The 2-Minute Thought: Extreme Stock Price Reactions

Recently, there have been some pretty extreme stock price reactions after earnings announcements.

Why would Chinese test prep company New Oriental Education trade down by 17% after announcing a negative 2% earnings surprise -- while the shares of apparel company VF Corp see a drop of 11% on a 9% positive earnings surprise and higher guidance? Why would Vulcan Materials jump more than 22% on a 2.4% positive surprise? And why would Caterpillar fall almost 8% after meeting earnings expectations but seeing a modest decline in backlog?

It’s hard to make sense of it all – and perhaps fruitless to try.

According to FactSet, a positive earnings surprise usually leads to a 1% rise in the company’s stock price. But as of the end of last week, the average earnings “beat” sent stock prices down by 1.5%. We haven’t seen such negative responses to positive reports since 2011 – and if you remember 2011 like I remember 2011, that was a hard year.

Obviously, a single quarter is only a single quarter. But this is weird.

The Financial Times wrote this morning that S&P 500 companies are on track to reporting average earnings growth of more than 26% -- and that more than 75% of the companies that have reported results so far have exceeded expectations. But good results haven’t counted for much this quarter. And companies that haven’t met expectations have gotten severely punished. That means that double digit percentage declines in a single day have been pretty common.

The popular narrative is that stocks – and all asset classes – are getting re-rated in light of tariffs, China, inflation, and the possibility that economic growth and earnings are peaking in the U.S. Those all seem like good reasons to reassess stock valuations. But in truth, there is very little clarity yet on what is going on – nor is there ever much clarity when it comes to short-term stock price movements.

In his blog this week, NYU finance professor Aswath Damodaran looked at the most common explanations that have been put forth for October’s market chaos. They include the Fed raising interest rates, a technology meltdown, a correction in overvalued stocks, an end to U.S. economic outperformance versus the world, and just plain old panic. But there wasn’t enough evidence behind any of these explanations to say anything definite.

In addition, Damodaran found that stock declines in October happened regardless of valuation. The idea that “overvalued” stocks would decline more than “undervalued” ones just didn’t play out.

That is a reminder that short-term stock price movements have a lot of noise in them and probably are best ignored. In the short term, prices are a puzzle. And while things will get sorted out longer-term, we know far too little to do anything yet except pause and take a breath.

If we are seeing individual stock prices decline 10% or 20% or sometimes even more in a single day, and those declines don’t make sense in light of the new information being released – well, that suggests that either the price was quite wrong before the announcement or that the extreme reaction after the announcement is. But since we don’t yet know which of those is true, take that breath . . . and hold on.

Is Globalization Dead?...

The simple answer is no, globalization is not dead but we have to add some big caveats. President Trump wants to re-shore jobs lost to globalization in the 80’s, 90’s and 2000’s. If America can bring manufacturing back then we will be strong again. At least this is the theory.

The problem, however, is that globalization has gone too far and America has lost too much of the infrastructure and logistics of the manufacturing process. Globalization is not just about China and our trade deficit with them. Take the iPhone for instance, the most visible and the most successful global product. The new iPhone camera comes from Japan, the power management chip from England, the memory from South Korea, the wireless circuit from Taiwan, the user interface processor from the Netherlands. The radio frequency transceiver and the Gorilla glass face (Corning) still come from America. And the final product is put together in China which has the flexible workforce that can expand and contract to adjust to spikes in product demand.

But just because the components and assembly come from somewhere else doesn’t mean we are weak. The lion’s share of the profit from the iPhone goes to Apple. The chart at the bottom is a little confusing but the important point is that it costs $390 all-in to make the iPhone whereas the phone can command a retail price of nearly $1,100. The biggest share of the difference between cost and retail price goes to Apple. The Chinese assemblers get less than 5% of the total cost of the phone.

The biggest benefit of globalization goes to those companies who can design and market products that the growing number of worldwide consumers (both in the developed world and in the developing world) want to buy. And America still comes up with a significant number of these products.

The answer to our trade deficit with China is not a simple tariff but leveraging America’s greatest strengths. Thomas Friedman in The New York Times says we have three huge assets we are not taking advantage of: immigration, allies and values. We are not allowing in the talented immigrants who have made America so great in the past. We are also alienating our allies today, the very countries who want to be our friends not our enemies. And finally, we are not maximizing the values which America represents and which the world respects: the dignity of human beings, the rights of minorities and women and the rule of law.

Tariffs on Chinese imports might actually do more harm than good over the short term. Tariffs might push China to develop even faster its high value-added manufacturing abilities. Tariffs might also simply shift our importing (and thus our deficit) from China to other low-cost areas like Vietnam, Cambodia and Thailand. Globalization is still a good thing. It is sad that it is being so maligned today.

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Financial Freedom Under FIRE...

There is nothing new under the sun when it comes to financial planning. All you really need to know is that you should spend less than you make – at least that is what Benjamin Franklin believed. But much like diet fads, there will always be a new theory on how you can gain financial freedom.

