Stocks swooned yesterday after a services PMI came in hot prompting fears that the Fed will raise rates higher than expected next year. A strong showing in economic numbers implies that the economy remains healthy… except for the fact that all those numbers except 1 are lagging indicators.
Look who’s borrowing now. I know we have all been a little obsessed with interest rates lately. Yesterday morning we got an oversized batch of stronger-than-expected economic numbers which caused bond yields to spike and ultimately caused equities to drop. This has been a recently common theme which, I am sure, that you are quite familiar with. Good is bad. Why? Because “good” means that the Fed will have more room to raise rates higher, faster, and for longer. Over the past year or so investors have been trained, in Pavlovian fashion, to regurgitate their stocks when yields go up. Most of them kind-of know what the reason is, and I have spilled much ink on the topic. The fact is that the relationship exists and yesterday was proof that the learned response is still strongly entrenched. I sometimes speak about it in a joking fashion as the basis for the relationship is deeply steeped in somewhat obscure financial theory. However, at the end of the day, theory or not, the market is the ultimate arbiter over the success or failure of your investments. If you buy stocks that everyone wants to own, you may enjoy some limited near-term success and you may realize that success if you are lucky enough to sell before everyone else changes their minds and moves on to another “great” idea. I say that jokingly as well. You all know that there are many fundamentally strong companies with good products that always underperform the market and that is because… well, the market just doesn't favor them. But before I convince you that stock prices are all random, I want to press on the brakes. Strong fundamentals DO matter, especially for investors. Investors, you know, the folks who invest wisely for the long run, as opposed to traders who seek quick short-term gains and most likely receive an equal, if not a greater, number of losses. Strong fundamentals along with competent management give investors the highest potential for long-term success. Now, that doesn’t mean that a strong stock will simply only go up for ever and ever. Macroeconomic strength ebbs and flows. Wars and pandemics happen. Did I miss any calamity from the past 3 years? That means even strong companies have good times and bad, but the best ones emerge from those challenges in a position of strength.
Why am I writing this now? You probably assume that all those attributes exist in all the companies’ stocks you own, and they may have… at one point. I am writing this now because fundamentals are becoming more and more critical as we enter this challenging stage for the global economy. There was a time, not too long ago, where most investors were intrigued by companies with HUGE growth prospects which may not even have been profitable. Buying some of those companies were likely profitable trades, if timed properly. Many of those emerging companies with good prospects relied on lots of borrowing to make ends meet. “Unprofitable” implies that you are spending more than you are making, and for companies that means borrowing from capital markets, banks, and investment companies in order to survive. Now, ALL companies, weak and strong, emerging and established, are facing sales headwinds. Rational companies, when faced with this dilemma, initially cut excessive costs to maintain margins. When those opportunities to save run out, companies resort to layoffs. First non-essential employees are sacked and then over time the layoffs become more widespread. That is painful, but if the company manages to navigate the process effectively, it could emerge even stronger after the storm.
Going back to all that fund-raising for less-than-profitable growth companies. Emergent companies with little or no revenue must pay higher interest in order to get their hands on life-giving capital, because they are a higher credit risk. Most of those companies can barely cover their debt service. Debt service is fancy financial terminology for payments, like your monthly credit card bills. If, under diminished circumstances, a company is unable to cover its debt service, it is likely to default. As the word implies, that is not a good thing, especially if you own those bonds. That situation is made even more challenging in a rising interest rate environment. No matter what your credit rating, you will pay more to borrow money today than a year ago. So, companies who rely on borrowing to stay afloat will find it more expensive to do so… assuming that they are even able to borrow. Oh, and it gets worse yet. Many of those companies have variable rate debt, such as leverage bank loans. That means interest payments can go up if interest rates, in general go higher… which I am sure you have noticed, they have. Now, even healthy companies use floating rate debt, and that can be a challenge for them in this current environment, but weaker companies tend to rely more heavily on those types of instruments. You don’t have to search too far on the Internet to find an article or two from either Moody’s, Standard & Poor’s, or Fitch to see that those rating agencies expect global defaults to rise next year. What does this all mean for stocks?
Though earnings season is mostly over with the last few trickling, we can comfortably say that companies are cutting costs, laying off, and lowering sales forecasts. These revelations are coming from upstarts as well as well-established companies. Higher debt service means decreased profitability, and a credit default is sure to affect a company’s stock… er, negatively. As mentioned above, all will be challenged in the months ahead as a growing number of economists are expecting an economic downturn next year. It is, therefore, more critical than ever… or at least, the last 10 years or so, to make sure that your portfolios are diversified with companies that have strong fundamentals and capable management. A strong horse with a capable rider is a better bet than a fast horse with a hotshot jockey… especially when you are expecting a long, arduous trek.
WHAT’S SHAKIN’
NRG Energy (NRG) shares are lower by -6.68% in the premarket after it announced that it will be buying Vivant Smart Home (VVNT) for $2.8 billion, which represents a +33% premium over yesterday’s close. The company announced earnings early last month, missing on earnings but beating on Revenues. Dividend yield: 3.43%. Potential average analyst target upside: +8.7%.
Textron (TXT) shares are higher by +9.30% in the premarket after it was announced that the US Army selected Bell Textron’s V-280 Valor as its next-generation assault aircraft. The company beat out Lockheed Martin (LMT) and Boeing’s (BA) to replace the Blackhawk helicopter. Dividend yield: 0.11%. Potential average analyst target upside: +16.7%.
JPMorgan Chase (JPM) shares are higher by +1.47% in the premarket after received a rating upgrade to BUY from SELL by Morgan Stanley. Dividend yield: 3.04%. Potential average analyst target upside: +6.9%.
YESTERDAY’S MARKETS
Stocks sold off yesterday on stronger than expected services PMI numbers (I warned you). The S&P500 gave up -1.79%, the Dow Jones Industrial Average fell by -1.40%, the Nasdaq Composite Index traded lower by -1.93%, and the Russell 2000 Index dropped by -2.78%. Bonds fell and 10-year Treasury Note yields gained +8 basis points to 3.57%. Cryptos fell by -1.51% and Bitcoin lost -0.83%.
NEXT UP