2018 was a “difficult” year for most investors. Long bull markets in both US equities and fixed income encountered severe headwinds, and international stocks underperformed following a strong 2017. The fiscal stimulus from tax cuts that took place in late 2017 started to fade. This stimulus slow down paired with the Fed’s unwind made for the worst fourth quarter in a decade. Still however, analysts and pundits alike continue to step in and tell you why this time the economy is different and that though there is a slowdown, there is no recession or serious economic fault taking place. I’d like to take a minute and address the extreme opposite case and assess possibilities for why this could be incorrect and give some context should these assessments in fact be incorrect.
AAPL
Apple (AAPL) warned about financial results this afternoon, calling for first quarter revenue to fall ~5% Y/Y. That might sound like sacrilege to Apple fans but it doesn't come as a huge surprise given warnings and reports of order cuts from suppliers. However, this is pretty unprecedented news for Apple, which has been enjoying stellar sales of the iPhone for over a decade. Tim Cook and AAPL have been able to deliver strong quarters time and time again regardless of reports regarding order cuts.
Looking back, the degree to which suppliers recently warned about financial results (QRVO, LITE, SWKS etc.) was proof that this time was different. The second tell should have been Apple’s decision to no longer give itemized breakdowns of iPhone sales figures. Specifically, Apple has been focused on increasing iPhone ASPs (Average Selling Price) and driving service revenue. Unfortunately for them, and for the market, this shift is not matured yet and does not offset the decay that they will ultimately see in iPhone unit sales.
Apple said fewer people upgraded iPhones. The company said "Lower than anticipated iPhone revenue, primarily in Greater China, accounts for all of our revenue shortfall to our guidance and for much more than our entire year-over-year revenue decline." In the first quarter last year, iPhones accounted for 70% of revenue while Great China represented a 20% overall geographic mix.
This news will surely add to broader market fears about the slowdown in China and Sino-US trade tensions.
Apple guided for 'record' EPS, but the forecast down the income statement implies Q1 EPS of $4.16 vs. $4.65 consensus and $3.89 last year.
The stock was down 29% since guiding down first quarter estimates and announcing the reduced disclosures on November 1. Prior to the announcement, the stock was already trading at 12x FY19 earnings estimates. Earnings estimates will clearly come down tomorrow along with the share price.
Apple (AAPL) -7% is weighing on the Nasdaq 100 (QQQ) -1.8%, technology stocks (XLK) -2.6% and chip stocks (SMH) -2.4% in the after hours.
On a daily chart, AAPL is probing its recent lows (146.59) made on Christmas Eve. Should this support fail, look for the stock to try to gather itself around the 140 level as the coincides with its monthly trend line from its climb starting in 2010. Should that level break, AAPL will contend with breakout support near the 135 level.
BIG BEAR?
As stated above this is a monuments occasion as AAPL has been the largest beneficiary of the repatriation tax cuts. Specifically, AAPL has been able to buy back and shrink its share count pretty substantially with the repatriated dollars the company has been able to put to use. Beyond that, AAPL has often been viewed as “teflon” and able to sustain almost every fearful hit. Now, AAPL joins a list of large corporations that have stated quite plainly that economic headwinds have in fact impacted their business. In many of these other instances (FDX for example) the mention of tariffs was inferred but not necessarily direct. In this case, AAPL specifically mentions China and creates an added fear that the imposed tariffs may drive world economic output to a grinding halt faster than anticipated.
This guide down, though predicted by some (like Gene Munster), caught the majority off guard. It has an eerily similar feeling to the guide down by CSCO in 2008. Specifically, in 2008, CSCO was the first large technology company to reveal its sales data dropped 9 percent compared year over year. On Nov. 5 2008, Cisco cautioned because a “completely of different environment,” revenue in its current quarter could plummet as much as 10 percent. At the time, this was a major reversal from the 7 percent growth that Wall Street had been expecting.
With these similarities, it is important to consider the potential for the unseen and/or unexpected. Though many are weary of a potential recession and/or bear market, the predominant majority of analysts have not lowered their earnings estimates specifically for this reason. In fact, many analysts have brought down their estimates as a function of the overall market coming down. This is cautionary as the same type of events transpired in 2008. With that in mind, I found it to be an important exercise to take a look at how previous bear markets turned out and just how dangerous/ugly this could potentially get.
The SPX has had 13 bear markets since 1928. 10 of those markets have coincided with US recessions. The exceptions were 1961, 1966 and 1987. Those events were short lived (relatively) and were followed by furious recoveries. Typically, the stock market leads the overall economy by 1-2 quarters, and on average, the market peaks 7-8 months before a recession (typically). It is important however to remember that these are averages. In 1948 for example, the market peaked 2.5 years before the official start of a recession. Below you will find a table that highlights the mentioned bear markets. In this figure below it is important to primarily focus on the median and the average drawdowns in a bear market.
Bear Markets
The above is pretty impressive/staggering right? With an average drawdown of 39% during bear markets it really sets the bar low and creates an unpalatable apprehension moving forward. It is important to remember, however, that all bear markets are in fact not built equally. The danger behind a potential recession here is that interest rates are attempting to “normalize” from a 0% rate.
Secondly, the recovery has been a very slow and steady one with the recovery likening one large “soft patch” with the standard business peak yet to have hit. Analysts and economic data is/are looking for that blow off top in economic conditions. I find that the issue here is in fact that narrowed focus. The problem here is that the when the last recession hit the Federal reserve and the US government worked in tandem to suppress interest rates and to stimulate the economy. They created an artificial floor in the markets and did not fully allow capitalism to reign. Secondarily, during this expansion phase, the economy has enjoyed once again, artificial growth with the help of suppressed interest rate.
The third and most dangerous of the concerns should be that everyone looks for euphoria in their calculations for tops. Specifically people look for this euphoria to manifest itself in the form of market bubbles. The danger here however is that the bubbles that participants are looking for could be right in front of them. This cheap money that was created with the help of interest rate suppression and the fiscal stimulus has only created lazy and poor business habits. Specifically, corporations have started to lack innovation in their business practices and have more heavily relied on financial engineering to spur their stock price higher. This is in part AAPL’s problem as it is reported that they once again will fall behind Samsung in their innovation with the roll out of 5G anticipated this coming fall and AAPL being behind on the release of 5G compatible devices. The point here is not to knock on AAPL but rather to alert that even the most profitable company on the planet had failed to innovate appropriately and had been so heavily reliant on shrinking their share count and the ability to financially engineer their way to promise. This is a company that has one of the healthiest balance sheets around and hundreds of billions of dollars in the bank. If this company is susceptible to tariff and interest rate sensitivity it does not bode well for the levered companies that are not as financially resound as Apple.
Take Notice:
Since 1938 there have been 13 bear markets. 10 of those bear markets have coincided with a US recession with the exceptions being 1961, 1966, 1987. The exceptions I mention were short lived and followed by quick recoveries. There are other takeaways to keep in mind moving forward.
Historically, Health Care, Staples, and Utilities have been the best performers in bear markets. Beyond that, vice stocks like alcohol and tobacco have also performed well. Sectors that are rooted in economic growth are typically the ones that falter. Specifically, Industrials, Financials, Tech, and Materials have been the sectors to get beaten up.
Below I highlight some important levels should things get out of hand.
SHAMLESS PLUG
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