Where Fundamentals Meet Technicals

By Lyn Alden Schwartzer:

In the weekly “Where Fundamentals Meet Technicals” series within our Stock Waves service, we approach markets like a Venn diagram of outcomes, to blend fundamentals with technicals where possible.

I focus on fundamental research, either for the long side or the short side of particular stocks, while Zac Mannes and Garrett Patten focus on the technicals.

Fundamentals involve the performance of the company itself, and any impacts the broad economy may have on it. This includes things like revenue, earnings, balance sheet strength, and a discounted cash flow analysis to provide a reasonable valuation range for those fundamentals.

Stock markets, however, are a very emotionally-driven world, and so sentiment can cause stock prices to materially overshoot or undershoot company fundamentals for quite a while. In addition, sometimes collective market wisdom can discount a fundamental problem or price in good news ahead of time. Both human traders and algorithmic traders focus on chart support levels, momentum indicators, technically overbought and oversold conditions, and so forth, and so they can become self-reinforcing loops.

To ensure purity of each discipline, we don’t let our work influence each other.

I do fundamental analysis on various stocks, taking into account growth expectations, valuation, balance sheet strength, qualitative aspects, and macro headwinds and tailwinds, and let the chips fall where they may in terms of the conclusion, bullish or bearish, regardless of what the technical analysts are putting forth as their primary expectation based on charts.

Likewise, Zac’s and Garrett’s analysis are based on what the charts are telling them within the context of their technical/sentiment framework, regardless of what the fundamentals are pointing to. Stocks rarely go up or down in a straight line; instead they tend to exhibit “several steps forward, a few steps back” dynamics, with certain Fibonacci levels often serving as various upside or downside resistance/support levels along the way, and watching those levels can address probabilities around sustained uptrends or downtrends, or to identify periods of reversal.

Sometimes, there are two clear potential outcomes for a chart pattern depending on where the price breaks or doesn’t break support or resistance, and fundamental analysis can help lean one way or another ahead of time in terms of probabilities.

For our weekly “Where Fundamentals Meet Technicals” series, we combine the two disciplines. I look through Zac and Garrett’s recent collection of technical charts, and highlight cases, bullish or bearish, that align with the company's fundamentals, in my view.

This type of article is normally within our Stock Waves service, but I’m publishing it publicly to give some thoughts about broad market conditions.

Many things have gone as expected, but some segments have surprised me to the upside in terms of price sentiment, so it’s good to review conditions and do a check-up from time to time.

In most recessions, S&P 500 earnings fall, while stock prices fall as well. Usually prices overshoot fundamentals to the upside when times are good and undershoot fundamentals to the downside when times are bad.

This recession has been unique; with so much income replacement from government transfer payments, as well as record low bond yields, investors have flooded into a segment of stocks, particularly mega-cap tech stocks, at seemingly any price.

The S&P 500 price index rebounded to record levels, even as analysts don’t expect S&P 500 earnings to exceed previous highs until the end of 2021 or potentially 2022.

I expected strong stock performance due to stimulus, and therefore kept with an equity-overweight position, but the scale of the divergence between the mega-cap tech names and the broader index has been somewhat surprising, and so I’m getting more cautious on broad equities and particularly some of these popular growth names.

Here is the S&P 500 price level (black line) vs where it would be at 20-year average valuation levels based on analyst S&P 500 earnings expectations (blue line):

Chart Source: F.A.S.T. Graphs

This of course can mean a variety of potential outcomes. One potential outcome is that the S&P 500 deeply corrects to match fundamentals, and fundamentals might be as bad or worse than analysts expect. Another potential outcome is that the S&P 500 chops sideways, up and down in a big range for a while, until fundamentals catch up with prices (and this is my base case at the current time). Yet another potential outcome is that analysts are totally wrong, and earnings break out to new highs sooner than expected, and so fundamentals quickly catch up to prices.

Near-zero yields haven’t really boosted foreign equity valuations much, and yet near-zero yields are often cited as a key reason for unusually high U.S. equity valuations, since despite high equity valuations, the the equity risk premium compared to Treasury yields is still within a historically reasonable range.

All in all, there is plenty of risk in this market, bullish probabilities aren’t great with a long-term view here, and the weird valuations are primarily centered in the mega-cap tech stocks. Low discount rates benefit long-term growth stocks, but many of them currently seem stretched by most rational standards.

Zac's S&P 500 chart looks for a continued correction:

A ratio I’ve been tracking in particular is the ratio of the normal market-weight S&P 500 vs the equal-weight S&P 500. Those indices track the same 500 companies, but weight them differently, either by market capitalization where the highest-valued stocks have the biggest weightings, or with each company in the index accounting for 0.2% of the index regardless of size or value.

Over the long-term since the late 1970’s, the Wilshire equal weight large cap index has outperformed the Wilshire market weight large cap index. More recently over the past three decades, the S&P 500 equal-weight index has outperformed the S&P 500 market-weight index.

Here is the ratio of the equal weight S&P 500 divided by the market weight S&P 500, inclusive of reinvested dividends.

