No Place To Hide? The Fed And Earnings; EPAM Systems

Two factors influenced this week’s market action most directly: the Federal Reserve’s announcement that it was raising the Federal Funds Rate by 0.50% and the continued barrage of 1^st quarter earnings. Initially, market participants were buoyed by a smaller than expected hike. However, on Thursday/early Friday, the mood soured and the stock market gave back its gains, and then some.

We also received another torrent of earnings, with company managements sharing mixed results. E-commerce has clearly been one of the biggest losers, as pandemic restrictions fall to the wayside. Meanwhile, we have seen a handful of impressive earnings report, but one thing is certain: investors are favoring companies that are generating cash flow in the now, while continuing to reject those that are still unprofitable. We know that this message borders on repetitive, but it is one of the few principles we can count on.

As the Federal Reserve telegraphed a continue to its hawkish approach moving into summer 2022, bond investors continue to vote with their feet, selling fixed income instruments of all varieties. The 10-year US Treasury rate pushed above 3% this week for the first time since late 2018 and shows no signs of slowing at this stage. In our opinion, this argues for investors to consider allocating to the types of companies we profiled in last week’s article, those that generate consistent cash flows and pay generous dividends. We think these types of companies provide ballast to any portfolio and, more importantly, income that retirees need from their portfolios. One theme that does continue to work is energy. As you can see in the table below, oil prices rose yet again this week and oil stocks, as measured by the XLE, rose more than 4% this week. We have been clear throughout the year that energy shares are the only asset class in which we feel comfortable concentrating funds and that continues to be the case. In this week’s “What Working?” section, you will see that energy securities again were dominant.

We preach caution in the current market, especially in growth stocks. We will discuss in “Earnings Implosions” about some of the biggest disappointments we have observed in recent releases. What we think investors must realize is a pattern we have observed: growth stocks are not reporting one-off bad quarters; rather, when a business like Netflix (NFLX) produces one bad report, it is usually the beginning of a trend, not a one-off. Though many of these stocks are down 50% (or more) from their all-time highs, we think investors need to break themselves of this “buy the dip” mentality on these companies until business and stock price trends reverse substantially. We still haven’t seen the type of capitulation that would suggest these stocks will stop falling.

Whether your portfolio is composed of stocks, bonds, or some combination, you likely are down significantly on the year. Through our conversations with investors, we know that portfolios need a repair strategy. We think investors need to approach their planning with active management, as finding stocks that perform in the current environment is a huge challenge!

With that all being said, let’s get into it!

Below is the performance data of key indices, ETFs for the five trading days between 4/29/22 and 5/5/22:

What Is/Is Not Working?

As far as What’s Working, energy is the obvious area of focus, with 9 of the top 20 performing ETFs this week coming from that sector. Natural gas was especially strong this week, as the United States Natural Gas Fund, LP (UNG) rose by more than 20%! Other ETFs that populated the list were the Energy Select Sector SPDR Fund (XLE) and SPDR S&P Oil & Gas Exploration & Production ETF (XOP). This trend shows little sign of slowing, but we note that most of the share price growth has come from higher earnings rather than multiple expansion.

With both stocks and bonds falling, securities betting against these markets were profoundly strong, including Direxion Daily 20+ Year Treasury Bear 3X Shares (TMV) and AdvisorShares Ranger Equity Bear ETF (HDGE).

With markets overall weak, we saw another extreme skew toward the negative in this segment of our data analysis. Our 20 worst performing ETFs in our list were all down 6.8% or more!

We saw plenty of repeat performers on “What’s Not Working?” this week, including AdvisorShares Pure US Cannabis ETF (MSOS), Grayscale Bitcoin Trust (OTC:GBTC), Renaissance IPO ETF (IPO), and First Trust Cloud Computing ETF (SKYY). Again, we want to emphasize here that “buying the dip” in these downtrodden sectors is unlikely to be a winning strategy, at least in the near term.

We saw some new entrants to the “What’s Not Working” list this week, including Amplify Online Retail ETF (IBUY), The Real Estate Select Sector SPDR Fund (XLRE), and First Trust NASDAQ Cybersecurity ETF (CIBR). We will get to the online retail piece in “Earnings Implosions”. Cybersecurity had been strong due to concerns that the War in Ukraine would lead to higher incidences of cyberattacks. Enterprise customers are remaining vigilant in this area, but many of the businesses that comprise the index are still unprofitable and, thus, out of favor. The weakness in real estate is new and one can certainly understand how interest rates that are rising sharply is a bad backdrop for that sector.

Earnings Implosions

We follow earnings reports very closely here at Left Brain, as they not only let us know what is happening inside of individual businesses, but also, they direct us to trends that are happening in the broader economy. The last two weeks of earnings have directed us to a crucial trend we have observed: growth and earnings (to the extent that there are earnings) are slowing dramatically, as pandemic restrictions ease and consumers begin spending their hard-earned dollar in different ways than they have in the last 2 years.

Last week, we heard from the company that typifies e-commerce, Amazon (AMZN), which reported a loss (negative earnings) in the 1^st quarter, as revenue came in just below analyst estimates. Sales growth slowed, as the company is comparing to elevated revenues from 2021 and other retailers are beginning to cut into the online sales advantage that Amazon has enjoyed for years.

