Financial Review

Welcome to Earnings Reporting Season

Sinclair Noe — October 11, 2016

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DOW – 200 = 18,128
SPX – 26 = 2136
NAS – 81 = 5246
10 Y + .02 = 1.76%
OIL – .49 = 50.86
GOLD – 7.00 = 1253.40

Alcoa reported third quarter earnings before the bell today, in what has been traditionally known as the start of earnings season. The raw aluminum and specialty parts maker missed estimates on both top and bottom lines. S&P 500 companies are expected to post their sixth straight quarter of declining earnings, according to FactSet data. And while sales are expected to break their six-quarter streak of declines, that optimism may be overdone, based on the dozens of sales warnings to pop up in the last several weeks.

When you look at a chart of the S&P 500, you’ll see we’ve been in a sideways or consolidation pattern since mid-July. Earnings season could be the catalyst for a breakout or a breakdown; with the S&P 500 trading at an historical high valuation in terms of P/E and P/S, the pressure is towards the downside.

In fact, stocks must justify the current 12-month trailing P/E of 25 and the current CAPE ratio of 27 (cyclically adjusted price to earnings ratio) through positive earnings growth. Analysts are usually very conservative on their predictions. Actual earnings have beaten analyst’s estimates since 2014. As this is well known by investors, one should not get too optimistic over the possibility that earnings may beat estimates by a small margin.

In fact, be careful to buy on slightly better than expected earnings given that valuations are high. Now, the good news is that most of the bad news has already been baked into price; by that, I mean we are all aware of concerns with Brexit, China, the price of oil, the US election, and a possible Fed rate hike. The bad news is that the market is complacent. The VIX is low at around 15.

Except for a couple of weeks in September, where the S&P took a big hit and then bounced back, the tight range has been getting tighter, like a rubber band wound to the limit. A break above the September highs of 2180 would serve as a bullish sign that could lead to new all-time highs. Today’s close below 2140 exposes weakness and a break down below 2120 looks dangerous.

Long-term bond yields continued to rise. The yield on the 10-year Treasury note was slightly higher at 1.76%. Earlier Tuesday it hit 1.8% for the first time since early June, marking a four-month high. Futures markets are now pricing in roughly 70% odds of a rate hike at the Fed’s December meeting. We should learn more tomorrow, when the Fed releases minutes of its last policy meeting.

British cabinet ministers are being warned that the Treasury could lose up to £66-billion-pounds a year in tax revenues under a “hard Brexit,” according to leaked government papers seen by The Times. The document also cautions that leaving the single market and switching to WTO rules could cause GDP to fall between 5.4%-9.5%.

The British pound sterling slipped below $1.23 and €1.11 in morning trading to its lowest value since last week’s flash crash. The fall in the pound has boosted the FTSE 100 as many of the companies in the index generate most of their revenues abroad. The UK’s benchmark index broke through its previous record intra-day level to hit 7,129.83 before losing some ground.

Igor Sechin, Russia’s most influential oil executive and the head of state-controlled energy giant Rosneft, said his company will not cap oil production as part of a possible agreement with OPEC. Sechin told reporters that Rosneft planned this year to raise its oil production, already the world’s largest among listed producers. Sechin said he doubted some OPEC countries, such as Iran, Saudi Arabia and Venezuela, would cut their output. Yesterday, WTI pushed above $51 per barrel after Vladimir Putin said Russia was ready to join an output freeze, but not one world producer has willingly taken one solitary barrel off the table this fall.

Samsung’s Galaxy Note 7 has been permanently discontinued, following a problematic recall operation that replaced Note 7 phones with faulty batteries at risk of explosion… with new phones that have the same batteries. The replacement lithium ion batteries in the phone tend to catch fire. The cost to Samsung of the Galaxy Note 7 could be $17 billion, the amount the company was expected to bring in from the sales cycle of the phone.

