The Stock Market Has a Problem That Apple Doesn't

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Stocks closed off their record high today, with the S&P 500 losing 0.4%. However, the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) did achieve another record high with a 0.1%, respectively. Both crossed psychological levels intraday, 1,700 for the S&P 500 and 18,000 for the Dow, prompting a flurry of warnings that we are in the middle of a stock market bubble.

Some warnings are more legitimate and better-reasoned than others. Speaking at the Reuters Global Investment Outlook Summit on Monday, legendary activist investor Carl Icahn said he is "very cautious" on the stock market, adding that he could see a "big drop" due to the fact that corporate earnings have been goosed more by low borrowing costs than managerial excellence.

Back on September 19, Icahn made it clear just that he is acting on that concern, telling CNBC: "... we're up 30% and yet we have a huge hedge on... I think right now the market is giving you a false picture. I don't think a lot of companies are doing that well. They're taking advantage of low interest rates." The S&P 500 is up 5.1% since then.

Icahn may have a point, though: Low interest rates (and low tax rates) are goosing the bottom line of U.S. companies. That's fine, as far as it goes, but it suggests that "core" profitability isn't as impressive as it appears. To confirm this, I took a look at the last 12 months' EBIT margin for the 420 non-financial companies in the S&P 500; EBIT stands for earnings before interest and taxes, i.e., the company's profits prior to having paid interest and taxes. It turns out that more than 40% of the companies sport current EBIT margins that are lower than their median value over the past 10 years.

Furthermore, low interest rates aren't immutable -- at some point, they will increase, sending interest costs higher and putting pressure on profits. That isn't the end of the story, however: If margins fall, it does not mean stocks will automatically do the same. As Richard Bernstein, of asset allocation firm Richard Bernstein Advisors, noted in July, margins peaked in 1981 and 1982 and declined through the great 1980s bull market. "I don't think history supports the notion that margin compression equates to bear markets," he told Reuters.

Of course, none of this discussion applies to Carl Icahn's favorite idea: Apple (NASDAQ: AAPL  ) . The maker of the iPhone and the iPad only issued its first $17 billion slug of debt in April and, given, the ultra-low rates it obtained, the interest payments are essentially a rounding error compared to its profits. In addition, assuming it keeps a cash cushion, Apple will not need to refinance its debt at maturity. Those profit margins are all-natural -- no performance-enhancement (financial) products used here. (As far for Apple's tax rate is concerned, that's a separate matter altogether. Those are definitely not all-natural.)

While rising interest rates could hurt profit margins -- and stocks along with them – Apple's margins are driven by the quality of its franchise and competition within its industry. The threat of competition is genuine, but at 11.9 times next 12 months' earnings-per-share estimate -- a 22% discount to the S&P 500's multiple -- I know which of Apple shares or the market look the safer bet right now.

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Comments from our Foolish Readers

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  • Report this Comment On November 18, 2013, at 10:06 PM, DanManners wrote:

    A+ That is your grade! Great article. I rarely give that grade to anyone.

    Why? Because you made a point that 900 other journalists are making at the same time. You gave us something new to think about. Apple has hardly any debt. Now. But not if Icahn gets them to do a $ 150 billion buyback. Of course there would be less shares and the rates might still be low as they have the cash to pay that off.

    But let investors remind themselves that at the present Apple will fare better than most when it comes to rising interest rates. However, rising interest rates could mean a better economy so more sales though bigger debt payments. They could offset themselves? I am not sure but you can respond.

    Anyway, great point.

  • Report this Comment On November 19, 2013, at 12:26 AM, iphonerulez wrote:

    Amazon is damn near killing Apple in shareholder value. I expect Amazon's share price to pass Apple's share price by the middle of next year. Apple intends to keep holding onto its reserve cash hoard like Linus holds onto his red security blankie. The company doesn't want to do a darn thing to expand its business and increase revenue while its core business gets hammered. Apple is practically telling shareholders and potential investors to take a hike.

    Apple will fare no better than any other company when interest rates rise. It will fall just as hard if not harder than any other company with one-tenth its wealth. Investors have no faith in Apple or Tim Cook. They all believe that Android products are going to put Apple out of business sooner than later. Apple's grand profits continue to disappear into some black hole and never reaches shareholders' pockets while nearly profitless Amazon is stuffing shareholders' pockets with pure cash wealth.

    Every day there is some odd reason or another as to why Apple's share price continues to fall. Options expiration or supply chain hiccups or unfavorable moon phases. Apple is an investor's nightmare despite always being claimed as undervalued as if being constantly undervalued is a good thing. Google has become Wall Street's tech darling company and Apple is being tossed aside like a toothless, old hag with sagging jowls. Give thanks to Tim Cook... for not making things a lot, lot worse than it already is.

  • Report this Comment On November 19, 2013, at 12:59 AM, JokerJoey wrote:

    @iphoneruez: For a guy with a name like that, you sure are anti-Apple. Sorry to burst your bubble, but Amazon works on vapour and sooner or later their sleight of hand will catch them. For example, they lose money on every one of their core sales, whether it be books or other products. They make it up on vendors who they hammer on fees and shipping charges for warehoused products, but sooner or later these vendors will largely wise up and stop dealing with them. They have also raised their minimums for free shipping (NOT FREE for the vendors!), making it harder for most customers to qualify while trying to bolster their own margins.

    As far as Google and Android are concerned, Android is eventually going to implode on itself as the cheap-o inferior copy of iOS that it is. Witness the current ruling instructing Judge Koh to re-examine Apple's request to ban certain Galaxy phones and how this will impact Apple's new action to ban more recent versions of those products. I predict the Judge will rule this time in Apple's favor, and then watch out!

    Anyway, keep buying that over-priced Google stock at $1K +, and watch as it plummets while Apple rises to exceed it. You will not get any sympathy from anyone.

  • Report this Comment On November 19, 2013, at 1:14 AM, Mega wrote:

    "Every day there is some odd reason or another as to why Apple's share price continues to fall."

    Are you looking at the chart upside down?

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