Monday, July 21, 2014 - A Three Legged Stool

Financial Review with Sinclair Noe

DOW – 48 = 17,051
SPX – 4 = 1973
NAS – 7 = 4424
10 YR YLD - .01 = 2.47%
OIL + 1.46 = 104.59
GOLD + 1.30 = 1313.20
SILV + .04 = 21.03

First leg:

Let us start with earnings reporting season, which kicks into full gear this week with 140 of the S&P 500 companies posting results.

Netflix reported a profit of $71 million, or $1.15 a share, on revenue of $1.34 billion. This was in line with expectations, but for Netflix, an important component is how fast they are adding subscribers; turns out – fast; 1.69 million new net streamers in the second quarter; 570,000 in the US and 1.12 million international subscribers; now topping 50 million worldwide.

Allergan, the botox company, posted better than expected 2Q profits and sales but also announced it is cutting 1,500 jobs in a restructuring.  BB&T, the southeastern financial company, posted weak 2Q results as mortgage activity lagged; this has been a theme among banks for the second quarter, but the bigger banks have been compensating with profits in investment banking and trading; smaller, regional banks find it harder to compete in that arena. Chipotle Mexican Grill, theme park operator Six Flags, oilfield services company Halliburton, Manpower Group, and chipmaker Texas Instruments all reported better than expected results.

Tomorrow we will get the earnings report from McDonalds; after the close, we will get earnings from Microsoft and Apple. Wednesday’s results include Facebook. Thursday we will hear from General Motors and Amazon.com.

So far, earnings season has been strong, of the S&P 500 companies that reported through the end of last week, earnings are up 7.6% from the same period last year on 4.2% higher revenues, with 65.9% beating EPS estimates and 68.2% coming out with better than expected revenue. This is better performance than we have seen at this stage in other recent reporting cycles. The +7.6% earnings growth at this stage in Q2 compares to an earnings decline of -3% for the same group of companies in Q1 On the revenue side, the +4.2% growth thus far compares to growth rates of +1.7% and +3% in Q1. The earnings and revenue beat ratios for these companies are similarly tracking better relative to Q1.

Second leg:

Israel and Hamas continue to battle in the Gaza Strip and Russian separatists continue to impede Malaysia Airlines Flight 17 investigation efforts. President Obama delivered a statement this morning on the geopolitical hotspots. Secretary of State John Kerry was dispatched to Cairo to discuss cease-fire negotiations with international officials. Though Obama cited Israel’s “right to defend itself” against Hamas missile strikes that now number in the thousands, he said he has instructed Kerry to prioritize de-escalation.

Obama said investigation efforts into what caused the crash of Malaysia Airlines Flight 17 have been impeded by pro-Russian separatists, who have assumed control of the crash site and have begun removing evidence. “Unfortunately, the Russian-backed separatists continue to block the investigation,” Obama said of the militants. “All of which begs the question, what exactly are they trying to hide?” Obama said responsibility lies with the Russian government, and Russian President Vladimir Putin, to convince the separatists to cooperate with an international investigation.

A train carrying the remains of most of the almost 300 victims of the Malaysia Airlines plane downed over Ukraine left the site on Monday, after the Malaysian Prime Minister reached a deal with the leader of pro-Russian separatists controlling the area. The aircraft's black boxes, which could hold information about the crash in rebel-held eastern Ukraine, will be given to the Malaysian authorities.

At the United Nations, the Security Council unanimously adopted a resolution demanding those responsible "be held to account and that all states cooperate fully with efforts to establish accountability". It also demanded that armed groups allow "safe, secure, full and unrestricted access" to the crash site. It will be difficult to use the forensic evidence at the site to determine exactly what happened, but it is becoming increasingly obvious the plane was shot down with Russian weaponry.

Clearly, Putin did not want nearly 300 civilians to die, but it happened and it probably happened because of things he set in motion. If Russia is even loosely tied to the destruction of the passenger plane, even if it was an accident, the incident could represent another escalation of Russian aggression and mark a major turning point in how Russia is perceived around the world.

