05 Dec Capital 19 Catch-Up

Weekly Index Movement

S&P500	+1.1%
Nasdaq	+2.0%
Aussie All Ords	+0.8%

The big news from last week was comments from Fed Chair Powell.

“the time for moderating the pace of hikes may come as soon as December”

Which the markets took to mean he will raise rates by only 50bps at the next meeting on December 14th. It shows the times we live in when markets get excited because the raise will only be 50bps.

The bulls have a head of steam up here with these comments coming on the back of only 7.7% year-on-year inflation. There’s that only again.

Add to that the fact December is often positive and we could well get another week of positive prices here.

But I think we should not get fooled by recent prices. I don’t believe the market is discounting 2023 earnings properly yet and prices are now too high.

It’s difficult to decide to sell with such positive events, but I definitely would not be buying.

The last three quarters (basically calendar year 2022) of S&P500 earnings have been 54.09, 56.69 and 55.65. The expectation for Q4 is 54.57. Note the consistency.

That will put full-year earnings at 221.00 and means the S&P trades on a PE multiple of 18.4. The long-run average is 17.6.

Can we justify this multiple?

We know the Fed is trying to slow the economy and they are not yet done with interest rates. They are going higher still, even if the pace of those increases slows.

There is an age old maxim in the markets. Do not fight the Fed. The Fed wants the economy to slow. They will get what they want.

Analysts are expecting earnings in 2023 to be $232.53 and puts the S&P500 on a forward PE of 17.5.

I can sort of justify that.

But $232.53 is an increase of 5.2% over 2022 at a time when the Fed is trying to slow things down.

I find it hard to envision an environment where the economy slows, people spend less to bring inflation down and yet companies increase profits. Presumably, this must come from margin expansion. Yet we are already running at higher margins than pre-pandemic. To expand even further seems like a big ask.

So I think the market has gotten ahead of itself here.

We can break down where those analysts think the earnings growth in 2023 is going to come from, thanks to our friends at FactSet.

This shows the consumer discretionary sector will be doing the heavy lifting in that earnings growth.

What? How? The Fed are trying to rapidly remove purchasing power from the consumer to slow inflation.

(Quick aside – the Fed is losing. Employment numbers on Friday were +263k so more people have a job than last month and more worryingly, wages grew by 0.6% in the month and +5.11% year-on-year. As fast as the Fed has been raising rates, wages growth is exceeding it. Maybe that 75bps is back on the table?)

Nope. I think the analysts have the numbers for 2023 wrong and that means stocks are overpriced right now.

In fact, I think they have them 100% wrong. They are expecting earnings growth in consumer discretionary and financials but declines from Materials and Energy. I don’t quite understand this thinking.

China is losing its battle with zero-Covid. Despite harsh lockdowns, their Covid numbers are rapidly expanding. They are at an interesting inflection point. Do they back down to get their economy going and stop the protests? If so they will experience a large number of deaths because they do not use Western vaccines. The communist party has only approved a Chinese-made vaccine that isn’t as effective.

I doubt they will admit to serious deaths though so we will probably never hear about it.

But a re-opening China will add significant demand to Materials and Energy prices, which will lead to growth in profits for these sectors.

This is where you should focus. Add in industrials. Particularly defence such as Northrup-Gruman (NOC). That stock is at an all-time high but will go higher next year.

Here is a little graph for all you technical analysts to that puts my thoughts this week into pictures.

The red dots are all the times the S&P500 has closed 1.8+ standard deviations above its 50-day moving average. It is a measure of short-term overbought conditions.

Finally, some graphs to show the interesting things happening inside the markets.

All three of the above are similar. The Nasdaq has been the weakest and the Dow Jones Industrials the strongest. The S&P500 falls in-between. Which makes sense as it is kind of half Nasdaq and half Dow Jones Industrials (and that’s the reason it is most widely followed)

But take a look at what is happening in the small-mid cap end of town

This is a very constructive pattern. If small-cap can continue to add to gains in December, then this could be a very interesting area in 2023. (stocks here are outside the S&P500 and so the argument above about earnings expectations does not hold)

Top 30 Strategy in 2023 anyone?

CatchUp Stock Tips

	Buy Date	Buy Price	Current Price	Gain / Loss	Stop Loss
TXN	1 Aug 22	177.94	177.66	-0.2%	145.00
ASC	8 Aug 22	8.52	16.00	+87.8%	6.40
CDNS	15 Aug 22	188.83	172.43	-8.7%	130.00
UNH	22 Aug 22	541.39	536.16	-1.0%	450.00
GMS	5 Sep 22	6.50	5.60	-13.8%	4.00
AAPL	12 Sep 22	159.59	147.81	-7.4%	130.00
CRK	19 Sep 22	18.22	16.54	-9.2%	12.00
OXY	24 Oct	70.81	68.21	-3.7%	58.00

Nine has moved back up over $10. It’s a shame we missed it by just 5 cents last week but let’s keep the plan the same and add under $8.

Buy Nine Energy Service (NINE) at no more than $8

Nine Energy Service, Inc. is a service provider for the unconventional oil and gas industry in North America and abroad. It does cementing and coiled tubing services for oil drillers

Our thinking on this one goes like this. Capex spending by the oil industry has fallen dramatically. That hurt Nine back in 2018 and 2019 and was compounded by the Pandemic in 2020. But Nine survived and was made lean during the process.

With the new upcycle in the oil price and increasing demand from Europe the US oil drillers are likely to expand capex going forward. They can do this because they are making more profits so have money to spend and have a longer-term demand structure from Europe. Biden would even be happy as it might keep a cap on oil prices.

For a company the size of Nine, increased Capex spend by the big guys is massive. We saw the first signs of this in their Q3 results

“Q3 was a very strong quarter for Nine,” said Ann Fox, President and Chief Executive Officer, Nine Energy Service, “driven mostly by price increases across our service lines, as well as increased volumes within completion tools, which enabled us to drive strong incremental margins again this quarter.”

One aspect we don’t particularly like is the amount debt they run. But they are addressing this

“De-levering the balance sheet continues to be a top priority for Nine. During Q3, we repurchased $13.0 million par value of bonds for $10.1 million of cash or 77.7% of par, leaving $307.3 million outstanding. I am extremely happy with our team’s ability to take over $90 million of debt off the balance sheet, while also maintaining strong liquidity throughout one of the most volatile environments we have faced. The Company is poised to generate free cash flow going forward and we plan to continue to reduce our financial leverage. Going forward, we believe that Nine can de-lever through a combination of growth in profitability, as well as reduction in net debt.”

When it comes to valuation, the recent margin expansion and increased demand changed the dynamics of the business. From making a loss in 2021, the company is forecast to make a profit of $2.29 in 2023, putting it on a PE of 4.5.

The stock has had a stellar run recently, we watched it go from $7 to $10 so now we don’t want to chase it but will wait for a pullback to buy into. Hopefully around the $8 mark which allows us to buy it on a PE of under 4 and we will aim to sell when that PE approaches 8 for at least a 100% gain.

Warning

Stock values can go down as well as up. It is possible to lose 100% of your investment in a stock. Any advice given by Capital 19 is general advice only and does not take your personal circumstances into account.