What reality check is going on in the market? Well, we know that economic forecasts for 2023 were pretty gloomy when they were made in 4Q22. As it happened, the full-year earnings rather gave a positive surprise, and the outlook was not as bad as expected. So far, earnings had a positive surprise in store for 70% of the S&P500 reporting companies.
Stocks rallied on the news. Fine. Why are the markets flip-flopping now? Well, rates are no longer part of the equation. They’ll be higher for longer around 4.5% to 5%, it is priced in, let’s move on. Inflation is still a wild card. Although it looks like it continues to tapper down, used car prices and commodities remain elevated.
Now, the real problem is profitability. All points to the fact that companies are past peak profitability. In FY21, they were passing higher price increase in a rising volume environment, while in FY22 the tide has turned, and consumers are feeling the pinch. The case in point is consumer-behemoth Procter & Gamble. In Oct-to-Dec22 quarter, P&G posted a 3% rise in volume and a 3% price increase. One year later in Oct-to-Dec23 quarter, a 10% rise in prices resulted in a 6% drop in volumes. As a result, earnings per share dropped from $1.66 to $1.59 (-4%) on these respective periods. You can safely imagine that the story is the same for most of retail companies. Profitability goes down.
As the story is unravelling, and the threat of a recession is only milder, but has not disappeared, the recent rise in valuations feels a little uneasy. So, where does the rubber meet the road?
On the one hand, you can give a shot at increasing profitability. First, companies are tidying their ships. Layoffs are rolling out, wage increases are past peak, projects are streamlined. Secondly, m&a activity springs back up, re-centring on core businesses and improving return on capital.
On the other hand, you can count on exogenous forces to boost valuation, or not. Higher rates for longer has the potential to quadruple the interest charge, and the impact will be passed on the companies P&L as they refinance their debt. This might be avoided, as yields go down already. Credit supply is tighter as rates have increased, and it looks like the days of credit-sponsored purchases are behind us. This could result in higher default rates for consumer finance operators, and lower consumption levels.
Lastly, you can count on the “free hand of the market” to give a boost to valuations through sharebuybacks. Simple but efficient, it reduces to denominator of the Earnings-per-Share ratio by reducing the number of shares in circulation, thus mechanically boosting the EPS.
But let’s rejoice. Not all sectors, and companies will be impacted the same way. Agile companies who play their cards right will get a disproportionate advantage in a shifting economic environment. Microsoft incorporating ChatGPT in Bing to challenge Google’s incumbent 70% market share in search engine is a prime example. In a sense, the days of passivity are over, both for those at the helm of companies, and their investors alike. It’s when the going gets tough that the tough get going.
360 Advisory LLC is a Boston-based RIA managing investments, including crypto