British Prime Minister David Cameron will urge other European leaders to consider imposing tougher sanctions Russian oil, gas, defense, and banking sectors at an EU meeting tomorrow. However, EU diplomats made clear today that sectorial sanction would still be extremely difficult for some of Europe's poorer nations. They are especially nervous about the energy sector, central to the Russian economy, but also to the European Union.

EU nations rely on Russia for about 30% of their gas demand and have intertwined interests based on decades of energy reliance. Russia exports around $60 billion a year in gas and the Netherlands was Russia's biggest export destination last year, mostly oil and metals. Energy sanctions would most likely derail the fragile European recovery in general and might even lead to a complete economic collapse in certain member states. Many Eurozone countries see sanctions as collective economic suicide that helps no one. What they should see is that dependence on imported fossil fuels has made them economically weak and subservient. As long as the Eurozone relies on Russian gas to heat their homes in the winter, Putin can get away with murder.

Third leg:

Financial markets have been largely whistling past geopolitical hotspots, with just the occasional jittery pullback. The simple fact is that the Federal Reserve and all other global central banks have been providing the markets with unusually accommodative monetary policy; which is to say, the central banks have been throwing easy money at the markets. In addition, there is growing concern that the continuation of this “unconventional” and “extraordinary” state of affairs involves an entirely new set of risks.

Clearly, the Fed would like to do what it can to prevent bubbles from forming while they hold off on raising rates; it is a delicate balancing act. If the Fed raises rates too soon, it risks a downturn in the economy, just as the Fed expects the economy is ready for liftoff. If the Fed continues with its easy money policies it risks the chance of bubbles; already Fed Chair Janet Yellen has acknowledged pockets of overvaluation. Last week, during Humphrey Hawkins testimony of Capitol Hill, Yellen singled out social media stocks and biotechs.

What does Yellen know about social media and biotech valuations? Probably not a great amount, but that doesn’t devalue her perspective; there may be some kind of asset bubble taking shape in at least some corners of the financial market. Moreover, do not think Yellen just tossed out the overvaluation comment in a flippant or offhand manner. She is well aware of Alan Greenspan’s notorious remarks about “irrational exuberance”. This was a chance for Yellen to jawbone the markets. The very fact that she’s doing so means that she probably sees good reason for speaking out.

Yellen knows she is walking a very narrow line as she tries to guide monetary policy back toward some kind of “new normal” for the first time since the 2008 financial crisis. Yellen seemed to be saying that if small corners of the market over-inflate and pop, well tough luck; it will not change the Fed’s path toward escape velocity. You might want to buckle your seat belts and get ready for a bumpy ride.

One reason for the overvaluation has been that the Fed has pumped up markets to such a point where it has been a bad trade to try to fight the Fed, and this has removed normal checks on overvaluation. Under normal market conditions, short sellers provide the right amount of pessimism to temper the optimism that leads to a wildly overvalued stock market. Short positions help keep companies with weak earnings potential and bad management from riding the bull market herd mentality to unjustifiably high share prices. However, this market is far from normal. The stock market has climbed to fresh new highs, not today, but the Dow has hit record highs 15 times this year, even with geopolitical hotspots and negative first quarter GDP.

Short sellers are in retreat. It’s hard to fight the Fed and a bull market. The proportion of shares in short positions is at its lowest level since before the collapse of Lehman Brothers, with short interest on the S&P 500 index hovering around 2%.

Shorting a stock involves borrowing it from a broker at one price with the promise to return those shares after a certain period. The short seller will then sell the borrowed shares, and if the stock price goes down, they can buy them back, return them to the broker, and pocket the difference. When shorting, the risk is that the price goes up and you have to buy back the shares at a higher price. Shorting can be a good way to make big money fast. If a stock drops 50%, the short seller stands to make 100% on the trade; and when a stock starts to fall, it can fall fast.

