Ground Zero

By David Nelson, CFA

Ground Zero
the point on the earth’s surface directly above or below an exploding nuclear bomb.

2022 has forced investors to rethink popular mega cap growth strategies that have dominated investor returns for most of the last 12 years. Of course, its outperformance coincides with a Federal Reserve quantitative easing policy that started post the financial crisis. Keeping the risk-free rate at close to zero for most of that time and an ever-expanding balance sheet the Fed continued to pump liquidity into the system.

IVW (Growth) vs IVE (Value) vs S&P 500

Data by Bloomberg

Today, the Fed is in the process of unwinding that policy as the debate centers on just how much they will have to tighten financial conditions to fight an inflation threat that has forced them to retire the phrase transitory. The TINA trade (There Is No Alternative) suddenly doesn’t ring true as institutions including pension plans, endowments and insurance companies are turning to high grade corporate bonds to match assets with liabilities.

The popular group of mega cap stocks or FANG trade has morphed through the years. Today I use FAANMG including Meta (FB), Apple (AAPL), AMZN (AMZN), Netflix (NFLX), Microsoft (MSFT) and Alphabet (GOOGL). Other stocks in technology and communications have fallen much further. Some cloud and stay at home favorites like PTON and ZOOM are down 90% and 83% respectively.

But FAANMG is where the money is and clearly Ground Zero for capital losses. The group comes in at just shy of $7.8 Trillion in market cap. Add Tesla’s (TSLA) $897 Billion and you’re talking serious money.

Ground Zero

Data by FactSet

Given the sheer size and wide moats around their business models many money managers have chosen to keep some exposure even if underweight. In hindsight if you sold the group in January, you’d be feeling a lot better about your performance this year. 

One by one the mighty have fallen with Apple as the last domino and only one of the group currently outperforming the S&P 500 year to date. While multiple compression on the heels of rising rates which act as Kryptonite for growth shares tops the list of investor concerns, more than half the names have witnessed significant slowdowns in their revenue and or subscriber base.

S&P 500 vs NTM Earnings

Data by Bloomberg

Apple, Microsoft, and Alphabet put in the best quarterly returns but even for Apple chinks in the armor have developed. Close to 19% of AAPL Revenue comes from China not to mention a significant manufacturing footprint in a country that can’t seem to get a handle on its current Covid response. Turning to zero-covid policy in part because they don’t have an effective vaccine the rolling shutdowns have caused havoc throughout global supply chains sparking a worldwide de-globalization effort as countries look to decouple. Today, the prevailing view is that dependence on a single country or region for critical supply chain needs is a national security threat.

Apple Revenue Exposure by Country

Data by Bloomberg

Supporting Apple is a P/E ratio of 25x below most in the tech sector and a reasonable Free Cash Flow Yield of 4.2%. A 0.6% dividend is nothing to celebrate. Unfortunately, at 25x earnings, mid-single digit top and bottom-line growth is hardly compelling forcing management to turn to the standby financial engineering routines of buying back stock. Apple repurchased $22 Billion in the previous quarter and is currently working off a $90 Billion authorization. I don’t mean to signal out AAPL in that stock buybacks are a Wall Street gimmick used by many companies to prop up the bottom line. Of course, it does nothing for revenue or net income. Just earnings per share because the share count is lower.

Can Buybacks Save Us?

The debate looms large as buybacks have become a political battleground in Washington with many including yours truly questioning its real value to economic output. However, I do concede it is a wonderful tool to prop up earnings per share targets and other metrics used to reward management. Those bonuses usually aren’t cash and are almost always in stock, further diluting the shares forcing companies to go into the open market and buy back stock just to hold the EPS flat. Over time the CEO is essentially selling his shares back to the company.

Percentage of stocks trading above their 200-day moving average

Data by Bloomberg

Bottoms often happen when investor sentiment is at its worst and the last dominos have fallen. While the percentage of stocks above their 200-day moving average has been falling all year we’re still not at levels associated with other washouts. Since 1993 many occurred in the low 20’s. The financial crisis and covid pushed stocks trading above the 200- day moving average briefly below 10%

Catalyst for a Growth Rally

If there’s a near term event that could push investors to the other side of the lifeboat and back into growth and tech shares it could be this week. On Tuesday and Wednesday, we get back-to-back inflation reports including the CPI (Consumer Price Index) and PPI (Producer Price Index). Inflation isn’t just a hot button for Wall Street but Main Street as well. Inflation expectations in an election year will shape the debate and weigh heavy at the polls.

Sentiment is awful and positioning against tech and growth is very high so any good news could spark a strong reversion to the mean trade. I have no edge on the number. I’m paying the same high prices at the pump and grocery as you are.

The Value Trade could last a while

Data by Bloomberg

Growth investors have taken the pain in the past but often bounced back quickly. The changing dynamic this time seems to be a Federal Reserve determined to stamp out inflation even at the risk of tightening into a slowing economy. I don’t think one good inflation report, or a hint of economic slowdown will change FOMC resolve like we got in the 4th quarter of 2018. The Fed Blinked and we were off to the races.

Stock factors that lean toward value and dividends have been leading for about a year. The last time Large Cap Value (IVE) outperformed on sustainable basis was post the bubble. It lasted for close to 8 years.

*At the time of this article some funds managed by David were long AAPL, MSFT and GOOGL