August 30, 2016

Financial Asset prices vs Real Economy divergences

It looks from my perch like the schism between financial-asset prices and the U.S. real economy is growing ever wider.

For example, we got word Tuesday that Markit's U.S. Manufacturing PMI declined to 52.1 in August from 52.9 in July. That's below the 52.7 reading that analysts had expected. Manufacturing employment also saw its slowest growth in four months, while new orders declined even though exports increased.

And yet, Mr. Market remains nonplussed. For now.

August 24, 2016

Media and traders like volatility

Unlike "King of Nothing" Jerry Seinfeld, both the business media and people who trade and invest typically like excitement and volatility.

Many people will love a heated Hillary Clinton vs. Trump election, and many love Ryan Lochte's apparent screw-up in Rio more than they love many actual Olympic events.

What they don't love is a boring, uneventful stock market -- but that's exactly what we're getting right now.

Forty-seven years ago this week, I experienced the "The Summer of Love" at Woodstock on Max Yasgur's farm in Bethel, N.Y. But this year, we're all experiencing the "Summer of Nothing" on Wall Street, with low volume and little in the way of volatility.

Hmm ... I think I might have something here. It's obviously time for me to make a "Nothing Pitch" to business TV, because they've got to have something, right?

Maybe I'll call CNBC or Bloomberg to pitch a new show whose plot is: "Hey, these pretzels are making me thirsty!"

via thestreet

August 22, 2016

What will Janet Yellen say on in her August Jackson Hole speech

A newsletter that a research acquaintance of mine recently read noted that Microsoft now has $35.3 billion in debt, up from zero less than a decade ago. Apple also has $85 billion in debt vs. $23 billion less than four years ago, while Cisco has grown its debt 122% to $28.6 billion in less than three years.

Obviously, most of this debt hasn't gone to capex or other organic growth, but to dividends, acquisitions and stock buybacks. Who can blame these companies given how low borrowing costs are?

However, we might be reaching the "productive" debt crescendo here, given that corporate revenues and earnings are in decline. 

The Bottom Line

Add up all of the above and I believe that inflation protection should be the next theme for investors to embrace as we close 2016 and enter 2017.

After all, we're facing:
* Continuing currency debasement.
* Gold prices that are gaining momentum.
* Wage growth that's ticking up.
* Energy and other commodity prices that have seemingly bottomed out.
* U.S. fiscal spending that seems poised to gain steam.
* Both Democratic presidential hopeful Hillary Clinton and Republican rival Donald Trump are proposing huge infrastructure programs.
* Central banks decidedly erring on the side of too much stimulus vs. too little.
* European and Japanese government-bond markets that have no cushion from losses if an exogenous event hits, given that they currently have manipulated prices (i.e., negative yields).

Now if the Fed were to shift gears and definitively signal that U.S. rate hikes lie ahead, that would squash my view here. But that seems unlikely through year's end.

Still, Fed chair Janet Yellen's planned Aug. 26 speech at Jackson Hole will be interesting to hear. We'll want to see what she has to say given U.S. stocks' recent record highs and the futures market putting the odds of even one 2016 Fed rate hike at less than 50/50.

August 17, 2016

Analysis on Disney stock

A number of subscribers have asked me to describe the bull case for Disney (DIS) . Examining the opposite case that one holds is a useful exercise as no one has the concession on truth in the investment business.

While I don't endorse to the bull case for Disney ... here it is, as I see it:

The bull case is the company's cost of capital -- and not operations or what resides on the income statement.

Disney has a bit more than $15 billion of net debt on its balance sheet. It also has $17 billion of 12-month trailing Ebitd. Ergo, leverage is under 1x. As a means of comparison -- Time Warner (TWX) is at 3x and Viacom (VIA) is at over 3x (and rising).

Today, Disney can borrow $30 billion or more and probably not offend the rating agency minders. Even more interesting is that the average cost of the company's debt is probably under 2% before the tax deduction. Trailing 12-month interest is only a little over $200 million. Put another way, cash flow covers interest over 85x (over 6x is viewed as reasonably conservative).

Over time and very quietly, Disney has bought stuff for cash and then paid off the purchase by using the cash flow of the acquired entity to buy back its own stock. The "stuff" includes Pixar, Marvel and LucasFilm. I suspect the latter will be paid off from its cash flow in under two years as "Star Wars: Rogue One" is released. Share count at Disney is down close to 25% from peak levels.

So, it is reasonable to expect a lot more share repurchase activity from the company.

