Cloud stocks have treated investors well with recurring revenue, resiliency during Covid, and some of the strongest examples of product-market fit available on the public markets. However, not even this can overcome the effects of lower budgets and cloud spending, which is the top driver in terms of year-over-year comparisons. Due to macro uncertainty, companies are optimizing their cloud spending.
We track the results of big tech companies and best-of-breed cloud stocks to gauge the sentiment of the cloud sector. We came up with our premium analysis in December when we said, “Cloud spending may turn out to be softer than industry surveys indicate, especially until inflation cools off. This is because surveys capture a perception while earnings results are the culmination of a 7.1% inflation rate, plus a softer Chinese market and a softer European market.”
We noticed the sequential decline in cloud stocks in December and saw a steeper decline during our analysis in March. Best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and a 83% slowdown in QoQ/YoY growth for Q1 guides. There’s technically an improvement in the recent quarter, as the best-of-breed cloud stocks are guiding for a 72% slowdown in QoQ/YoY growth for Q2 guides.
However, the drastic slowdown will begin to run out of room until either one of two things happen:
The low comps that cloud begins to lap in Q3 becomes a tailwind and companies are able to bounce back from the sudden drop off in growth that was reported last year, beginning in Q3.
Or, the sequential growth will soon turn negative, which will result in a negative reaction in the market. The objective data below shows which stocks are most at risk for this happening.
Cloud Trends: Big Tech is the best proxy.
Big Tech Companies are more insulated than Best-of-Breed, yet offer a 360-degree view as to how the cloud industry is faring. We had said the following in our premium analysis in December.
“The Big 3 are the best proxy because their reports represent the layer in the tech stack that tends to be the most resilient in terms of churn. The switching costs are quite high for cloud IaaS services. The Big 3 also afford a more concentrated view by owning 66% of market share across three companies whereas SaaS is spread across thousands of companies.”
If the Big 3 are decelerating it simply makes it much harder for Best-of-Breed to accelerate given the Big 3 represents an appetite for cloud budgets and provides strong clues if we are in a period of expansion or a period of optimization and digestion.
Source: Company Results
Key Highlights from the Big Three Earnings:
Microsoft
Azure grew by 27% and 31% YoY in constant currency.
The growth is down 31% in the last quarter and 46% in the same period last year.
The company’s guide for the next quarter is 26% to 27% (in constant currency), an expected deceleration of 4-5% from the recent quarter.
Even though cloud growth is decelerating, there are some bright spots like AI and the guide for the next quarter includes roughly 1% from AI services.
The company’s priorities are related to the cloud, and subsequent AI spend. Satya Nadella said in the earnings call, “We continue to focus on three priorities. First, helping customers use the breadth and depth of the Microsoft Cloud to get the most value out of their digital spend. Second, investing to lead in the new AI wave across our solution areas and expanding our TAM.” Second, investing to lead in the new AI wave across our solution areas and expanding our TAM.” He further highlighted that Azure is taking market share, especially benefiting from the AI trend.
The growth is lower than the 20% the last quarter and is a remarkable slowdown from 37% in the same period last year.
Management discussed in the earnings call that April revenue growth for AWS further decelerated to 11%. This is due to the ongoing tough macro environment, causing customers to optimize their cloud spending in the recent quarter.
The company’s CEO, Andy Jassy, highlighted that enterprise customers were being cautious. “In AWS, what we’re seeing is enterprises continue to be cautious in their spending in this uncertain time. Customers are looking for ways to save money however they can right now. They tell us that most of it is cost optimizing versus cost cutting, which is an interesting distinction because they say they’re cost optimizing to reallocate those resources on new customer experiences.”cost optimizing versus cost cutting, which is an interesting distinction because they say they’re cost optimizing to reallocate those resources on new customer experiences.”
Google Cloud
Google Cloud revenue grew by 28% YoY to $7.45 billion.
The growth is lower than the 32% growth reported last quarter and 44% in the same period last year.
The company’s CFO, Ruth Porat, said in the earnings call, “Our investments in product innovation, our go-to-market organization and our partner ecosystem delivered strong results as customers across industries and geographies increasingly rely on Google Cloud to digitally transform their businesses. That being said, in Q1, we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”we continued to see slower growth ofconsumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”
More on Best-of-Breed Cloud Stocks
To help illustrate how the deceleration has continued for some best-of-breed names, we took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin and/or valuations.
Among the best-of-breed cloud stocks, only MongoDB’s guide shows sequential growth. The company’s QoQ growth was 6% last year and is expected to be 7% this year. The largest deceleration was in HashiCorp, which grew 13% last year and is expected to have flat 0% sequential growth this year.
“Among the best-of-breed cloud stocks, only ServiceNow’s guide shows sequential growth. The company’s QoQ growth was 7% last year and is expected to be 8% this year. The largest deceleration was in GitLab, with revenue that grew 12% QoQ last year, is expected to decline (4%) sequentially this year.
Overall, the category is slowing down sequentially (a rather drastic) 83% for Q1 guides compared to the previous year — from an average of 12% QoQ last year to 2% QoQ growth this year.
For example, best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for 83% slowdown in QoQ/YoY growth for Q1 guides.”
We now see an improvement in the recent quarter, as the best-of-breed cloud stocks are guiding for a 72% slowdown in QoQ/YoY growth for Q2 guides – from an average 15% QoQ last year to 4% this year.
Source: YCharts/Seeking Alpha
In our writeups following last earnings season, we were wary of flat guides on YoY basis given cloud has decelerated ever since these companies went public. Due to the slowing revenue growth, companies must report perfect earnings reports. Otherwise, the stock is sold off after hours.
We had seen in the recent earnings season that companies like HashiCorp (lost 25% of its value), SentinelOne (lost about 35% of its value), Cloudflare (lost 25% of its value), and Snowflake (lost 10% of its value) as their guidance missed the Wall Street expectations. This is why we prefer to wait until the Cloud sector reports flat to accelerating growth on a QoQ basis. Due to the strength of the products, we believe this could be early 2024 (see below).
Our Snowflake premium article in January 2022 explained the downside of the consumption-based pricing model, especially during increased macro uncertainty. “Consumption-based pricing has a few drawbacks. For example, its less predictable than subscription revenue and there isn’t a ‘floor’ on revenue, because if consumption declines then so will sales.”
We further highlighted this point in the risks. “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption.”
In the quarter following this premium note, Snowflake guided for slower growth during the announcement of the Q4 results in March 2022, which led to the stock being down 30% in after-hours. Similarly, the company missed the Q1 earnings, and Wall Street analysts grew concerned, mainly due to the company’s consumption-based model.
Price Action
There has been an improvement in the price action of cloud stocks in Q2 till date, particularly after May, as seen in the chart below. MongoDB is leading among the best-of-breed cloud stocks after announcing the strongest results in the group pictured above. HashiCorp and SentinelOne rank at the bottom, and are reporting steeper deceleration QoQ – 25% for SentinelOne and then a thin 0%QoQ growth for HashiCorp.
Source: YCharts
The I/O Fund’s Cloud Plan:
Generally speaking, the cloud category has weaker bottom lines and is unprofitable. Therefore, it’s our view that the cloud category will need to return to top line acceleration QoQ before it becomes an obvious buy. This is not true for all tech categories as some can lean on operational efficiencies to drive bottom line growth, and this is rewarded by the market.
Certainly, there are outliers each earnings season, yet the outliers last quarter failed this quarter – and vice versa. As discussed, Cloudflare and Snowflake did quite well last quarter yet missed their guidance this quarter. This is not due to the strength of their product rather how unpredictable budgets are in the current environment.
Per Cloudflare’s CEO: “In the first quarter, we continue to witness a challenging business environment, which deteriorated significantly in March when negative headlines emerged related to SVB, the broadening banking crisis and the worsening macroeconomic outlook. With intensifying business uncertainty, companies became increasingly cautious in more deeply scrutinized field, which impacted numerous areas of our business, including a material lengthening of sales cycles, delays in collections and the significant back-end weighting in the linearity for the quarter.”
Snowflake’s CFO said the following: “In Q1, consumption varied from month to month. We benefited from strong consumption in February and March. Starting in April, consumption slowed after the Easter holidays through today.”
For the most part, many cloud stocks are underperforming the Nasdaq YTD, whereas in the past, this category greatly outperformed the Nasdaq.
Source: YCharts
Conclusion:
In order for cloud companies to outperform the Nasdaq again, we will want to see a return to top line growth QoQ and YoY. The reason we track QoQ is because this shows deceleration quickly compared to YoY. The QoQ data above predicts MongoDB would be the strongest stock, and HashiCorp and SentinelOne would be the weakest stocks, and this matches the market’s reaction.
Below are the forward estimates for MongoDB. Assuming consensus is correct for this stock, the rebound would happen around October 2024 with an entry best timed in January 2024 when the company reaches a low point of 10.95%. One area of concern is the 29% in the current quarter won’t return until nearly two years later.
H2 2024 and 2025 look optimal. Should anything change before then on the fundamentals, we will keep you updated.
The I/O Fund Analyst Team contributed to this article
Please note: we plan to release a June stock tip later this month, as we are in a holding pattern with our portfolio until we see how a few key technical indicators are resolved, likely week of June 15th. As a reminder, we are a real portfolio and we do not publish stock tips or trades that we don’t plan to pursue ourselves in real-time.
Supply chain issues have been a well-publicized event that has been hard to predict. While there have been improvements in supply chain management since the production halts enforced during the pandemic, semiconductors continue to be a bottleneck in numerous industries, especially automotive.
The semiconductor bottleneck has had a ripple effect and has impacted industries outside of automotive production, such as ad-tech. In fact, ad-tech has been one of the most beaten-down industries due to the supply chain crisis. This is because automotive is a significant category of ad spend, and without inventory to sell, advertising budgets were slashed.
Domestic auto inventories declined to a record low in February 2022 and appear to have bottomed out in 2022. Supply chain issues are stabilizing, while the supply of raw materials and logistics are also expected to improve.
Supply Chain Management
The pandemic began in early 2020 and resulted in a whipsaw effect that impacted both supply and demand. With governments enforcing strict shelter in place orders, production of goods declined in 2020 but consumers still demanded goods. Government stimulus further bolstered demand and there was less of a contraction in total demand than there otherwise would have been. This dynamic led to the supply shortage that many sectors have been working through.
