Investors everywhere are starting to conclude that stocks are in a bear market. How could you not? The S&P500 is down almost 26% from the peak, including dividends. At the same time, market observers, strategists, and pundits think that the bear market sits in the 8th or 9th inning.
We beg to differ, but time will tell who is correct. In our video entitled; “Why Value Investors are Bearish Stocks & Why You Should Be Too,” we discuss the concept of Intrinsic Value. The Intrinsic value of a stock is equal to the present value of all future cash flows investors will collect by opening stock in the company. To make that analysis digestible for those unfamiliar with present value analysis, we walk a simplified model for a stream of cash flows with infinite life. This applies to equities. If interest rates continue to rise, one should expect the price of equities to fall by 5o to 80% from the peak reached at the turn of the year.
The lesson of the 1970s suggests inflation will remain elevated longer than the current consensus expectation. That means interest will remain high and probably go higher. As measured by the CPI, inflation is over 8%, and the 10-year US Treasury bond yield is 3.8%. This is an unsustainable situation. Anyone who invests in bonds loses 5%+ of their purchasing power. Investors are incentivized to borrow and buy assets when inflation exceeds bond yields. In the current fiat currency system, the money supply expands every time one borrows money, fueling more inflation. The only way to spring inflation to an end is to stop the growth in the money supply. The way the Fed does this is to sell assets and raise interest rates. This discourages borrowing, and the growth in the money supply slows.
The Fed and central banks worldwide created an asset bubble by purchasing government debt. They got the money to do this by printing little pieces of paper or changing their bank balances. The Fed has the keys to the database and can change account balances at their whim. The Fed forced interest rates on short-term government debt to zero and long-term debt to near zero. ECB went overboard, forcing interest rates to go negative. They were paying people to borrow money. This caused the biggest bond bubble in the history of mankind. Since all risk assets like stocks and real estate are priced relative to bonds, these assets also became massively overvalued.
Economic law tells us there is no such thing as a free lunch. If someone is going to consume something, they have to pay for it. If they got it for free, someone else must pay for it. When central banks print money, we all pay for it through higher prices.
While the Fed (and the Federal Government) has not come clean and admitted they made an enormous mistake, they are taking steps to address their error. They stopped printing money, allowing the price discovery process to occur. The Fed and market participants are raising interest rates, driving equity values down. The price of real estate will start falling in short order.
The risk, of course, is the Fed goes too far. We do not see that as much of a risk as we are sure they will go too far. It is part of our base case scenario. In time, we will see levered investors suffer margin calls. Companies borrowed heavily and used the proceeds to invest and buy back stock. As the economy falls into recession, companies will see revenue and cash flow fall putting them into financial distress. Some will tip over. When companies start to lay off employees, people will default on personal debt obligations and their mortgages as real estate value fall.
We are seeing individual investors sell stocks at the margin and raise cash balances. They do not have to hold stocks. They do so by choice. On the other hand, institutional investors hold risk assets through thick and thin as they have a very long time horizon. This means they will hold stocks. But when the going gets tough, they upgrade the quality of stocks they hold. This brings us to the scariest stock price chart. The following is a chart of Apple Inc from the day they went public to the present.
Apple is a huge cash flow generator, and every institutional investor holds it. It is the only tech-related company that Berkshire Hathaway owns. It has an enterprise value of $2.4 trillion and has generated $100 billion in profits over the last 12 months. The stock trades at 23 times earnings and 18 times cash flow as measured by EV/EBITDA. This is a bit lofty for a company that is unlikely to grow revenues in a recession, but it is best of breed, so people pay up for the stock.
We think this chart is scary because it tells us the stock price is likely to put in a top sometime in the next year if it has not done so already. The stock has been in a steady uptrend since the bottom of the NASDAQ bust. This was when the company opened the Apple stores and introduced the iPod. From that point forward, the company and the stock were unstoppable. We see a contracting triangle if we connect the tops with a resistance line and the bottoms with a support line. This means the stock is approaching an apex and the resolution is probably a break to the downside. It could wiggle higher for another year or two, but we think the recession may be the catalyst that breaks the stock.
From a technical perspective, where the fall stops is difficult to tell. There are no clear lines of strong support, only weak ones. So what fundaments scenario could play out that would cause the stock to go into free fall? Well, a deep and lengthy recession could do it. That could slow sales dramatically.
The chart above shows how long people and companies hold on to their iPhone. In 2023, the Apple expects everyone with an iPhone to replace it in 2.58 years. If the company is provided by their employer, they expect everyone to replace their phone within 2.36 years. Anyone who owns an iPhone knows that replacing it within 1.5 to 2 years is a bit of a luxury. So if te economy goes into the tank, people are sure to hold on to their phones for 4 or more years. This would reduce sales by 35%. If that happens with iPhones, the same is sure to happen with iPads and Macs. Services are likely to fall as well as many people are likely to cancel subscriptions to music and the like.
That is one scenario. The other is that China decides to take Taiwan by force. If this happens, Apples supply chain breaks and the company will not have product to sell. The company is starting to prepare for this contingency by contracting with manufacturers in India. That will help, to be sure, but the company is still vulnerable to such an outcome.
We are not saying that the price of AAPL stock will collapse in the emmediate future. We are saying that the market is giving a signal that it could happen. The chart also indicated a sharp selloff is possible. It also suggests the stock price could hold up for another year or two before the bottom falls out. What we are saying is that we are watching this situation closely. If the lower trendline is broken, we think it will signal bad things for Apple, the economy, and the market.
Special thanks to Carter Braxton Worth for bringing this price action to our attention.
Photo by Pedro Figueras: https://www.pexels.com/photo/person-behind-white-cover-626164/