Through nine months, the company has repurchased $6.6 billion in shares. Twelve-month trailing Ebitd is 10x, indicating a 10% return from buying the stock. Each share bought results in not having to pay the $1.42 after-tax dividend. Thus, the financing cost of share repurchase is negative.

While reasonable people may differ on the unit growth of the cable networks and Disney's least squared earnings growth projections, the company will (under almost any assumptions) generate large amounts of free cash flow.

August 16, 2016

Going long on JC Penny shares

I initiated a small starter position against my short exposure in retail in J.C. Penney (JCP)this morning, and I plan to buy more on weakness. JCP reported a solid quarter in a weak retail industry setting. Sales increased slightly (+$43 million) or +2.2% on a straight compare in units, so its market share grew modestly.

Earnings before interest taxes and depreciation (EBITD) increased by $80 million as gross margins improved and expenses were well under control. Interest expenses declined by $1 million as inventories remained under control and debt was reduced in a period where it normally increases seasonally.

While interest coverage is only 2.2 times, it is rising steadily and predictably.

The shares moved up briskly along with its retail peers on Thursday, so I plan to build on weakness.

Guidance was not increased ($1 billion this year, $1.2 billion next year in EBITD). Shares closed Friday up over 6% to $10.55.

On a short-term basis, the company is hosting an analyst day next week in Dallas, and I suspect it may strike a more optimistic tone. Valuation is reasonable. Debt is $4.2 billion compared to equity at $3 billion; enterprise value totals $7.2 billion.

Twelve-month trailing EBITD is $888 million. The 12-month multiple is 8.2 times. While this is an elevated multiplier, it's acceptable as EBITD is rising, the chain's competitive position is improving, and the company is moving into a free cash flow position.

Residual bearishness remains in this name, manifested by nearly 30% on the shares short. The short story is growing long in the tooth.

I expect the shares to climb out of its trading range and I have a year-end target of $12 to $13. (While I am comfortable with the reward/risk ratio, it's not out of balance enough to place the stock on my Best Ideas list.)

I am currently limiting my buy order to $10 per share.

August 15, 2016

Market strength is surpising

It's been risk-on in 2016, although the journey has been a dramatic rollercoaster ride rather than a straight line.

And fixed income has been the the star of the show -- a dominating influence that brought us the notion of "TINA." (as in, "There Is No Alternative" to stocks).

But just as many see Woodstock as the 1960s' "the last waltz," I'd suggest that bonds' recent rising prices and falling yields might represent a last waltz for the stock market. Let's check out where we've been and where we might be heading.

Actin' Funny, But I Don't Know Why

The Dow industrials, S&P 500 and Nasdaq Composite all hit all-time highs on Thursday. Consider:

- The S&P 500 is now +21% from its Feb. 11 intraday low.
- The iShares iBoxx U.S. Dollar High Yield Corporate Bond ETF (HYG) is +14.2% from the February lows.
- The JPMorgan Global High Yield Index is +13.9% year to date on a total-return basis.
- The JPM CCC bond index is +23% on a total return basis year to date.

But amazingly, Treasuries and investment-grade bonds have also also rallied big-time even as this huge risk-on move occurred. Of course, the Bank of Japan, the European Central Bank and the Bank of England have all accelerated bond buying, while expectations for Federal Reserve rate hikes have plummeted. As a result:

- Treasuries have rallied, with the 10-year yield tumbling from a 1.66% peak on Feb. 11 to a 1.32% all-time low on July 6. The 10-year yield closed Friday at 1.51%.
- JPMorgan's Investment-Grade Bond Index is +8.9% year to date.

In fact, virtually every fixed-income sector is having a strong year. But with macroeconomic data generally slowing and corporate revenues and earnings on the decline over the past few quarters, it's hard to attribute a large part of bonds' success to anything other than global central-bank activity.

After all, you might recall that the markets actually had a risk-off move at the end of 2015 and into 2016's first quarter following the Fed's December 25-basis-point rate hike and global fears about China's economy.

This accelerated the U.S. dollar's rally and commodity prices' collapse (led by oil). As this chart shows, West Texas Intermediate tumbled to a $26.21 low on Feb. 11 after the dollar had surged:

But the greenback had clearly gotten way ahead of itself in pricing in a Fed rate hike. So, as the chart above shows, the U.S. Dollar Index had already begun weakening from its 100.17 high on Nov. 30 before WTI put in its eventual bottom on Feb. 11.

Add in a blowout in high-yield spreads and the S&P 500 bottoming out 15% below its May 2015 peak by February and we got a dramatic shift in rate-hike expectations. Fed chair Janet Yellen's March 29 speech to the Economic Club of New York only confirmed that she had no desire to raise rates quickly.