Since inventories are essentially the difference between production and sales over a period of time, the dynamic of reduced production but increased demand led to a sharp reduction in inventories in 2020 and 2021.
Chart 1. 50-year Trend of Changes in Private Inventories
Source: U.S. Bureau of Economic Analysis
As shown below in Chart 2, changes in private inventories, which is a measure of the value of the physical volume of inventories that businesses maintain to support their production, materially declined in Q2 2020. In fact, the $300 billion drawdown in inventories in Q2 2020 was the steepest drawdown in history.
However, while Q2 2020 represented the steepest decline on record, Q4 2021 represented the largest increase on record, as inventory levels bounced back by over $200 billion. However, with the increasing macro uncertainty, businesses have been liquidating inventories, leading to a drop in inventory levels in 2023.
Chart 2. Five-year Trend of Change in Private Inventories
Source: U.S. Bureau of Economic Analysis
In Chart 3 (below), inventories are also rising relative to sales, suggesting that there has been a build in inventory levels. Furthermore, the metric is above the five-year average, implying that inventories are not low on a systemic scale. However, it has been on a downward trend since Q2 2022.
Chart 3. Five-year Trend of Private Inventories to Final Sales of Domestic Business
Source: U.S. Bureau of Economic Analysis
Chart 4. Domestic Auto Inventories
Source: U.S. Bureau of Economic Analysis
The above chart from the U.S. Bureau of Economic Analysis shows that domestic auto inventories that had declined to a record low have bottomed in 2022.
Chart 5. Auto Inventory to Sales Ratio
Source: U.S. Bureau of Economic Analysis
Curiously, despite the fact that auto inventories are at record lows, automobile manufacturers’ total inventories are high. As shown below in Chart 6, total inventory levels in the automotive manufacturing industry have seen a sharp surge in 2021.
Chart 6. Automotive Total Inventories
Source: U.S. Census Bureau
These disparate trends are driven by the well-publicized semiconductor bottleneck. As Chart 6 highlights above, automotive manufacturers have large amounts of nearly completed inventory that remained idle due to the semiconductor supply. While there has been a stabilization in the supply chain issues, manufacturers are often faced with a situation where they are successful in obtaining one type of material and unable to find another. This was echoed by RJ Scaringe, CEO and Founder of Rivian Automotive, in the Q3 2022 earnings call, “But with a vehicle that has hundreds of suppliers and thousands of components coming from suppliers, it only takes 1 part from 1 supplier to stop the line.And as Claire referenced earlier, we had 5 days we lost already this quarter because of a single component supply shortage.”
"For sectors where demand is still strong, we are still seeing issues of materials shortages, and these problems will take additional time to resolve," said Jason Miller, associate professor of logistics at Michigan State University's Business School.
Management comments on the Supply Chain Stabilization
Arno Antlitz, CFO of Volkswagen, said in the Q4 2022 earnings call, “We expect that in 2023, the structural shortage of semiconductors will improve and the supply with raw materials and logistics will gradually stabilize. The latter one is within our clear focus.” He further updated in the recent Q1 2023 earnings call, “The supply situation is easing slowly, but continuously. We still experience disruptions, mainly in global logistics hindering us to deliver our vehicles to customers worldwide. Restrictions in vehicle delivery are also the reason for slightly higher inventory of finished goods.”
General Motors mentioned that the supply chain issues are improving. GM CFO Paul Jacobson said in the Q4 2022 earnings call, “We continue to face some supply chain and logistics issues, but overall things remain trending in the right direction.” He further updated in the recent Q1 2023 earnings call, “As we mentioned on the last earnings call, our plan is to balance supply with demand, and that's exactly what we did this quarter. Early in the year, production improved as supply constraints started to ease and began to outpace proactively plan some downtime, which allowed us to end the quarter with U.S. dealer stock flat compared to December, while we gained 1.3 points of share and increased volumes 4% year-over-year.”
John Lawler, CFO of Ford, mentioned the improving supply chain while providing the outlook for EBIT. He said in the recent earnings call, “And tailwinds driven by improvement in the supply chain.”
Richard Palmer, CFO of Stellantis, the company that was formed by the merger of Fiat Chrysler and the French PSA Group, also echoed the stabilization of supply chain issues. He said, “We continue to gradually reduce the level of production losses related to semiconductor shortages, and we expect supply to continue normalizing as we progress through the rest of the year.” He further said, “After the last two years of supply constrained environment marked by the pandemic, unfulfilled semiconductor orders and production disruptions, our inventory has now returned to a more normal level consistent with the current sales rate.”
EVs versus ICE:
According to some management teams, EVs will fare better if there is a pricing war between EVs and internal combustion engines (ICE).
Once the semi bottleneck improves and inventories increase, auto pricing will start to decline.
The hard part is to separate that inventory between internal combustion engine (ICE) and EV. i.e., ICE may grow but EVs may stay steady or not increase as much. Another data point related to inventories is SAAR (Auto Sales Seasonally Adjusted Sales Rate). This is what ON said in Q322:
Question
“the supply-demand balance on the automotive side. There is a concern that automotive could be kind of this next show to drop in this rolling correction in semis. What are you hearing from your auto customers about? Are they building inventory right now? What is the supply-demand balance when you look at OEMs and Tier 1s, especially towards the first half of next year?
Hassane El-Khoury
“If you look at the demand environment and where our growth and our demand is coming from, it's coming from EVs. No matter what report you look at or what customer you talk to an OEM, pure-play EV OEM or a broad OEM, there's one thing consistent. No matter what the SAAR does, they will build more EVs next year than they do this year. That's where our growth is coming from, both power and then more and more safety is getting into cars. That's where our sensing comes in. Between those two megatrends, our content is going to grow and remain growing even through '23, no matter what the SAAR does in this case, based on a lot of the prediction. So that's what gives us the confidence. Again, we have secured that outlook with LTSAs. So I'm not worried about that part of it.
Is ICE engine going to have some softness because of rates going up or demand going down? Potentially. But again, the EV plants are the ones that we focus on the ones that our OEMs want to make sure they secure their EV penetration or they're going to lose share. So that's what we work on. But it is not because of any inventory. If anything, it's potentially just demand. But at this point, we don't see it for our business given our exposure to EV.”
If the macro worsens and inventories increase, there will likely be a pricing war in ICE vehicles. First, because they need to sell them but also they likely need the cashflow to fund their EV programs. This may be positive for adtech because OEMs may have to advertise the discounts and EV programs.
Conclusion:
It has been some time that inventories in auto were back to normal, although it appears we may be approaching peak pricing. When inventories return to normal, this will be a much-needed tailwind to ad-tech. We also believe EVs are stronger in this regard due to comments that industry leaders have made, which is essentially that there will be more EVs produced every year regardless if overall auto sales decline.
When the market was selling tech last year, the I/O Fund was buying AI leaders. For example, from September 2021 through January of 2023, we initiated 9 buy alerts for NVDA below $210. The last two alerts were at $108 and $149 in late 2022. We initiated buy alerts for additional AI stocks, as well, resulting in a 45% allocation to AI going into May. Compare this to Stanley Druckenmiller, who had 29.5% allocation in AI, and has been covered by the press as the leading AI investor.
Our high allocation to AI is not a surprise to anyone following our firm, as Lead Tech Analyst, Beth Kindig, has covered Nvidia’s AI thesis 27 times over the past 5 years.
Now that the AI frenzy is building, I/O Fund has been raising cash from these positions in 2023, while still holding them as our top holdings. For example, going into NVDA’s historic earnings call, we had raised cash in 2023 from this position, and we were still able to hold it at a 15% allocation, plus we held another leading AI stock at a 12% position.
While the market has rewarded those early to this microtrend, the broad market is currently signaling that volatility is likely to return in the summer/fall time. There are simply too many divergences amongst Tech and economically sensitive sectors to suggest a healthy market is building. Furthermore, inflation is far from under control, meaning the FED is unlikely to provide liquidity any time soon. But, even if the market is looking past this, and we are in the early stages of a new bull run, we are likely setting up for a large pullback into the summer/fall.
We combine broad market analysis with tech analysis to help us better time when to get aggressive and when to be defensive. We believe now is a time to be cautious until we see how the nature of the coming volatility. Whether we are starting a new bull market, or targeting fresh lows, we do not believe now is the time to buy tech even with a long-term time frame in mind.
Broad Market Analysis
Contrarianism is a rewarding investing thesis. The idea is that the market is a zero sum game. For me to win, others must lose, and vice versa. When the crowd stampedes into a trade, this explains why taking the other side of that bet is often correct.
Today, we are seeing one of the largest net short positions in the hedge fund community since 2011. Every time this level of sentiment led to a crowded bet, the market snapped back, punishing the crowd. This information is one of the primary points in the ongoing bull theses.
Source: Bloomberg
The other argument I hear from the bull narrative is that stocks are not crashing from the ongoing, negative news cycle. They instead appear to be climbing a wall of worry as we are now approaching the 4300-resistance level.
This bull thesis is worth considering, yet there is one important twist to this narrative that needs to be explained. The question is not: why is the market not breaking down on terrible news? The more important point that needs to be addressed is this: why is the market not breaking out in a meaningful way? With such an extreme allocation to short positions, as well as markets continuing to shrug off really bad news, it’s odd that we cannot meaningfully clear the 4280 – 4380 barriers.
I was beating the drum in mid-October and early November that a sizable rally was unfolding when the market was extremely bearish: “more and more signs are pointing to a bigger trend reversal underway. Several markets are in new uptrends and suggesting a push to new highs is on the horizon. This will lift all boats, but I do not expect all stocks/markets to make new highs. It’s important to identify the winners, and stick with them in these new uptrends.”
In our premium analysis, we went on a buying spree around this time, loading up on some of our leading positions. Today, after a sizable rally, we have raised a considerable cash position, and rebalanced our portfolio to coincide with the new macro that we are in.
We believe another reason the market cannot make up its mind is that the current macro environment is showing stubborn pockets of growth, which is keeping equities from falling. However, with stubborn growth comes stubborn inflation, which is preventing these markets from powering too much higher.
There’s plenty of evidence of this unhealthy bifurcation. For example, we’ve covered in the past that while Big Tech continues to power higher, underneath the hood, your more economically sensitive sectors, which tend to be early cycle sectors, are being sold aggressively.
