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: December 2017

THE TAAL EQUITY MARKETS

Some 30 miles south of Manila (a nearly 2 hour drive given Philippines roads and traffic, not counting the 20 minutes lost to a corrupt police officer with a sharp eye for foreign drivers), stands the Taal Volcano. This unique volcano complex is truly spectacular.

Sunrise on Mt. Taal and Mt. Tabaro June 2012 by Steven Rascoe.JPGBy Steven Rascoe – Own work, CC BY 3.0, Link

The view from the Taal Vista Hotel in Tagaytay provides a false sense of calm and serenity.

There are actually 3 volcanoes in the above picture. The lake fills most of the original crater which itself hosts 2 smaller volcanoes, one of which is the second most active volcano in the Philippines.

The crater lake on Volcano Island is the largest lake on an island in a lake on an island in the world. Moreover, this lake contains Vulcan Point, a small rocky island that projects from the surface of the crater lake, which was the remnant of the old crater floor that is now surrounded by the 2-kilometre (1.2 mi) wide lake, now referred to as the Main Crater Lake. Vulcan Point is often cited as the largest third-order island (island in a lake on an island in a lake on an island) in the world (…).

Therefore, Taal has an island within a lake, that is on an island within a lake, that is on an island: Vulcan Point Island is within Main Crater Lake, which is on Volcano Island, which is within Taal Lake, which is on the main Philippine Island, Luzon. (Wikipedia)

In brief, there is a lot more than what meets the eyes.

Taal Volcano aerial 2013.jpgBy TheCoffee (Mike Gonzalez) – Own work, CC BY-SA 3.0, Link

Climbing the volcano, we can see and feel the hot steam coming out of the ground here and there.

Although the volcano has been quiet since 1977, it has shown signs of unrest since 1991, with strong seismic activity and ground fracturing events, as well as the formation of small mud pots and mud geysers on parts of the island. The Philippine Institute of Volcanology and Seismology regularly issues notices and warnings about current activity at Taal, including ongoing seismic unrest.

Yet, we felt safe during the climb, seeing all the people working and living there. They surely know it’s safe, even though we all know the live monster is right under our feet.

The most recent period of activity lasted from 1965 to 1977 with the area of activity concentrated in the vicinity of Mount Tabaro. The 1965 eruption (…) generated “cold” base surges which traveled several kilometers across Lake Taal, devastating villages on the lake shore and, killing about a hundred people. (…) The population of the island was evacuated only after the onset of the eruption. Precursory signs were not interpreted correctly until after the eruption.

Since the 1911 major eruption which claimed some 5,000-6,000 lives, this volcano is constantly monitored and analysed. Filipinos have avoided going near the mountain for years after 1977. But tranquility gradually restored confidence and, even though scientists have declared the area as high-risk and a Permanent Danger Zone, people have gradually moved back to the attractive islands.

Indonesia’s Mount Sinabung erupted a few weeks ago after 400 years of silence, amid a series of eruptions that have also hit Bali volcano Mount Agung in recent months. The monster mountain lies just miles from supervolcano Lake Toba, that has a 62-mile crater filled with water and was responsible for what was thought to have been the largest explosive eruption ever on planet Earth, 74,000 years ago.

Tranquility can be very deceiving. Calmness is no guarantee against eruptions. Hyman Minsky famously coined that “stability breeds instability”. And the higher you climb, the higher the risk.

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Looking at the mountain, all we see is the inviting calm and serenity. The invite is so tempting…

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image(Yardeni.com)

We want to get there as fast as possible.

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But the volcanoes are there, quiet but nonetheless very much alive underneath the beautiful and serene landscape:

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Tremors are increasing:

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The above are the obvious volcanoes that everybody can see. They’ve been visible and scrutinized for so long, they now scare nobody.

But there are other volcanoes within, some never seen by a large numbers of investors:

  • Like rising interest rates, especially when debt is high after a long period of very low financing costs.

