Taking stock of Corporate America’s ‘Risk Factors’⚠️
Plus a charted review of the macro crosscurrents 🔀
Stocks rallied last week, with the S&P 500 climbing 1.9%. The index is now up 5.4% year to date, up 13.1% from its October 12 closing low of 3,577.03, and down 15.7% from its January 3, 2022 closing high of 4,796.56.
The stock market will fluctuate as expectations for the future evolve. These expectations are informed by the various risks facing the companies underlying the market.
Publicly traded companies provide lengthy lists of “Risk Factors” that affect their businesses in their 10-Q and 10-K filings, the quarterly and annual financial reports publicly traded companies are required to file with the SEC. (You should check these out. They can be very interesting.)
Over my career, I’ve thumbed through hundreds (if not thousands) of these. While these risks aren’t listed in any particular order, companies tend to lead with risks that are intuitively most impactful to their business operations. Here’s a sampling of the first risk identified by some big companies:
“The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition.“ - Apple
“We Face Intense Competition.” - Amazon.com
“We are subject to complex and evolving global regulations that could harm our business and financial results.“ - Visa
“Economic conditions.” - Exxon Mobil
“The Company’s businesses operate in highly competitive product markets and competitive pressures could adversely affect the Company’s earnings.“ - Johnson & Johnson
“Failure to successfully execute our omni-channel strategy and the cost of our investments in eCommerce and technology may materially adversely affect our market position, net sales and financial performance.“ - Walmart
“Unfavorable general economic and geopolitical conditions could negatively impact our financial results.“ - Coca-Cola
“If we fail to estimate, price for and manage our medical costs or set benefit designs in an effective manner, the profitability of our risk-based products and services could decline and could materially and adversely affect our results of operations, financial position and cash flows.“ - UnitedHealth Group
“Global economic conditions could have a material adverse effect on our business, operating results and financial condition.“ - Nike
As you can see, the language is often vague. Some are risks are more specific than others to the industry in which these companies operate.
When I was thumbing through Berkshire Hathaway’s 2022 annual report released last week, I was taken aback by what the conglomerate identified at the top of their list. From the filing:
Terrorist acts could hurt our operating businesses.
A cyber, biological, nuclear or chemical terrorist attack could produce significant losses to our worldwide operations. Our business operations could be adversely affected from such acts through the loss of human resources or destruction of production facilities and information systems. We share the risk with all businesses.
Cyber security risks
We rely on technology in virtually all aspects of our business. Like those of many large businesses, certain of our information systems have been subject to computer viruses, malicious codes, unauthorized access, phishing efforts, denial-of- service attacks and other cyber-attacks. We expect to be subject to similar attacks in the future as such attacks become more sophisticated and frequent. A significant disruption or failure of our technology systems could result in service interruptions, safety failures, security events, regulatory compliance failures, an inability to protect information and assets against unauthorized users and other operational difficulties. Attacks perpetrated against our systems could result in loss of assets and critical information and expose us to remediation costs and reputational damage…
These risks are a bit more jarring than what you typically see at the top of most lists. They explicitly involve bad actors seeking to do harm and create chaos in the world.
To be fair, they’re appropriate for Berkshire Hathaway. As a globally diversified conglomerate with a presence in most industries, it would be vulnerable to mass shock events like the ones identified. Furthermore, Berkshire is a massive player in insurance and resinsurance, which means they could be forced to pay for the associated damages incurred by the companies they cover.
But it’s notable that Berkshire only began ordering its list of risks like this with its 2020 annual report. In its 2019 report, Berkshire led with: “We are dependent on a few key people for our major investment and capital allocation decisions.“ This made sense as the company is led by Warren Buffett, arguably the most successful investor in history. (This risk is now listed right below cyber security risks.)
Buffett certainly has made no secret that terrorism — specifically terrorism in the form of cyberattacks — worries him.
“There is, however, one clear, present and enduring danger to Berkshire against which Charlie and I are powerless. That threat to Berkshire is also the major threat our citizenry faces: a “successful” (as defined by the aggressor) cyber, biological, nuclear or chemical attack on the United States.“ - Buffett in 2016
"I don't know that much about cyber, but I do think that's the number one problem with mankind." - Buffett in 2017
“Cyber is uncharted territory. It’s going to get worse, not better.” - Buffett in 2018
“I think cyber poses real risks to humanity.” - Buffett in 2019
Buffett and Berkshire could’ve done like Apple and Exxon Mobil and led with a generic statement about “economic conditions,” which arguably encompass the effects of terrorism and cyber attacks. But they didn’t.