If this is a new bull market, we need to see the coming volatility hold the SPX 3805 level and a rotation from Big Tech into these neglected sectors. This will be our signal to safely pivot for a renewed bull market.
The Macro Gamble the Bulls are Making
The chart below is looking at various economic metrics on a 3-month annualized basis. The reason I prefer this measurement is because we can see the current trend within the economy, as opposed to measuring the reading against an arbitrary month in the distant past.
The chart below helps to illustrate how pockets of growth in the US economy have stayed surprisingly resilient. Even housing is reaccelerating as well as the consumer. These are simply not the type of readings we see going into an imminent recession. This is fanning the hope that the looming recession will result in a soft landing, or possibly even no landing at all.
What these investors are failing to realized is that buoyant growth means buoyant inflation. In prior soft landing scenarios, like 2016, inflation was running well under the FED‘s 2% target, allowing them to keep rates next to 0 to defend declining asset prices. Today, the FED does not have this convenience, as inflation is far from their 2% target.
When we look at the same inflation metrics on a 3-month annualized basis, what investors should notice is how far away we are from the 2% target. In some instances, we are triple the desired target. These metrics have remained virtually unchanged for up to a year, while compounding sequentially.
Peak inflation is behind us, but the real battle will be getting these numbers back to the 2% target. In fact, going back in history, there is no instance where core PCE inflation backs off from an inflation impulse without a recession.
The reason markets are not breaking out in a substantial way after the 2022 bear market is because as growth and the consumer surprise to the upside, inflation becomes more problematic. We expect the FED to continue their fight against inflation by continuing to raise rates into 2023. The more they raise, and the longer they stay elevated, the higher the odds are that something gets broken in the economy.
Two Scenarios; SPX 3805 is Important
However, we have to be open to all possibilities, which is why we rely on price action to be the final arbiter of our risk management decisions. Regarding, the broad market, here are two scenarios that I am tracking based on the structure from the October 2022 low. Both counts suggests that we are in the final swing before topping in a large degree correction. Where the two counts differ is on the depth of this drop. The blue count will break to new lows, likely targeting around 3000 SPX. The Red count will find support above 3805 SPX, and begin a strong uptrend to new highs in the coming years.
Both scenarios see volatility returning into the summer. If this is a new bull market, we not only need to see 3805 hold, but we will need to also see a rotation from Big Tech into more economically sensitive sectors/styles, like small caps, transportation, financials and the equal weighted S&P 500.
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Broad market breakouts tend to occur with most markets and sectors participating. Strong breadth expansion tends to equate to an improving economy. As a result, early bull markets tend to see economically sensitive sectors leading the way. This is simply not what we are seeing today, as the market piles into the perceived defensive Big Tech trade.
As of today, both Apple and Microsoft account for more than 14% of the S&P 500. In fact, over 25% of the S&P 500’s top 10 holdings are in Big Tech.
Source: YCharts
Furthermore, if we look at economically sensitive sectors, we are not seeing the type of relative outperformance that we tend to see in an early expansion cycle.
Small Caps (IWM)
Small Caps appear to be tracing a large triangle pattern. More times than not, these triangles tend to be the mid-point in a larger trend. The current bounce is expected, and as long as $205 holds, I’m expecting IWM to break below its October lows.
Transportation
Transportation stocks continue to falter in the current macro, suggesting that we are not starting a new growth cycle, yet. Note the head and shoulders pattern forming on weakening volume. If the trend line breaks that has held up transports since the COVID low breaks, a new leg lower will begin.
Financials
I tend to believe that financials are leading the market down, not Big Tech leading us up. The weakness can be seen outside of the regional bank stocks, which I’ve discussed in great detail here.
While everyone focuses on the regional banks, the financial sector that tracks the biggest financial institutions in the US looks quite unhealthy, as well.
Equal Weight S&P 500 (RSP)
The Equal Weighted S&P 500 gives all 500 stocks in the index the same weighting. So, Apple, for example, has the same weighting as Home Depot. Because of this, in an expanding economy, this index tends to outperform the market cap weighted version. As of now, it is has made a series of lower highs since February while the Big Tech dominated S&P 500 has made a series of higher highs.
As of now, RSP is looking quite weak as it attempts to jump off of critical support. If the below trend line breaks to the downside, this index will likely be retesting its October low.
Conclusion
The main point I want to convey to investors is the more economically sensitive stocks and sectors appear to be setting up for a breakdown instead of a breakout. The markets have no reason to crash, as growth remains stubborn, but the piling into Big Tech while other sectors get sold is due to the fact that the FED cannot abandon their fight against inflation to support asset prices.
We are open to a new bull market being formed, which is our red count in the SPX chart above. In order for us to pivot, we will need to see the coming volatility hold 3805, and a rotation from Big Tech into the more economically sensitive areas of the market. This doesn’t mean tech won’t lead in a scenario where there is a rotation out of Big Tech, it only means that the market is seeing a soft landing and pricing that into equities.
The argument for the bulls is that the market is climbing a wall of worry, as the majority of the market piles into cash and short positions. We discussed the net short positions going back to 2011 to support this; however, if we pull this data back farther, we can see that the net short positions were even more extreme in late 2007.
Source: Real Investment Advisors
That being said, there are times when the crowd is right. The damage done to the economy by the Fed’s fight against inflation will likely prove to be vast. We believe it is prudent to see how this next pullback manifests before getting too aggressive on the long side of this market.
The I/O Fund has been beating the drum about AI for 5 years. Now that it is here, we are targeting choice mid-cap to mega-cap names in the coming pullback. Once this exuberance runs its course, and the market gives up on AI, we will be buying the dip for this once-in-a-lifetime tech trend that is just starting. Join us next week, Thursday, 6/15, at 4:20 EST where we will go over the specific AI stocks we are targeting. We will provide the macro backdrop, along with entry prices.about AI for 5 years. Now that it is here, we are targeting choice mid-cap to mega-cap names in the coming pullback. Once this exuberance runs its course, and the market gives up on AI, we will be buying the dip for this once-in-a-lifetime tech trend that is just starting. Join us next week, Thursday, 6/15, at 4:20 EST where we will go over the specific AI stocks we are targeting. We will provide the macro backdrop, along with entry prices.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Last year, the I/O Fund reinitiated a position into AEHR and published a deep dive entitled: “AEHR Analysis: The Silicon Carbide Revolution.” This is a must-read for anyone new to our site. Currently, the position is up over 100% YTD and is second only to our Nvidia position, up 170% YTD. Notably, Aehr was also the primary winner for the portfolio in 2022, based a series in entries beginning in August.
ON Semiconductor is Aehr’s number one customer. We wanted to take a look at ON to see if it has a place in our portfolio. This analysis also helps to provide a 360-degree view of the silicon carbide market.
As a refresher on silicon carbide, below are some notes from an analysis we published in August.
Recap of why Silicon Carbide, also known as “SiC,” is disrupting Silicon-insulated gate bipolar transistors (Si-IGBTs):
The result in switching to Silicon Carbide (SiC) is that charging is quicker and the range of miles for electric vehicles increases with SiC. Si-IGBTs are inefficient, oversized and have trouble achieving pure sine wave voltage requirements whereas Silicon Carbide can withstand and manage high voltages. This is a good fit for electric vehicles which have high-voltage batteries.
When you replace silicon with silicon carbide, the breakdown strength increases 10X and can operate at higher temperatures and provide higher current density. SiC devices offer 3X more thermal conductivity and allow for faster heat dissipation. As silicon devices become smaller, it’s more difficult to extract the heat from the electrical conversion process.
By replacing silicon with silicon carbide in MOSFETs, the low switching losses and higher switching frequencies are retained. Due to the durability of silicon carbide, MOSFETs are now also able to handle higher voltage at lower heat. Notably, silicon carbide combines silicon with carbon and is the third-hardest substance in the world. The durability of silicon carbide is also ideal for the various conditions electric vehicles must operate in and the design is also more compact.
By withstanding higher temperatures combined with lower switching losses and lower thermal resistance, silicon carbide (SiC) can handle more power while using less energy. SiC reduces the power consumption and reduces the size of power supply systems that require high-voltage conversion, which makes SiC especially compatible with electric vehicle (EV) on-board chargers and solar photovoltaic power systems.
Tesla was the first to adopt silicon carbide for the 2018 Model 3 by working with ST Microelectronics to add SiC MOSFETs to an inverter design. The result was a more compact, lighter inverter at 4.8Kg compared to Si IGBT inverters that weigh 2-3X more (8kg to 12kg). Published in the New York Times: “Tesla made this fantastic move,” said Claire Troadec, an analyst at Yole Développement, a high-tech research and consulting firm in France, referring to the company’s switch to silicon carbide. “What they did in a year and a half was really amazing.
Pictured below, the main roadblock to SiC MOSFETs adoption is cost yet this was largely solved for as the second-gen Tesla’s SiC inverters, which analysts believe are now comparable to Si-IGBTs. Not only is the SiC inverter on par in cost but is known to be one of the best on the market at 97% efficiency, resulting in more range. This was accomplished without increasing battery capacity.
Aehr provides the testing equipment necessary to ensure the reliability of silicon carbide devices. The stakes are high should an electric vehicle or solar panels fail in the field, considering not only the costs involved with these products ($50,000+ for EVs, $10,000+ for solar systems) but it also protects the reputation of a particular brand in a competitive environment. AEHR’s testing equipment provides the necessary step of quality assurance. The testing equipment is also used to increase battery life before going to market.
Aehr has a unique technology called FOX-XP test systems, which are used for wafer level burn-in testing of silicon carbide and silicon photonics. As stated, ON Semi is the number one customer for Aehr’s test systems and wafer paks.
To learn more about Aehr, please reference the following analysis:
ON Semiconductor provides the silicon carbide MOSFETs (which are semiconductors that switch or supply voltages) for electric vehicle components for EV drive trains, such as traction inverters, DC/DC inverters, on-board chargers, fast chargers and energy storage applications.
ON is Aehr’s number one customer because they must test silicon carbide semiconductors for failures before supplying silicon carbide-based powertrains and charging systems for key Electric Vehicle OEMs, such as Tesla, Volkswagen, Mercedes Benz, Nio and BMW.
EliteSiC is the portfolio of SiC products that ON provides to popular EV OEMs to increase electric power train efficiency and extend EV range. Of the estimated $8.13 billion in revenue that On Semi is expected to report this year FY2023, $1 billion is from silicon carbide components. This is up 5X from 2022. In Q1, the SiC revenue doubled from Q4.
