Financial Review

Justice Delayed is Par for the Course

Sinclair Noe — February 18, 2015

 

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DOW – 17 = 18,029 SPX – 0.66 = 2099 NAS + 7 = 4906 10 YR YLD – .08 = 2.06% OIL – 2.56 = 50.97

The S&P 500 closed above 2,100 for the first time ever on Tuesday, delivering year-end target goals to Goldman Sachs, Credit Suisse and Barclays nearly 11 months early.

Greece confirms that it plans to submit a request to the euro zone tomorrow to extend a “loan agreement” for up to six months, but EU paymaster Germany says Athens must stick to the terms of its existing international bailout. Greece wants to maintain a budget surplus before interest payments equal to 1.5 percent of gross domestic product; the current plan calls for a budget surplus equal to 4.5 percent of GDP. It’s still unclear what the terms of the extension will look like, as both Athens and its creditors seem determined not to compromise over the loan’s conditions.

The Federal Reserve released minutes from the January 27-28 Federal Open Market Committee meeting. The minutes reveal that “Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time.” Allow me to translate; the Fed would like to put off raising interest rates because the economy is still a bit risky.

Well, that’s good news and bad news; good that the Fed isn’t going to raise rates; bad because the economy is still not recovered. The FOMC says the risks are “nearly balanced” but then they list the risks: a strengthening dollar, international flash points from Greece to Ukraine, slow wage growth, and even lower energy prices. Wait a minute; low energy prices are supposed to be a positive for the economy, and they are except some people in the energy industry are losing their jobs, and when people save money at the gas pump they aren’t spending it elsewhere. So, lower energy prices are good except maybe the energy market is telling us something.

Beyond that, low energy prices mean next to no inflation, so why raise rates when there are no inflationary pressures? Fed members who supported an early move said they were concerned that holding rates low for too long might lead to asset bubbles, but backers of waiting longer said an early move would result in the Fed’s having to cut rates back to zero afterward.

Speaking of asset bubbles; for the first three quarters of 2014, companies spent $420 billion on share buybacks, on track to set a record. As buybacks and dividends have risen, so has corporate debt. Since 2012, annual U.S. corporate bond issuance has topped $1 trillion a year. About $503 billion of corporate debt is set to mature this year, and each successive year will see higher amounts of debt maturing, with about $3.7 trillion is set to mature through 2019, according to Standard & Poor’s RatingsDirect.

So, the Fed is playing a delicate balancing act and we should not expect any sudden movements from the Fed; they will eventually raise rates but they will move at about the pace of an arthritic tortoise.

As widely expected, the Bank of Japan maintained its massive 80 trillion yen annual stimulus program today, its main tool to hit 2% inflation by next fiscal year. Data earlier this week confirmed that the country pulled out of recession in the fourth quarter of last year, although annualized growth of 2.2% was much weaker than expected. The Nikkei closed up 1.2% at 18,199 following the decision, its highest level since July 2007.

Bank of England officials voted unanimously to leave the central bank’s benchmark interest rate unchanged at 0.5% this month and the stock of assets purchased under its bond-buying program unchanged at £375 billion.

Construction on new U.S. homes dropped 2% in January to an annual rate of 1.07 million units, as heavy snowfall hindered builders in some regions such as the Midwest and Northeast.

Industrial production rose a seasonally adjusted 0.2% in January, well short of expectations. Another sign of weakness came in a slight downward revision to output in the past four months. Even with the revisions, industrial output advanced at a 4.3% annual rate in the fourth quarter.

Wholesale prices posted a record 0.8% decline in January. Low energy costs kept a lid on Producer Prices, but even when you strip out food and energy costs, the so-called core index dropped 0.3%. The price of goods fell sharply owing to a 10.3% decrease in energy costs. Gasoline prices in particular tumbled 24%, the biggest drop since 2008. Producer prices have shown zero change in the past 12 months because of plunging energy costs. The core PPI is up 0.9% in the same span, however.
 
