Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: January 2016

NEW$ & VIEW$ (27 JANUARY 2016): Housing Mystery; Oil & Equities; Earnings

FED BETWEEN A ROCK AND …

From the January 2016 NABE Business Conditions Survey:

For the first time in more than a decade nearly half (49%) of respondents report their firms’ wages and salaries rose in the latest quarter. The NRI [net rising index] for wages and salaries rose sharply to 45 in the January survey from 28 in the October survey—the highest NRI since at least January 2005. But wage increases were much less prevalent in the goods-producing sector (35% of respondents) and in TUIC firms (33%) than in the finance, insurance and real estate (FIRE) sector (61%) or the services sector (50%).

Expectations for wage increases over the next three months are more prevalent than in the previous six surveys. (The question was not asked prior to July 2014.) Fifty-eight percent of respondents anticipate increases in wages and salaries at their firms, resulting in an NRI of 54, compared to an NRI of 40 in the October survey. (…)

“Equal numbers of participants report declining and rising profit margins at their firms, the first time since the July 2013 survey that rising margins did not predominate,” said Survey Chair Patrick Jankowski, senior vice president of research at the Greater Houston Partnership. “Nevertheless, more respondents than in the previous survey in October report that their firms had raised selling prices, and more firms experienced falling than rising input costs. Fewer panelists than in the past three surveys report difficulty filling open positions, and shortages of skilled labor are less prevalent among respondents’ firms than in the two previous surveys.”

BTW: Walmart announced that it “will increase all 1.2 million hourly workers wages by at least 2% on Feb 20, as the company hopes to stem defections.”

U.S. Home Price Growth Picks Up in November, Case-Shiller Says

The S&P/Case-Shiller Home Price Index, covering the entire nation, rose 5.3% in the 12 months ended in November, greater than a 5.1% increase in October.

After seasonal adjustment, the national, 10-city and 20-city indexes all gained 0.9% from October to November.

Strong price increases are being driven in part by employment and wage growth and low mortgage rates. But economists also warn that a stubborn shortage of new homes for sale is helping to drive down the volume of sales, while pushing up home prices. (…)

Portland, one of the hottest markets in the country, saw the number of homes on the market drop 26% since this time last year, according to Redfin. Overall, the 15 biggest markets in the country saw inventory declines of 10%.

After years of volatility, home price growth appears to have stabilized at an annual rate of close to 5%. But West Coast markets with strong job growth are seeing much more rapid price gains than other cities. Portland had an 11.1% price gain, followed by San Francisco with 11% and Denver with 10.9%. Three cities—Dallas, Denver and Portland—have reached new all-time highs, while San Francisco pulled even with its previous peak.

In contrast, prices in Chicago, Cleveland and Washington, D.C., rose by around 2% in November.

The U.S. House Price Index from the Federal Housing Finance Agency (FHFA) increased 0.5% in November (5.9% y/y), the same as during October. Over the last three months, the annualized rate of change picked up to 7.5%, the quickest growth since December 2014.

Prices were strongest during November in the Mountain states where a 1.8% monthly increase (10.0% y/y) was the firmest since June 2012. A 1.5% rise (8.6% y/y) in the Pacific states also was largest since late-2012. In the South Atlantic region, a 0.8% rise in prices left growth firm at 7.6% y/y.

Moderate price increases were logged in the East North Central region where prices rose 0.5% (5.0% y/y) and in New England where a 0.3% rise lifted prices 3.7% y/y. Prices gained 0.2% (4.9% y/y) in the West North Central states but they declined elsewhere in the country. House prices fell 0.4% (+5.5% y/y) in the West South Central region. They also were off 0.2% (+3.3% y/y) in the East South Central states and ticked 0.1% lower (+2.6% y/y) in the Middle Atlantic states.

Think about that:

  • Demand for housing has remained essentially flat since 2013 in spite of rising employment and low mortgage rates (chart from Haver Analytics).

image

  • Yet, house prices have jumped nearly 30% in the last 4 years and are almost back to their previous bubble peak (next 2 charts from CalculatedRisk).

