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The Bright Side - How a Painful Correction Can Be Healthy

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We hear the phrase all the time – “This is a healthy correction.”

Just about everyone can attest that looking at declining asset prices – and softening account balances – doesn’t feel particularly healthy. It feels terrible.

Amazon’s recent earnings report and the market’s reaction to it are indicative of why a correction in prices is actually healthy and indeed necessary for the efficient functioning of the markets in the long-term.

On Thursday, Amazon (AMZN - Free Report) reported net earnings of $5.75/share, well in excess of the Zacks Consensus Estimate of $3.29. Total Revenue was $56.6B, just shy of the expected $57.1B and revenue in Amazon Web Services – Amazon’s fastest growing and highest margin division – was $6.68B, also slightly missing estimates of $6.71B. Overall revenue growth was 29% over Q3 last year and growth in AWS revenue was 46% YoY.

AMZN stock sold off 10% on the news and is now trading 20% below its all-time high of $2050/share, reached less than 2 months ago. The shares are still up 50% in 2018.

So why would a positive earnings surprise and a near misses on revenues cause such a negative reaction in the price?

The answer seems to be that Amazon’s sky-high valuation was predicated on the delivery of huge growth. When a stock is trading at a trailing P/E ratio of 161X and a forward P/E ratio of 100X, investors are clearly expecting extraordinary increases in revenues.

In the case of younger companies that are still spending a large portion of their revenues on expansion, investors are often willing to pay a high multiple with the expectation that at some point in the future, a combination of increased sales and reduced spending will result in net earnings that justify that price on a reasonable valuation basis.

The company will have effectively “grown into” its valuation.

Amazon is a different story.

Having evolved from an innovative internet bookseller to the world’s second largest company in just 20 years, Amazon has consistently impressed the markets with its exceptional growth in revenues. Expanding into higher-margin businesses like web services and third party sales have pushed net earnings over $1B for four quarters in a row, but anyone who was willing to pay over $2000/share clearly expected that pace of growth to continue - or even increase.

Although revenues and earnings continue to grow at an impressive rate, the Q3 report seems to suggest that the rate of growth is slowing somewhat. That’s all it took for investors to readjust their opinions about the proper multiple. That’s exactly why the correction is healthy. Clearly, there’s nothing wrong with Amazon as an enterprise – the business is as strong as ever. In layman’s terms, they sell tons of goods and services and make a lot of money doing it, and there’s no sign of that changing anytime soon.

Overall economic conditions remain quite strong. U.S. GDP grew by a better than expected 3.5% in the third quarter and consumer spending grew by 4% - the highest in over four years.

The markets are simply digesting all the current information and applying it to what they’re willing to pay for stocks. That is a positive development for the long-term.

Runaway bull markets are exhilarating, but bubbles all burst sooner or later. Markets that occasionally take a breather to reassess value tend to have the legs for multi-year gains.

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