Here is where the other $7 billion in revenue comes from:
Intelligent sensors used in automotive ADAS systems, which are abundant in Level 1+ autonomous vehicle systems.
Note: ON Semi has the #1 global position in image sensors with a 46% market share in Autos and 68% market share in ADAS. This particular segment accounts for 69% of total revenue, up from 64% in the year ago quarter.
Smart factory automation and robotics
Energy infrastructure, such as EV charging stations
Retail applications, such as for surveillance or doorbell cameras
Cloud and 5G infrastructure
The company has been ambitious in vertically integrating the manufacturing process to reduce dependencies. For example, ON Semi acquired GT Advanced Technology in 2021, a SiC manufacturer, which eliminates the need to rely on a partner to source SiC. The company also acquired a 300mm fab from Global Foundries to strengthen its imaging sensor business. Both facilities are located in the US and also benefit from tax credits from the CHIPS act.
What’s Driving Growth:
The key markets underpinning the growth in the Intelligent Power and Sensing businesses are the Automotive and Industrial sectors which comprise over 75% of total revenue. Of which Auto is 50% and Industrial is 28%. Importantly, the similarity in customer requirements – increased power and efficiency – provide engineering and product development synergies between the two businesses.
In the chart above, ON expects to grow 3x the market and forecasts an average sales growth of 10-12% from 2022 through 2027.
Intelligent Sensing
Within Intelligent Sensing, this Advanced Driver Assistance Systems (ADAS) schematic from Spiceworks demonstrates the impact car electronification has had on car safety with the radar, light detection and ranging (LIDAR), cameras and embedded ultrasound technology.
In Image Sensors, ON has the #1 global position in autos and industrials. It has a 46% market share in Autos and 68% in ADAS. Below are examples of cameras embedded on ON chips used in automotive and industrial applications.
The quality (i.e. megapixels) and integration of these sensing technologies is one of ON’s key advantages. For example, it can operate at lower temperature operation, has reduced cooling requirements and weighs less.
In addition, the range and ability to function in low light environments are also differentiating factors. This is how ON has described the market drivers: “We introduced our new Hyperlux Family of image sensors to support the transition to eight megapixel devices where ASPs (average sales prices) can be up to 2.5 times that of one or two megapixel image sensors.”
ON was the first to market with 8 megapixel automotive-grade sensors that provide both high detection range and a wide field of view, delivering consistent performance across all temperature and lighting conditions. Based on this industry-leading dynamic range, dark noise performance and LED flicker mitigation feature of its sensor, ON has been winning new designs. Last year ON displaced the large incumbent at local Japanese automotive OEMs.
In addition, one of the primary drivers of increasing number of cameras per car has been the efforts by traditional OEMs to match the ADAS and related safety features offered by the new EV models. For example, ON secured a design win for a digital mirror that incorporates four cameras for the rear and outside views. This mirror overcomes obstructions caused by passengers, headrests and other objects and provides integrated rearview and side view for blind spot monitoring.
In industrial end markets, growth is driven by industrial and warehouse automation applications where ON has 27% market share. ON’s image sensors are used for scanning in industrial and warehouse applications. This growth is driven by expansion and increased automation of warehouse by global e-commerce leaders. Customers include Amazon on warehouses and Schneider, Siemens, ABB and Honeywell in factories.
ON is the only image sensor supplier with internal and external capabilities across every manufacturing stage of the supply chain for automotive and industrial sensors.
Intelligent Power
Within Intelligent Power, ON’s key product is its Silicon Carbide technology. In Silicon Carbide and Silicon power, ON has #2 Global position with 9% market share.
Beyond traction inverters for electric vehicles, the SiC solution can be applied across several different end markets where AC/DC or DC/DC power conversion is needed including high speed trains, photovoltaic converters, medical equipment, motor drives, electric power transmission and solid state transformers.
ON’s EV customers require SiC technology that meets two basic requirements, greater range with less weight. Take for example, ON’s EV clients such as Tesla and VW. They require SiC technology that will provide greater efficiency, increased voltage and greater power density, which reduces charging times and increases driving ranges between charges.
ON has a broad portfolio of product solutions to meet EV maker needs.
ON’s EliteSiC and VE-Trac module solutions provide the foundation for traction inverter design, making automotive products more powerful and reliable. Main traction inverters are the heart of electric vehicles and provide incredible amounts of torque and acceleration. The responsiveness of the inverter and the electric motor it controls correlate directly to the “feel” of the vehicle and consumer satisfaction.
Power levels from 40 kW to 250+ kW are common, and these systems require extremely robust IGBT and silicon carbide (SiC) components. Scalability, enhanced thermal performance, and the low packaging inductance allow ON’s traction inverters to achieve peak efficiencies, state-of-art power density, and swift response times.
EV makers seek increased range and reliability but with less size weight in their SiC requirements. ON is currently on M3 silicon carbide technology and is developing M4 and M5. The key is that each new generation is able to reduce the size of the cell but increase the amount of current that goes through it.
The packaging around the Die is also very important. The packaging has to effectively allow heat to be extracted from the Die, through the packaging and into the fluid and be able to operate at higher temperatures. For example, ON’s gel-based Case Modules are a good choice for applications up to 150 degrees Celsius. However, EV based SiC based modules require packaging such as Transfer Molded that can function at 200 degrees Celsius. By reducing thermal resistance, this enables more power, efficiency and better range at a lower cost.
Importantly, it weighs less. For example, a gel-based Case Module weighs 5 lbs., while a metal Dual Side Transfer Molded weighs 50% less but with higher power performance at higher temperatures. This reduces the weight of the vehicle. ON recently developed polymer-based package which weighs 90% less than the metal based. Packaging solutions can be “mixed and matched” depending on the need.
Longer-Term Supply Arrangements (LTSA)
As part of ON’s strategy, it seeks to enter into longer-term supply arrangements (LTSA) with strategic end-customers. Typically, they last from 4 to 5 years. LTSA’s provide a level of visibility on pricing and volume through the duration of the arrangement.
Coupled with the value-added products that ON is providing, these arrangements typically lead to a more stable pricing environment. ON provides a quarterly update on the level of LTSAs which provides a good proxy of future growth.
ON ended q123 with $17.6B in LTSA’s, of which about $4.5b is silicon carbide related. To provide some context, ON’s 2022 revenue was $8.3bn.
Importantly, the LTSA’s provide a roadmap as to when and how much to expand capacity. Rather, than building capacity with the hope that they can fill it. ON can now build capacity to fulfill its LTSAs. This reduces the margin volatility inherent in the “build it and hope they will come” model. In addition, it has helped ON to provide accurate profitability guidance to wall street analysts.
Per management on the earnings call:
“LTSAs also help reduce our exposure to the volatility in the consumer and computing markets. Volkswagen as an example, signed a three-year agreement for more than 100 current production devices giving them the required supply chain sustainability with a major semiconductor partner, our committed revenue through LTSAs increased again in Q1 by $1 billion.”
Key Earnings Driver: Increasing ON Content Per Product
The key to ON’s earnings and continued growth will be the increase of its semiconductor content in automotive and industrial applications in its key growth markets as well as in units shipped.
Below is a diagram showing the typical ON content in a higher end German EV. Silicon Carbide, Silicon Power components and Power ICs are supplied by the Intelligent Power division. While Sensor Interfaces and Image Sensors are supplied by Intelligent Sensing.
Currently, the value of ON content for electric vehicles ranges from $350-$1,800, depending on the type of car. As EV penetration increases, ON will continue to benefit both from the increase in content per car and the number of EV cars made. Importantly, the former helps reduce the cyclicality of the latter (i.e. Auto Sales SAAR).
Per the earnings call: “We also lead the market in automotive ultrasonic sensors with more than 20 sensors in one of the latest EV models from a leading European OEMs.”
An important factor to point out is that the cost of ON’s content relative to its client’s overall costs for its product is fairly small. The costs of ON’s EV components are only about 2.7% of the total COGS for an EV manufacturer while the Advanced Safety components are a bit less than that, compared to $40,000 total COGS for an EV maker. Yet, the importance to the operation and quality of the car is much more valuable than that. This should provide ON a healthy level of pricing power in its LTSAs.
Recent Acquisitions
GTAT acquisition
In November 2021, ON completed its acquisition of Hudson, New Hampshire based GT Advanced Technologies, a manufacturer of Silicon Carbide (SiC).
With GTAT, ON is now vertically integrated and canprovide end-to-end power solutions from SiC crystal growth to fully integrated intelligent power modules. ON is the only integrated device manufacturer that grows its own silicon carbide and silicon boules.
This vertical integration enables ON to maximize production efficiency between the 3 facilities. Since the acquisition, substrate production is 10x higher, die up 12x, internal packing 4x, yields 1.7x and new product 3x.
East Fishkill Fab – Global Foundries
ON is the only image sensor supplier with internal and external capabilities across every manufacturing stage of the supply chain for automotive and industrial sensors.
In February 2023, ON finalized its acquisition of Global Foundries’ 300 mm fab in East Fishkill, NY (EFK) which will enhance its competitive position by enabling the conversion of ON’s wafer processes from 200mm to 300mm. The fab increases the processing capabilities required for image sensor production.
Management/CEO:
Hassane El-Khoury has been CEO since December 2020. Prior to that, he was the President and CEO of Cypress Semiconductor before its sale to Infineon. Since joining, he has increased ON’s focus toward higher growth/higher margin markets, price maximization across its product offerings and increased vertical integration.
CEO El-Khoury spearheaded the transition and divestment from sub-scale factories overseas into a lighter internal fabrication model with the goal of reducing gross margin volatility while at the same time making strategic acquisitions, such as the GT Advanced Technology acquisition and the East Fishkill Fab acquisition from Global Foundries – actions all with an eye toward increasing gross margins while reducing margin volatility inherent to the sector.
So far, CEO El-Khoury has a track record of saying what he will do and doing what he says. In doing so, he has built credibility with the investment community and Wall Street. Since December 2020, ON has outperformed the SOX by 140% and 250% outperformance compared to Wolfspeed through May 2023.
ON has characterized 2023 as a transition year, mainly due to integration of its acquisitions and divestment of its non-core assets. We see 50%+ valuation potential when this transition is completed by 2h23 (see more on valuation below).
