December 30, 2013
In the end, let's not lose sight of the fact that we are nearly five years into an economic recovery, and we are still very much on monetary life support. This underscores the secular challenges that have produced and will continue to produce sub-par growth despite short-term interest rates anchored at zero.
December 27, 2013
December 26, 2013
The domestic economy is heavily doped up by abnormally low interest rates and monetary accommodation.
Because of our inept and divided leaders in Washington, D.C., the shoulders of monetary policy (the Fed) have been needed to support growth in our domestic economy. With that monetary support moderating coupled with the lack of fiscal responsibility and the inability of Democrats and Republicans to come together, more uncertainty than less certainty of policy lies ahead. This should be valuation-deflating.
December 24, 2013
The stock market responded in a dramatic fashion, though bonds, the U.S. dollar and gold did not move all that much. In my view, the S&P 500's rise was too strong given the FOMC statement and the response of other markets.
December 23, 2013
Before the FOMC decision, I was positioned market-neutral because I not only didn't have a strong view of whether tapering would be implemented -- albeit, I did not expect a tapering -- but I also didn't know how the market would react to the two likely Fed scenarios.
December 16, 2013
Doug Kass, president of Seabreeze Partners Management Inc., in a recent Real Money article argues the current P/E multiple would be a lot higher if you applied a normalized profit margin on the revenues of S&P 500 companies.
Mr. Kass points out earnings are also inflated due to unsustainable low corporate tax rates. As politicians in Washington begin taking a hard look at the U.S. deficit, it is likely tax rates will trend higher, thereby taking a bite out of corporate profits. Another factor that has contributed to record corporate profit margin growth is ultra-low interest rates. They have boosted corporate profits in the U.K. and the U.S. by 5% in 2012 alone, according to a new report from the McKinsey Global Institute.
More importantly, firms such as Tim Hortons Inc. and Yahoo! Inc. have been issuing billions of dollars of low-cost debt and using the proceeds to buy back stocks. Companies can inflate earnings per share by reducing their share counts and either taking on more debt or using their excess cash rather than reinvesting it in their companies.
More than 80% of S&P 500 companies are currently buying back shares, and they are doing it at twice the pace seen in the 1990s, according to a recent Goldman Sachs report. In total, buybacks are now up 40% on a trailing four-quarter basis and are expected to expand by an incremental 10% in 2014 given that cash balances are currently over US$1-trillion.
Overall, the magnitude of financial engineering by corporations has been quite remarkable and something that most, if not all, rational market strategists are only now recognizing. Looking ahead, it wouldn't be surprising to see more of the same as long as the U.S. Federal Reserve under Janet Yellen continues to keep interest rates at or below current levels via quantitative easing.
via- the Star Phoenix
Predictions of the future are never anything but projections of present automatic processes and procedures, that is, of occurrences that are likely to come to pass if men do not act and if nothing unexpected happens; every action, for better or worse and every accident necessarily destroys the whole pattern in whose frame the prediction moves and where if finds its evidence.
-- Hannah Arendt
Stock market history teaches us to be mindful and respectful of patterns but also to recognize the influence and importance of the unexpected. Today investors, strategists and the business media seem to have a singular focus. They are currently obsessed with forecasting when a taper will be introduced and are attempting to interpret its impact on the bond and stock markets.
When it is universally agreed that one factor (tapering) holds the key to the market, it likely means that that determinant is priced in (and so, I might add, is the likelihood of very dovish forward guidance coincident with the inevitable tapering). According to a Bloomberg survey of economists, there is a 34% probability of a December tapering, a 26% probability of January and a 40% probability in March.
My view is that a December tapering has almost a zero probability as there will be insufficient economic data to make the decision and it could potentially disrupt year-end funding and confidence (during the important holiday sales season). A more likely January tapering would encompass three full improving jobs reports, incorporate holiday sales results and there would be greater visibility of the outcome of fiscal debate in Washington.
As to interest rates (the second part of the riddle), that's a more interesting question. Specifically, what level of interest rates would pose a risk to stocks (defined as a 5%-plus correction)?
Most view 3.25% or higher in the 10-year note yield within three months (indicating that yields have broken out of a two-and-a-half-year range and that forward guidance is not sufficient to hold down rates), 3.75% or higher within six months, 4.25% or higher within nine months or 4.5% or higher within 12 months as threshold points. My view remains that 3.5% or higher will be surprisingly negative for housing, the mortgage-backed securities market and potentially for the stock market.