  • Surprisingly, sharply higher prices are having zero impact on supply……which is seen as the main reason for the slow sales…

Existing Home Inventory

  • And while lenders are slowly loosening lending standards to help demand, prices are running away, hurting demand.

JANUARY RETAILS SALES IN RICHMOND FED DISTRICT:

Retail sales rose sharply in January after a weak reading in December, pushing the index to 27 from -36. The index for big-ticket sales climbed to 30 from last month’s reading of -32. In addition, shopper traffic was heavy this month, driving the indicator up to 26 from December’s index of -19. Retail inventories increased moderately with the index gaining 13 points this month to finish at 12. Retailers anticipated further strength in sales prospects during the next six months, elevating the gauge for expected product demand to 16 from last month’s reading of -3.

RETAIL DEFLATION IN THE U.K.

As in the U.S., deflating retail prices are causing confusion on retail sales statistics:

(…) As the Office for National Statistics puts it in its latest data release on U.K. retail sales:

“Although the annual change in the quantity bought was strong (4.5%) between 2014 and 2015, the amount spent increased by only 1.1%. This could be explained by falling prices in stores, which decreased by 3.2%, as shown in Figure 2. Essentially, as a consequence of falling prices, consumers were buying more items which were costing less.”

Amount spent, quantity bought and average store prices in the 4 main retail sectors,
seasonally adjusted, 2015.

Amount spent, quantity bought and average store prices in the 4 main retail sectors, seasonally adjusted, 2015.

US shale groups slash capital spending Continental and Hess react to collapse in crude oil prices

(…) Oklahoma-based Continental Resources, controlled by its founder Harold Hamm, said it would cut capital spending by 66 per cent this year to $920m, following a 46 per cent reduction last year.

New York-based Hess said it would cut spending by 40 per cent this year, following a 29 per cent cut in 2015. (…)

The costs of drilling and completing wells in the US has fallen sharply — in some cases by 40 per cent in the past year — but not as fast as oil prices.

The slowdown in activity at both Continental and Hess means their production is set to decline.

Continental predicted average output of 200,000 barrels of oil equivalent per day this year, down 5-9 per cent from 2015.

Hess said production would be 330,000-350,000 b/d for 2016, a drop of 7-12 per cent from its rate in the first nine months of last year. (…)

Continental’s production grew by an estimated 24-26 per cent last year, the company has said, while Hess’s output for the first nine months of last year was 19 per cent higher than in the equivalent period of 2014.

US oil production is expected to drop by about 1.2m b/d, or 12 per cent, from its latest peak in April 2015 to the end of 2016. (…)

Oil and stocks. Correlations that work until they don’t.

There comes a time when the level of correlation hits a point where people start to notice. They will trade one asset on the back of moves of another asset because the correlation tells them that the two will move in lock step. In doing so they create a positive feedback loop of tighter and tighter correlation.

Algorithmic trading relies on correlations and there are correlations out there that only algorithms have seen and trade on. Some of them will make absolutely no sense to humankind as humankind attempts to satisfy its desire to justify correlations. The correlations algorithms trade on may be so obscure that the human brain would not even bother to look under the stones they are hiding as the number of stones to look under is almost infinite and humans like to apply filters to make the search easier.  But computers? Well computers can look under stones that our logic filters would have discarded as duds. Humans have a desire to understand or justify the correlation before they trade on it. Why? Because justification is the excuse humans raise in case of failure. Without excuse there is little chance of being excused. Many years back we spotted a correlation between USD/DEM and the Icelandic fish catch. In fact it was better than USD/DEM vs Oil. Did we trade on it? No way. We would have been laughed out of the manager’s office should we have had to excuse our losses.