Why are we talking about this?
To be clear, I have no idea if the world is in imminent danger of a crippling cyber attack.
But I do think the risk is not to be totally ignored.
If you’ve been following business news, the most talked about concerns have been about inflation, monetary policy, fiscal policy, recession risks, and the effects of the war in Ukraine.
However, known risks that are top of mind tend to be at least somewhat priced into the markets.
And according to TKer Truth No. 8: “The most destabilizing risks are the ones people aren’t talking about.“
Sure, Buffett may be talking about cyber threats. And so is the White House. But you don’t often see it identified as a top concern in the investor community.
All of this is to say that the mere fact that cyber currently garners so little attention could be in itself a reason to be concerned as a stock market investor.
Managing risk in the context of investing means finding balance between “hoping for the best” and “preparing for the worst.” How you decide to position your portfolios in this context is between you and your financial advisor.
For more investor wisdom:
Warren Buffett reminds us how picking winning stocks is very hard 🤓
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
That’s interesting! 💡
From Delta Dental (via Axios): “According to new Delta Dental findings from its 2023 Original Tooth Fairy Poll®, the average value of a single lost tooth during the past year increased 16% from $5.36 to $6.23… Since the poll’s inception, the average cash gift left by the Tooth Fairy has surged 379% from $1.30 to $6.23 per tooth. At this rate, in 2048, the Tooth Fairy would be leaving a whopping $30 under the pillow for a single tooth.“
Reviewing the macro crosscurrents 🔀
There were a few notable data points from last week to consider:
👍 Businesses are investing. Orders for nondefense capital goods excluding aircraft — a.k.a. core capex or business investment — climbed to a near-record $75.2 billion in January.
The backlog of unfilled core capex orders was at $267.2 billion in January.
For more on this massive economic tailwind, read: 9 reasons to be optimistic about the economy and markets 💪
📈 GDP growth estimates are rosy. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 2.3% rate in Q1. This is up considerably from its initial estimate of 0.7% growth as of January 27.
For more on the improving economic outlook, read: Economic forecasts are getting revised up, and people aren't thrilled about it 🙃
👍 Survey says services are hot. The ISM’s Services PMI stood at 55.1 in February, down slightly from 55.2 in January. A reading above 50 signals expansion in the sector.
Notably, the employment subindex jumped to 54.0 in February from 50 the month prior, signaling an acceleration in hiring.
🤨 But survey says manufacturing is cooling. The ISM’s Manufacturing PMI ticked up to 47.7 in February from 47.3 in January. A reading below 50 signals contraction, which suggests manufacturing activity continues to deteriorate but at a decelerating rate.
For more on the conflict between hard data and soft survey data, read: What businesses do > what businesses say 🙊
⛽️ Gas prices are down. From the EIA: “U.S. average price for regular-grade gasoline on February 27, 2023 was $3.342/gal, DOWN 3.7¢/gallon from 2/20/23, DOWN 26.6¢ from [a] year ago.“
For more on energy prices, read: The other side of the surging oil price story 🛢
🚢 Shipping costs are down. From Apollo’s Torsten Slok: “The price of transporting a container from China to the US is basically back at pre-pandemic levels, and this is boosting manufacturing production and putting downward pressure on goods inflation.“
For more on the improving supply chain, read: We can stop calling it a supply chain crisis ⛓
🏠 Home prices are down. According to the S&P CoreLogic Case-Shiller index, home prices fell 0.8% month-over-month in December, the sixth consecutive month of declines. On a year-over-year basis, prices were up 5.8%, down from 7.6% the month prior. From S&P DJI’s Craig Lazzara: “The prospect of stable, or higher, interest rates means that mortgage financing remains a headwind for home prices, while economic weakness, including the possibility of a recession, may also constrain potential buyers. Given these prospects for a challenging macroeconomic environment, home prices may well continue to weaken.”
For more on the housing market, read: Why home prices and rents are creating all sorts of confusion about inflation 😖 and The U.S. housing market has gone cold 🥶.
