FINANCIAL REVIEW

Faster and Faster but No Liftoff

Sinclair Noe — November 25, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 2 = 17,814
SPX – 2 = 2067
NAS+ 3 = 4758
10 YR YLD – .05 = 2.26%
OIL – 1.95 = 74.22
GOLD + 2.90 = 1202.20
SILV + .20 = 16.77

The major stock indices couldn’t close at records, but Apple reached a milestone today. Apple’s market capitalization hit a record $700 billion; that’s double from 3 years ago when Tim Cook became CEO. Apple is the first S&P 500 company to ever reach a $700 billion market cap. Yet, on an inflation-adjusted basis, it still has way to go to be the most valuable company of all time. Microsoft’s market cap peak of $613 billion in 1999 translates to nearly $874 billion in 2014 dollars. When Microsoft was at the top, it was trading at 72 times earnings. Apple’s price-to-earnings ratio is currently 18, in line with the overall S&P. It’s a little tough to imagine what Apple will do in the future to match the growth they’ve experienced in the past.

The economy is better than you thought. The Commerce Department revised its estimate of third quarter gross domestic product from 3.5% up to 3.9%. There will be another revision before settling on a final number. Second quarter GDP came in at a 4.6% growth rate; combined second and third quarter GDP was the strongest back to back growth since 2003. Let’s break down the data.

A couple of key factors behind the increase include more consumer spending along with a little more business investment. Falling gas prices meant that people could go to the gas station and still have cash for other purchases. A separate report from the New York Fed show household debt balances also increased $78 billion in the third quarter at $11.7 trillion. Overall household debt still remains 7.6% below the 2008 peak of $12.7 trillion, but the increase was enough for the NY Fed to conclude that household deleveraging is over. Not so fast. The Conference Board reported that consumer confidence declined in November. The Consumer Confidence Index dropped to 88.7 from 94.1 in October. Consumers lowered their opinions on business conditions and the labor market. Maybe consumers are finished with deleveraging, or maybe they took on debt because wages haven’t kept pace with a growing economy.

Growth in domestic demand was revised up to a 3.2% pace in the third quarter instead of the previously reported 2.7% pace. Consumer spending grew at a 2.2% pace instead of the previously reported 1.8% rate.

Business investment was also up. Nonresidential investments grew by 7.1%, revised up from 5.5%, while investment in equipment reached 10.7%, with a stronger pace of spending on equipment than previously thought accounting for the bulk of the revision. Corporate, after tax profits grew at a 3.2% rate in the third quarter; that was down from a very strong 8.6% increase in corporate profits in the second quarter; still, after 6 months of extremely strong profit growth, companies were well positioned to spend a little on equipment. The strength in business investment spending would point to more hiring as well. In a separate report, the Federal Reserve Bank of Atlanta says the quality of new jobs is improving; 95% of the new jobs in October were full-time, which is a move in the right direction.

Export growth was lowered to a 4.9% rate from the previously reported 7.8% rate, while imports were revised up. That left a trade deficit that contributed 0.78 percentage point to GDP growth instead of the previously reported 1.32 percentage points. Government spending, which grew 4.2%, turned out to be a little lower than the Commerce Department initially estimated.

The Department of Agriculture reports net farm income in the US is forecast to be $97 billion, down 21% from a year ago and the lowest since 2010. Farmers are selling livestock for more, but that’s because many farmers culled their herds during the droughts of the past couple years; crop receipts are down, along with prices for many commodities, while expenses have increased.

Also today, the S&P/Case-Shiller home price index increased 4.8% for the 12 months ended in September, down from 5.1% reported for the 12 months ended in August. So home prices are going up, but at a slower pace; and that has been the trend; home price gains have now slowed for 9 straight months. In Phoenix, home prices dropped 0.1% from August to September, and for the past 12 months, prices increased a modest 3%.

A couple of extra bits on the housing market; Corelogic reports that distressed sales, both REO and short sales, accounted for 11.8% of total home sales nationally in September; that’s down from 15.2% distressed sales from September of 2013, but it is still a pretty high number. And another consideration is that back in the mid-2000s we saw a surge in mortgage debt fueled by an increase in home equity lines of credit, or HELOC, loans; it was a way for homeowners to tap into equity. The majority of HELOCs were originated at the peak of the home equity boom between 2004 and 2006, so there is concern of an oncoming wave of defaults when the estimated $190 billion in HELOC loans reset between Q4 2014 and 2017. The fear is that payment shock will not only cause a wave of defaults, but that it also may impact bank balance sheets and the mortgage markets where HELOCs are concentrated. Unlike the first-lien market when banks sold off most of the credit risk, more than 85% or $580 billion worth of HELOC loans are on bank balance sheets.

So, when you combine the stronger GDP numbers with the weaker consumer confidence index and a lackluster housing market, what you get is more of the same; an economy that looks like it should fly but can’t quite achieve escape velocity. Even when you add in corporate capital expenditures improving, that is just a step in the right direction without creating a discernible trend. Part of the problem is that the rest of the global economies are stuck in quicksand.

The Organization for Economic Co-operation and Development says the global economy will slowly improve over the next 2 years but Japan will grow less than previously expected while the euro zone struggles with stagnation and an increased deflation risk. The OECD calculates that a gradual 10% depreciation of the euro and the yen against the dollar over the next two years could potentially raise growth in the euro area and Japan by around 0.2 percentage point next year and twice as much the following year. Overall, the global economy is set to grow by 3.3% this year, 3.7% in 2015 and 3.9% in 2016. In the United States growth is projected to gain more momentum and remain above trend, reaching 3.1% next year.

Oil prices have plunged more than 30% since midyear on growing global supplies of oil and weak demand growth. OPEC is meeting Thursday in Vienna to discuss oil prices, but before the official meeting an official from Venezuela says that informal talks before the meeting point toward no output cuts. That’s bad news for Venezuela, and even worse news for Russia, which is watching its oil-dominated economy stumble under lower prices. Crude futures extended losses on that news. Rumors on production cuts were flying today. The low prices for oil may be considered another indicator of global economic growth. As oil producers such as Venezuela and Russia fret about the drop in oil prices, more affordable energy would benefit the worldwide economy. Many people feel the global recession was really triggered by the rise in oil prices from 2000 through 2008 and some of the slow growth or stagnant growth in the global economy is because prices stayed so high for so long.

Jeff Gundlach, the CEO of Doubleline Capital, says oil markets are in their “second part of the cycle” wherein prices will drop because producers are getting squeezed after oil settled below $80. Production will see an increase “maybe on the sly” by countries that depend on oil revenue, creating a “vicious cycle” for the commodity’s price. He predicted that $70 is the “line in the sand” for West Texas Intermediate: Any drop below that level will lead to a significant fall in price. He also said an oil price around $75 (which is where we are today) would suggest that the consumer price index should probably be near zero, meaning that there is no inflation in the economy.

And just to keep things interesting, much of the oil boom in the US was done with financial engineering. There is an astonishing amount of debt that continues to build up on the smaller exploration and production companies’ balance sheets. Even before the oil price plunge, aggregate debt-to-equity ratios in the smaller publicly traded energy companies are now at 93%, up from around 70% in 2012 and 2013, and around 50% between 2005 and 2011. This in a highly cyclical industry that used to go through periodic banker-driven shakeouts and even bankruptcies.

And it is not just OPEC countries holding on for dear life waiting for production cuts. Particularly in the gas and natural gas liquids drilling directed sector, every operator (and their financier) is waiting for every other operator to stop or slow their drilling programs, so there can be some recovery in the supply-demand balance. And at some point, you have to wonder if the banks will put an end to the boom.