Many years ago my friend Gerald Ashley (@Gerald_Ashley), told to me that ‘Correlations work really well – until you put the trade on’. I have never forgotten that and often quote it, normally to 12yr old quants. This statement may sound as though it flies in the face of my original comment that correlations become reinforced by those trading on them, but what it really expresses is the point where that artificial forced correlation caused by the actions of the observer (their trading) can no longer hold down the reality that the two assets are not naturally correlated but had wandered together through chance and at some point will start to diverge again causing mass liquidations of all these hearded correlation trades in a classic high volatility blow up.

I raise this thought because of the current “correlation du jour’. That of oil and global stock indices. This correlation is not just real in mathematical terms but also has handy justifications that can be strapped to it to keep the human mind happy too. (…)

Odd things can happen when large things are pushed around by small things. Now whilst the oil market is vast it doesn’t take that much to push the price round in $ terms relative to moving the price of, say,  every stock in all the countries whose indices appear to be following oil. Which means that if you want to move a stock market at the moment all you have to do, rather than buying the huge volumes of stocks that would normally be required, is to buy a relatively small amount of oil and have the rest of the market do your job for you on assumed correlations. In simple terms . (…)

I think we are getting to the point where the correlation is going to break down between oil and stock in general. (…) But more importantly, oil does not normally correlate so closely to the stock market, if it correlates to it at all, so the artificial correlation imposed upon stocks and oil due to traders acting and reinforcing that correlation could well be due a blow up. This has been running a while now and when I hear of traders looking at oil for a guide as to where telecom stocks are going I think something is wrong. (…)

Screen Shot 2016-01-26 at 10.11.13 AM

David Stockman:

(…) Brent crude was down 14% during 2016 as of Friday. That rout is hurting oil-dependent nations from the Middle East to Central Asia, whose sovereign-wealth funds are huge holders of global stocks.

J.P. Morgan estimates those funds could sell $75 billion of stocks this year to prop up their countries’ budgets. (…)

This a.m:

Aberdeen Asset Management Plc reported 9.1 billion pounds ($13 billion) of net outflows in its fiscal first quarter amid waning investor confidence in emerging markets and as sovereign-wealth funds continued to withdraw cash.

Investors pulled a net 6.3 billion pounds from a range of equity funds in the three months through December, including 3.5 billion pounds from global stocks, the Scottish firm said in a statement on Wednesday. (…)

EARNINGS WATCH

Becoming more significant after one third of market cap in:

  • 101 companies (32.1% of the S&P 500’s market cap) have reported. Earnings are beating by 4.3% while revenues have missed by 0.4%.
  • Expectations are for a decline in revenue, earnings, and EPS of -3.5%, -4.9%, and -3.3%. EPS is on pace for -0.4% (+0.1% yesterday and +1.4% last week), assuming the current 4.3% beat rate for the remainder of the season. This would be +5.6% (+6.1% yesterday) excluding Energy.
  • The beat rate is 73%, 75% ex-Financials (68%).
  • Earnings projections have been far too pessimistic for more global businesses, largely on growth and currency concerns. Specifically, more globally-oriented names have surprised by 4.0% vs. 1.5% for more domestically-focused firms. (RBC)
FYI: Morgan Stanley Analyzed 43 Bear Markets and Here’s What It Found

NEW$ & VIEW$ (26 JANUARY 2016):

Vehicle Sales Forecast: Sales to Reach 10-Year High for a January

The automakers will report January vehicle sales on Tuesday, February 2nd. Note:  There were 24 selling days in January, down from 26 in January 2015.
From WardsAuto: Forecast: January SAAR Set to Reach 10-Year High

A WardsAuto forecast calls for U.S. automakers to deliver 1.13 million light vehicles in January.

The resulting daily sales rate (DSR) of 47,126 units, a 10-year high for the month, over 24 days represents a 6.8% improvement from like-2015 (26 days) and a 19.2% month-to-month decline from December (28 days).

The 5-year average December-to-January decline is 26%, but the traditional pull-ahead of sales in December was not as strong as expected this time. Lighter deliveries allowed dealers to remain well-stocked with vehicles highest in demand going into January.