So, what is the “Big Money” doing? SEC filings are showing us who has been buying or selling, and what:
Warren Buffett dumped Exxon Mobil. The billionaire’s Berkshire Hathaway holding company disclosed that it sold a $3.7 billion stake in the energy giant as oil prices have plunged. The company also purchased a 5% stake in agriculture equipment maker John Deere, plus shares of Twenty-First Century Fox and Restaurant Brands International, the owner of Burger King and Tim Hortons.
Soros Fund Management, the family office of billionaire hedge fund manager George Soros, cut holdings of U.S. stocks in the fourth quarter and shifted assets globally. Soros, which manages almost $30 billion, moved about $2 billion into companies in Asia and Europe. Warren Buffett and George Soros both boosted their stakes in General Motors.

Carl Icahn’s equity holdings declined by 5.2% during the fourth quarter to $31.9 billion as of Dec. 31, even as he bought more EBay and Hertz.

Daniel S. Loeb’s Third Point acquired five million shares of Phillips 66, a stake worth $384.5 million. And Leon G. Cooperman’s Omega Advisors acquired a 2.1 million-share position in Laredo Petroleum and a 652,500-share position in Sanchez Energy. At the same time, Omega sold about 29 percent of its big stake in Sandridge Energy, ending the quarter with 32.2 million shares. ValueAct Capital Management, an activist hedge fund, acquired big new positions in Halliburton and Baker Hughes, two oil field services companies that agreed to a $34.6 billion merger in November.
In the technology sector, David Einhorn of Greenlight Capital reduced his fund’s stake in Apple by about 6 percent, to 8.6 million shares, a stake worth more than $1 billion as of Tuesday. Another hedge fund, Coatue Management, which focuses on technology, reduced its Apple holdings by about 15 percent, to 8.9 million shares, as of the end of 2014. Appaloosa Management, David Tepper’s hedge fund, sold its entire 1.2 million-share stake in Apple, as well as its stakes in Facebook and the Chinese Internet giant Alibaba. Appaloosa Management had $2.74 billion less in U.S. stocks in the fourth quarter, a 40 percent drop from the previous quarter. Louis Bacon’s $14.8 billion Moore Capital Management had $2.3 billion in U.S. equities at the end of the year, about 25 percent less than the end of September.

Are you familiar with Snapchat? Let me explain how it works. Remember the old Mission Impossible shows? The team would get their mission and then the message would self-destruct in 10 seconds. That’s the idea behind Snapchat; it’s an app for your phone, and after you receive a message, the message will erase after a few seconds. Last month Snapchat received $485 million in funding, valuing the company at about $10 billion. Now Snapchat is looking to raise an additional $500 million, which would put the valuation “as high as $19 billion.” That would make the disappearing messaging platform the third-most-valuable VC-backed startup, behind Xiaomi and Uber, and give it a valuation nearly equal to the $22 billion paid by Facebook for WhatsApp.

Now for today edition of “Banks Behaving Badly”:
Switzerland raided HSBC. Police searched the bank’s Geneva offices for evidence of money laundering, in the wake of leaks that document HSBC’s attempts to help clients evade taxes through the use of private Swiss accounts. The story about leaked documents aired 10 days ago. The actual leaked documents were leaked 6 years ago. Justice delayed is par for the course.

BNY Mellon has restated its Q4 results it announced in January, taking a $598M litigation charge that suggests it is on course toward a settlement of cases, including a three-year-old forex lawsuit filed by the DOJ. The adjustment lowers net income for the year by about a fifth, to $2.5 billion. BNY Mellon (NYSE:BK) is one of the many banks under investigation for forex manipulation.

Next, let’s give credit where it is due: Citigroup says it will commit to spend $100 billion on initiatives to help combat climate change over the next ten years.

According to the company’s release the money will be used “to finance activities that reduce the impacts of climate change and create environmental solutions that benefit people and communities.” In 2007, Citi pledged $50 billion over ten years and met that goal three years early, hence the new, higher number.

Citi says it will use its $100 billion climate fund to finance infrastructure projects “that increase access to clean water and manage waste, while also supporting green, affordable housing for clients, including in low- and moderate-income communities”. Citi will also back “sustainable transportation” projects and help cities protect against climate extremes.

