WHEN CAPITAL GAINS AND EPS GROWTH ARE 'TRANSITORY'
Market Dichotomy Intensifies as Breath Continues to Narrow
February 2, 2022
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LINEAR EXTRAPOLATION ENDS WITH AN ABRUPT EXPECTATION RESET
Last week we wrote about Netflix and the abrupt nature of selloffs. Much of this dynamic can be attributed to positive momentum turning into negative momentum. The former price action reinforcing itself on the way up and the latter reinforcing itself on the way down.
But, in large part, these kind of elevator down moments are also years in the making. Investors have a tendency to extrapolate positive earnings revisions going forward by slapping future earnings assumptions with a growth rate derived from past performance. Most of the time this works well. If a company grew earnings by 15% last year, it’s reasonable to assume 12% this year and 9% the year after that.
But this kind of exercise does not work well when earnings are positively revised upwards from a temporary benefit. The bigger the temporary benefit, the bigger the eventual expectation reset. Netflix benefitted from a confluence of tailwinds: fiscal stimulus, work-from-home, lockdown measures, etc.
As we write this, PayPal (PYPL) is -26% on the day after reporting earnings. What is particularly interesting is that its FY22 EPS estimates are now completely unchanged since pre-pandemic, valuation multiples are unchanged, and the stock has gone nowhere in two years.
As you can see, Netflix’s earnings expectations followed a similar pattern, and its valuation multiple is actually lower today than it was pre-pandemic. Go figure. Likewise, the stock is only up 11% total in two years (and only recently popped higher when Bill Ackman disclosed a large position).
We aren’t cherry-picking these examples either. Plenty of stocks have round-tripped back to pre-pandemic levels.
THE DICHOTOMY OF THE MARKET
We approach investing from a bottom-up perspective and, from an individual stock standpoint, it appears as though we are already in deep bear market territory. It feels incredibly weird to write this when the S&P 500 is only 5% off all-time highs but our extensive watch list is littered with stocks that have been cut in half over the past year. Many now trade at or below pre-pandemic levels.
While, on the one hand, plenty of stocks have already been taken behind the woodshed, on the other, broad indexes remain in the stratosphere. Breadth is incredibly narrow and only a handful of mega-caps are propping up the S&P 500. The market is totally bifurcated right now.
Investors overwhelmingly expect a correction in Q1-Q2 as the Fed raises rates four times this year (lol ok) and begins to tighten QE. We don’t want to prognosticate what will happen to the broader market but, assuming this does take place, there will be plenty of stocks trading for incredible bargains. A bear market for swaths of stocks followed by a widespread liquidity-driven selloff will present many great buying opportunities if you can separate the babies from the bathwater.