The report puts the seasonally adjusted annual rate of sales for the month at 17.3 million units, compared with a year-ago’s 16.6 million and December’s 17.2 million.

Looks like another solid month for car sales.

Confused smile The Five Scenarios Now Facing the Fed (Timothy A Duy)

(…) I see five likely scenarios:

  1. The economy slips into recession, and the December rate hike is yet another in a long line of central banks’ failed efforts to pull up from the zero-bound.
  2. Financial market conditions stabilize, and the economy slows to a sustainable path of activity such that the unemployment rate stabilizes while inflation remains moderate. This limits the Fed to just one or two more rate hikes later in the year.
  3. Financial market conditions stabilize, economic activity remains sufficient to push the unemployment rate down further, and inflation remains moderate. This would be similar to the Fed’s baseline scenario in which it hikes rates in four 25-basis-point increments this year.
  4. Financial market conditions stabilize, economic activity remains sufficient to push the unemployment rate down further, and inflation begins to accelerate. This would push the Fed toward more than 100 basis points in rate hikes this year.
  5. Financial markets remain choppy in the first half of the year, pushing the Fed into “risk management” mode despite solid labor market activity. The Fed skips the March and April meetings. Officials’ delayed response calms markets and prevents a slowdown in activity, but they feel behind the curve and try to catch up with a steeper pace of hikes late in the year.

Financial market participants at the moment are likely caught somewhere between the first two scenarios.

Scenario five, however, requires serious consideration (and would currently be difficult to differentiate from the first two). It’s consistent with the Fed’s behavior during the Asian financial crisis.

Like now, the U.S. economy faced risks associated with slowing economies abroad as well as capital inflows driving the dollar higher. The Fed then was able to cut rates rather than just delay rate hikes, as is the case now, but found it had to reverse course after the external crisis had passed. Under this scenario, the Fed would find itself exactly where it didn’t want to be—hiking rates at a fairly rapid pace.

Bottom Line: If there was ever any doubt about the “about” of this week’s FOMC meeting, it has long since been eliminated. The Fed will hold policy steady and affirm the faith in its underlying forecast while acknowledging the global and financial risks. This will be interpreted dovishly, probably more so than the policymakers at the central bank would like. Given that I’m in the “no recession” camp, I am wary that the Fed falls into risk management mode now, but at the cost of a faster pace of hikes later. Of course, if you’re in the “recession now” camp, then the game is already over.

How does one play the odds with 5 scenarios? Better to not play…

OIL

The official also said there will be no emergency meeting on the plunging prices of oil, unless countries both inside and outside the OPEC cartel make a concerted effort to curb production. (…)

“The stocks are higher than the five-year average and this is difficult, especially with the expected shutdown in refineries in the second quarter of this year, so the first half of this year is going to be difficult,” she said.

Regarding the prospect of emergency discussions, Ms. Fuzaia said “if there is no real, clear, and studied cooperation to reduce output from OPEC and non-OPEC there will be no meeting and any meeting without real results will backfire and have a very negative impact on the market.

“OPEC is willing to cooperate with producers outside the group if they show that they are serious about cooperating. [However] non-OPEC producers keep on making statements that they are willing to cooperate but the reality is different.” (…)

(…) This year’s budget was initially planned around oil averaging $50 a barrel and a deficit of 3 percent of gross domestic product. Belt-tightening measures totaling 1.5 trillion rubles ($18.9 billion) are needed to avoid a shortfall of over 6 percent of output this year, Siluanov said. (…)

The currency has nearly halved in value since Putin’s annexation of Crimea in March 2014 and the U.S. and the European Union imposed sanctions against Russia.

Currency weakness accelerated inflation to a 13-year high of 16.9 percent in March 2015. Annual consumer-price growth eased to 12.9 percent in December, still more than three times the central bank’s goal. (…)

Saudi Arabia and Russia, the world’s biggest oil producers, are now more flexible about cooperating to cut output as crude prices have fallen to levels that hydrocarbon-rich nations didn’t foresee, Iraq’s Oil Minister Adel Abdul Mahdi said.

