Still under Powell’s thumb; Quo Vadis Capital November investing letter

As we have written in previous letters, stock prices are simplistically a function of only two factors. They are expected future earnings and the multiple investors are willing to pay for those earnings.  This multiple is also commonly called a stock’s valuation, frequently expressed as a ratio such as price-to-earnings or P/E.  We have observed that when earnings expectations are rising (companies are performing better than expected), the multiple that investors are willing to pay expands.  When earnings estimates are falling (companies are missing analyst expectations or guiding lower), the multiple compresses.  In both scenarios (expansion and contraction) we have seen many examples when momentum takes over and demonstrating that there is no limiting factor to valuations.

Let’s take the NASDAQ (an index normally considered a proxy for technology stocks) to illustrate this point.  In aggregate, these businesses benefited from the Corona-panic lockdowns, stimulus dollars, and monetary policy (ultra-low interest rates).  Earnings growth accelerated.  In 2022, some of these profit gains have reversed.  Inflation has not been helpful.  Rising interest rates have clipped earnings, partially via the impact on the strong US dollar, which has reduced the value revenues and earnings for global companies.  Expected future earnings for the NASDAQ peaked in May 2022 (see chart) and have since been caught in downward revision cycle.

Last month, we wrote about a “positive” signal, that being a big drop in job openings.  Unfortunately, the trend was not sustained, as job openings rebounded (you can check out the chart here).  The U.S. also managed to generate another month of job creation in October.  We have heard that hiring in housing-related industries has screeched to a halt.  There have also been sporadic layoff announcements and hiring freezes from a few tech companies.  However, this has not offset robust hiring in other industries.  (Musk’s attempt to help by eviscerating Twitter won’t do much, sorry.)   The bottom-line is that demand for workers has not reached equilibrium with supply.  This continues to put upward pressure on wages, a key inflation input and one of Powell’s main considerations for additional interest rate increases.

There are two main issues with the Fed’s tool to put the breaks on the economy. The Fed cannot control the economy directly.  It can only influence it via monetary policy.  (Fiscal policy, i.e. taxation and government spending is the purview of Congress and the Administration (the President) and this may or may not work in concert with what the Fed is doing.)  Anyway, the main tool at the Fed’s disposal is interest rates.  When rates are higher, borrowing and financing investment becomes more expensive for companies and consumers.  This means earnings (after borrowing costs) will be lower and growth will slow (due to lower investment spending).  This is the first issue and the reason stocks sell off when rates go up or are expected to move up.  The second issue is that the impact of higher rates is only evident after a significant delay of indeterminate length.  The Fed’s objective is to cool off the economy and bring inflation under control, but the markets are concerned the rate increases are too much, too quickly, and will end up trashing the economy (causing a recession).  In this scenario, the expected earnings for companies will be much lower than currently forecasted, which means more downward revisions.  Until this cycle is broken, multiples are going to keep contracting.

This should be a positive catalyst for stocks.   The main issue for stocks is going to remain the interest rate-inflation complex.  However, policies in Washington also matter.  Without making a political comment of any kind, in general, the markets prefer status quo and when neither party is in full control.  Currently, the Democrats control the Presidency and have narrow majorities in both branches of Congress.  Assuming Republicans take back either the House or the Senate, this should be perceived positively.

We have owned GOOGL shares in client portfolios since inception (2018).   GOOGL has not been spared the tech wipe-out and has lost 40% of its value year-to-date.  The company’s core advertising business does have some cyclically and expectations for future earnings have been revised lower.  Back in April, analysts thought GOOGL would earn about $6.12 per share over the coming year.  Now analysts think earnings will be around $5.27.  This represents a 14% decline in expected earnings relative to peak estimates.  The negative reductions are not wonderful but when we think about Google’s long-term positioning as a business, it’s challenging to identify something that has changed.  Arguably, Google’s position is so dominate and essential that if it were to cease operating for some reason, a significant portion of the internet and modern life in general would simply stop functioning. The company has built an incredibly profitable business around its dominate position, enjoying operating margins (EBIT) of nearly 28% over the past year.  Reflecting the company’s scale and its profit margins, GOOGL has also amassed a net cash position over $100B on balance sheet.  Looking back over the past 10 years, GOOGL has traded at an average P/E ratio of 23x.  Negative revisions spark valuation contraction, as we’ve discussed, and numbers might still be headed lower.  Nevertheless, the current P/E on 2023 and 2024 EPS estimates are 16x and 14x, respectively.  We can’t say the valuation won’t go lower first, but we ultimately expect GOOGL will grow its earnings again even in a post-bubble Powell-controlled world and we feel confident that valuations will expand from current levels when the positive inflection becomes visible.

* Consult your financial advisor for advise appropriate to your financial situation and risk tolerance.

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