Apple shares likely not rated for a recession (NASDAQ:AAPL)

Top-down approach

I have outstanding sell odds on the S&P 500 (SPY) and NASDAQ 100 (QQQ). Note, Apple (NASDAQ: AAPL) accounts for nearly 14% of QQQ by weight and nearly 8% of SPY – the most influential stock in these two major stock market indices. So, indirectly, I also recommend a sell on AAPL, because it’s hard to see a significant decline in SPY and QQQ without at least a modest decline in AAPL.

Accordingly, it is important to analyze Apple individually, to determine if the bearish case for the broader market is still true. Note that this is a top-down analysis of an individual stock.

The bottom-up approach generally starts with the company itself, by examining the different company-specific variables (product, services, management, ratios, etc.). The top-down approach begins with general macroeconomic analysis (based on monetary/fiscal policy, trade policy and geopolitics), and from there it moves to the effect on individual sectors, and finally to stocks individual.

Is Apple stock recession proof?

The top-down approach to analyzing individual stocks boils down to estimating the likelihood of an impending recession and assessing how individual stocks would be affected by the forecast recession.

So, let’s start with the discussion of whether the potential recession would have a significant negative impact on Apple’s financial performance. Rather than trying to have an opinion on this issue, I am interested in knowing what the Company itself is saying about the effect of market risk (systematic risk) on the financial performance of the Company. I retrieved the latest AAPL annual report (10K statement) and researched “risk factors”. Here’s what I found (bold text by author): Apple Inc. | Form 10-K 2021

Company operations and performance highly dependent on global and regional economic conditions and adverse economic conditions may have a material adverse effect on the Company’s business, results of operations and financial condition.

The Company has international operations with sales outside of the United States representing the majority of the Company’s total net sales. In addition, the company’s global supply chain is large and complex and the majority of the company’s supplier facilities, including manufacturing and assembly sites, are located outside of the United States. Therefore, the operations and performance of the company highly dependent on global and regional economic conditions.

Adverse macroeconomic conditions, including inflation, slowdown in growth or recessionnew or increased tariffs and other trade barriers, changes in tax policies and monetary policy, credit crunch, interest rate hike, high unemployment and currency fluctuations may have a material adverse effect on demand for the Company’s products and services. In addition, consumer confidence and spending may be adversely affected in response to financial market volatility, negative financial news, real estate and mortgage market conditions, declines in income or asset values, changes in fuel and other energy costs, labor and health care costs and other economic factors.

In addition to a negative impact on demand for the Company’s products, uncertainty or decline in global or regional economic conditions may have a significant impact on the Company’s suppliers, subcontractors, logistics providers, distributors, cellular network operators and other distribution partners. Potential effects include financial instability; the inability to obtain credit to finance the operations and purchases of the Company’s products; and insolvency.

A downturn in the economic environment may also lead to an increase in the Company’s credit and debt collection risk; failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair value of the Company’s financial instruments. These and other economic factors may have a material adverse effect on the Company’s business, results of operations and financial condition.

Thus, without having to provide my own opinion, I infer from Apple’s management discussion that the potential recession “would have a material adverse effect on the company’s business, results of operations and financial condition” per the through multiple channels, ranging from lower consumer demand to higher interest rates interest rates, increased credit risk, stronger dollar, global demand…the list goes on. Based on the “Risk Factors” statement, it looks like Apple management probably doesn’t think Apple stock is recession proof.

How likely is an impending recession?

Since AAPL is unlikely to be a recession-proof stock, the top-down approach can be used to predict AAPL’s performance. The critical variable, however, is to accurately estimate the probability of recession.

Again, without needing to have an opinion on an impending recession, we can get the recession probability directly from the New York Fed. The New York Fed uses the proprietary logit model to estimate recession likely over the next 12 months based solely on the spread between 10-year Treasury bills and 3-month Treasury bills. As the 10-year-3-month spread narrows towards the 0 level, the likelihood of a recession increases and when it reverses to a certain level, an impending recession becomes almost a certainty (very few false signals over a long period). More specifically, when the estimated probability of recession exceeds the 30% level, the recession follows in all cases since 1961.

Currently, the New York Fed’s recession probability is 25.149%, as updated on September 9, 2022. Note that the 10y-3mo has since narrowed, but it remains positive. However, as the Fed raises short-term interest rates on September 21, it is likely that the 10-year-3-month spread will reverse, sending the recession probability above the 30% threshold. – and will signal an impending recession. Here is the New York Fed’s recession probability chart:

What kind of company is Apple?

From a macro perspective, Apple is essentially a one-product company. According to the latest Apple 10Q quarterly report of July 29, 2022, Apple derives almost 50% of its sales from the iPhone. Services account for almost 25% of sales, but these services are probably related to the iPhone. Other products are also likely part of the iPhone ecosystem. (There is “someone I know” who needs to buy a new laptop, and when asked what kind of laptop he wants for school purposes, the person says Mac, so that he can be connected to his Apple AirPods, which work with the iPhone. And the same person keeps asking me to buy more cloud storage for his iPhone.)

The chart below shows that iPhone sales grew by 3% compared to the same quarter in 2021, while it seems that services are growing at a high rate of 12%. Clearly, Apple is trying to offset the slowdown in product sales with an increase in service sales.

Apple is also an international company, with almost 50% of its sales in America, almost 25% in Europe and more than 15% in China. Thus, Apple is considerably exposed to the disastrous economic situation in Europe and the geopolitical situation in China, in addition to the weakening of the American economic situation.

Thus, it seems that Apple is seriously exposed to the dire economic situation in the United States and around the world. Still, analysts predict Apple’s EPS would rise from $6.10 in 2022 to $6.44 in 2023, or 5.5%. I think this is an unrealistic forecast, given the high probability of an impending recession over the next 12 months. Not only do I think analysts should downgrade earnings growth, but they should also consider factoring in declining earnings over the next 12 months.

More importantly, Apple’s forward PE ratio, which factors in current earnings growth, is 24. This is likely overstated for a company that has only modest growth in its key product. But, given the very high probability of a recession, these expected earnings are likely to be revised downwards, which would also require a significant contraction in valuations in my opinion.

Estimated annual EPS

Click to enlarge

Consequences

Based on the “risk statement” in Apple’s 10K statement, Apple is likely not a recession proof stock. Currently, the probability of an impending recession is very high. So, if an actual recession occurs in the next 12 months, Apple’s financial performance is likely to be significantly affected.

However, Apple shares are unlikely to be rated for a recession. Valuation metrics are overstretched and analysts still expect 5.5% EPS growth in 2023.

Thus, I think Apple’s stock has a significant downside, as earnings forecasts will likely be downgraded to reflect an impending recession, and the valuation multiple is likely to contract.