That figure doesn’t include the damage to the Samsung brand, though. Samsung shares have lost $18 billion in market cap since the problems started. If you have a Galaxy Note 7, and it doesn’t matter if it was the original phone or a phone with a replacement battery, just turn it off and get a refund and buy a phone that doesn’t explode.

Although Salesforce was thought to be out of the mix as of this weekend, a new report suggests the company is still evaluating the benefits of a Twitter deal and what an appropriate valuation might be. Meanwhile, in an internal memo reportedly sent to Twitter employees last week, CEO Jack Dorsey made no mention of any deals, instead highlighting initiatives revolving around the company’s live strategy and other merits.

General Electric said it would buy LM Wind Power, a maker of rotor blades used in wind turbines, from private equity firm Doughty Hanson for $1.65 billion, as it looks to capture a bigger share of the fast-growing renewable energy market. GE separated its renewable energy business from its power unit last year, following the $13.6 billion acquisition of Alstom SA’s power business. Denmark-based LM Wind Power is the largest supplier of rotor blades to GE.

Fiat Chrysler has reached a tentative deal with unionized workers in Canada by agreeing to make more than $300 million in investments for local operations. The pact was announced just minutes ahead of a midnight strike deadline that could have sent more than 9,000 Fiat workers off the job. Union members will vote on the accord at ratification meetings on October 16.

Chicago’s schools and its teachers’ union agreed to a contract proposal late on Monday, averting a strike set for today in the third largest U.S. public school system. Teachers contribute 2 percent to their pension, with the school board chipping in an additional 7 percent. Under Monday’s deal, new hires will not get the 7-percent “pension pickup,” but will get a salary adjustment to compensate for that.

Airbus plans to slow the assembly rate of its A380 to one aircraft per month from 2018 as the European plane maker struggles to revive sales of the world’s largest passenger jet.  Airbus’ assembly rate for the superjumbo currently stands at 2.5 aircraft per month.

Theranos has been sued by one of the blood testing start-up’s biggest backers, Partner Fund Management, for attracting $96 million in investment “through a series of lies, material misstatements, and omissions.” The suit accuses Elizabeth Holmes of deceiving the hedge fund by claiming Theranos had developed “proprietary technologies that worked” and was close to getting regulatory approvals. The suit comes less than a week after Theranos stopped all of its clinical operations, cutting 340 positions and closing its Wellness Centers where blood tests were performed.

A recent update from the Arizona Multiple Listing Service shows Phoenix real estate sales in September were up 6.3% year-over-year. Active inventory was up 3.4% year-over-year, marking the seventh consecutive month of increases in inventory. Cash sales declined to 20.2% of total sales. Meanwhile, foreclosure inventory continues to plunge across the nation, with the foreclosure inventory rate at 0.9% in August, down 29.6% compared to last year. Arizona has one of the lowest levels of foreclosure inventory, at just 0.3%.

Americans are increasingly shopping online and we have been spending less at the malls; overall, we just got tighter with money following the financial crisis. According to a new report from Morningstar, we have a shopping mall problem. The US has 23.5 square feet of retail space per person, compared with 16.4 square feet in Canada and 11.1 square feet in Australia – the next two countries with the highest retail space per capita.

Department stores like Sears, Macy’s, and JCPenney have been closing stores to try and get rid of unprofitable stores, and that’s had a devastating effect on malls. When an anchor stores closes, it often triggers a downward spiral in performance for shopping malls that in some cases has led to massive losses on loans.

When an anchor store closes, shopping malls don’t only lose the income and shopper traffic from that store’s business. It often triggers “co-tenancy clauses” that allow the remaining mall tenants to exercise the right to terminate their leases or renegotiate the terms, typically with a period of lower rents, until another retailer moves into the vacant anchor space. The Morningstar report supports a recent analysis from Credit Suisse that said about 200 shopping malls are at risk of shutting down if Sears continues to close stores.