Financials:
ON Semi had a streak of strong revenue growth in the 20% range that has recently flatlined to the single-digit negative growth expected for the remaining quarters this year. The expectation is that ON Semi returns to growth in FY2024 at 7.5% revenue growth.
EPS returns to growth in FY2024, as well, at +11.74% for $5.43 EPS. This compares to (-8.77%) EPS decline in FY2023 to $4.86.
Margins:
Gross Margin has been in the 49% range yet has currently dipped to 46.8% in the most recent quarter. The guidance is for 45.4% to 47.4%. This is a much better margin than competitor Wolfspeed in the 30% range.
The operating margin was 28.8% last quarter and net margin was 23.6%. This is also much better than competitor Wolfspeed, a company with double digit negative profit margins.
ON has guided for gross margins to be lower in 2023 vs 2022. ON has characterized 2023 as a transition year on the path toward a resumption of higher margins.
The main headwinds are:
Continued elimination of 10-15% of sales (~$700m) from non-core/lower margins businesses first announced at the end of 2021 to be concluded by 2023
Lower fab utilization to manage inventories at its EFK facility
Start-up costs related to its SiC Hudson and facilities which will weigh on margins
Ultimately, silicon carbide components are helping margins yet the East Fishkill fab is weighing on margins. Per Management, the headwinds are temporary: “Based on our current outlook, we are confident we can realign the cost structure of the fab and drive efficiencies to recover by early 2024.”
Cash Flow:
Last year, ON had an operating cash flow margin of 31.60% and a free cash flow margin of 19.60%. This margin has been fairly consistent until this quarter when it dropped to 20.90% for op cash flow and 4.50% for free cash flow margin. There is $2.7 billion in cash on the balance sheet and $3.46 billion in debt.
The free cash flow is softer from “lost” net income from higher inventory, or in other words, the elimination of sales.
Per management, regarding inventory increasing QoQ: “Inventory increased by $198.1 million sequentially and days of inventory increased by 23 days to 159 days. This includes approximately 43 days of bridge inventory to support fab transitions and the impending silicon carbide ramp. We continue to proactively manage distribution inventory, decreasing inventory in the channel by $79 million sequentially and at historically low levels with weeks of inventory at 7 weeks, compared to 7.3 weeks in Q4.”
Management also stated they are directing “a significant portion” of capex toward silicon carbide and the 300mm capabilities of the East Fishkill fab.
Key Metrics:
Last quarter, the automotive business grew 38% year-over-year to $986 million yet was flat QoQ. The YoY growth is in line with the year ago quarter, also at 38% growth YoY. The company guided to automotive being “positive” quarter-over-quarter in the upcoming quarter.
Industrial grew 2% in the March quarter to $556 million in revenue while the “Other” category declined (-39.3%) from $687 million to $417 million.
Here is a breakdown of the revenue segments:
Valuation:
ON Semi is trading higher than its historic average on the top line. The PS Ratio is 4.6 compared to 5-year average of 2.56.
The PE Ratio of 20.89 is lower than the 5-year average of 30, yet notably this valuation has been range bound in the 16-20 range since early 2022.
ON’s valuation is not demanding relative to the market and semiconductor sector indicating that the market has not yet looked past 2023. Once the market gets indications that the 2023 year of transition is almost over, it can begin to focus on 2025 eps estimates and the 50%+ valuation potential.
Per the table below, currently, consensus is modeling $4.86 (2023), $5.43 (2024), and $6.39 (2025). At the moment, the earnings potential is 31% from 2023 to 2025. The 2023 estimates were negative y/y at the beginning of the year but they have increased post the better than expected q123 and the analyst day. So, the positive eps revisions (albeit the absolute eps is still down y/y) are a positive factor.
Our goal for an entry would be to see 50% upside in price from $86 to ~ $130. The rationale is that once ON gets through the 2023 transition, analysts will turn toward the 2025 valuation based on $6.39 2025 EPS where currently it trades 14x. Putting 20x multiple on that gets you to around $130 (before discounting).
At the investor day, ON gave targets out to 2027 with ON guiding for operating margin expansion from 35% to 40% by 2027.
Earnings Call:
Question on East Fishkill dragging on Margins:
“On the gross margin side of things. It seems like there were quite a few moving parts, especially the East Fishkill and on the silicon carbide side, but the net of it all seems be right in line with your plan. Can you just talk a little bit about those moving parts? East Fishkill is more expensive, but silicon carbide is ahead of plan. Does that still net out to the same trajectory through the rest of the year? Just walk us through those puts and takes and maybe the utilization side as part of that as well, please?”
Thad Trent, CFO:
“Yes. So the utilization dropped in the quarter from about 74% to 71%. We expect, kind of, what we're seeing right now is utilization to stay in that range plus or minus for the remainder of the year. Obviously, if there's a second-half recovery, we can ramp up quickly. You nailed it on the rest of it silicon carbide performed better-than-expected, EFK cost as I said is coming in significantly higher than we expected. You can think about these as being, kind of, orders of magnitude more dilutive than what we expected.
The good news is we are absorbing that. As I said, we're finding additional opportunities to improve gross margin across the company and we're able to absorb that. We believe by the time we get into 2024, we've got the cost structure of EFK back in line to where we would expect it to be. So we're really confident in the margin outlook for this year, I don't think anything changes. I think if we look at Street consensus for gross margin for 2023, even with these headwinds, we think we can execute to that — those expectations.”
Question on When the Company Will Return to Growth:
“Yes, thank you and congratulations as well on great results in a tough environment. Just a quick question on the automotive market, you mentioned Hassane, a modest inventory digestion in the end market and then you're also kind of reducing distribution inventory. Can you talk a little bit about the overall demand picture for automotive. I know it's hard to kind of separate the significant ramp that you're seeing in electric vehicles and in turn silicon carbide. But just curious if there's a softness in the demand market, if there's a shift away from high-end to mid-range, any kind of color on the automotive market will be appreciated?”
Hassane El-Khoury:
Yes, look. We don't see a big disconnect into demand. It was like I said, it was a momentary thing where we use this opportunity to kind of reposition the inventory that we have externally and we'll get back to growth in the second quarter and through the year giving us an increase in our automotive revenue year-over-year.
Question on Lead Times at the Company:
Question:
Anyway, can you just give us a little update and some color on the shortages and the lead time situation? I guess for Hassane, our shortage is pretty much exclusively in the automotive business or are they elsewhere? And then there any point in time this year where you think the shortages will go away?
Hassane El-Khoury
Yes, look, so the — for me, I always refer to shortages as technologies, because they're across all markets where we provide them. High voltage silicon is of course constrained technology for us. We ramped capacity, yet the demand is much higher than even our increased capacity. And for that business, for example, it goes into automotive and it goes into industrial specifically in our alternative energy. And as Thad said, that's ramping very nicely this year after a very stellar ‘22 ramp that we talked about last year. So that is technology that is constrained. We have some intelligent power technologies that are constrained. Think about it as mixed signal analog where demand in automotive and demand in industrial both have been increasing ahead of the capacity we've added.
Past Performance:
At the end of 2021, ON provided medium term financial targets. In particular a 45% Gross Margin target by 2025, exiting 10-15% (~$700m) of non-core revenue by 2022-2023 and optimizing manufacturing to increase profitability.
By the end of 2022, ON had reached and exceeded those 2021 profitability targets ahead of schedule. In particular, gross margins reached 49%. In doing so, ON has been establishing a track record of saying what they will do and then doing better than that which has helped management build credibility with the market as reflected in the stock’s performance.
From 2020 to 2022, ON’s revenue growth was 26% CAGR and Gross Margins improved by 1,310 bps and free cash flow increased significantly.
“In Q1 alone, these results allowed us to nearly double our Q4 revenue and more than half of our 2022 full-year revenue. We are on track to grow our revenue to $1 billion in 2023 and that's approximately 5 times the revenue of 2022 setting ourselves up for leadership in the silicon carbide market with the majority of the substrate sourced internally.
Demand for electric vehicles, ADAS and energy infrastructure remained healthy amid a broad-based macroeconomic slowdown. While our automotive revenue increased 38% year-over-year, it was flat quarter-over-quarter. We are still supply constrained across several automotive technologies, while in some other technologies, we are cautiously monitoring inventory digestion.”
Investor’s Day and 2027 Targets
Following the May Q123 earnings call, ON held an investor day later in the month.
ON provided new financial updates through to 2027. A gross margin target of 53% based on 1) product mix, 2) estimated growth rate of 10-12% from 2022 through 2027 in its Automotive and Industrial markets 3) contribution from SiC and 4) manufacturing efficiencies and cost savings.
Per an analyst note, the 10-12% annually through 2027 is three-times the semiconductor industry growth.
ON also guided for operating margins to go from 34.7% to 40% in the same time period.
How does this impact the short and medium term profitability?
Taking into consideration these moving pieces, we can look at the impact on Wall Street consensus estimates. In 2022, ON had sales of $8.33b and normalized EPS of $5.33. In 2021, sales were $6.74b and normalized EPS of $2.95.
For 2023, analysts are forecasting sales of $8.13 and normalized EPS of $4.86, reflecting the exiting of non-core sales, lower profitably from start-up costs and decline sales in its non-auto/industrial related businesses. After the 2023 transition, estimates begin to increase in 2024 (Sales $8.74b and EPS $5.43) through 2025 (Sales $9.65b and EPS $6.39).
The y/y decline in quarterly eps impact from the 2023 transition year appears to be well reflected in analysts’ estimates in the chart below, with an improvement starting in 2024. In Q1, management stated they can meet analysts’ 2023 gross margin expectations.
Revenue estimates paint a similar picture.
What to do from here?
Over the past month, quarterly earnings estimates in 2023 through 2025 are being revised up on the back of its new 2027 financial targets and better than expected Q123 execution, particularly in SiC, which was a catalyst for the recent positive price action.
ON has done a very a good job of guiding the market on a quarterly basis. In the past six quarters, ON has exceeded Wall Street expectations. If this pattern continues in 2023, this could continue to be a positive catalyst for the stock price.
For the remainder of 2023, ON will likely continue to effectively manage Wall Street earnings expectations. While analysts will look for signs that the 2023 transition year is close to reaching the inflection point.
Conclusion
Management deserves credit for implementing smart strategic initiatives and making acquisitions to vertically integrate to capitalize on the secular trends of electrification, automotive ADAS, alternative energy infrastructure and factory automation to position itself as a long term winner.