In 2012, Bank of America set a goal of $50 billion to provide loans and other financing for environmentally friendly energy projects over 10 years. The same year, Goldman Sachs set a 10-year target of $40 billion for investments in renewable energy projects. Clearly, Citigroup thinks they can make some money on Green Energy.

Thursday, April 24, 2014 - The Bridge From Bubbles to Prosperity

Financial Review with Sinclair Noe

DOW unchanged 16,501
SPX + 3 = 1878
NAS + 21 = 4148
10 YR YLD unchanged 2.69%
OIL + .46 = 101.90
GOLD + 10.20 = 1294.90
SILV + .20 = 19.75

The Dow closed unchanged. That is just one of those freaky things that happens every few years. I remember it happened in 2008, and 1998 and 1996. I’m fairly sure there were other days where the Dow closed unchanged. I don’t know if there is any particular significance.

Orders to factories for durable goods rose 2.6%, adding to the 2.1% rise in February. The back-to-back gains followed two big declines in December and January, which had raised concerns about possible weakness in manufacturing. The earlier declines, however, were likely tied to bad winter weather.

On the jobs front, the number of people seeking unemployment benefits jumped 24,000 to a seasonally adjusted 329,000 last week. The four-week average of weekly unemployment claims decreased to 316,750, which puts us back to 2007 levels.

The big earnings report today was Microsoft, which posted income of $5.6 billion, or 68 cents per share, compared with $6 billion, or 72 cents, in the year-ago quarter. They beat estimates of 63 cents per share, but take it with a grain of salt; the estimates started the quarter around 80 cents per share.

Yesterday we talked about a tech bubble, and whether we were in one or not, and we looked at comments from Greenlight Capital manager David Einhorn; he says there is a bubble but it doesn’t necessarily mean the bubble will pop any time soon.

Today, Warren Buffet weighed in on whether stocks are too frothy. Buffett says, “we’re in a range, and it's a big zone always of reasonableness." He went on that "Stocks will become worth more decade after decade, not in any precise manner, not in an even manner or anything of the sort, but 10 years, 20 years, 30 years from now, stocks will be worth more than they are today."

A friend stopped by this morning and asked about bubbles; apparently this is a hot topic these days. How do you know you’re in a bubble? The most obvious answer is when it pops, but there are more helpful ways to address the issue.

The first indicator is that prices spike; a parabolic increase in prices. From March 1999 to March 2000, the Nasdaq rose 110%. Think of an airplane that climbs too fast; it stalls out, rolls over and plummets to the ground; same thing in most markets.

The next thing to watch is valuation. Prices can go up very fast, and if valuations also go up fast, we call that “growth”. When prices go up but valuations lag, we call that a divergence, and a bubble in the making. For stocks, this means that earnings need to keep pace with price.

Back in 2000, the P/E passed 44 based upon inflation adjusted 10 year average earnings, or what’s known as the Shiller P/E; now the Shiller P/E stands at 16. However, for some sectors, we are seeing a divergence; the P/E for internet stocks is up around 47. The P/E for utility stocks is 19, but that is significantly above the historical median of 16. One reason for that divergence might be the recent spike in natural gas prices combined with investors chasing dividend yield. A parabolic spike is relative to the underlying asset, which makes it a bit more difficult to identify, but some examples are not tough to spot.

Look at the spike in Bitcoin about 6 months ago; it went from around $150 to almost $1200 in about one month, and its underlying value was impossible to quantify; that was a bubble. It popped. Remember when gold prices jumped up in spring of 2011? Pop. How about bond prices right now in Spain and Italy? Up 1.1 percentage points in 12 months and just slightly above comparable US Treasuries. It might be a parabolic price increase in combination with a divergence from the underlying asset; or maybe it says something about US Treasuries. You decide.

Of course, the valuation of the underlying asset can change very quickly due to an exogenous event. For example, if Russia shuts off nat gas supplies to Europe, it would quickly change the underlying value of Italian or Polish bonds. When the tsunami hit Fukushima, it changed the value of nuclear sector stocks. When the Hindenburg exploded, it was a black swan event for manufacturers of dirigibles.

And then the other indicator to consider is the madness of the masses. As investors identify a price move, they jump in; when everybody has jumped in, there is no one left. Or as Joe Kennedy said in the winter of 1928: “You know it's time to sell when shoeshine boys give you stock tips. This bull market is over.” By the way, the shoeshine boy reportedly told Kennedy to buy stock in the Hindenburg.

