP500, from 2019 through 2022 (using consensus 2022) revenue is expected to increase +29% while EBIT margin is expected to rise +400bp (23% in 2019 to 27% consensus for 2022). (This is rolling up the numbers for all SP500 constituents, market cap weighted – may differ from the reported “index” data).

    Yup, it has been a great pandemic for the SP500. While much of the economy suffered, the unlucky companies don’t matter in the index.

    Now we are in an atypical cycle in which the Fed is actively trying to suppress demand and force asset prices and wage growth down – unlike normal cycles when the Fed supports prices and employment.

    I believe the Fed will not stop tightening until one of three things happens: 1) inflation is substantially lower (by half or so) and heading lower yet, 2) the employment market breaks down with unemployment substantially higher, or 3) something in the financial system breaks (an “orderly” decline in stock prices doesn’t count).

    Translating the above to valuations, let’s assume that consensus estimates for 2022 and 2023 SP500 revenue are correct (consensus has revenue +10% in 2022 and +5% in 2023, so this is not a cautious assumption) but that operating margin in 2023 returns to 2019 levels (about a -500bp drop from current consensus 2023 margin). That would imply that the current consensus 2023 SP500 earnings is about 18% too high. (Again, rolling up from single-stock level). Suppose we use the mid-point of PE NTM range from the last time interest rates rose quickly and the economy slowed (the “mid-cycle correction” period of 2013-2016). That suggests the SP500 may be about 10-20% overvalued.

    Alternatively, a discounted cash flow valuation, assuming a haircut to medium-term FCF estimates and interest rates rising by another full percentage point from today, suggests a similar degree of overvaluation.

    Of course, in the near term, catalysts matter more than valuation (let’s be old-fashioned and assume that valuations matter). Right now, the negatives seem to outweigh the positives. Continued Fed tightening. The war in Ukraine seems likely to continue for at least some time. China is easing its Covid restrictions, but as long as it sticks to a zero-Covid policy new lockdowns can happen at any time. Finally, I believe SP500 consensus estimates will start getting cut – kind of like we’ve started seeing in tech and retail.

    Arguably, if all the negatives are fully “priced in” then they are by definition no longer negative catalysts. One way to assess that is to watch if the stock(s) are reliably going up on new negatives, such as misses, guide-downs, and estimate-cuts.

    As for the FAAMG group, a similar analysis can be done at the single company level.

    1. Given that the piece by Mr H that references an analyst with similar thoughts https://heisenbergreport.com/2022/06/06/bear-market-rally-on-borrowed-time-sp-to-3400-wilson/

      Makes me wonder if we’re watching the train wreck, and how long will it take for the market to actually reflect…
      1. earnings going down
      2. Fed definitely raising rates at least 1.00 (and reducing the balance sheet)
      3. global events aren’t “better”

      (i.e. how long can Retail, Algos, and others keep putting chips in hoping it’s the bottom?)

NEWSROOM crewneck & prints