“This flexibility should be finalized, and we should hear some solid suggestions coming from all parties,” Abdul Mahdi told reporters at a conference in Kuwait City. He didn’t give details about what the increased Saudi and Russian flexibility entailed, nor did he say how he knew about it. (…)

EARNINGS WATCH

The earnings picture has not gotten worse during the last week. Thomson Reuters still sees Q4 EPS down 4.5%, slightly better than the –4.7% it was seeing on Jan. 15. And if this is worse than the –3.7% TR was expecting on Jan. 1, most of the deterioration is in Energy. Importantly, Consumer Discretionary EPS are expected up 8.6% vs +8.5% on Jan. 1. Consumer Staples: –2.2% vs –2.1%. Financials: +9.3% vs +10.9%.

TR sees Q1’16 EPS down 0.8% from –0.4% last week.

RBC includes yesterday’s reports:

  • 78 companies (21.8% of the S&P 500’s market cap) have reported. Earnings are beating by 4.8% while revenues have missed by 0.3%.
  • Expectations are for a decline in revenue, earnings, and EPS of -3.4%, -5.2%, and -3.6%. EPS growth is on pace for +0.1% (+1.4% last week), assuming the current 4.8% beat rate for the remainder of the season. This would be +6.1% (+7.3%) excluding Energy.
SENTIMENT WATCH
Thumbs down Why So Much Pessimism in the Stock Market?

(…) As Samuelson explains, cheap oil hurts many more companies than those in the production and servicing sectors. “Oil companies have canceled $1.6 trillion worth of projects through 2019, estimates the consulting company IHS. The loss of these projects (and jobs) represents a drag on the global economy and, to some extent, justifies lower stock prices,” he writes.

He adds that for investors, cheap oil is also a “symptom,” and reminder of the distress in emerging market economics, which demand more of the product during better times and thus help keep the price higher.

But as several other articles point out, there are other factors that may be souring investors on both the markets and the economy that have little to do with the aforementioned economic fundamentals.

A piece by Wall Street Journal senior writer Greg Ip blames the fear and loathing on the Federal Reserve itself.

“The newfound attention on the January meeting illustrates something few people, even at the central bank, truly appreciate: The Fed is a key reason markets have plunged and the risk of recession, though low, is rising,” he writes.

Who knows whether Ip is right. After all, stocks have fallen hard on days when the economic data from China was particularly bad. And one would think that the Fed’s long-planned intention to raise rates is already baked into stock prices. But there’s no doubt that many investors have been emboldened in recent years because the Fed was in their corner, even if a slow-growth economy wasn’t really cooperating. Now that the era of zero rates and bond buying is over, some investors are arguably moving in the other direction.

In finding reasons for the current market pessimism, one can’t forget about the role that this off-beat presidential campaign is playing in depressing both stock values and investors themselves.

As market commentator Zachary Karabell wrote in a column last week on the Politico site, candidates are overstating the problems in the economy on a daily basis in order to create a rationale for their candidacy. Some investors may well be succumbing to all this doom and gloom talk. After all, despite the fact that unemployment is at 5%, Donald Trump regularly tells us that the country is a mess economically.

“The doomsayers are not limited to Republican presidential hopefuls. At times, Bernie Sanders taps into a similar vein of deep pessimism about the direction of the country,” Karabell writes.

But even more importantly, the pessimism on stocks may be heightened by the fact that non-establishment candidates like Trump and Ted Cruz are leading the polls for the Republican nomination and Sanders, a progressive, is giving Hillary Clinton a run for her money for the Democratic nomination. Randall Forsyth, an associate editor with Barron’s, made that point in a column last week.

It’s a cardinal rule of investing that political uncertainty isn’t good for stocks: the prospect that a maverick could be our next president may be unsettling to many who vote with their investment dollars.

Thumbs up Oil and U.S. Stock Market

By David R Kotok, Chairman and Chief Investment Officer of Cumberland.