Although this will impact profitability in 2023, the progression starting in 2024 through 2027 is significant. Importantly, management has done a credible job of explaining the roadmap to analysts and has consistently reached its quarterly targets. Since 2020, the management team has delivered on its strategic and earnings goals.
The valuation does not price in much expectations beyond the 2023 transition year. We expect management to continue its track record of effectively managing wall street quarterly eps expectations for the remainder of the year. Once analysts believe the transition is nearing its completion, likely sometime in 2h23, the focus will shift to 2024 and 2025 earnings potential.
For reference to terminology used, please look at technical analysis under our resources section here. Regarding the charts below, the vertical tan shades represent time factors. These are inflection points where we have high odds of something significant happening. More times than not, (3/4 of the time), they mark a turning point in the trend. So, what matters is the direction we are trending into these periods. Regarding the vertical lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.
Elliott Wave count are meant to provide context. There is a pattern unfolding in real-time, one of which will play out. By monitoring price levels that are held/broken, it will help us figure out which one is in play
S&P 500 Analysis
The market is very close to completing the upward pattern off the October, 2022 low. As pointed out many times, it is an overlapping and corrective pattern, which has us cautious until it resolves to the downside. Either the coming drop will break through 3805 SPX and confirm that we are heading to new lows (the blue count), or it will hold the 3900 – 3805 region and turn back up, confirming a new bull market (green count). The other necessary event I want to see in order to confirm the green count is a rotation from Big Tech and into more economically sensitive sectors/markets – more on this below. We need breadth expansion in a meaningful way if we truly are in a lasting bull market.
We now have mixed signals from our weekly internals. The weekly RSI is breaking out of its bear market momentum pattern. We now need to hold this level on any pullback. If we fail here, it will be likened to a false breakout in price. Also, breadth continues to flash warning signs, as the % of stocks above their 200 day SMA continues to trend lower against price trending higher. It is rare to see both momentum and breadth be so weak in the early stages of a bull market, and warrants further caution until resolved.
If we zoom in on the structure of the pattern off the October low, you can see how overlapping it is. I labeled the wave patterns so that you can see how this structure fits best as a corrective pattern.
Statistically, when you see an overlapping uptrend, it is more than likely a correction in a larger downtrend. This increases the risk substantially, as it now opens the door to a +1000 point drop from current levels. This is a rare potential to have to risk manage around, yet the wave structure suggests this is more than a possibility to respect until invalidated.
If we are in a new bull market, the only pattern it can take to new highs is a diagonal pattern. This is a series of overlapping, corrective moves that ultimately trends upwards to new highs. It is characterized with big swings, and if this is playing out, we are only coming to the end of the 1st wave. We will know more once we see the character of the coming pullback.
So, how far can we climb before we see a pullback? If we zoom in on this final swing, it appears to be playing out as a diagonal on a smaller scale. This tends to limit the upside move, but a blow off sentiment could push us as high as 4414 SPX. In the chart above, you’ll notice this price will be the symmetrical price where the swing up that started in March will be the exact length as the first swing up off the October low. These corrective patterns tend to be quite symmetrical.
We should see a pullback early this week. If it can hold 4200, and then turn back up, we could see a final blow off move into the +4300 region. If 4200 breaks, the final support is 4170. Below this level and the odds will increase greatly that the top we are looking for is in.
Regarding when we could see this inflection point. The time factor is coming up between June 15 – 25.
The DJI may get a run up to the upper trendline, but that would likely be it. I had a count from months ago on my chart where the Dow makes a run to new highs. When you look at the stocks inside the Dow, they do not suggest this is a high probability. Like most of the weak markets I track, it has to hold the trendline being used as support to keep pushing higher.
Small caps continue to look weak. We are seeing a push into our original target zone on weakening momentum. We would need to take out the February highs to invalidate the crash setup. This is a lot to ask, but if IWM can break above this level, it will be quite bullish.
While tech is pushing the market higher, the more value-oriented names above, which are more economically sensitive, continue to trend lower. If RSP breaks that trendline, it’s game over. Like small caps, it needs to get above the February highs to invalidate the crash setup.
NASDAQ-100
NDX is in a world of its own. I’m counting this move as a 3rdwave top, followed by a 4th wave retrace and one more push higher. This will likely result in even more divergences (lower highs in other markets), if it plays out it will be a clear sign to be very cautious. Emotions are high, and money is piling into tech right now. There is nothing healthy about these divergences. If we are in a new bull market, we must see a rotation from big tech and into your more economically sensitive sectors and indexes.
TLT and the Dollar (Risk-Off)
These are two risk-off plays, and they appear to be bottoming and pointing higher, or in the middle of an already defined uptrend. Long-dated bonds appear to be completing a large degree B wave just as equities are approaching a bigger top. The c wave break out will likely coincide with fear returning to the markets. As long as TLT holds $98, I’m expecting this to play out.
Recent Eurozone PMIs are very concerning. With Germany already entering into a recession, most of Europe isn’t far behind. This is contrary to both US economic data remaining resilient, along with inflation. With the EUR/USD pair coming off of extreme overbought conditions, the setup is there for the dollar to keep pushing higher.
We have been anticipating this move for some time in the dollar, and it’s only a matter of time before the markets react. Two necessary ingredients for a macro environment supporting a new bull market are: 1) The FED starting a fresh liquidity cycle soon; 2) the dollar continuing its downtrend. This is not a good sign for equities.
Global Markets
One factor that will likely hold back a push into our upper target zone in the US markets is the state of global markets. Some of the major markets appear to have topped, while others look like they have room for one more minor swing, at most.
Canada
The Canadian TSX looks like it has topped out before most global indexes. If this bounce drops and makes one more low, it will be confirmed. What should follow is one last bounce before the wheels fall off. The TSX historically leads the US, so when they diverge (like now), it’s important to pay attention.
Europe
The French CAC40 looks to have completed its bigger uptrend off the 2022 low. We were expecting one more push, but this drop is too deep to suggest anything more than a b wave retrace on the next swing. This will complete the larger uptrend off the 2009 low.
The German DAX is in agreement with the French CAC40. Note the island top reversal where sellers keep stepping in at the start of the gap. There’s not much gas left in this market before a larger reversal takes hold.
The Swiss Markets are largely overlooked, but they provide some of the cleanest wave patterns in Europe. This is clearly a larger b wave playing out. It looks like we are completing the 4th of C with one more minor swing to finish off the uptrend. There’s not much left here before a bigger reversal manifests.
Japan
The Japanese Nikkei has been leading the NASDAQ for a long time. It looks like one more minor correction, followed by one more push higher and then that’s it.
Conclusion: global markets have either topped, or are within 1 – 2 more swings away of a larger top, at most. The US market has a revived animal spirit driving prices; however, considering the state of global markets, it should limit how high the US markets can push in the coming weeks.
Macro
The macro thesis that supports the concerning price action above can be summed up in a single phrase – stubborn economic growth = stubborn inflation. To prove my point, the below chart compares the 3-month annualized growth in various economic metrics as well as inflation metrics.
Though it is obvious that we are weakening in growth, we are not yet in recessionary readings. This is emboldening the popular narrative that a soft-landing, or no-landing is what’s playing out. The narrative further goes that even if we do see a recession, it will be mild and was likely priced into equities in 2022. What this narrative is not seeing is that inflation is far from under control, meaning the FED is likely not about to drop rates and start a fresh round of QE.
Note the growth in core inflation, once you strip energy and food out. Two points need to be made: 1) we have been stuck in the 4% – 5% range for nearly a year, showing no progress. This is between double to triple the FED’s target goal. 2) These numbers are compounding sequentially. If there is any hope to have the YoY reading hit the FED’s 2% target, these 3-month annualized readings need to start trending down for several months in a row, which is not happening.
Furthermore, history shows that the FED needs to break the economy to get inflation back in line. Going back to the 1950s, there is no example of core inflation going back down meaningfully once the inflation genie is let out of the bottle. Every instance where core inflation went down meaningfully was on the back of a recession. This means that the bull narrative, whether aware of it or not, is claiming that this time is truly different.
This means that the necessary ingredient for a new bull market, which is liquidity, is not likely anytime soon. There is also no example of a meaningful bull market taking shape without an expanding liquidity cycle. The last liquidity cycle was started in March of 2020. It ended when the FED started raising rates and commenced with Quantitative Tightening. Since then, the FED is continuing its rate hike campaign while rolling off securities from their balance sheet to this day.
One could argue that the market is very forward-looking, and anticipating a pivot soon. Based on where inflation is, this is also unlikely. The bigger risk to the economy is not equities taking another hit, but the FED losing control of the bond market.
Imagine what the bond market would do if the FED dropped rates with the S&P 500 at 4300, and core inflation readings staying stubbornly high? The last time the FED started a liquidity cycle too soon was in the late 1960s. They lost control of the bond market for over a decade, as rates remained very high due to ongoing inflationary pressures. Higher rates compound into lower growth. This is a much bigger risk to the economy than equities continuing lower, especially with the level of debt in the system.
To those arguing that the market is pricing in a pivot early, history is very much against this narrative as well. The below chart compares when prior bear markets have bottomed in relation to the FED’s pivot, which is the start of a new liquidity cycle.
What the above chart shows is that when the FED starts a new liquidity cycle, the market tends to bottom within a 1-2 month spread of the actual pivot. There are instances where the FED’s pivot is not enough to offset the credit cycle within the recession, like in 2008, 2001, and 1981, and a bottom isn’t found until the credit cycle ends. However, there is no instance in time where the market bottoms more than 1 month from the FED’s pivot, which starts a new liquidity cycle.
What this means is that for this to be a new bull market, the market would have had to bottom +7 months before a FED pivot. Not only is this an extreme statistical outlier, but it would truly be stating that this time is also different.
The Market is Too Bearish?
There has also been a narrative that the market is so bearish, as the masses pile into short positions prematurely. While we do think that it is possible for this run higher to push into the fall, the implication is not as valid as one might think.
The AAII investor sentiment survey shows the current allocation to stocks around 34%. This is nowhere near the level of drop we see in stock allocations during a credit cycle downturn. Even though the reading isn’t suggesting exuberance, it is very disconnected from the reality of a credit cycle downturn.
