Amazon and Tesla: A Tale of Two Stocks

Summary

• The S&P 500 consumer discretionary sector is down a third since late last year vs about 11% for the broader SPX. This meltdown is largely due to two stocks – Amazon and Tesla, which are nearly half the sector.
• We think this sector is still overvalued by 20% based on projected forward earnings.
• Analysts are starting to cut their outlooks – forward earnings for the consumer discretionary sector are down 8% in recent weeks and should fall further as companies battle rising costs.
• Amazon and Tesla dominate the sector’s outlook. Tesla in particular appears vulnerable as meaningful competition emerges in the electric vehicle space.

Market Implications

• Given the prominence of these two companies, the consumer discretionary sector promises to be volatile. But from a fundamental standpoint, we think it is headed lower in coming months.

Introduction

The consumer discretionary sector (IXY) of the S&P 500 (SPX) has had an extraordinary run over the past decade. It has outperformed the S&P 500 by more than 100% at yearend 2021 and 75% after the recent selloff (Chart 1).^[1]

The outperformance was driven in no small part by the two elephants in the index: Amazon (AMZN) and Tesla (TSLA). They currently account for about 47% of the market cap of the index; 57 other companies comprise the rest (Appendix). Excluding these two companies, the IXY looks rather more normal (Chart 2).

IXY has struggled lately. From the recent high to low, it dropped 33%; excluding AMZN and TSLA, it was down 16%. Much of that deflation occurred in the past two months. Several companies announced unexpectedly weak outlooks for the rest of the year due to supply chain problems and rising costs that they cannot pass on to consumers.

Still Overvalued Relative to Earnings Outlook

As a result, the IXY sector has gone from being 50% overvalued in early April to 32% overvalued today, relative to forward earnings projections. As we discussed in a recent article, a close historical relationship exists between major price indices (here the IXY sector) and forward earnings (Chart 3). Note that forward earnings are down 8.5% in recent weeks. This is largely because AMZN was downgraded 21% to 77.68. As companies increasingly face rising costs and difficulties passing them on to consumers, we expect forward earnings will fall further, and consumer discretionary equities will follow them lower.

Consumer Discretionary P/E Ratio Still at Premium Level

The consumer discretionary sector also trades at a premium by historical standards, and to the SPX. Before the pandemic, it traded about 10-15% above the SPX. It has declined over the past year but remains about 30% above the SPX (Chart 4, truncated axis). Part of the reason for the premium, of course, is AMZN and TSLA, which sport forward P/Es of 38 and 60, respectively. Many other companies in the sector have more rational P/Es below 20.

Much of any decline in the sector P/E will likely come from AMZN and TSLA. AMZN will likely retain a premium P/E, although it should soften further. It is clearly experiencing an adjustment now. And, as noted below, recent CAPEX has been high. But its outlook in coming years is just too robust to imagine it will collapse.

TSLA is another story. Its current premium reflects its near-monopoly status in the electric vehicle (EV) sector, its investments in driver-related and auto software, and the ongoing mystique surrounding Elon Musk. But over the next year, TSLA will face rising competition in the EV space, as General Motors (GM) and Ford (F) enter the market. And the Elon Musk factor could cut both ways, either inflating or deflating TSLA stock.

Other Minuses and Plusses

Fuelled by the pandemic surge in demand and spending, profit margins for both the SPX and consumer discretionary sector are at a high (Chart 5). If what many companies are saying about rising costs and difficulty passing them on is true, profit margins will fall in coming quarters. Some of this is surely already priced in. But as we are learning from this past earnings cycle, equity investors tend to hold on until they actually see the bad news.

On a more positive note, most companies in the sector appear to be holding the line on CAPEX (Chart 6). Yes, overall CAPEX is up 53% since before the pandemic. But this is solely due to a massive CAPEX program by AMZN. Excluding AMZN, CAPX is essentially flat versus prepandemic levels.

As AMZN finishes this round of CAPEX and its free cashflow rises, its equity price will likely benefit handsomely.

Outlook Is Negative

Between the already high valuation for the IXY sector and the prospect for further cuts in earnings outlooks for many companies, we continue to recommend an underweight position.

But because of the prominence of AMZN and TSLA, this sector is likely to be volatile and driven by short term sentiment factors that tend to swamp the bearish fundamental outlook.

We recommend investors with a medium-term horizon underweight the IXY sector via the XLY ETF. Trading-oriented investors should find this potential volatility attractive, although the single-name AMZN and TSLA equities offer far more opportunities for upside and downside.

Appendix – S&P 500 Consumer Discretionary Index Members

[1] The Bloomberg ticker for the S&P 500 consumer discretionary sector is IXY INDEX. The XLY ETF is structured to reflect the IXY index. We list IXY companies in the Appendix.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.