Thus far, the capital markets have not been impacted by somewhat improving economic data. In all likelihood, what will really move the markets over the next six to nine months isn't priced in at all right now. As mentioned previously, the consensus on tapering (it's schedule and market impact/importance) is more or less all the same -- that is, January or March in timing (67% chance) and basically not impactful and essentially irrelevant to the markets.
December 15, 2013
What and when the Fed may or may not do has obviously resulted in poor action in U.S. Treasuries since the kneejerk bounce after the no-taper in September, and this is continuing as longer-term rates are normalizing on their own. This is healthy in the long term, as the market takes a greater role in pricing the cost of money, but possibly very disruptive throughout the process -- just as any addict deals with the pains of withdrawal.
The Jobs Data
The job openings/labor turnover survey (JOLTS) of the government showed job openings in October of 3.925 million vs. expectations of 3.898 million and 3.883 million in August. This is the best since mid-2008 and consistent with the better labor data reported in the recent government payroll report and this morning's survey of small businesses.
The better labor market data is important because as mortgage rates should move higher so should home prices. To offset these impacts on housing affordability and keep the benefit to consumer spending from better home prices, employment/income growth must accelerate.
Wholesale inventories lifted a large 1.4% month over month in October vs. expectations of 0.3% in September. Wholesale sales increased by 1%. Inventory build has been substantial in the last few months, but the inventory-to-sales ratio has only lifted slightly. Third-quarter real GDP growth has a very heavy component of inventory building, so fourth-quarter real GDP growth should be 2% or a bit less vs. third-quarter growth of 3.6%. Fourth quarter should be a quarter when a big third-quarter inventory build is digested.
More important with respect to inventories, there is no excess inventory overhang that would signal a cutback in production/manufacturing sector employment. It is almost always the case that excess inventory precedes a recession -- no such excess exits currently.
December 10, 2013
Doug Kass, says of hedge funds, “they take uncommon risks for common returns.” (His article, “Profiling the 2006 – 07 Bear Market,” appeared on thestreet.com, 08/07/06.) In other words, many hedge funds do not outperform other investments, or generate solid returns with lower risk. If you look at hedge fund performance during the most recent financial crisis, most did poorly. Not only did they not make money in a dismal market, many lost money – in some cases a lot!
That is not to say there aren’t great hedge fund managers out there who can add value to your portfolio. But I suggest they are few in number and difficult to evaluate. Like finding gold, is the success of a hedge fund the result of skill or luck? Some managers are truly skillful, but how can we establish that? When it comes to investment returns, what was bestowed by good luck can just as easily be taken away by bad luck!
Therefore, let the buyer beware.
Investors of all sizes and shapes are nearly all in the pool now. Investor sentiment (in most surveys) is tilted very bullish, mutual fund investors hold near-record-low cash reserves, hedge funds are at multiyear highs in terms of net long exposure, and retail investors (though not at the extremes of 1999-2000) have plowed money into domestic equity funds en masse since the beginning of the year.
Importantly, margin debt, the straw that stirs the market's drink, reached another high in October of $413 billion (up 3% month over month after rising 5% in September). In fact, margin debt is approaching the March 2000 and July 2007 highs as a percentage of GDP. Currently, margin debt is about 2.4% of nominal GDP vs. 2.6% in July 2007 and 2.8% in March 2000.
The many potential headwinds (e.g., Washington shutdowns, geopolitical risks/uprisings, a probable taper, rising interest rates, tepid bottom- and top-line corporate sales and profit growth, signs of ineffective Fed quantitative easing policy, the vulnerability of corporate profit margins, the growing schism between the "haves" and the "have-nots" in a failure of trickle-down economic policy, the consequences of financial repression done for the greater good on the savers class, etc.) have, to date, been ignored and dismissed by stock market participants.
Importantly, the disconnect between the real economy and the stock market has grown more pronounced, as the markets continued their ascent in recent months.
The most recent leg of the bull market started at about 1670 on the S&P 500 (which approximated my fair market value). Since then, the S&P has rallied by over 8%.
Since October, however, the Citigroup Economic Surprise Index has declined from 53 (reflecting a period in which reported economic data substantially outdistanced consensus forecasts) to only 6 recently (as the last two months of economic data have been only in line with consensus).
Taken back to Jan. 1, 2013, Citigroup's Surprise Index has dropped from 40 to 6; at the same time, the S&P 500 rose (year-to-date) by almost 28%.