Some traders like to look at the charts for short targets, and that is important; you never want to short a stock that is in a strong uptrend; you want to wait for it to turn over. You can also look at the fundamentals, and earnings season is a great time to look for really high price to earnings ratios, heavy debt burdens, downward guidance, or anything else that might raise a red flag. It is good to remember shorting, especially if one of the three legs starts to wobble.

Tuesday, July 08, 2014 - Everything Except Productive Purpose

Financial Review with Sinclair Noe

DOW – 117 = 16,906
SPX – 13 = 1963
NAS – 60 = 4391
10 YR YLD - .05 = 2.56%
OIL - .13 = 103.40
GOLD - .40 = 1320.60
SILV - .03 = 21.12

 

Down 2 days and already I’m seeing the financial talking heads asking if this is the start of a correction. Just a reminder that markets go up and down and sometimes sideways. The markets don’t need a big reason to move. Right now, we’re heading into earnings reporting season, and a few things happen; first, some investors might look at a position and determine that prospects for earnings are not so great, or some investors are taking the opportunity to put some cash in their pockets, just in case they see a bargain basement opportunity.

A trend in place is more likely to continue than it is to reverse, and it reverses when we can see clear evidence of a reversal. Yes, the market looks overvalued by many metrics, yes there seems to be irrational exuberance; but the markets can remain irrational longer than you can remain solvent; yes, we’ve seen a couple of down days but we’ve gone 33 months without a correction, but we’ve had a bunch of down days during that same time. Right now, we’re seeing a minor pullback into a trading range as we await earnings season.
 

 Should you stay or should you go? The markets have hit recent highs, and so you have to wonder if you get out when the getting is good. After hitting record highs, the past 2 days have seen declines; let me be very clear, 2 down days do not constitute a trend; not unless you trade the minute bars. Still, it can be sickening to see profits melt away. Conversely, cutting exposure with the aim of putting cash back to work when valuations drop can be soothing at first, but maddening if stocks continue climbing. There is a fine line between adjusting exposure based on valuations and timing the market; and either way it’s a real trick heading into earnings reporting season.

With interest rates at historic lows and stocks climbing, holding cash in a portfolio has been costly, but on the flip side, cash can serve as a buffer against market pullbacks and corrections, and it provides flexibility to buy again if prices drop; in other words, you keep your powder dry. The real return on cash has to consider the idea that you can use it to make even more money down the road. Of course, for that strategy to work, you have to reinvest the cash; you have to look for bargains or look for other opportunities. If you aren’t willing or able to do that analysis then the risk is that you build up cash and don’t know when to get more invested.

This is where the idea of rebalancing comes in; it doesn’t require sophisticated analysis; you just sell high and buy low. If your risk tolerance points you toward a 60% allocation in stocks, and the stocks go up in price and now you hold 70% in stocks, cash out, to bring the equity allocation back to 60%; turn around and put that cash into a part of the portfolio that has dropped. The idea is that you are buying low; the unfortunate side effect is that you might be dumping your winnings into a losing position. A variation on the theme is sell high and buy something you don’t already hold.

But then the question is where do you go to find value? An article in the New York Times suggests that everything is in bubble territory. The chief investment strategist at BlackRock, one of the world’s biggest asset managers, spends his days searching for potential opportunities for investors to get a better return relative to the risks they are taking on, and he says there are very few cheap assets these days. At the current level of the Standard & Poor’s 500 index, every dollar invested in stocks buys you about 5.5 cents of corporate earnings, down from 7.4 cents two years ago, and lower than just before the global financial crisis in 2007-2008.

Bonds offer next to nothing in the way of returns, and if you want to chase yield in the debt markets, you’ll find some of the riskiest issues can’t even breach 5%. Real estate has spiked in many locations, even farmland has rocketed. It’s not that any one area is outrageously overvalued. Most people would agree that stock valuations are lower than 2000, and real estate peaked in 2006, and we haven’t really recovered to those levels. It’s just that everything that could be considered a financial asset has gone up. And of course, as prices go up, the potential future returns drop.

