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Nasdaq and S&P 500 Volatility & How best to navigate it

The volatility & decline in Nasdaq and to some extent S&P stocks can be broadly attributed to three factors, we will discuss those three factors and what to expect moving forward.

Factor 1: Extrapolating covid growth trends to the future (3-5 years): Many companies, especially the ones in the tech space benefitted from Covid as most of the shopping, ordering services etc. went online. Companies benefitting from that trend for multiple years during covid started believing that it was the new normal, projected those growth trends 3-5 years out, and consequently, most of the analysts built it into their growth forecasts. Covid era worked like a Vacuum cleaner for companies such as Netflix, Paypal, Amazon, etc. which sucked future demand/customers (dust) into the present (CY2020 & CY2021). However, what these companies missed was that the vacuum cleaner also creates a dearth of dust (new customers) once it completes sucking most of it. As more economies opened in 2022, companies faced a dearth of customers since they had been sucked into 2020 & 2021. Some companies accepted this reality and immediately slashed guidance in Q4CY2021 calls while others were hoping it would not affect them as much, continued guiding to higher growth, and finally threw in the towel in Q1CY22 earnings guidance calls. There are many companies that haven’t slashed their growth guidance yet and that’s a risk in those stocks.

Factor 2: Covid Era expense savings & subsequent hiring binge: Most companies saved significantly on travel, marketing, and other expenses during covid. This inflated earnings significantly as sales grew and expenses declined. Operating leverage was off the charts for companies in this category. For e.g: Netflix sales saw a CAGR of 23% and an adjusted EPS CAGR of 66% for three years ending CY2021. Even smart money believed this operating leverage was sustainable; Bill Ackman bought his Netflix stake after Q4CY2021 results and sold it in less than three months after Q1CY22 results stating they were wrong about Netflix’s operating leverage. Now, if this (inflated sales) was not enough, companies went on a hiring binge based on these inflated sales and lower expense numbers. So, just when Sales were about to decline or flatten due to the vacuum cleaner effect from Factor 1, companies were spending heavily on new hires. Hence, the exact opposite effect (negative operating leverage) is now playing out in CY22, higher expenses with lower or flat sales. We are about to experience the ugly side of operating leverage: It’s a double-edged sword that hurts equally badly when sales flatten or decline. The saving grace, if you will, is that very few of these companies have financial leverage (high debt). Negative operating leverage is hurting but combined with financial leverage it would be a recipe for disaster.

Factor 3: Liquidity fuelled valuations on steroids: Irrespective of Factors 1&2 discussed above, this (Factor 3) would have happened anyway due to the excess liquidity from loose monetary policies combined with fiscal stimuli around the globe. Prolonged periods of lower interest rates led to lower discount rates for cash flows resulting in higher valuation multiples. Higher multiples on inflated earnings and growth projections from Factors 1&2 moved valuations to bubble territory. Now, the market has priced in multiple fed rate hikes, valuations have declined and multiples are not in bubble territory anymore. S&P 500 is trading at @15.6x CY23 PE multiple. So, while Factor 3 seems less of an issue, moving forward, one will have to focus on Factor 1&2.

Bottom line: Not all companies had all the three issues mentioned above but they had at least two out of the three. Any company that had only one of the three issues is likely to outperform the markets (Nasdaq & S&P 500). Obviously, if a company, had none of the three issues mentioned above, it’s outperforming the markets by a wide margin. Moving forward, the way to create a robust portfolio is to not only avoid any company that still has any of the three issues but also include stocks that have corrected these issues (if they meet all the other investment criteria).

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