Stocks are becoming more expensive. Yet earnings have not bolstered these prices. In fact, earnings surprises have been mostly negative, causing the Citigroup Economic Surprise Index to diverge with the price-to-earnings ratio of the market:
This index, almost by necessity, oscillates. As earnings continue to disappoint, analysts will inevitably lower their expectations, in turn creating an environment of more positive earnings surprises. This is bullish for the market, especially for companies reporting earnings in the coming months.
When earnings surprise, stocks rise. This is true even when stocks are perceived to be expensive. Those who are concerned with the inflated equity costs should be comforted to know that we are still in a bull market.
Don’t Worry Yet
Leading economic indicators tell us not to worry just yet. For example, ISM New Orders show continued growth in customer demand – 38 consecutive months of growth, in fact.
Note that new orders trend down before recessions:
We might be seeing slower growth, but we still see growth. Eventually, the top will be in, and leading economic indicators will start to decay before the next recession. For now, the economy is as strong as ever but with slowing growth.
Because the economy influences company earnings and because the economy is still strong, the Citigroup Economic Surprise Index being low is likely the result of analysts’ expectations being too high. With growth slowing, this makes sense. Analysts have been assuming the fast growth in corporate earnings will continue, neglecting the slowdown in economic growth.
Currently, the slope of leading economic indicators (LEIs) is flattening. This could be a temporary stall, but we often see this toward the end of a bull market. The economy is likely leaving the expansion phase of the business cycle and entering a slowdown phase:
At this point, the risk/reward curve begins to become concave, meaning that the downside risk is beginning to outweigh further upside reward. From here, we will likely see lower volatility as the market makes its way up to a peak for this bull market. Before we hit the recession phase of the business cycle, we will likely see another rally, but one of much lower volatility and speed than the post-December rally.
The bull market is not over. With foreign economies clearly being deep in the slowdown phase, the US market is one of the last places for bulls. Yet the fact that the economy is slowing down means investors should be rebalancing their portfolios for the sake of maintaining alpha.
According to research on sector performance during the business cycle, at this point, investors should be ditching real estate and consumer discretionary stocks in favor of healthcare and consumer staples:
Drawing inspiration from this, here is my list of positions to hold during the coming economic slowdown:
Macquarie Infrastructure (NYSE:MIC)
This company falls in the “industrials” sector. This is a B2B service company – or set of companies, rather.
MIC has seen a stable, positive growth rate since around 2013. The slowdown earlier this decade did not make a significant impact on the company’s growth, implying that we should see growth continue during the next slowdown:
(Source: Damon Verial; data from ADVFN)
Cash flows too have been strong and growing:
(Source: Damon Verial; data from ADVFN)
Putting it all together, I calculate the company as undervalued as per its discounted cash flow valuation. Here is my discounted cash flow valuation plotted against the stock:
(Source: Damon Verial; data from ADVFN)
You can see that MIC was not underpriced until the last selloff. My chart only generated a buy signal in 2018. The valuation implies a 60% upside.
Four analyst downgrades after February’s earnings brought the stock to a discounted level. We know this was an overreaction because the stock is quickly filling the down area gap that appeared after earnings:
One key reason for my choice of MIC is its mispricing. Yet once the gap fills, the post-earnings drift will be officially over. Get in on this one early for some excess returns and to lock in on the company’s 10% dividend yield.
TreeHouse Foods (NYSE:THS)
This food and beverage company falls in the “consumer staples” category. It attracted my attention last month with an odd earnings reaction. The company reported a revenue decline of over 10%, causing the stock to fall.
Yet it was bought right back up, with dip-buying erasing all losses. The stock carried on as if nothing happened. This type of post-earnings reaction shows a strong investor base, which limits news-based drawdowns:
I dug into the earnings call transcript to see if I could find anything of interest. Lexical analysis is useful here. Proper financial lexical analysis can generate management sentiment, which is a predictor of a stock’s price over the coming month.
THS’s earnings calls were quite interesting. Rarely does a call contain more pessimism than optimism. However, THS was the rare exception for most of this and last year – except for the recent quarter.