In "Flawed Case for a Bull Market," I highlighted that the U.S. stock market has been driven by the liquidity of monetary policy, not by the underpinning of domestic economic growth and corporate profits, and that many market metrics are at danger zones:
December 9, 2013
Doug Kass of Seabreeze Partners is known for his accurate stock market calls and keen insights into the economy, which he shares with RealMoney Pro readers in his daily trading diary.
Among the posts this past week were entries about the meaning of the payroll report and some Twitter nonsense.
Productivity Data Signal a Mean Reversion in Profit Margins
Year-over-year productivity growth in the third quarter of 2013 was zero compared to +0.2% in the second quarter of 2013. Productivity growth has slowed steadily over the past year, as year-over-year unit labor costs are now +1.9%. With profit margins peaking and unit labor costs accelerating a bit, the profits landscape is growing more challenging.
Third-quarter earnings for the S&P 500 grew by +4%, but the quality of that gain was low, as more than half of the gain was the byproduct of share repurchases, lower effective tax rates, declining interest costs and the banking industry's reserve reversals.
For now (and obviously), the liquidity infusions of quantitative easing has trumped the aforementioned concerns -- or any concerns for that matter.
A Stunning Bull Market or the Height of Lunacy?
Originally published on Thursday, Nov. 14 at 7:50 a.m. EDT.
"Every now and then, markets behave like schoolchildren. They overreact; they run around like crazy. We know we're going to have tapering; we know we are living in an artificial state of excess liquidity right now. And it's happening because the economy is recovering."
-- James Gorman, chairman of Morgan Stanley
Yesterday's market reversal was astonishing to me -- from bottom to top, the S&P futures climbed 28 handles.
I write this because the rumor of a dovish Janet Yellen testimony (released at 4:30 p.m. EST yesterday) was the proximate cause of the reversal, and there was little question that the baton exchange from Helicopter Ben to Whirlybird Janet would be a smooth one, with similar objectives to adhere to the Fed's dual mandate.
Here is Yellen's complete written testimony. In it, she highlights that the same old refrain that unemployment is too high and that the domestic economy is running below potential and needs Fed support.
Her remarks were all consistent with prior Fed comments by Helicopter Ben et al.
Most recognize that Yellen is a meticulous planner, so it is unlikely she will tip her hand meaningfully about monetary policy. But we don't know how well she might deal with unscripted questions this morning.
Some of those questions will be predictable, so she will be prepared. For example, Yellen likely knows that this question will be asked by liberals: "Show me the evidence that quantitative easing is helping others than Wall Street and the wealthy." Or, "Isn't continued QE serving to allow our leaders in Washington to not address fiscal issues?"
December 8, 2013
Joe Kernen: So tell me, Jim, what are your thoughts on the U.S. stock market?The above conversation, though not real, has grown more popular and repetitive, embodying the market narrative these days with any of a number of market strategists. The simple market logic template is being trumpeted ad nauseam throughout the day in the business media not only on CNBC but also on Fox Business, Bloomberg, financial blogs and other media venues.
Strategist: Stocks are cheap, trading at only 15x my 2014 estimate of $120 a share for the S&P 500. That's in line with the historic averages. But stocks are cheap with the 10-year U.S. note yielding under 3% compared to around 6% over the last five or six decades.
-- An imaginary CNBC "Squawk Box" interview between Joe Kernen and a strategist
This morning's opening missive attempts to address and possibly refute the logic of this accepted (and simple) valuation argument that embraces the essence of current bull market thinking.
The cornerstone of the bull market case is that valuations are reasonable and not excessive by historical standards. It is further argued by the bulls that given the low rate of inflation (and inflationary expectations) and very low interest rates, the current level of valuation is justified and even inexpensive.
The conventional method of calculating P/E multiples based on stated or raw earnings is, arguably, a fundamentally flawed approach that assumes currently elevated profit margins and profits are sustainable. Indeed, measures that normalize margins have almost always correlated better to U.S. stock market performance over history.
It is only the cyclical (and elevated) position of profit margins that prevents recognition that equities are richly valued.
I would argue that to utilize earnings that reflect profit margin that are more than 70% above the norm (over a documented span of over 65 years) is an aggressive assumption and fails to adjust for the unique and changing conditions that contributed to the sharp improvement in margins since 2009 -- all of which are deteriorating and likely putting renewed pressure on margins.
Investors should consider evaluating current valuations from the context of normalized earnings not based on today's elevated (raw) profits and profit margins.
There are three important factors that have contributed to unusually high corporate profit margins -- all of which have begun to reverse.