Stocks are ignoring the fundmentals

The market has swung fairly aggressively in both directions over the last 2 years, and all before we’ve actually seen the consequences of higher rates.

Does the slight difference in ‘terminal rate’ really justify Apple losing $846.34 billion in 2022, and then adding $1 trillion in 2023?

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That’s rhetorical: the answer is no.

The long-term resting place for interest rates over the next few years will make some difference, as will US GDP, but mostly, the mega-tech firm will need to find some way of improving its own growth. Such ‘fundamentals’ seem to be all but forgotten.

For 15 years, rates were close to 0%. Now, they will remain between 3% and 4% for the foreseeable future. That is a lot higher than before, but the finer details haven’t stopped a rally in both small-caps as well as mega-tech.

As of 1^st November, small-cap indexes were down close to 5% for the year. Today, the Russell 2000 is up nearly 16% year to date and it’s all down to shifting rate expectations. But the main shift has simply been that cuts will come sooner in 2024 than originally expected.

Rates will still remain high compared to the last 15 years, and this will have to have some repercussions on refinancing for companies. Input prices are more expensive as inflation really was a thing. Higher prices in, higher prices out, higher interest rates on debt will all filter through to corporate profits.

Small-caps' rebound is more simply down to shifting expectations for Federal Reserve policy rather than with fundamentals.

Investors have been nervous about economic and earnings growth over the next few quarters. However, the growing belief that the Fed has stopped its aggressive interest-rate increases brought buyers into these battered stocks.

This seems a little exuberant and may not have been fully thought through. ‘Interest rate’ was the buzzword of 2023 but we haven’t actually seen any consequences other than a very brief blip known formerly as Silicon Valley Bank.

We believe that recession will be the buzzword of 2024.

They may be avoided in some parts of the world, but not all. We only tend to face the problem right in front of us, and if inflation comes down to normal levels, we need to address the next issue. Assuming there are no more invasions next year, it will be recessions.

Ironically, it was a spate of ostensibly bad news that set up the recent rally. For components of the S&P 600 index, 2024 earnings per share estimates are down 33% in the past year and a half, according to FactSet. Expectations for profit margins are down amid higher product costs, higher employee pay, rising interest expenses, and fixed costs such as depreciation of equipment. 

This is all especially painful for smaller companies — the S&P500’s 2024 EPS projection has dropped about 9% in this span — because smaller firms generally have more difficulty cutting costs. In addition, a larger percentage of their debt is short-term, which means their re-financings happen at higher rates, adding interest expense. 

At 14 times the lowered earnings estimate for the coming 12months, the S&P 600 trades 28% lower than the S&P 500’s 19.4 times, bringing small-caps close to the cheapest they have been versus large-caps in the past decade, according to FactSet. Although this is more likely to be that large-caps are expensive, rather than small-caps are cheap.

No company comes with as many big numbers as Apple. The stock is up 50% in 2023, adding $1 trillion in market value, to exceed $3 trillion today. Apple's net income reached $97 billion on revenue of $383 billion in its fiscal 2023, which ended in September.

A pair of numbers that have been rather small lately are Apple's earnings and revenue growth rates. Sales were down last year. Earnings per share ticked up only 0.3%, even after lavish spending on buybacks.

You wouldn't know it from the stock's rip-roaring rise in 2023. The result is that Apple shares have only gotten more expensive. They now trade for a forward price/earnings multiple of 30, up from 20 at the start of the year — and a 50% premium to the S&P 500.

This is the Apple paradox: The company’s stock trades near record highs, with a market value no other company has ever attained. But its growth is gone — sales fell 3% in the latest fiscal year, and they’re forecast to be up less than 4% in the current fiscal year, which ends next September — and there’s no clear plan for getting it restarted. 

It’s possible that Apple could stick to its current script and still find a way back to top-line growth. It requires some optimistic assumptions about the upgrade rate for iPhones, an ever-rising sales price for its devices, and continued low-double-digit growth for its portfolio of services, including the App Store, Apple Music, and iCloud. 

But Apple’s legacy is innovation, not incremental feature creep. Apple fans — and its shareholders  — have been trained to expect products that are insanely great, that think different, or that “put a dent in the universe,” as co-founder Steve Jobs once said. 

At the end of the day, Apple's fate and fortune depend on the iPhone. Sales of that device — which was first introduced in 2007 — generated some $200 billion of sales in the past year, or about half of Apple's total.

That's not the growth market it once was. There are few flip-phone users left to convert to smartphones, and people are holding onto their devices longer between upgrades. iPhone sales were down 2% last year.

Unfortunately for Apple, the iPhone is also the biggest driver ofsales for many of its services and other hardware products. People pay foriCloud storage because of how seamlessly it works with their Apple devices, forexample. And, "there aren’t a lot of Android phone owners with an AppleWatch," Eric writes.

Elsewhere, sales of Mac computers and iPads have also flatlined or declined lately. Expectations for Apple's upcoming $3,499 Vision Pro headset are modest.

It's a challenging setup for a pricey stock at a record high, to say the least.