Financial Review

3Q Earnings and Political Uncertainty

Sinclair Noe — October 10, 2016

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

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DOW + 88 = 18,329
SPX + 9 = 2163
NAS + 36 = 5328
OIL + 1.39 = 51.20
GOLD

Today is Columbus Day. Even though stock markets were open today, bond markets were closed, the majority of banks and credit unions were closed, and most federal and local government offices are closed for the holiday. (In case you were wondering why the mail wasn’t delivered.)

Oil prices rose to their highest in a year after Russia said it was ready to join a proposed deal to cap oil production. The Organization of the Petroleum Exporting Countries (OPEC), of which Russia is not a member, aims to agree an output cut by the time it meets in late November. Russian President Vladimir Putin said an output freeze or even a production cut were likely the only right decisions to maintain energy sector stability.

Analysts at ABN Amro took a more cautious view on an OPEC deal, saying previous hints by the group on output cuts have always failed to be followed up by action. Iraq, OPEC’s second biggest producer, had already poured cold water on expectations, saying over the weekend that it wants to raise output further in 2017.

Further complicating OPEC output caps is that inventory levels in the US have reached record highs since the oil-price collapse in 2014. This surplus supply is a major factor keeping oil prices low. Current inventories are 45 million barrels higher than 2015 levels, which were more than 100 million barrels higher than the average from 2010 through 2014. Until the present surplus is reduced by almost 150 million barrels down to the 2010-2014 average, there is little technical possibility of a sustained oil-price recovery.

The Federal Reserve’s September meeting was contentious. The Fed extended its stimulus campaign, but three officials voted to raise rates, the largest bloc of dissenting votes in several years. On Wednesday, the central bank will release an account of the meeting that may reveal more about the lines of conflict. Fed chair Janet Yellen said at a news conference after the meeting that the majority of officials saw no reason to rush ahead with a rate increase. The dissenters say the Fed is playing a dangerous game by dragging its feet. On Friday, Yellen will have another chance to explain her own views when she addresses a conference in Boston.

The publication of Alcoa Q3 results tomorrow after the closing bell, will mark the beginning of Q3 earning season for major US companies. According to FactSet consensus estimates, profits are likely to decline by 2.1% y/y, the sixth consecutive quarterly decline. Earnings should drop despite the expected 2.6% increase of sales. On June 30, analysts estimated a 0.3% increase of profits in Q3.

The decline in corporate profits should be mainly driven by the energy sector, whose earnings are expected to tumble by 67% y/y. Industrial and real estate should also record falling earnings, at -7.8% and -6.3% respectively. On the opposite side, utilities should post the highest earning growth rate (+5.3%), followed by consumer discretionary at +5%. According to FactSet consensus, corporate profits should return to a positive growth rate in Q4, with a 5.6% y/y increase.

During earnings reporting season, companies publish what passes for the results of the prior quarter and they also have the chance to explain their successes or failures. We tend to hear plenty of excuses such as a “strong dollar” or “Brexit” or the old standby “bad weather”.

The excuse for poor third quarter results is likely to be uncertainty related to the presidential election.  People aren’t buying enough potato chips – political uncertainty. Companies aren’t buying new computers – political uncertainty. Consumers aren’t buying new cars – political uncertainty. Recent measures of consumer confidence have exceeded or neared post-financial-crisis highs, and consumer spending remains one of the bright spots of the US economy. So, when you hear the excuse of “political uncertainty” you can be fairly certain that is not the answer.

The British pound resumed its decline as investors waited for clues about the cause of last week’s flash crash and on whether Britain is truly headed for a hard Brexit. U.K. Prime Minister Theresa May will meet with foreign leaders this week in a bid to build understanding for her negotiating position ahead of this month’s EU summit. Meanwhile, officials are still trying to figure out what triggered last week’s flash crash in the pound. Sterling remains the world’s worst-performing major currency this year.