Source: YCharts
This is further backed up when we look at the exposure of households to equities as a % of financial assets. Though this number is well off its all-time highs, it is notably higher than the 2007 top and just off the 2000 top. The private sector is also not factoring in the possibility of a credit cycle downturn and has a long way to drop once the reality sets in.
Source: FRED
Conclusion: it takes time for rate hikes to filter into the economy. The rate at which the FED raised rates has created an unusual lag between their effects and the market rebound. However, core inflation will not allow the FED to lower prematurely. They need a recession to both correct core inflation and also provide the cover needed to start a fresh liquidity cycle so that the bond market does not start another leg of selling.
The gamble the bulls are making is quite high: 1) Core Inflation will just go down on its own short of a recession for the first time in modern history; 2) the market sniffed out a FED pivot +7 months before an actual shift in policy, which is an extreme statistical outlier and the first of its kind; 3) the ongoing rate hikes will not create a credit cycle downturn, or if there is one, it will be minor and was priced in last year; 4) This overlapping and corrective uptrend off the October low is the start of an ending diagonal, even though probabilities do not favor this scenario.
I/O Fund Portfolio
The move in AI and the I/O Fund’s overweigh this trend is a large reason why we are doing so well this year. It has offset our early and excessive bearish positioning, as well as having to log a few outsized losses on our hedge. We believe that by 2024 the frustration around current hedges dragging on returns as well as our defensive positioning will be worth it.
We continue to hold a large cash position, and though it may not feel like it, we believe this decision will pay off over a long-time horizon. We do believe a credit cycle downturn will start in late 2023/early 2024, and that the equity market is not pricing this in today. Our goal is to have plenty of cash to buy choice tech positions at much better bargains than we are seeing today.
Any pullback in the summer needs to hold $347-$333. If this level holds, we will likely begin buying again as NVDA sets up for a push towards $585. Below this level and NVDA will likely go lower than many believe possible.
Unlike NVDA, AMD is making a lower high. The weekly candle was a nasty one last week, with some follow-through this week. I think, at best, we get a pullback into the $80s-$70s. We will likely be buying some of our target allocations based on the red count playing out.
Bitcoin (BTCUSD)
Here is the flush we were expecting. So far, it looks like 3 waves down. Below $23K and we will get concerned. Below $19K and we will be stopping out of a portion of our position.
We will continue to target AEHR on the next pullback, now that we know what count is playing out. This move up is likely of the final 5th wave higher. If the coming pullback is a 3 wave move into our support targets, we’ll buy.
This bounce still counts best as a large B wave, which lines up with the rest of the broad market. There’s a shot, like AAPL, where it can pullback in the summer and then continue to new highs in the red count. Once we get a pullback, we will reassess. Interestingly, the blue count for MSFT and NVDA lines up really well with the coming AI trend once we get on the other side of the credit cycle downturn.
The big picture in Ethereum is promising. Bitcoin looks similar in that we are working on a very large 5th wave in an incomplete uptrend that began years ago. As with Bitcoin, we will defer to the WealthUmbrella team’s signal to help us position or cut our losses.
I’m struggling to count TSLA’s price action in a way that makes sense. So, instead, we’ll identify downward targets and the level that must hold to avoid getting there. First off, the bear market downtrend has been building its swings from the $244 Fibonacci confluence zone. You can see the perfect symmetry of swing highs leading to symmetrical swing lows from this price zone. The next swing up in $84.75 based off the January 2022 top. If we break below $153, this will be our target.
Chainlink (LINKUSD)
I’m zooming out on LINK today. The consolidation is just too messy and going nowhere. However, LINK is one of the rare alt coins that has completed a 5 wave pattern off its ICO. There’s still a chance that LINK can push towards $3.5 before bottoming. However, there will likely be a time when LINK is in our top 5 holdings…just not now.
This article was originally published on Forbes on Jun 1, 2023,08:15am EDTForbes Forbes on Jun 1, 2023,08:15am EDT
The smartphone market continues to be hit hard in q1, with prices down 20% and shipments down 13%, according to Canalys. Despite double digit decline across the industry, Apple delivered marginal growth on its iPhone sales at +1.5%. According to Counterpoint Research, Apple grew smartphone shipments by 1 million year-over-year from 59 million in Q1 2022 to 58 million in Q1 2023. The decline of (1.7%) was better than the (14%) decline for the global smartphone market.
Source: BETH KINDIG
According to Apple’s management, the reason the company was able to overcome smartphone weakness was due to sales in the emerging markets. The company’s CFO, Luca Maestri, said in the earnings call, “We set March quarter records in several developed and emerging markets with India, Indonesia, Turkey and the UAE doubling on a year-over-year basis.”We set March quarter records in several developed and emerging markets with India, Indonesia, Turkey and the UAE doubling on a year-over-year basis.”
Within the emerging markets, India is a primary focus for Apple due to a growing middle class. According to a survey from a non-profit, the middle-class population has grown from 14% in 2004-05 to 31% in 2020-21. Tim Cook also points to the fact that the country is at a tipping point. “There are a lot of people coming into the middle class, and I really feel that India is at a tipping point, and it's great to be there.”There are a lot of people coming into the middle class, and I really feel that India is at a tipping point, and it's great to be there.”
Although Apple does not break down India sales figures, Bloomberg News reported that sales grew by 46% YoY to about $6 billion for the trailing twelve months ending March 2023. According to a Wedbush analyst, “Apple is now aggressively looking at India from both a production and retail expansion over the coming years that the firm believes will be a strategic poker move for Cupertino that could ramp annual revenue to $20 billion by 2025 in India.”
Tim Cook recently visited India in April and opened two company-owned retail stores. Apple was the second biggest revenue generating brand in India in 2022, second only to Samsung as it gained 18% of the total value of smartphone shipments, according to research firm Counterpoint.
The company also plans to make India a manufacturing hub and this move is seen as the company’s efforts to rely less on China. JP Morgan mentioned in its research note last year that the company plans to produce 25% of all iPhones from India by 2025. However, it could take a few more years to reach the 25% level. According to Bloomberg News, the company now produces 7% of total iPhones from India and this is up from 1% in 2021.
Apple supplier Foxconn announced recently that the company plans to invest $500 million to set up a manufacturing plant in India. It had also announced in March that it received approval from another state in India for a $968 million investment. Similarly, Foxconn has plans to expand its existing manufacturing plants in India.
There are 2 billion Apple devices active in the world and there are 659 million smartphone users in India, compared to 975 million in China and 276 million in the United States. With India being second place, it makes sense that Tim Cook is focused here.
Source: Statista
According to Morgan Stanley analyst Erik Woodring, “The firm's 2023 revenue and EPS forecast increased by 1% and 3%, respectively, post-earnings and while the firm calls out iPhone 15 and an AR/VR headset as the next catalysts, it adds "don't sleep" on the emerging markets and India story at Apple.”
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Apple’s Brand Needs a Catalyst
Warren Buffet was recently asked why he is invested in Apple and his reply was “If you’re an Apple user and somebody offers you $10,000, but the only proviso is they’ll take away your iPhone and you’ll never be able to buy another, you’re not going to take it. If they tell you if you buy another Ford car, they’ll give you $10,000 not to do that, you’ll take the $10,000 and you’ll buy a Chevy instead.”
Not surprisingly, Apple is one of the world’s most valuable brands, rivaled only by Amazon and Google.
Source: I/O FUND
Despite this strong brand, the next chapter for Apple has been slow to materialize. As seen below, wearables have not become the “next big thing” for Apple with $8 billion or so in revenue per quarter. Emerging markets are promising, yet at the $20 billion per year or $5 billion per quarter, Apple will struggle to move the needle for some time by relying on this strategy alone.
“Investors looking for the “next big thing” will point toward companies like Stripe, Sofi or Square as the leading fintech stocks. Meanwhile, the next big thing to disrupt the financial sector may be sitting in plain sight. Apple grew its cash trove through legendary design and hardware, yet how Apple chooses to leverage its enormous reserve of cash may be what writes the next chapter for the world’s most valuable company.”
Services remain a long-term opportunity for the company to monetize its installed base of over 2 billion active devices. Apple recently launched a new high-yield savings account that offers a 4.15% interest rate, which is 10 times higher than the United States national average and 415 times higher than what Chase or Bank of America offers at 0.01%. Apple is also lending from its balance sheet for the first time ever through Apple Pay’s Buy Now and Pay Later product.
To illustrate how effective Apple’s move into finance tech has become, the cornerstone product, Apple Pay, currently has 75 percent adoption among iPhone users. This is up from 10% in 2016. In addition to taking on banks, Apple is also competing with Mastercard and Visa with features that allow merchants to use iPhones and iPads to send and receive payments. The long-term goal is to replace wallets with iPhones.
Spotlight on Earnings
For some time now, Apple has been a value stock. We discussed this when we stated:
“While comparing to other popular value stocks like Walmart, Apple is trading at a slightly higher forward P/E ratio of 23 compared to Walmart’s 19. However, the company’s net profit margin of 25.71% is very good compared to Walmart’s 1.45%.
Similarly, Apple has an excellent free cash flow margin of 26.37% compared to Walmart's negative free cash flow margin of -5.15%. This helps illustrate why Apple’s stock has held up well as investors are able to participate in the most cash efficient company of all time while also participating in the company’s future innovation cycle.”
The most recent earnings results continue to prove that Apple’s management team is strong on efficiency. Despite revenue declining by (2.5%) YoY to $94.84B, the gross margin improved from 43.8% to 44.3% in the most recent quarter, up 50 basis points due to cost savings and a favorable mix from Services. The free cash flow margin remained solid at 27% compared to 26.4% in the same period last year. The board also authorized an additional $90 billion share repurchase and increased the quarterly dividend by 4% to $0.24 per share.
Source: COMPANY IR
Operating income declined by (5.5%) and net income declined by (3.4%) YoY to $24.2 billion. EPS of $1.52 remained unchanged from the same period last year, and notably, the company beat EPS estimates by 6.4%.
As stated, iPhone sales were up +1.5% to $51.3 billion. Mac revenue declined by (31%) YoY to $7.2 billion. This was due to a strong comp with M1 MacBooks sales from last year and a weaker consumer. iPad declined (13%) YoY to $6.7 billion. Wearables declined (0.6%) to $8.8 billion.
Services grew 5.5% YoY to $20.9 billion.
Paid subscriptions of 975 million, was up 18.2% YoY. This segment is important as there is a higher gross margin of 71% compared to 36.7% for products.