So, markets can get frothy and remain frothy, prices fluctuate, and the market can remain irrational longer than you can remain solvent. Spotting bubbles is possible, but tricky; so it’s important to remember you won’t go broke taking a profit.

Some things seem pretty straightforward. You accept that some things will work in very specific ways. You drive over a bridge and you expect that bridge to not fall into the river below. Yea, good luck with that. A report, released today by the American Road and Transportation Builders Association, warned that there are more than 63,000 bridges in this country in need of urgent repair; the dangerous bridges are used some 250 million times a day by trucks, school buses, passenger cars and other vehicles.

 Pennsylvania led the list of structurally deficient bridges, with 5,218, followed by Iowa, Oklahoma, Missouri and California. Nevada, Delaware, Utah, Alaska and Hawaii had the least. Overall, there are more than 607,000 bridges in the United States, according to the DOT's Federal Highway Administration, and most are more than 40 years old, and more than 10% are considered structurally deficient.

States rely heavily on federal funds to pay for road and bridge projects. The Fed collects 18.4 cents-a-gallon tax on gasoline and 24.4 cents-a-gallon tax on diesel to fund the Highway Trust Fund, which then pays out to the states. The Highway Trust Fund may be insolvent by this time next year unless Congress extends a temporary funding measure which is scheduled to expire in September.

The American Society of Civil Engineers estimates it will take $20.5 billion annually to clear the bridge repair backlog, up from the current $12.8 billion spent annually. That’s just the backlog; to really make a difference, it will take an investment of $3.6 trillion by 2020 to keep the transportation infrastructure in a good state of repair.

Meanwhile, we’ve been watching the Fed’s quantitative easing plan for some time and wondering why it hasn’t really helped the broader economy; it has helped banks, but not much beyond Wall Street. This is not to say the large scale asset purchase program hasn’t had an impact; it has. There is fairly concrete evidence that it has led to lower long-term interest rates; which in turn helped lift some real estate markets that were battered after the housing bubble burst. Some real estate markets are downright hot. Home values in San Francisco and Honolulu are at least 20 times as high as estimated rents. In other words, prices have jumped up and there is a divergence with the underlying asset, which has the makings for a bubble, but that just a couple of markets.

The broader real estate market has experienced a slowdown in the recovery and one cannot help but wonder about the extent to which Fed actions to pull back on their large scale asset purchases is implicated in the said slowdown. When former Fed chair Bernanke set off the "taper tantrum" in a press conference in June of last year by pointing out that at some point, the Fed would start scaling back the LSAP, bond and mortgage rates spiked. The 30-year fixed-rate mortgage went up about a point around then from the mid-threes to the mid-fours and has stayed there.

The Fed has tried to explain away the housing slowdown on the bad winter weather, but that’s just part of the problem. The other part of the problem is that the housing recovery only helped recover lost equity, it didn’t help create equity. In other words, it was a recovery effort not a wealth creation effort.

Kind of like the situation right now with bridges. From the day President Eisenhower signed the Federal-Aid Highway Act of 1956, the Interstate System has been a part of our culture; as construction projects, as transportation in our daily lives, and as an integral part of the American way of life.  Every citizen has been touched by it, if not directly as motorists, then indirectly because every item we buy has been on the Interstate System at some point.  President Eisenhower considered it one of the most important achievements of his two terms in office, and historians agree.  Economists recognize that this enormous public works project helped propel the economy, and still does.

Right now, interest rates are low; they won’t stay low forever. Right now, people need jobs; a massive infrastructure project would provide jobs, especially for long-term unemployed workers. Putting more people to work would mean more money moving through the economy, increasing demand, improving productivity. It seems like a no-brainer, until you remember that the problem rests squarely with our elected officials. Maybe the Federal Reserve could stop its insane and ineffective large scale asset purchases; stop the helicopter drops over Wall Street and instead make helicopter drops of cash strategically, directly over about 63,000 bridges.