According to a 2017 survey, 1 in 3 Americans have no retirement savings and it’s projected that more than half of Americans will retire broke. This is not a new problem, Thomas Jefferson was very successful, but died broke from spending more than he made. So behaviorally something needs to change to correct this – but what?

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One such movement hoping to change this trend is FIRE – “financial independence, retire early”. FIRE advocates strive to retire in their 50s, 40s or even 30s by stashing away more than half of their paychecks. There is a documentary on how this all works titled, “Playing with FIRE,” which is worth checking out.

This movement of extreme frugality and early retirement began in 2001 and today it has become wildly popular with hundreds of thousands of people ditching their BMW’s for a bicycle. Advocates view retirement differently than most. Early retirement means quitting any job you wouldn’t do for free – but many continue to work after “retirement” in areas they enjoy. They cut spending and increase savings in an extreme way so they can eventually choose what to do without financial worry.

Some sell their houses, buy an RV and travel around the country. Others work part-time at Starbucks to cover health insurance costs or backpack across Europe. If this sounds good to you, the math is simple; Accumulate a nest egg equal to 25x your annual expenses. So, if you can live on $40,000 per year, you need to save $1 million dollars to achieve financial independence.

This all sounds well and good, but implementing such a dramatic shift in one’s behavior is the hard part. Committing to altering spending habits is difficult especially for us Americans who are so good at spending our hard-earned money on the next thing.

Anne wrote a few months ago about the adrenaline rush most people feel from buying new stuff, be it a car or article of clothing. Conversely, some people save diligently all their working days and then have extreme anxiety during retirement when they need to pull from their accounts. We are all wired differently. Most cannot follow through with something like FIRE, but we can learn from it. Do not bite off more than you can chew. Start with small changes. Repair your credit, create a budget, control your spending and save more for retirement.

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But remember what’s most important in life is your happiness, not money or things. Making smart decisions with your money provides the flexibility needed for you to pursue what’s most important to you, whatever that might be.

What Amazon Has Done To Us...

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The “Amazon Effect” usually refers to the way Amazon completely disrupted the retail market. It pushed some bricks-and -mortar competitors out of business and knocked others off their feet for a bit until they could regain their bearings in a changed world. It didn’t matter if a company competed directly against Amazon or not. By offering virtually frictionless online shopping -- and previously unknown convenience and customer delight -- Amazon forced nearly all retailers to rethink the customer experiences they offered online and at physical stores.

But there’s more to Amazon’s effects than just that. Amazon has reached far beyond consumer shopping. It dominates cloud computing with more than 30% market share, and is well ahead of second-place Microsoft. It took an early lead in smart speakers with Alexa before Google and Apple followed. And it keeps pushing into new markets.

NYU marketing professor Scott Galloway wrote about a year ago that we should forget about Apple, Facebook, and Google and just focus on Amazon as the “one firm that will come to dominate search, hardware and cloud computing, that will control a vast network of far-flung businesses, that can ravage entire sectors of the economy simply by announcing its interest in them.” Indeed, just think about how supermarket stocks reacted when Amazon announced buying Whole Foods, or the blip in pharmacy stocks after it announced buying internet pharmacy PillPack.

And NYU finance professor and stock valuation expert Aswath Damodaran had this to say not too long ago: “From a valuation perspective, Amazon terrifies me as a company simply because you find it overvalued but you cannot bet against it because this is a disruption machine. I’m not even sure what business the company is in anymore. It’s a platform that can be used to disrupt pretty much any business, and that is what is being priced in.”

Researchers now also are taking a look at the wider-spread economic implications of Amazon’s rise. One often discussed topic is whether the outsized power of Amazon and other dominant technology giants has been pressuring wage growth. And recently, Harvard Business School professor Alberto Cavallo presented a paper to central bankers at Jackson Hole called “More Amazon Effects.” It addresses how Amazon has been changing pricing behavior and how it might affect the future course of inflation.

It’s been widely speculated that Amazon has helped to keep inflation low by forcing competitors to reduce their markups. Cavallo says this is a possible explanation for low inflation, but it’s too hard to distinguish the Amazon Effect from other factors to be sure.

Instead of focusing on markups, Cavallo looks at pricing behavior overall. Not surprisingly, one of the things he finds after sifting through massive databases is that price differences across geographies have decreased over time. Online retailers tend to offer uniform pricing across regions, so the suggestion here is that as online shopping has grown, increased price transparency has limited the ability of local bricks-and-mortar stores to price-discriminate.

Another finding is that the frequency of pricing changes has been increasing the last 10 years, especially in sectors where online retailers have high market share -- like electronics and household goods – and in goods that can easily be found on Amazon. The suggestion here is that Amazon’s rise has led to intense monitoring of pricing among competitors and much more frequent adjustments. That means we could get ever closer to something like real-time dynamic pricing of multiple goods.

Cavallo confirms that online retailers have more pricing flexibility and can pass through higher costs more quickly than traditional bricks-and-mortar players. So here’s the kicker: The worry is that as we move toward more dynamic pricing, prices could become much more sensitive to shocks from tariffs or oil prices. If that happens, inflation could really ignite – and that is something central bankers may need to consider in the future.