Economy & Markets

Dearly beloved

“Dearly Beloved”: Hurricanes and a eulogy for unprofitable growth stocks

JP Morgan CEO Jamie Dimon stated last week that he expects a “hurricane” resulting from the end of the largest fiscal and monetary experiment in history, and from the ongoing impact of Russia’s invasion of Ukraine on food and energy prices. There are four brief points I’d like to make given the number of questions I have received.

[1] Jamie is one of the most candid and straight-talking CEOs I have seen in my lifetime, particularly in financial services (1980’s JP Morgan CEO Lew Preston who many of us worked for was close). Whether it’s the economy, regulatory costs and benefits, inner city development and job training, tax-funded infrastructure and education programs, energy myths and realities, voting rights, incarceration and “second-chance” hiring or other topics addressed in the annual shareholder letter, Jamie takes a clear stand. You may not always agree with him, but I wish more CEOs would do the same instead of seeking to avoid controversy and candor at every turn. As the CEO of the largest bank in the free world, he has a very informed view of the global economy and I’m always interested in what he has to say about it.

[2] Jamie’s hurricane comments (as I interpret them) are primarily focused on the view that currently elevated US employment, consumption and wages will not survive the unwinding of the Fed’s ill-advised negative rate experiment, the withdrawal of fiscal stimulus and rising food/energy costs. I agree with him. However, there’s an important timing issue for institutional and individual investors to consider. In every business cycle downturn, equity markets lead the economy by several months if not longer. In other words, equity markets anticipate the kind of economic hurricanes that Jamie expects. See the charts below on six major post-war business cycle downturns. In each one, equity markets declined, the economic hurricane worsened a few months later and equity markets bottomed while the economy was still getting worse. That’s what appears to be happening this time as well, at least so far.

Line chart compares the S&P 500 index levels to US GDP throughout the Eisenhower recession from June 1957 to September 1958. S&P 500 index levels bottomed near December 1957, whereas the GDP bottom did not occur until March 1958.
Line chart compares the S&P 500 index levels to US GDP throughout the Stagflation era from June 1973 to March 1977. S&P 500 index levels bottomed in October 1974, whereas the GDP bottom did not occur until March 1975.
Line chart compares the S&P 500 index levels to US GDP throughout the double-dip recession from December 1980 to June 1983. S&P 500 index levels bottomed in August 1982, whereas the GDP decline did not occur until October 1982.
Line chart compares S&P 500 index levels to US GDP throughout the savings and loan crisis of the 1990’s. S&P 500 index levels bottomed in October of 1990, well before GDP bottomed in March of 1991.
Line chart compares S&P 500 index levels to US GDP throughout the global financial crisis from May 2007 to May 2013. S&P 500 index levels bottomed near March of 2009, whereas GDP bottomed a few months later.
Line chart compares S&P 500 index levels to US GDP throughout the global COVID pandemic from January 2020 to December 2021. S&P 500 index levels bottomed in March of 2020, whereas GDP did not reach its bottom until June 2020.

So far, US equity benchmarks (large cap, small cap, growth) are down 20%-30% from peak levels and the US has experienced just one quarter of negative GDP growth. Under the hood, equity markets have sustained more damage than that as we discuss next, since economic risks became more apparent after the surge in inflation and other aftershocks of Russia’s invasion in February.

[3] Any investors taken aback by Jamie’s hurricane remark must not be paying attention: a lot of hurricanes have already hit equity markets. The average stock in the NASDAQ, Russell 1000 Growth Index and the Russell 2000 Small Cap Index is down 40%-50% from peak levels1, with many down much more than that.  The fever dreams of many investors have already been completely decimated.  As such, I have prepared the following eulogy for some growth stocks, many of which are the YUCs (young unprofitable companies) that I’ve been writing about for the last few years.  All figures represent declines from peak levels unless otherwise noted.

“Dearly beloved...