Wednesday, April 23, 2014 - A Brilliant Future From Cool Ideas

Financial Review with Sinclair Noe

DOW – 12 = 16,501
SPX – 4 = 1875
NAS – 34 = 4126
10 YR YLD - .05 = 2.68%
OIL - .2- = 101.55
GOLD un 1284.70
SILV + .06 = 19.55

It’s earnings season, and this is a chance to compare and contrast. This morning, Facebook posted earnings of $642 million in net income, or 25 cents a share, in the first quarter, versus $219 million, or 9 cents a share in the year ago period. Overall revenue grew 72% year-on-year to $2.5 billion in the first quarter, topping estimates. Facebook now has 1.28 billion active users, and more than 1 billion do their Facebook stuff on a mobile device. Then Facebook announced their Financial Director was resigning. Shares were up about 3%.

Nobody puts on a better presentation than Apple, that’s how they grew to be the most valuable company in the world. Steve Jobs would walk out and announce Apple had created a new mp3 player, and also a new way to connect to the internet, and also a new camera. Wow, three new products, nope…, he would hold up the iPhone – just one very cool thing from Apple; tech geeks heads would explode.

Today, Apple posted earnings of $10.2 billion or $11.62 a share, on revenue of $45.6 billion. Analysts expected the company to report earnings excluding items of $10.18 a share; Apple reported a 4.6% rise in March-quarter revenue to $45.6 billion; Apple sold 43.7 million iPhones in the quarter. Then they announced they were adding to their stock buyback with an additional $30 billion over the next year. Then they announced a 7 for one stock split, to make their $500-plus shares a little more affordable. Wow, the share price exploded in after-hours trade by about 8%.

You see the difference.

The really cool thing that Apple is now working on is something you’ve probably never heard of and wasn’t part of the earnings report today. Apple is making sapphires. Natural sapphire is a gemstone variety of the mineral corundum, a crystalline form of aluminum oxide. Corundum is colorless, but in natural sapphires, various impurities create a range of colors: chromium makes the gem red, becoming a ruby; iron and titanium create the prized cornflower blue of a true sapphire. Synthetic sapphire is colorless, unless deliberately colored.

Sapphire has been used in a variety of specialized applications for years, where its purity, clarity, high stable dielectric conductive properties, and high optical quality, along with its hardness, have made it worthwhile despite its relatively high price. Think lasers and high end, luxury watch faces.  Apple is making a billion dollar bet on sapphire as a strategic material for mobile devices such as the iPhone, iPad and perhaps an iWatch. Though exactly what the company plans to do with the scratch-resistant crystal, and when, is still the subject of debate.

Apple is creating its own supply chain devoted to producing and finishing synthetic sapphire crystal in unprecedented quantities. The new Mesa, Ariz., plant, in a partnership with sapphire furnace maker GT Advanced Technologies, will make Apple one of the world’s largest sapphire producers when it reaches full capacity, probably in late 2014. By doing so, Apple is assured of a very large amount of sapphire and insulates itself from the ups and downs of sapphire material pricing in the global market.

The Arizona project was revealed in November, with Apple paying $578 million for GTAT to install and run its advanced sapphire growth furnaces in a plant built and owned by Apple. The news triggered a frenzy of speculation that Apple planned to use sapphire crystal sheets to replace the glass currently used in touch displays for its 2014 iPhones, iPads or a new line of “wearables” such as the long-rumored iWatch, or all of the above.

That’s only the tip of Apple’s investment. Once the synthetic sapphires emerge from the furnaces, they’ll be shipped to Apple’s supply chain partners in Asia for slicing, polishing, laser cutting, coating and eventual assembly. No one has used sapphire in large-scale consumer electronics or consumer goods products. Apple created a sapphire cover for the iPhone 5 camera lens, and for the iPhone 5s Touch ID fingerprint sensor. It’s mainly the sheer foundry capacity that Apple is creating in sapphire that fuels the speculation that it has big plans for sapphire in bigger uses, such  as a replacement for the cover glass, presumed to be Corning Gorilla Glass, in at least the high-end iPhone model.

A sapphire cover would presumably be less likely to break or scratch, but the big payoff could be the ability to change the underlying LCD technology of the screen, rendering more colors and using less power than today’s LCDs, while improving the speed and accuracy of the touch interface. 