Check out this slide from a friend of mine. It shows the odds that the futures market was pricing in for Fed hikes as of Jan. 11, when the S&P 500 stood at 1,924 (some 14% below today's levels):

Whatever It Is, Those Banks Put a Spell on Me
British voters' unexpected decision on June 23 to back a Brexit ultimately saw just two sessions of risk-asset selling. Literally two:

- The S&P 500 sold off 5.4% between the close on Thursday, June 23 (before the results were known) and the close on Monday, June 27, two sessions later.
- High yield probably dipped three points on the higher-beta side, while WTI fell by more than 7.5%.

Even for those of us who thought the vote was hardly global economic disaster, the fact that the correct course would have been to wave in any and all financial assets since Monday, June 27, is rather unbelievable.

It's true that the Brexit vote was a huge surprise, but it enabled central banks to adopt even more extreme stimulative measures. The ECB, BoJ and now the BoE have all increased quantitative easing in recent months and are moving out the risk curve to corporate debt. (And in the Bank of Japan's case, even into stocks.)

Would we actually have had less spread compression and perhaps less of a risk-on move had the Brexit vote failed? Who knows? But I can't imagine a scenario where we would have had more.

Now, high-yield bonds' rally from their February bottom seemed to stem from the reversal of a virtually bidless environment reversing (with junk bonds briefly reaching 9.5%). But the move since the Brexit vote has felt like a huge technical move spurred on by:

- Inflows. July's first two weeks saw $6.1 billion flow into high-yield mutual funds.

- 'Reach for Yield.' The collapse of global risk-free yields has popularized a mantra that credit investors will have to "reach for yield."

- Commodity Debt. The bid for energy- and commodity-related debt has become seemingly price-insensitive due to new funds being raised and a general underweight to these sectors. This has happened even though oil prices have tumbled since early June (although they've since bounced sharply).

via thestreet

August 10, 2016

Hartford Financial could be takeover target due to its low price

I'm aggressively adding to my long of Hartford Financial ( HIG) despite the stock's 8.6% pullback in the wake of last week's large second-quarter earnings miss. Hartford reported $0.31 in second-quarter earnings per share falling way short of analysts' roughly $0.80 consensus.

However, my experience has shown that buying strong business franchises whose shares have temporarily dropped due to "fixable" operating shortfalls usually provides good gains (especially in recent years).

We also can't ignore Hartford's takeover potential given the stock's current low price. Possible suitors include Travelers, Zurich Insurance Group and even a large Japanese insurer. However, shareholders don't appear to be "paying up" for this possibility.

Other reasons why I'm sticking with HIG:

- Hartford's second-quarter miss was materially a function of weak results in the company's auto-insurance business, which faced "loss-cost" issues for current and prior-year claims. However, HIG lifted auto-insurance rates early this year. Because most auto policies are annual, the resulting margin improvement should begin to appear in 2017's second half.

- Hartford's earnings shortfall also partly reflected special charges for exposure to asbestos/environmental, catastrophic experiences, etc. Many of the firm's other business lines (group benefits, mutual funds and runoff business Talcott) performed as expected.

- HIG has had to deal with the continued adverse impact of low interest rates, which are hurting all insurers by reducing reinvestment opportunities.

- Importantly, forward-looking premium renewals were in line. Hartford's core small-commercial-insurance business also remains a "plum" even though it faces increased competition from Chubb (CB) .

- Hartford's overall commercial business faced difficult comps in the second quarter due to lower property costs and favorable weather a year earlier. However, the unit continues to thrive amid mild competition that allows for a good rate backdrop. The line's expenses have temporarily risen as HIG makes long-term technology investments, but these will likely eventually improve operating efficiency and lead to market-share gains.

- HIG has also embarked on strategic actions with its non-AARP personal-lines business, which should produce a quicker resolution to Wednesday's low margins and profitability (including a lower advertising spend).

- As a result of the second-quarter shortfall, analysts have cut their 2016-17 earnings estimates for Hartford by about 10%. But HIG will still produce about a 9% return on equity if analysts' roughly $4.30-a-share consensus 2017 earnings estimates prove to be correct.

- Hartford's book value rose to $47.02 during the latest quarter, up nearly 5% year over year. This reflects favorable marks on investments and quarterly results. The company also repurchased 7.8 million of its shares outstanding during the latest period.

- I remain short Lincoln National (LNC) and MetLife (MET) against my HIG long.