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Aggregate U.S. debt has increased by nearly $11 trillion in a decade but interest expense has been flat thanks to very low interest rates. The total interest bill will be rising sharply in coming years, inevitably squeezing government spending and slowing growth.

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  • Like a rout in the high-yield markets.

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  • Like rising inflation which reduces real income. The U.S. is vulnerable since very low savings provide no buffer to any squeeze in real income.
  1. Core CPI troughed at +1.7% YoY in August. It was +1.8% in October. Aug-Oct. annualized: +2.4%.
  2. Total CPI troughed at +1.6%  last June. It was +2.0% in October. Aug-Oct. annualized: +4.2%.
  3. Core PCE inflation troughed at +1.3%. It was +1.4% in October. Aug-Oct. annualized: +1.9%.
  4. Total PCE inflation troughed at +1.4% last July. It was +1.6% in October. Aug-Oct. annualized: +3.0%.
  5. The Cleveland Fed median CPI troughed at +2.1% in July. It was +2.3% in October. Aug-Oct. annualized: +2.8%.
  6. The Cleveland Fed 16% Trimmed-mean CPI troughed at +1.8% in August. It was +1.8% in October. Aug-Oct. annualized: +2.0%.
  7. The Cleveland Fed Inflation Nowcast suggests Q4/17 annualized CPI of +3.6%, PCE of +2.7%, core CPI of +2.2% and core PCE of +1.9%.
  8. The NY Fed Underlying Inflation Gauges (UIG) “currently estimate trend CPI inflation to be in the 2.25% to 3.00% range, with both registering above the actual twelve-month change in the CPI.”
  • Like speculative bubble blowouts. Bitcoins? Leveraged crypto derivatives? ICOs? Da Vinci paintings?
  • Like political eruptions. Trump? North Korea? Saudi Arabia?

Volcano science remains very imprecise. Sensors and satellites are useful to monitor tremors and magma activity but are of little help in forecasting eruptions.

Although volcanologists are well aware of the [eruptions] processes, they cannot yet predict a volcanic eruption. (…) Forecasting involves probable character and time of an eruption in a monitored volcano. The character of an eruption is based on the prehistoric and historic record of the volcano in question and its volcanic products. (Scientific American)

Equity investing also remains very imprecise in spite of all the attention and dollars involved. The main volcano is thoroughly analysed and pretty well understood. But the lack of volatility provides a false sense of safety which is drawing in the crowds, right when danger is rising underneath. The less visible volcanoes add to the risks as their eruptions can set up a violent chain reaction.

The prehistoric and historic record of equity markets provide ample evidence of overvaluation and high probability of meaningful corrections. The current “volcanic products” are not of a benign character as this volcano is filled with debt and speculation, highly flammable material with rising interest rates and inflation.

  • Equity, bonds and high yield market valuations are just as excessive, if not more than in 2008.
  • Complacency and bullishness are as high as in 2008.
  • Overall indebtedness is as high, if not higher than in 2008.
  • The Fed has turned clearly more hawkish and the ECB will likely soon become less accommodative.

It is thus wiser to keep a certain distance, making sure every investment is made with an appropriate margin of safety.

The S&P 500 trailing P/E ratio very rarely gets above 20 and generally troughs around 15 except in inflationary periods. At 20.6, it offers little reasonable upside while threatening a 15% decline to its 17.5 median in non-inflationary times.

The Rule of 20 P/E, which takes inflation into account, fluctuates between 15 and 23. With current inflation levels, the Rule of 20 says that fair P/E is 18.0-18.2 (20.0 minus 1.8 (core CPI) or 2.0 (CPI)), which is 19% lower than the current 22.4 reading.

Thus, on trailing earnings and inflation data, valuations offer little rational upside and a 15-20% cliff to “fair or median valuation levels”.

The only possible margin of safety is offered by rising earnings. In truth, most forecasters have been dumbfounded by corporate America’s capacity to increase profits in rather slow and complicated economic environments. Earnings beats have been so regular that few pundits even discount future earnings even though history shows that 12-month out estimates are always too high. Current forward EPS on the S&P 500 Index are $142.48 (Thomson Reuters/IBES), up 11.1% from the current $128.22. Equities are thus selling at 18.6 times forward earnings, a level rarely exceeded in the last 60 years. Also note the very uneven floor for P/Es which makes the downside difficult to calculate but still in the 20% range.