It will cost more, by some estimates about $20 more per screen, but what it shows is that when Apple believes in a new technology or material, they’re willing to take a hit on the bill of materials costs. Of course, to commit for the long term, there needs to be a convincing cost reduction roadmap somewhere.

Some think technology stocks are poised for a 2000-style crash. And if they aren't ready to fall now, they may be soon. What is it about financial bubbles that make them so hard to detect? One reason is that memories are short. Some 20 years ago Wall Street merrily poured into technology stocks, and was horribly burned. Not many years later, the rest of America piled into residential real estate with similar abandon, and similar results. Meanwhile, big tech companies are using their stock to fund eye-popping mergers and acquisitions, most famously Facebook's $19 billion takeover of WhatsApp in February (of which $12 billion is in Facebook shares). Apple seems to be able to continue to do cool stuff, and maybe a billion dollars is a good price for a better iPhone screen. Maybe it’s a sign of over valuation in tech. David Einhorn of Greenlight Capital thinks tech may be ready to resume its slide, but it is a cautionary tale:

We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly. This understanding limited our enthusiasm for shorting the handful of momentum stocks that dominated the headlines last year.

Now there is a clear consensus that we are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it.

In our view the current bubble is an echo of the previous tech bubble, but with fewer large capitalization stocks and much less public enthusiasm. Some indications that we are pretty far along include:

The rejection of conventional valuation methods;

Short-sellers forced to cover due to intolerable mark-to-market losses; and

Huge first day IPO pops for companies that have done little more than use the right buzzwords and attract the right venture capital.

And once again, certain “cool kid” companies and the cheerleading analysts are pretending that compensation paid in equity isn’t an expense because it is “non-cash.” Would these companies be able to retain their highly talented workforces if they stopped doling out large amounts of equity? If you are trying to determine the creditworthiness of these ventures, it might make sense to back out non-cash expenses. But if you are an equity holder trying to value the businesses as a multiple of profits, how can you ignore the real cost of future dilution that comes from paying the employees in stock?

Given the enormous stock price volatility, we decided to short a basket of bubble stocks. A basket approach makes sense because it allows each position to be very small, thereby reducing the risk of any particular high-flier becoming too costly. The corollary to “twice a silly price is not twice as silly” is that when the prices reconnect to traditional valuation methods, the derating can be substantial. There is a huge gap between the bubble price and the point where disciplined growth investors (let alone value investors) become interested buyers. When the last internet bubble popped, Cisco (the best of the best bubble stocks) fell 89%, Amazon fell 93%, and the lower quality stocks fell even more.

In the post-bubble period, people stopped talking about valuing companies based on eyeballs (average monthly users), total addressable market (TAM), or price-to-sales. When the re-rating occurred, the profitable former high-fliers again traded based on P/E ratios, and the unprofitable ones traded as a multiple of cash on the balance sheet.

Our criteria for selecting stocks for the bubble basket is that we estimate there to be at least 90% downside for each stock if and when the market reapplies traditional valuations to these stocks. While we aren’t predicting a complete repeat of the collapse, history illustrates that there is enough potential downside in these names to justify the risk of shorting them.

So is there a tech bubble, or isn't there? Maybe tech stocks aren’t overvalued; the market is more balanced now than it was in 2000. Back then, tech stocks accounted for 14% of all earnings in the S&P 500, but a third of the index's capitalization. Nowadays the two figures are about the same at 19%.  Nor is the IPO market overly frothy like it was 15 years ago. In the first quarter of 2000, 115 companies went public, raising $18 billion; in the first quarter of this year, 63 IPOs raised $11 billion. Moreover, the IPO market isn't as crazed as it was 15 years ago: The first day run-up in share prices after their IPO is a third of what is was in 2000, evidence that investors haven't lost all sense of proportion.

The problem is that bubbles, tech and otherwise, can easily be analyzed away. No one expects the tech bubble to explode using exactly the same formula it did 14 years ago. Tech is more bubble-prone than other industries. Investing by nature is betting on the future, but in the case of tech, the future is a growth story based on extracting a brilliant future from a cool idea.