Management’s directional insights for the June quarter were soft with foreign exchange negatively impacting growth by about 4%. The company’s CFO, Luca Maestri, said in the earnings call, “We expect our June quarter year-over-year revenue performance to be similar to the March quarter, assuming that the macroeconomic outlook does not worsen from what we are projecting today for the current quarter. Foreign exchange will continue to be a headwind and we expect a negative year-over-year impact of nearly four percentage points.”
Analysts expect revenue to decline by (1.1%) YoY to $82.03 billion.
Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more here.
Where Can Apple Stock Go from Here?
There are two scenarios we are tracking for Apple based on the current price information:
The blue count suggests that we are in a long and drawn-out correction that will ultimately be targeting new lows. If Apple stays below $181.50 and then breaks below $150.50, the odds that this scenario is playing out will become very high. If this plays out, we will look towards the blue target box for a major low.
The red count suggests that the January low for Apple was a major one. This will put us in the final push in the large uptrend that began in 2009. If Apple can break above $181.50, we can see a final push to the upper red target box between $192 – $210.
Source: I/O Fund
Apple is currently under the major resistance zone between $176.25 – $181.50. Based on the relative weakness in most markets right now – small caps, industrials, materials, financials, transportation, the Dow Jones, as well as many global markets – we are expecting volatility to return sometime in early June. If Apple fails to punch through the $181.50 resistance before the market pulls back, it will need to hold the $160 – $150.50 range in order to allow for this final swing into the red target zone above. Below $150.50 and the top will be in for Apple, as the odds will greatly increase that we will be testing Apple’s January lows.
Conclusion:
My firm does not own Apple at the moment, yet given its enormous brand value and high install base, it’s a company we track closely. In addition, the company’s strong financials will only become more attractive in the event of a recession. For our purposes, my firm would want to see Services materialize as a leading Fintech play, and we would want to wait for the price action outlined above to play out before buying this stock.
The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund does not own shares in AAPL at the time of writing but may own other stocks pictured in the charts.
Royston Roche, I/O Fund Analyst, contributed to this article.
Each week, we provide a webinar for premium members where we analyze the macro environment and how it is currently playing out in global equity markets. From this backdrop, we then discuss the specific tech stocks we are targeting to buy/trim within the I/O Fund Portfolio. As a growth investor, it is essential to be aggressive when the macro environment supports such a position, and to be defensive when we see warning signs.
Because we believe that we are approaching another inflection point in the markets, we thought that we’d open up this week’s webinar to our Essentials readers. In this clip, the I/O Fund portfolio manager, Knox Ridley, goes into great detail around why the current macro backdrop is riskier than most investors believe. He discusses the current trends in inflation, liquidity and what we need to see in order to start aggressively betting on a new bull market playing out. Below are the time stamps, as well as the clip.
Liquidity, Inflation and why the FED needs a recession – 6:44
Broad U.S. Markets (SPX, NDX) – 17:40
Health of Economically Sensitive U.S. Sectors – 21:00
What are European, Japanese, Canadian Markets Telling Us – 24:15
Contrarianism is a rewarding investing thesis. The idea is that the market is a zero sum game. For me to win, others must lose, and vice versa. When the crowd stampedes into a trade, this explains why taking the other side of that bet is often correct.
Today, we are seeing one of the largest net short positions in the hedge fund community since 2011. Every time this level of sentiment led to a crowded bet, the market snapped back, punishing the crowd. This information is one of the primary points in the ongoing bull theses.
Bloomberg
The other argument I hear from the bull narrative is that stocks are not crashing from the ongoing, negative news cycle. They instead appear to be climbing a wall of worry as we are now approaching the 4200-resistance level.
This bull thesis holds merit, yet there is one important twist to this narrative that needs to be explained. The question is not: why is the market not breaking down on terrible news? The more important point that needs to be addressed is this: why is the market not breaking out in a meaningful way? With such an extreme allocation to short positions, as well as markets continuing to shrug off really bad news, it’s odd that we cannot meaningfully clear the 4200 – 4300 barrier.
I was beating the drum in mid-October and early November that a sizable rally was unfolding when the market was extremely bearish: “more and more signs are pointing to a bigger trend reversal underway. Several markets are in new uptrends and suggesting a push to new highs is on the horizon. This will lift all boats, but I do not expect all stocks/markets to make new highs. It’s important to identify the winners, and stick with them in these new uptrends.“
In our premium analysis, we went on a buying spree around this time, loading up on some of our leading positions. Today, after a sizable rally, we have raised a considerable cash position, and rebalanced our portfolio to coincide with the new macro that we are in.
We believe another reason the market cannot make up its mind is that the current macro environment is showing stubborn pockets of growth, which is keeping equities from falling. However, with stubborn growth comes stubborn inflation, which is preventing these markets from powering too much higher.
There’s plenty of evidence of this unhealthy bifurcation. For example, we’ve covered in the past that while Big Tech continues to power higher, underneath the hood, your more economically sensitive sectors, which tend to be early cycle sectors, are being sold aggressively.
If this is a new bull market, we need to see the coming volatility hold the SPX 3805 level and a rotation from Big Tech into these neglected sectors. This will be our signal to safely pivot for a renewed bull market.
Growth = Inflation
The chart below is looking at various economic metrics on a 3-month annualized basis. The reason I prefer this measurement is because we can see the current trend within the economy, as opposed to measuring the reading against an arbitrary month in the distant past.
The chart below helps to illustrate how pockets of growth in the US economy have stayed surprisingly resilient. Even housing is reaccelerating as well as the consumer. These are simply not the type of readings we see going into an imminent recession. This is fanning the hope that the looming recession will result in a soft landing, or possibly even no landing at all.
What these investors are failing to realized is that buoyant growth means buoyant inflation. In prior soft landing scenarios, like 2016, inflation was running well under the FED‘s 2% target, allowing them to keep rates next to 0 to defend declining asset prices. Today, the FED does not have this convenience, as inflation is far from their 2% target.
When we look at the same inflation metrics on a 3-month annualized basis, what investors should notice is how far away we are from the 2% target. In some instances, we are triple the desired target. Furthermore, these metrics have remained virtually unchanged for up to a year, and in some instances, and they have been growing sequentially.
Peak inflation is behind us, but the real battle will be getting these numbers back to the 2% target. In fact, going back in history, there is no instance where core PCE inflation backs off from an inflation impulse without a recession.
The reason markets are not breaking out in a substantial way after the 2022 bear market is because as growth and the consumer surprise to the upside, inflation becomes more problematic. We expect the FED to continue their fight against inflation by continuing to raise rates into 2023. The more they raise, and the longer they stay elevated, the higher the odds are that something gets broken in the economy.
Two Scenarios; SPX 3805 is Important
Regarding the broad market, here are two scenarios that I am tracking based on the structure from the October 2022 low. The blue count suggests that we are in the final swing before topping out with a push to new lows on the horizon. The Red count will find support above 3805 SPX, and begin a strong uptrend to new highs in the coming years.
Both scenarios see volatility returning into the summer. If this is a new bull market, we not only need to see 3805 hold, but we will need to also see a rotation from Big Tech into more economically sensitive sectors/styles, like small caps, transportation, industrials and financials.
Broad market breakouts tend to occur with most markets and sectors participating. Strong breadth expansion tends to equate to an improving economy. As a result, early bull markets tend to see economically sensitive sectors leading the way. This is simply not what we are seeing today, as the market piles into the perceived defensive Big Tech trade.
As of today, both Apple and Microsoft account for more than 14% of the S&P 500. In fact, over 25% of the S&P 500’s top 10 holdings are in Big Tech.
Ycharts
Furthermore, if we look at economically sensitive sectors, we are not seeing the type of relative outperformance that we tend to see in an early expansion cycle.
Small Caps
Note the head and shoulders pattern developing underneath a major trendline. There are no buyers at this critical support, and once it goes, the October lows will likely get taken out. Also, note the relative performance of small caps vs the S&P 500 in the green indicator below. When the green line is trending down, it means that the S&P 500 is outperforming Small Caps, while the green line trending up means that small caps are out performing the S&P 500.
Transportation
Transportation stocks continue to falter in the current macro, suggesting that we are not starting a new growth cycle, yet. They look a lot like the prior charts, with developing head and shoulder patterns forming on weak relative strength.
Industrials
Industrial stocks are the most concerning to me, at this point. They look a lot like Financials in late February, which we were warning investors about.
Twitter
What’s concerning is that we have a full bear pennant pattern completed at the February high, followed by a clear 5 wave drop into critical support. The current pattern is tracing a descending triangle pattern, which more than often, resolves to the downside.
Financials
I tend to believe that financials are leading the market down, not Big Tech leading us up. The weakness can be seen outside of the regional bank stocks, which I’ve discussed in great detail here.
While everyone focuses on the regional banks, the financial sector that tracks the biggest financial institutions in the US looks quite unhealthy, as well.
Conclusion
The main point I want to convey to investors is the more economically sensitive stocks and sectors appear to be setting up for a breakdown instead of a breakout. The markets have no reason to crash, as growth remains stubborn, but the piling into Big Tech while other sectors get sold is due to the fact that the FED cannot abandon their fight against inflation to support asset prices.
We are open to a new bull market being formed, which is our red count in the SPX chart above. In order for us to pivot, we will need to see the coming volatility hold 3805, and a rotation from Big Tech into the more economically sensitive areas of the market. This doesn’t mean tech won’t lead in a scenario where there is a rotation out of Big Tech, it only means that the market is seeing a soft landing and pricing that into equities.
The argument for the bulls is that the market is climbing a wall of worry, as the majority of the market piles into cash and short positions. We discussed the net short positions going back to 2011 to support this; however, if we pull this data back farther, we can see that the net short positions were even more extreme in late 2007.
Real Investment Advisors
That being said, there are times when the crowd is right. The damage done to the economy by the Fed’s fight against inflation will likely prove to be vast. We believe it is prudent to see how this next pullback manifests before getting too aggressive on the long side of this market.
Join I/O Fund Portfolio Manager, Knox Ridley, every Thursday at 4:30 p.m. Eastern on a webinar for Advanced Market Signals Members where he discusses the broad market as well as various tech positions the I/O Fund currently holds and is looking to buy. You can view the most recent webinar here.You can view the most recent webinar here.most recent webinar here.