The Bottom Line
The key to HIG's stock price in the absence of a takeover will be the company's ability to turn around its core property-and-casualty business lines at the same time that HIG shrinks and extracts capital from Talcott. I believe that in the fullness of time, management should be able to do this -- and that HIG's shares will likely rebound even if there's no buyout of the firm.

Position: Long HIG.

August 9, 2016

Why the markets could under-perform if Donald Trump quits the presidential race

In June, I wrote in Another Surprise that for the first time in history, a major party's presidential nominee would likely withdraw in the middle of the race:

    Surprise No. 16: Trump Bows Out

    "Donald Trump bows out of the presidential race some time between the Republican National Convention and Election Day." - Doug's Daily Diary, Another 2016 Surprise: 'The Trump Mutiny' (June, 2016)

People were skeptical of that call. (Indeed, many thought I was out of mind.) Now, none of this is meant to be a personal political statement.

Some six weeks after writing that, I now believe a Trump withdrawal is a more likely than ever. In fact, this might even represent a new baseline assumption for investors.

Now, there are certain things -- a degree of respect, a solid political organization, a thorough thought process, etc. -- that many believe all presidential candidates need. But arguably, Trump's tone and tactics don't conform to any of these.

From 'Chaos Candidate' to 'Kamikaze' One

No one seems able to control Trump -- not his family, not campaign chief Paul Manafort and certainly not Republican National Committee head Reince Priebus and the rest of the GOP leadership. In fact, Trump's recent behavior has become so aberrant and self-destructive that there's talk of top Republicans pleading for an "intervention."

I would challenge anyone to find an historical precedent to Trump's behavior over the past week. It defies political or intellectual reasoning. To some, The Donald appears bound and determined to destroy his own campaign, family and party. It almost suggests that Trump doesn't want to win the election -- something I consider a very real possibility.

Bleeding in the Polls

As I suggested in June might happen, the polls are starting to trend well in favor of Clinton over Trump. For example, a Fox News survey out this morning has Clinton with a 10% advantage. Even more importantly, Clinton's lead in swing states like Michigan and New Hampshire is now expanding.

I expect Trump's bleeding in the polls to only grow more conspicuous in the coming weeks. Next month's first presidential debate will be an important factor in determining whether my predictions come true. If Clinton wins the debate, that could easily move her lead in the polls toward 15%.

Top Republicans May Scorn Trump

A critical issue is whether top Republicans will come the conclusion that The Donald is more of a stain on the party than a standard-bearer.
For now, leading Republicans are laser-focused on defeating Clinton. But Trump's recent decision to not yet endorse the re-election of top Republicans like House Speaker Paul Ryan, Arizona Sen. John McCain and New Hampshire Sen. Kelly Ayotte could lead to senior GOP members to renounce support for him.

My guess is that McCain could be the first to break ranks and do so. But if Trump's poll numbers get bad enough, it'll become increasingly difficult for high-profile Republicans in tough re-election races to defend his behavior. They'll likely break away from the candidate as the cost of supporting Trump exceeds the benefits.

The Surprise

With tumbling polls, dwindling endorsements, a lack of organization and an absence of big donors like the Koch Brothers, Trump will likely enter the first debate as a dangerously exposed candidate.

Hillary Clinton with Warren Buffett
If polls show Clinton trouncing him after this one-on-one, I expect that will tip Trump's candidacy over. The embarrassment of a potential landslide loss to Clinton could serve as a breaking point for Trump, who doesn't like to lose or look bad.

In that scenario, The Donald would announce that he's "no longer an active candidate" -- in effect, quitting the race. Trump would remain on the ballot, but Clinton would essentially run unopposed. The Donald would likely blame his decision on others, perhaps stating that his party was not supportive to his candidacy or that the system is "rigged."

More Gridlock

Of course, this wouldn't necessarily mean that the Democrats would control the federal government.

After all, Republicans currently hold majorities in both the Senate and House, and I suspect they'll at least retain the House after November. To control both congressional chambers, the Democrats would have to pick up at least 30 House seats and five Senate seats if Trump wins the election or four if Clinton does (a Democratic vice president would break a 50-50 tie).

So, let's say that the Democrats take the Senate and win more than 25 House seats but the GOP still retains control of the lower chamber. What does that mean going forward? Two words: "More gridlock."

Possible Market Ramifications

With the Federal Reserve losing its effectiveness, the scenario outlined above would mean that needed fiscal stimulus simply won't happen. Even though I believe many investors' baseline expectations call for it, there'd simply be too much gridlock and partisanship in Washington.