📈 Mortgage rates are up. According to Freddie Mac, the average 30-year fixed-rate mortgage rose to 6.65% last week: “As we started the year, the 30-year fixed-rate mortgage decreased with expectations of lower economic growth, inflation and a loosening of monetary policy. However, given sustained economic growth and continued inflation, mortgage rates boomeranged and are inching up toward seven percent. Lower mortgage rates back in January brought buyers back into the market. Now that rates are moving up, affordability is hindered and making it difficult for potential buyers to act, particularly for repeat buyers with existing mortgages at less than half of current rates.“
👎 Consumer confidence ticks lower. From The Conference Board: “Consumer confidence declined again in February. The decrease reflected large drops in confidence for households aged 35 to 54 and for households earning $35,000 or more… And, while 12-month inflation expectations improved—falling to 6.3% from 6.7% last month—consumers may be showing early signs of pulling back spending in the face of high prices and rising interest rates. Fewer consumers are planning to purchase homes or autos and they also appear to be scaling back plans to buy major appliances. Vacation intentions also declined in February.“
👍 Labor market confidence improves. From The Conference Board: “17.8% of consumers said business conditions were ‘good,’ down from 19.9%. 17.7% said business conditions were ‘bad,’ down from 19.0%.“
💼 Unemployment claims remain low. Initial claims for unemployment benefits fell to 190,000 during the week ending Feb. 25, down from 192,000 the week prior. While the number is up from its six-decade low of 166,000 in March 2022, it remains near levels seen during periods of economic expansion.
For more on low unemployment, read: That's a lot of hiring 🍾, You should not be surprised by the strength of the labor market 💪, and 9 reasons to be optimistic about the economy and markets 💪.
💵 Tax refunds are up, but below pre-pandemic levels. From UBS: “Between 2016 and 2019, February refunds averaged $118 billion with little volatility, ranging between $111 and $125 billion. Similar to 2022, this year February refunds were below the pre-pandemic average with a total amount paid of just $94 billion ($85 billion in 2022).”
🚗 Car sales are trending up. Light vehicle sales came in at an annualized rate of 14.9 million units in February. From JPMorgan: “ Through some of the volatility in the monthly readings, it looks like sales have been trending higher in recent months, with improving inventory dynamics likely helping facilitate car buying. Clearly there are sector-specific issues related to autos that are not indicative of broader economic conditions. But we do think several key economic indicators will show similar pat- terns in activity across recent months to the auto sales data, with moderation in February following strong increases reported for January.“
For more on cars, read: What rising auto loan delinquencies tell us about the economy 🚗
🏢 Offices are very empty. From Kastle Systems: “Last week, office occupancy exceeded 50% for only the second time since the start of the pandemic. Occupancy rose by three tenths of a point to 50.1%, according to the Back to Work Barometer. Despite the data only measuring four days due to the Presidents Day holiday, seven of the 10 tracked cities saw moderate increases, while only three cities — New York, San Francisco and San Jose, Calif. — fell by a point or less. The week’s daily high was Tuesday at 57.2% occupancy, and the low was Friday at 32.4%.”
For more on office occupancy, read: This stat about offices reminds us things are far from normal 🏢
Putting it all together 🤔
We’re getting a lot of evidence that we may get the bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
The Federal Reserve recently adopted a less hawkish tone, acknowledging on February 1 that “for the first time that the disinflationary process has started.“
Nevertheless, inflation still has to come down more before the Fed is comfortable with price levels. So we should expect the central bank to continue to tighten monetary policy, which means we should be prepared for tighter financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations). All of this means the market beatings may continue and the risk the economy sinks into a recession will relatively be elevated.
It’s important to remember that while recession risks are elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs. Those with jobs are getting raises. And many still have excess savings to tap into. Indeed, strong spending data confirms this financial resilience. So it’s too early to sound the alarm from a consumption perspective.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
As always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a terrible year, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the previous TKer macro crosscurrents »
For more on why this is an unusually unfavorable environment for the stock market, read: The market beatings will continue until inflation improves 🥊 »
For a closer look at where we are and how we got here, read: The complicated mess of the markets and economy, explained 🧩 »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
700+ reasons why S&P 500 index investing isn't very 'passive'💡
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks. From January 1995 through April 2022, 728 tickers have been added to the S&P 500, while 724 have been removed.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
When the Fed-sponsored market beatings could end 📈
At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
'Past performance is no guarantee of future results,' charted 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. According to their research, 29% of 791 large-cap equity funds that beat the S&P 500 in 2019. Of those funds, 75% beat the benchmark again in 2020. But only 9.1%, or 21 funds, were able to extend that outperformance streak into 2021.
One stat shows how hard it is to pick market-beating stocks 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 22% of the stocks in the S&P 500 outperformed the index itself from 2000 to 2020. Over that period, the S&P 500 gained 322%, while the median stock rose by just 63%.