Its most recent earnings call was roughly as optimistic as the average company. Because the previous quarter and year showed negative sentiment scores, I cannot make a comparison. Suffice to say, management is indirectly pointing to an inflection point in the company.
Here are a few flagged statements from the earnings call:
“Importantly, pricing execution has gone a lot more smoothly than last year with a minimal disconnect between inflation and pricing.”
– A tangible factor for the recent turnaround in sentiment.
“We worked hard as an organization to resolve the majority of our service issues and to restore customer trust and TreeHouse’s ability to deliver.”
– A similar statement; an admission of problems that are being corrected. Acknowledgement of issues and plans for resolution remains a strong indicator of excess returns, according to financial lexical analysis. (The downplaying of problems in contrast implies negative excess returns.)
“Quite frankly, solving the Snacks issue right now is our most important and where all the focus is.”
– A continued focus on problems. Should the company again succeed, we will likely see another quarter of strong sentiment, implying upward pressure on the stock price.
THS has outperformed the US food market to a great extent: 68% annual returns versus -4%. Yet my analysis hints that mean reversion is still underway, as the company still has a lower price-to-book than the average food stock. The company is expected to see a 60% earnings growth over the next year, making now a good entry point.
Because THS does not offer a dividend, you can use options instead for this play. I recommend the Aug 16 $60 calls. These have a delta of 100, allowing you to fully mimic holding 100 shares of THS per contract at a cost of around $650 and with minimum theta decay.
Madrigal Pharmaceuticals (NASDAQ:MDGL)
This company falls in the “healthcare” category. Investing in MDGL gives you exposure to a pipeline of cardiovascular, liver, and metabolic treatments. The stock is trading at under half its previous price because shares were diluted via a public offering for the sake of raising capital.
This capital will be used to finance the company’s pipeline. The timing was smart: just before a slowdown. The company will be able to focus on its pipeline with little regard to decaying economic conditions.
The options market is pricing the stock at $130, which is slightly above MDGL’s current price. I, too, see the stock as undervalued. Over the past year, MDGL has outperformed the biotech sector with 8% returns versus -1% returns.
Since 2016, MDGL has had no long-term debt and can cover its short-term debt with its current cash and assets. With its moat of cash, MDGL can continue working on its pipeline without worrying about earnings. A strong clinical trial result or two should draw investors into this company, and the stock will rally in response.
This stock is more of a gamble than the other two, so do look into the pipeline to see if anything strikes your fancy. Biotech stocks are notoriously hard to predict, and so my philosophy is to bet on those that are (1) outperforming the sector, (2) have a decent pipeline or high-sales product, and (3) are financially healthy, whether that mean strong earnings or enough cash runway to support the pipeline.
This is a rather unpopular stock for the general public, but is popular with the “smart money”: venture capitalists, hedge funds, and institutions:
(Source: Simply Wall St)
If you want to play this without putting too much capital at risk, I suggest the June 21 $130 call options. If the option market’s prediction is correct, these contracts are currently underpriced. Aim for roughly 25% ROI over the next quarter and roll the options over quarterly.
The US economy is at peak growth. From here, it will soon (or already has by some measures) enter into the slowdown phase of the business cycle. During this phase, three sectors show excess returns: industrials, consumer staples, and healthcare.
While you could simply buy ETFs in these sectors, if we are to seek alpha, we should look for stocks that are to outperform in these sectors. Thus, we gain excess returns upon excess returns. I gave my three picks, one from each sector.
We have MIC, an industrial with strong growth; THS, a food company that is at an inflection point, having solved many of its major problems, and a management, which has recently traded pessimism for optimism; and MDGL, a biotech company that is cash-rich and focusing on its pipeline. All things being equal, holding these companies in your portfolio during the inevitable slowdown will produce alpha. Happy trading.
Exposing Earnings is an earnings trade newsletter (with live chat) that is based on statistics, probability, and backtests. My models are unavailable anywhere else online, as I designed them myself, keeping the code private for Exposing Earnings subscribers and myself. If you want a definitive answer on which way a stock will go on earnings, the probability of the prediction paying off, the risk/reward of the play, and my specific options strategy for the play, click here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.