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Now add the last layer of possibilities, the impact of tax reform currently estimated at +10% on 2018 (Congress) or 2019 (Senate) numbers. This puts the forward P/E at 16.7, still 10% above a reasonably “safe” 15.0.

But this is not the last layer in this forecasting game. One must also consider how higher inflation could impact valuations (let alone earnings). The Fed is determined to bring inflation to 2.0% which necessarily requires some overshooting. The Fed’s preferred gauge of inflation is the PCE deflator currently in the +1.5% range. Assuming the Fed is successful and that the CPI (used in the Rule of 20) remains about 0.5% above the PCE deflator, the Rule of 20 fair P/E would decline to 17.5 times trailing EPS. That would give 2250 on the S&P 500 Index (-15%) on current trailing EPS and 2500 one year out or 2660 including a full $10.00 of tax reform gain.

Under most calculations and scenarios, equities seem fully valued currently with a 15-20% downside.

As legendary mountaineer Ed Viesturs wisely said, “getting to the top is optional, getting down is mandatory.” He also said:

What some people call “summit fever,” he calls “groupthink,” which is when a majority of the group, desperate to reach the top, disregards dangerous weather, route conditions, or other important factors. The least experienced climber tags along thinking if everyone else is going, then it should be just fine. It’s almost a lemming-type effect. People get swept up in it, it’s that psychological feeling of safety. No one gives any thought to the acceptable level of risk.’

When I am climbing, I listen to the mountain. All the information is there, which helps me decide what to do. Arrogance and hubris need to be put aside, and humility and thoughtfulness are essential. I truly believe that is how I survived so many expeditions into a dangerous arena.

“When a volcano erupts, people get surprised, but it is a volcano! There is no ‘place’ for the surprise! The biggest problem with people is that they are not serious about the matters of life and death! Be serious or alternatively lose your existence!”  Mehmet Murat ildan

THE DAILY EDGE (6 December 2017)

U.S. Productivity Growth Accelerates; Unit Labor Costs Decline

Output per hour in the nonfarm business sector grew at an unrevised 3.0% annual rate (1.5% y/y) in the third quarter following a 1.5% Q2 gain. It was the quickest productivity increase in three years. A 3.3% rise had been expected in the Action Economics Forecast Survey. Output rose 4.1% (3.0% y/y) while hours-worked gained 1.1% (1.5% y/y).

Unit labor costs declined 0.2%, revised from +0.5%, following a 1.2% fall. A 0.2% rise had been expected. Compensation costs increased 2.7% last quarter (0.8% y/y), revised from 3.5%, after a 0.3% gain.

In the manufacturing sector, productivity declined 4.4% (+0.3% y/y) last quarter, revised from -5.0%, following a 3.6% Q2 rise. Output fell 1.1% (+1.5% y/y) while hours-worked lengthened 3.5% (1.2% y/y).

Unit labor costs in the factory sector strengthened 4.8% during Q3 (0.3% y/y) following a 1.2% decline.  Compensation per hour grew 0.2% (0.6% y/y) following a 2.3% rise.

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U.S. Trade Deficit Deepens as Petroleum Imports Surge

The U.S. trade deficit in goods and services increased to $48.7 billion in October from $44.9 billion in September, revised from $43.5 billion. A $46.6 billion deficit had been expected in the Action Economics Forecast Survey. Total exports were little changed (5.6% y/y) after a 1.1% increase in September. Imports strengthened 1.6% (7.0% y/y) after a 1.2% rise.