This week we received confirmation of the theme that e-commerce is beginning to struggle, not just at Amazon, but throughout the industry. Shopify (SHOP) has a platform that enables online retailers, both large and small, to sell goods and services online through their own online store and have payments, marketing, shipping, and other functions handled by a third party. This stock was one of the darlings of the pandemic, with the shares rising more than 5-fold between March 2020 and the end of 2021. Shopify has problems on both ends of the profit equation: its sales growth rate came in just under 22%, which represents a major deceleration when compared to the 57% growth in fiscal year 2021. At the same time, Shopify’s operating expenses grew by 67% in the quarter, as the company continues to invest especially in the sales and marketing of the business. As a result, the business delivered negative operating income for the first time since 1^st quarter 2020. Business is clearly slowing and SHOP shares show no signs of a bottom. Investors continue to have a hard time putting a valuation on businesses like this.

Two other big players in the e-commerce space reported this week, with similarly dreadful results. Etsy (ETSY), an online marketplace for selling handmade and vintage items of a craft variety, reported that the gross merchandise sold on the platform actually decreased in the 1^st quarter, relative to the same period in 2021. Net profits also fell by 40% on a year-over-year basis. The kiss of death was the fact that company management guided revenue estimates down for the 2^nd quarter. This is the opposite of “beat and raise”: the “miss and lower” earnings reports have been met with heavy selling in this market and have turned investors off from these “pandemic darling”-type businesses. Finally, we heard from Wayfair (W), another online marketplace. Revenue came in slightly above expectations for Wayfair, but Earnings per Share came in at -$3.04, much worse than was expected by investors. As you can see from the chart below, these three stocks, SHOP, ETSY, and W fell sharply this week.

Impressive Earnings From A Bounce-Back Candidate

Your author is the type of person that likes to hear the bad news before the good news. While, of course, we saw some really terrible earnings reports this week like the ones above, we also received reports from a few businesses that made us take notice, including from one of our strongest bounce-back candidates.

EPAM Systems (EPAM) is a software engineering company, which makes use of overseas engineering talent to help its clients complete digital transformations and other projects. The company’s challenges began with the War in Ukraine, since many of its employees are based in Ukraine, Russia, and Belarus, right at the epicenter of the conflict. When news of the war broke, EPAM shares fell by more than 70% almost instantly. EPAM was the type of business we had moved away from in early 2022, since high multiple software businesses have been out of favor, but we had to take notice when prices fell so dramatically, given that fundamentals didn’t change quite as dramatically as did the stock price.

EPAM has shifted strategy quickly in the wake of the war, moving employees out of the conflict zone and stepping up headcount in other global locations like Latin America. In doing so, EPAM has preserved the revenue growth trajectory of the business and the company delivered $1.17 billion in revenue, well in excess of analysts’ expectations (and representing a 50% increase over the same time last year). The company generated $2.49 in earnings per share, a beat of more than 30% over the consensus estimates. EPAM guided for $1.14 billion in revenue for the 2^nd quarter, above the anticipated $1.09 billion. We are imminently impressed with CEO Arkadiy Dobkin and his team’s ability to be flexible in an extremely difficult situation. The earnings report confirmed our belief that this company is a strong bounce-back candidate.

We want to note that we saw quality earnings reports from another key technology firm, which is counter to the overall trend in the sector. One of the impressive reports came from one of the behemoths of the semiconductor business, Advanced Micro Devices (AMD). CEO Lisa Su delivered again, as she often does, as the company reported revenue growth of 71% (55% if we exclude the acquired business of Xilinx). Operating margins increased from 22% to 30% from Q1 2021 to Q1 2022. While we are less than excited about the semiconductor space, as we expect a rush of supply in the coming months. However, it is good to see that a superior business like AMD continues to deliver, while many other tech firms have become chronically dissatisfying.

Takeaways From This Week

Investors are clearly rattled with the combination of hawkish Federal Reserve monetary policy and uneven reporting from this earnings season. We think the trends are visible for all to see at this point: companies that deliver consistent cash flows remain relatively in favor, while investors continue to sell the shares of those that burn cash, in pursuit of future profits.

More specifically, we continue to observe outperformance out of the energy sector, while technology and consumer discretionary, traditional “risk on” growth sectors, stay weak. The earnings reports that we received from the e-commerce and ride sharing businesses, along with the strong negative share price reactions, strengthen our belief that investors should be in no hurry to buy dips in these underperforming sectors.

With all the bad news we see in the financial press, we understand the impulse for investors to be pessimistic. Admittedly, there are plenty of reasons to be concerned. However, we do see some pockets of strength and we continue to look enthusiastically for businesses where fundamentals continue to accelerate. The positive earnings report from one of our bounce-back candidates, EPAM Systems, gives us hope that we can find areas to invest profitably, even in a difficult moment.

Again, predictable cash flows are what we crave and we will continue to lean into that theme for 2022. We think this is the clear recipe for portfolio repair in 2022!

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