Maybe that’s a reflection of a slowing global economy. Maybe it’s a result of the central bankers printing lots of money, but not directing where the money would go; and so the money was parked on the sidelines, and not put to productive use, not being invested in things like factories or infrastructure. And then the risk is that folks chasing yield take on more and more risk until something pops.

Taking a look at economic data today, the Federal Reserve report on consumer debt for May showed debt increased $19.6 billion, not including mortgage or real estate related lending; that’s down from a $26.1 billion increase in April. Revolving debt, including credit-card balances, rose $1.79 billion in May following an $8.85 billion April advance that was the biggest since November 2007. Non-revolving debt, which includes car and education loans, gained $17.8 billion in May, the biggest increase since February 2013, after climbing $17.3 billion in the previous month. Car sales continue be show strength, reaching a 16.9 million annual rate last month, the fastest pace since July 2006.

The JOLT survey, or Job Openings and Labor Turnover survey shows that as of the end of May, companies increased the number of job openings almost back to pre-recession levels. Despite greater demand for workers, pay scales have not budged much.  Wages for all private-sector employees increased 2% in the year ended in June, according to the Labor Department, exactly where wage growth has trended through all of this recovery.

News from the small-business sector, however, suggests pay growth is ready to break out of the 2% range. According to the June survey of small firm owners by the National Federation of Independent Business, a net 21% of small businesses report lifting compensation in the last few months. That is the highest reading since the end of 2007. So, it looks like we are getting closer to seeing wage growth in the near future, but we’re not quite there yet. And since we aren’t seeing actual proof of wage inflation, it could be argued that the Fed should wait a bit longer before tapping the brakes. And for that matter, even if we start to see signs of wage inflation, that might be a good thing.

Federal Reserve Bank of Richmond President Jeffrey Lacker said in a speech today that “subdued productivity gains” along with “moderate” increases in consumer spending and “more tempered” growth in housing construction, will lead to economic growth in the range of 2% to 2.5%, well below the Fed consensus of 3% growth. Lacker says “broad-based advances in technology are far less likely than in the past, and that we should prepare for relatively stagnant productivity growth trends going forward.”

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said today that inflation will likely stay quite low for about 4 or 5 years. Kocherlakota says the Fed is “undershooting its price stability goal” of 2% inflation and will likely continue to do so for some time to come; he sees the probability of inflation averaging more than 2% over the next four years as being “considerably lower” than the probability of inflation coming in less than 2% over the same time period. Kocherlakota is skeptical of improvements in the jobs market, saying “much of the decline in the unemployment rate since October 2009 has occurred because the fraction of people who are looking for work has fallen.” That means the Fed is also failing to meet its job creation goal, which is damaging for the economy.

When you look at last week’s jobs numbers something doesn’t seem to add up, at least it gives pause to consider the numbers. GDP growth equals productivity growth plus job growth, or at least growth in hours worked. We’ve been adding jobs at a good pace, but the economy contracted 2.9% in the first quarter. That leaves productivity, and it turns out that there is a long term trend in decelerating productivity growth. And the problem with productivity is not that workers aren’t working hard; the problem is that we haven’t been investing in the right tools for the job.

Earnings season kicked off with a report from Alcoa. It was better than expected. Including all charges, the company earned $138 million or 12 cents a share during the quarter. That reverses the company’s $148 million loss in the same period a year ago. Revenue also came in ahead of expectations. Alcoa reported revenue of $5.8 billion, which is 2.6% higher than expected. Revenue is flat from the year-ago period.

Earlier Samsung issued an earnings warnings, claiming profits could fall as much as 26% from a year earlier. Smartphone and tablet sales took a pretty big beating. Samsung put out a statement that says tablet sales are slow because consumers are slower to upgrade tablets compared to upgrading smart phones. They also blamed the rising Korean won, which is up 9% against the dollar in the past 3 months; they blamed excess inventory in Europe, and competition in the mid and low-end of the market, and a few other excuses as well.

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.