British-born Oliver Hart and Finland’s Bengt Holmstrom won the Nobel Economics Prize today for work that addresses a host of questions from how best to reward executives to whether schools and prisons should be privately owned. Their findings on contract theory have implications in such areas as corporate governance, bankruptcy legislation and political constitutions. Hart is an economics professor at Harvard University while Holmstrom is a professor of economics and management at the Massachusetts Institute of Technology.

Hart’s research work has included a damning assessment of America’s private prisons. He showed that the pressure to cut costs was too great, leading to an unacceptable drop in quality. At the core is the issue of “incomplete contracts” – the fact that contracts are not detailed enough to cover every small point.

Holmström is known for pioneering research into executive pay. His work on employment contracts has considered a range of professions from teaching to management and whether they should be paid fixed salaries or work on the basis of performance-related pay.

A group of nuns and other religiously-affiliated investors have lost faith in Wells Fargo and filed a shareholder resolution calling on the bank to report on the root causes of a fake accounts scandal that led to a $190 million settlement struck with regulators last month. The faith-based investors say they also want the report to cover improved controls after revelations bank employees opened as many as 2 million checking, savings and credit card accounts without the customers’ permission in order to meet sales quotas. The resolution is one among a series filed recently at Wells Fargo. Other resolutions call on Wells Fargo to study a breakup and to split the roles of chairman and chief executive officer.

Deutsche Bank CEO John Cryan was in Washington over the weekend for the International Monetary Fund and World Bank’s autumn meetings. Reportedly while there he met with Justice Department officials but was not able to negotiate down the $14 billion fine they have demanded. Deutsche Bank is expected to issue new shares, sell assets, or both, once it knows the scale of the fine, to ensure that its capital ratio remains within regulatory limits.

Mylan has agreed to pay the U.S. government $465 million in a swift settlement over how it charged Medicaid for its allergy shot EpiPen. The U.S. Centers for Medicare and Medicaid Services, or CMS, said in a letter this week that Mylan had misclassified EpiPen as a generic drug, while the government has said it was a brand-name product and that Mylan should have given states and the U.S. bigger rebates. The agreement with the Justice Department and other agencies resolves all potential rebate liability claims by federal and state governments. There was no admission of wrongdoing by Mylan or its employees.

Negotiators from Unifor and Fiat Chrysler will not be with their families today celebrating Canadian Thanksgiving. The union has set a strike deadline of midnight for its 9,750 members employed by the automaker, and is looking for a contract similar to the one it signed last month with General Motors Canada. Among other things, that deal traded pension benefits for shortening the time it takes newly hired employees to reach full wage rates.

Chicago’s public schools and its teachers’ union make the final push to avert a looming strike on Tuesday. Pensions are among a key sticking point. The district would like to phase out the 7 percent of annual salary that it contributes each year to teachers’ pensions. Unions want to keep the pension contributions and ink a new, three-year contract that would give teachers 2 percent raises in the second and third years. The state, the city and the school district have all had their credit ratings cut to junk, or just above it. The impasse and the threat of the strike would affect nearly 400,000 students.

Samsung has reportedly stopped production of its Note 7. The temporary production halt comes after five reports of fires in replacement phones, suggesting replacement Galaxy Note 7 devices remained plagued by the same faulty battery problem that occurred in the original device. Samsung’s decision came after major mobile carriers in the U.S., including AT&T and T-Mobile, said they would stop issuing Note 7s over safety concerns.

After five years of litigation, the U.S. Supreme Court will hear arguments on Tuesday in the patent dispute between the world’s two top smartphone manufacturers over the amount Samsung should pay Apple for copying the iPhone’s distinctive look. The justices’ ruling, due by the end of June, could have a long-term impact for designers and product manufacturers going forward because the Supreme Court, if it agrees with Samsung, could limit the penalties for swiping a patented design.

A jury found that Samsung had violated an Apple design patent by mimicking the iPhone’s round corners and grid of icons. The question for the justices is whether that means Samsung must turn over all its profits from the infringing phones or just those attributable to the disputed features. The court has not heard a design patent case in over a century.