We have gathered here today to mark the brief life and precipitous demise of many growth stocks. Having slipped the surly bonds of Earth just last year, they have now come asunder. Let us pray:

  • hydrogen and other renewable energy companies (-40%)
  • millennial oriented companies like SNAP which traded at 40x sales last year and which now trade at 5x sales2
  • pandemic specials like Peloton which traded at 20x sales last year, and trade at 1x sales now
  • Chinese internet stocks (-70%) whose decline now matches the NASDAQ decline from 2000 to 2002
  •  SPAC IPOs, an ecosystem of adversely selected generally unprofitable stragglers3 whose average post-merger performance trails the Russell 2000 by 35%, an index which has declined by 30% from peak levels
  • the brave new world assessments of the ARK innovation ETF (-70%)
  • the “pop culture disruption” VPOP ETF (-60%) and the “meme stock” ETF (-65%), both of whose names tempted fate and released the furies
  • biotech and genomics (-55%) which now trade at the lowest valuation relative to projected return on equity of all industries we monitor
  • and of course, crypto and its associated flotsam and jetsam (crypto prices -65%, crypto miners -60%, crypto lenders -65% and crypto broker-dealers -80%)

Having fallen far short of everlasting life, may their souls rest in peace.”

Line chart shows young unprofitable companies (YUCs) by % of equity market capitalization. The chart shows that YUCs have declined to pre-2020 levels.

[4] Despite these stock price declines, I do not believe that equity markets have yet hit bottom for this cycle.  That was the theme of our webcast last week: I expect another leg down in equity markets, possibly this summer, as ramifications of monetary and fiscal policy withdrawal become clearer and as corporate earnings and capital spending decline.  We are witnessing the first hint of stagflation since the 1970’s, which is not yet priced in: almost two-thirds of the NASDAQ by market cap still trades with a price to sales above 4x.  The biggest economic tension as things stand now: there are signs that core inflation may be cooling a little bit (e.g., Cleveland and Dallas monthly PCE measures), but tight supplies in oil and gas markets are one or two pieces of bad news away from another spike that would increase inflation and recession risks further.

The challenge: selling now after the equity declines that have already taken place with the goal of buying back at lower levels might require close to perfect timing and a lot of market depth which might not be there at the time.  Generally, after eulogies like the one above are delivered, we’re closer to the end of the market decline than the beginning.  And as shown on the prior page, once a market bottom is made, there’s rarely another significant partial selloff.  In any case, we will continue to monitor the PMI and other leading indicators which have been the best signals for investors to follow in prior cycles.  See the webcast replay for more details.

Webcast replay: Click here

Webcast slides: Click here

Michael Cembalest

 

Exhibits.  The end of the “Gargantua” era: investors will increasingly be left to fend for themselves without fiscal and monetary stimulus

Line chart compares the Fed balance sheet as a % of US GDP, real policy rates (inverted), and fiscal deficit as a % of US GDP. The chart illustrates the massive increase in all three series as a result of large amounts of monetary and fiscal stimulus
Gustave Doré, Scene from "Gargantua", 1875
Watercolor over pencil on paper, 13 1/16 x 19 1/2"
Frances Lehman Loeb Art Center, Vassar College
Gift of Mrs. R. Kirk Askew, Jr., 1983.40.1
Exhibits: inflation still peaking while growth and profit indicators are heading down; energy prices
Line chart shows leading indicators (short rates, 10-year DM and EM bonds yields, Brent oil and US dollar) which have served as a proxy for the global manufacturing survey from 2007 to now. These indicators point to a steep decline in manufacturing this fall.
Line chart shows wage growth in low wage sectors vs price increases by companies with low wage workers. The chart illustrates that companies that hire a lot of lower wage workers are paying large wage increases which they are passing along to customers
Line chart shows US oil prices per barrel since 2005. The chart shows that oil prices have spiked significantly since 2021, rising from below $40 to ~$120 per barrel.
Line chart shows natural gas prices in USD per MMBTU for US, Europe and the UK. The chart shows that Europe and the United Kingdom are experiencing 2-3x higher prices than the United States for natural gas. However, the current price of $9 per MMBTU in the US is significantly higher than the US long term average of ~$3 per MMBTU.

1 “How attractive is equity valuation?”, JP Morgan Global Markets Strategy, May 27, 2022

2 As I understand it, Apple’s new privacy policy effectively allows people to avoid being tracked, which reduces the value of advertising on SNAP and other similar platforms

3 See “Hydraulic Spacking”, Eye on the Market, February 8, 2021 which I wrote at the SPAC market peak, and “Spaccine Hesitancy”, Eye on the Market, August 19, 2021

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