Apple feels a market force even more powerful than gravity

There's a frightening reason Apple disappointed investors this quarter that doesn't start and end with how much it trailed Wall Street consensus estimates. Same goes for Google, Microsoft, Netflix, Visa and Starbucks. Yes, all these companies disappointed investors in earnings or outlook for the rest of 2016. But here's the fundamental disappointment across all the companies for anyone who follows the market.

In a word: overcapacity.

A young boy tips a bowl of apple peels into a compost bin
Paul Mansfield Photography | Getty Images

Gravity may have forced an apple down on the head of Sir Isaac Newton, but overcapacity is the powerful downward force in the universe of stocks. Some pundits now fear Apple is losing its innovation edge and are looking to see if the Apple Watch or Apple TV can be the next blockbuster. I think investor reaction to Apple results, and the tens of billions shaved off its market capitalization Wednesday, can be boiled down to this more fundamental issue: No company is immune to overcapacity.

Overcapacity of everything mined and made has been one of my chief concerns as a financial advisor for a while now, and it finally hit Apple, one of the most widely owned stocks in the investment universe. Overcapacity, when it occurs, is a relentless force that eventually overtakes companies with even the strongest pricing power. It's a deflationary condition that results in falling prices caused by oversupply, and it forces companies to hasten cost cuts to adapt to lower revenues or see their earnings take a hit. And when cost cutting is directed at the research and development budget, the short-term boost to earnings it brings could have an impact on long-term survivability. And this does ring louder for the tech sector, as it is dependent on relentless innovation.

Overcapacity is a market force that is particularly brutal when applied to the tech sector.

"Overcapacity, when it occurs, is a relentless force that eventually overtakes companies with even the strongest pricing power. ... Overcapacity is a market force that is particularly brutal when applied to the tech sector."

Here's my simplified version of the tech cycle:

  1. New product and first mover advantage.
  2. Massive market acceptance. Home run!
  3. Maintaining market leadership, staying ahead of the curve with innovation.
  4. Eventually, new iterations of these wonderful products offer less reason to upgrade.
  5. Competition catches up with products that are either as good or good enough.
  6. The market growth for these wonderful products decelerates as the first, second and third wave of the iterations make their way into the hands of billions of consumers. Overcapacity becomes prevalent.
  7. The competition begins to compete on price to stimulate demand.
  8. Prices fall. Deflation spreads to the manufactures and their suppliers.
  9. All of the market participants increase volume to make up for the fall in prices.
  10. It becomes an all-out blood sport to maintain market share.
  11. Profit margins get crushed.
  12. Growth stocks become value stocks.
  13. Some of these value stocks/companies come out with a new product that becomes a home run, and the cycle starts again. Low(er) P/E ratio and cash balance builds, which could be used to reinvest in innovation and/or financial engineering, like stock buybacks.

When I invest in a tech stock, I think about which number on the above cycle is the best match to the stock. But at numbers 5 or 6, for any market sector, the cycle is most likely at a peak.

Yes, Apple sold more iPhones than expected, but the ASP (average selling price) dipped a bit. Services grew a heck of a lot year-over-year, but quarterly revenue was down for the first time in 13 years. The next iteration of the iPhone, 7, should be available next autumn. But if you have an iPhone 6 or even a 5S, the 7 has to really have something extra special to jump upgraded unit sales.

Across the board — from sneakers, aircraft and oil to financial services, drugs and smartphones — overcapacity has overtaken nearly every sector of the global economy. Now it's bitten Apple, too.

The cure for overcapacity comes from one of two things: either demand catches up or the existing capacity becomes obsolete. Until then, very often, investors have to live without revenue growth.

Facebook, which just announced a blowout quarter, has proved that it can use its heft to further entice users and advertisers. But with it, and even Google after its recent earnings miss, it is tougher to recognize overcapacity, because these companies sell intangible products like ads and search. But you can look for signs of overcapacity by watching revenue, monthly average users and profit margins, which is why these metrics are so important to investors when attempting to put a value on these companies.

So what to do as an investor? Reconsider your holdings in light of the above cycle. There are other variables to consider when deciding whether to buy, sell or hold, but the almighty cycle of every sector and business remains fairly consistent. Overcapacity hit Apple this week, and that should be a wake-up call to every investor, invested across every sector.

By Mitch Goldberg, president of ClientFirst Strategy

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