Whenever the line in the above chart is going up, the equal weight index is outperforming, which means that the biggest companies in the index are underperforming. Whenever it is going down, the market weight index is outperforming, which means that the biggest companies in the index are outperforming and growing their level of concentration.

As you can see, there tend to be sharp transition points around recessions where market leadership changes.

In the early phase of an economic expansion, the equal weight index tends to do better, meaning that the mega-caps are lagging. In the later phase of an economic expansion, on the other hand, the market tends to chase the top mega-cap momentum names, and during a recession this hits an extreme with a sharp period of equal weight underperformance, until the next recovery.

Exxon (XOM) was the largest company by market capitalization in the early 1990’s. A decade later, at the top of the dotcom bubble, it was Microsoft (MSFT). By 2008, it was Exxon again (by then merged with Mobile). In the past couple years, Microsoft and Apple (AAPL) have been trading places as the most valuable company, with Apple currently in the lead and Microsoft at number two.

It’s funny to think that a little over a decade ago, Exxon Mobile was the largest company in the United States by value, and now Microsoft is nearly 10x more valuable, and Apple is over 10x more valuable, and Exxon Mobile was kicked out of the Dow. I don’t think Exxon Mobile will reclaim its crown at the top of the S&P 500 in the next cycle, but who knows, maybe I’ll be surprised.

If we zoom in on the past year, we can see market weight outperforming significantly, as the top mega-cap stocks crushed the equal-weight index:

In fact, the S&P 500 is the most concentrated into the top 5 stocks as it has been over the past 40 years.

However, this period of market-weight outperformance has been bouncing repeatedly from what may be a ratio bottom. The ratio briefly broke support and reached a lower-low in early September, led by Apple soaring on stock splits and extreme call options activity, but the ratio has since reversed upward once again, meaning that the equal weight index has made a bit of a comeback off of a potential breakdown.

My base case is to eventually see the equal weight version of the S&P 500 outperform for a while and put an end to its current period of 5-6 years of underperformance, but in the meantime I’ve been watching to see if the ratio holds this support area or continues deteriorating.

Apple’s stock price has been truly astonishing compared to fundamentals. It’s an extremely large company with a modest growth rate, but its stock price literally doubled within a five-month time-frame, completely disconnecting from fundamentals, and soaring to nosebleed heights on an unusually high valuation in terms of several different valuation ratios. As investors piled into indices and sought out the bluest of blue-chip companies, money poured into Apple:

Chart Source: F.A.S.T. Graphs

I’d be happy to buy the stock somewhere in the sub-$70 region, but it has been chilling in the $120+ region, with an apex well over $130. There are a variety of reasons why it should trade for a decent premium, with a shift towards software/services revenue, but its growth rate is what it is, and I personally wouldn’t buy at current levels with my money.

Interestingly, Zac has a corrective target that is right at the orange line in the above F.A.S.T. Graph, even though he strictly focuses on chart patterns rather than fundamentals:

Will Apple stock ever reach down there? I have no idea. But I like it when fundamentals and technicals point in the same general direction, and by most metrics, Apple stock is unusually expensive and with extreme sentiment that appears to be rolling over.

It’s about as overbought in terms of weekly RSI as it was right before the pandemic sell-off, and MACD might have topped. MACD already rolled over on the daily chart and may be topping out on the weekly chart. We can’t say for sure what will happen, but the risk/reward isn’t enticing for a moderately long timeframe at current high price levels, at least in my view.

Chart Source:

On the other hand, there are stocks that have a somewhat more attractive risk/reward profile, as part of a diversified portfolio.

As a leading Chinese company with several global investments, Tencent (OTCPK:TCEHY) is the world’s largest gaming company, and operates one of the world’s largest social networks and payment systems. In addition to their core operations, they own valuable stakes in several internet companies in China and elsewhere, including Chinese e-commerce giant JD (JD), Singaporean internet platform company Sea Limited (SE) that serves multiple countries in southeast Asia, Swedish streaming service Spotify (SPOT), and a variety of game developers in the United States, Europe, and elsewhere.

Tencent is of course pressured by the USA-vs-China ongoing trade dispute, but the vast majority of its income is internal to China and based around Asia. Investors must also weigh the risk of accounting quality for Tencent as a Chinese firm.

Here’s a breakdown of their core operations:

Source: Tencent 1H2020 Highlights

Tencent is not a cheap stock, but with a market capitalization and growth-adjusted valuation that is well-below several current US “FAANG” stocks and with a pristine balance sheet, it does show a lot of potential to become one of the next trillion-dollar companies in upcoming years. The Chinese market it serves has more than 4x as many people as the United States, and its reach extends worldwide thanks to its various investments.

Chart Source: F.A.S.T. Graphs

Likewise, Garrett’s charts suggest some near-term bullishness, a potential period of consolidation, and then a further uptrend from there:

Again, we can’t say what will happen for sure, but to manage risk on the downside and leave plenty of room on the upside, we like to identify stocks for which fundamentals and technicals align.

For the long side, this includes stocks that have valuations that are reasonable compared to their growth rates and balance sheets, and that are not overbought or exhibiting signs of euphoria.

See also Business Cycle Indicators: 16 October on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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