Recognizing the dwindling policy alternatives to catalyze growth, global markets would then plunge during the fourth quarter.

That's one reason why I'm net short in the market.

Position: Long SDS, Short SPY 

August 8, 2016

Life Insurance companies seriously exposed to central banks easing policies

With the Bank of England easing monetary policy Thursday, I'd like to point out that life insurance is the most-exposed sector to lower rates. (The second-most-exposed one is banking).

Frankly, the "float" ain't what it used to be for insurers, while reinvestment opportunities have become meager and dwindling.

Partly as a result, MetLife and Prudential reported big earnings misses after the close Wednesday night and are paying the price for it now.

As a reminder, MetLife (MET) and Lincoln National Corporation (LNC) are both on my "Best Short Ideas" list. So is Geico parent Berkshire Hathaway (BRK) , although that stock has held up for now.

Conversely, I remain long on Hartford Financial (HIG) . In fact, I've recently added to my position in the stock.

Position: Long HIG, Short BRK.B, MET (small), LNC (small).

August 3, 2016

Seasonal factors and other reasons point to a correction

I can't in four decades of investing remember such a mixed market as we've seen the past two years, with uncertain internal action and inconsistency of direction. We've experienced a series of large trading swings in both directions, as well as extremes in individual sectors' performances.

For example, the S&P 500 and the Dow Jones Industrial Average both recently hit new highs, but the broader NYSE Composite, Value Line Geometric Index and Russell 2000 are all more than 5% below record territory.

Some technical signs are also mixed. For example, the S&P 500's McClellan Oscillator is below neutral and supportive of a bounce, while its McClellan Summation Index (a measure of extremes on an intermediate basis) is stalling at an elevated overbought level.

These striking differences exist even within individual market sectors. For instance, theIndustrial Select Sector SPDR Fund (XLI) has traded into record-high territory recently, but the more-diversified First Trust Industrials/Producer Durables AlphaDEX ETF (FXR)remains well below its early 2015 high.

Is Change in the Air?

Now, we're some five weeks past Wall Street's post-Brexit-vote lows, and most measures of market breadth have been strong as we moved from oversold to overbought conditions.

This has pushed many active managers into the market. For instance, I noted last week that the National Association of Active Investment Managers Exposure Index recently hit 100%.

But to me, that says that stocks are now meaningfully overbought. I'd also point out that Friday's daily put/call ratio rose to an elevated 1.29 even as we enter the August-to-September period, which has traditionally been equities' weakest time of the year.

Perhaps not surprisingly, energy and miscellaneous commodities (the market's recent leaders) are both turning lower. Moreover, the S&P 500 has been in a remarkably narrow range recently -- the narrowest range that the index has seen in the past two decades by some measures. An old technical-analysis premise holds that narrow ranges often produce whipsaws.

The Bottom Line

My guess is that a market correction could be imminent, and that some important leadership shifts could lie ahead.

But the Bull Market in Complacency still looks alive and well to me. I see an absence of investor concern about any meaningful correction or market drawdown -- in a large part thanks to the liquidity and low or negative interest rates that the world's central bankers have bestowed upon markets.

August 1, 2016

Why I sold fertilizer stock POT

Potash Corp. ( POT) Thursday reported in-line earning per share for the second quarter, but weak sales.

It looks like the fertilizer cycle is bottoming out later than I had previously expected (just as I feared when I sold my POT shares at a loss months ago). As a result, management has cut the company's dividend for a second straight time, dropping it to $0.10 per quarter from a previous $0.25.

That said, the fact that Potash Corp. is paying a dividend at all is probably a slight positive. It's apparently a signpost management sees a cyclical bottom coming to fertilizer prices, as well a "channel restocking" from delayed contracts with India and China. (Potash prices are now below most cash costs, and POT is among the industry's lowest-cost producers.)

Of course, the negative here is that fertilizer prices probably won't recover any time soon. So, I expect Potash's earnings per share and cash-flow trajectory to disappoint for a long time to come.

Net/net EPS should be in the 60 cent to 90 cent range for several years -- well below the company's halcyon 2013 period. And given farmers' current state, I don't see a breakout coming any time soon.

At the same time, POT's valuation is in line with "trough" profitability. So, there's no "valuation case" to be made for the stock absent a better-than-expected recovery in fertilizer prices and profit margins.

The bottom line

Potash Corp. looks to me like it's "dead money" at best for the foreseeable future. That said, I'd be interested in the stock if it falls to around $12 to $14 a share from Thursday's $15.91 close.

Position: None.