Hartford Funds has published an analysis of “stock market returns after significant oil price declines.” They used the WTI crude oil price reference and examined a period of approximately 30 years ending in 2015. In their examination they found four events that were substantive. Independently, Jim Bianco published a similar analysis and brought the data current through January 20, 2016. We commend both firms on their excellent work.

The first event was the oil price drop that took place between October 1985 and March 1986. Hartford’s analysis indicated a price drop of approximately 66%. They then computed the S&P 500 Index total return one year after the price decline period ended. The result was a positive 37.66%.

The next period was September 1990 through February 1991. The oil price decline was 53% (57% if you use Bianco’s dating). According to Hartford’s computations, the subsequent S&P 500 Index total return one year after the price decline was complete was 15.99%.

The third event was December 1996 through November 1998. The oil price drop was 56%. Bianco uses a slightly different methodology and has the price drop at 61%. The S&P 500 Index total return one year after the price decline was 20.90%.

The last of the four events was June 2008 through January 2009. The oil price drop was 70% according to Hartford. Bianco gets 78% for that decline. Hartford computes that the S&P 500 Index total return one year after the price decline was 33.14%. (…)

According to Hartford’s calculation, during the period June 2014 through December 2015, the oil price drop was 65%. Jim Bianco data now shows 73% from peak to trough. In fact, depending on how you measure the oil price, the price decline this time could be the largest percentage drop in history. It may exceed the 70% decline that occurred in 2008 and 2009.

Will this oil price decline run its course? Yes, absolutely. At what price will it bottom? Not a single soul on the planet knows. What will happen after the bottom? History suggests that the transmission mechanism of low oil price to positive economic outcome, with rising consumption and other stimulative effects, takes about a year to unfold.

The historical data also suggests that once the positive rebound begins to unfold, it will become robust as a result of the $200 billion annual tax cut equivalent from the energy price fall. The 350 million of us who live in America and billions who live around the world have been receiving and will continue to receive this benefit.
After we rebalance our household balance sheets, raise our savings, and adjust our domestic budgets, we will start to spend this windfall. There are early signs that this process is underway. Subsequently, we will find ourselves with an extra $20 to $100 a week in our pockets. As we begin to realize the permanence of the excess, it becomes spendable. Economists call this the permanent income hypothesis. (…)

A drop in the oil price has immediate effects on credit, including high-yield and energy-related credit, and on regions of the country that are dependent on energy production, such as North Dakota and Texas. It is a negative force and quickly visible. We can already see it and measure its impact.

The oil price transmission mechanism that affects the entire nation and passes through the benefits of the price drop takes more time to operate and is more nuanced. We are starting to see those benefits now, and they are accelerating.

This analysis leads us to the following conclusions:

  • (1) We are not going to have a recession in the US. We are going through the negative phase of the energy price shock. The positive phase is still ahead of us; however, it has begun.
  • (2) The positive phase is likely to continue and become more robust. There is an accelerator function in the transmission from oil price decline to economic growth.
  • (3) There is no way to know how high the S&P 500 Index will go once the oil price downward shock is complete, nor can we time the upturn. There is a lot of history and supportive information to suggest that following the oil price shock, the US economy will be more robust. Our growth rate will pick up and do so from a platform that is fairly solid, because the economy will have run through the credit problems precipitated by the downward move in oil. Lastly, the rebound will be reflected in an upward movement in stock prices and higher total returns, with a strongly positive number from the S&P 500 Index.

Factoring in low global inflation and additional intervention by central banks worldwide, from the European Central Bank to the People’s Bank of China, we see the makings of an extended period – through the rest of the decade – with low single-digit interest rates, low inflation, ample liquidity, and a corrective mechanism that will express itself in rising asset prices as we go through this turmoil and come out the other side.

Furthermore, we remain optimistic about stock prices and committed to high-grade credits. We would not touch high-yield, and we won’t touch junk. (…)

Contact: edgeandodds [at] gmail.com