Deterioration in the goods deficit to $68.1 billion from $64.0 billion led the increase in the total deficit. Merchandise imports gained 1.8% (7.4% y/y), the largest monthly rise since January. Industrial supplies & materials imports rose 4.3% (13.8% y/y), reflecting a gain in petroleum imports. Nonauto consumer goods imports increased 1.6% (1.5% y/y) after a 0.7% rise, while auto imports gained 0.2% (1.5% y/y) following a 1.8% decline. Foods, feeds & beverage imports gained 0.1% (8.1% y/y) following a 1.8% surge. Nonauto capital goods imports eased 0.4% (+10.7% y/y) after a 2.8% surge. (…)

The value of nonpetroleum imports increased 1.3% (6.7% y/y), about the same as in September. (…)

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FROM THE MOST RECENT BEIGE BOOK:
  • Pre-holiday reports of consumer spending on retail and autos were mixed but largely flat.
  • Residential real estate activity remained constrained, with most Districts reporting little growth in sales or construction.
  • Employment growth has increased since the previous report, with most Districts characterizing growth as modest to moderate.
  • Reports of tightness in the labor market were widespread. Most Districts reported employers were having difficulties finding qualified workers across various skill levels, and several Districts reported that an inability to find workers with the required skills was a key factor restraining hiring plans. Wage growth was modest or moderate in most Districts. Wage increases were most notable for professional, technical, and production positions that remain difficult to fill. Many Districts reported that employers were raising wages as well as increasing their use of signing bonuses and other nonwage benefits to retain or attract employees.
  • Price pressures have strengthened since the last report. Most Districts reported modest to moderate growth in selling prices and moderate increases in non-labor input costs. In particular, construction-material costs rose in most regions, with many Districts citing increased lumber costs and/or increases in demand for materials due to hurricane rebuilding efforts.
  • Residential real estate prices generally increased as well. There were also reports of increases in costs in the transportation sector. Additionally, several Districts noted input cost increases in manufacturing. In many cases, these increases in transportation and manufacturing were passed through to consumers. Fuel prices also rose, with multiple Districts reporting upward pressure on oil and natural gas prices. However, agricultural price pressures remain mixed.
Challenger Shows Worst November For Job Cuts Since 2012

The sectors with the largest job cuts in November were Healthcare, Consumer products, and Services.

GE Plans 12,000 Job Cuts as New CEO Revamps Power Unit
  • That plan is part of a larger effort to cut $3.5 billion of expenses across the company through 2018.
  • The reductions, accounting for about 18 percent of GE Power’s workforce, include both professional and production employees.
  • While GE didn’t specify where the job cuts will come, the bulk will be outside the U.S., according to a person familiar with the matter who asked not to be identified discussing the details.
  • Pointing up Positions in France won’t be affected due to stipulations in an agreement when GE bought Alstom SA’s energy business in 2015.
  • Pointing up Pointing up “Alstom has clearly performed below our expectations,” Flannery said last month, referring to the assets acquired from the French company. Confused smile
  • (…) At the end of 2016, GE had around 295,000 employees.

Bank of Canada keeps rate hike options open

Stephen Poloz is no closer to pulling the trigger on another interest-rate hike in spite of a run of good economic news.

The Bank of Canada Governor underscored the cautious tone as he kept the central bank’s benchmark overnight rate at 1 per cent on Wednesday – its final rate decision of 2017. And he offered no clear indication about when the bank might hike again.

The Bank of Canada has already raised interest rates twice this year – in July and September – as it works to gradually return rates to more normal levels.

“While higher interest rates will likely be required over time, [the bank] will continue to be cautious, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation,” the bank said in a statement accompanying its rate decision. That sentence repeats nearly word for word the language of its statement in October, when the bank also left rates unchanged.

Investors had been looking for a hint from the central bank that another hike might be coming as early as January after a string of surprisingly good economic reports – on jobs, growth and exports. They didn’t get it, and the Canadian dollar promptly lost nearly a full cent on Wednesday to 78.39 cents (U.S.). (…)

Among the things possibly holding Mr. Poloz back is potential failure of talks with the United States to renegotiate the North American free-trade agreement. The threat of NAFTA’s demise has put a chill on business investment in Canada, particularly in the manufacturing sector.

The bank’s statement mentions only that the global outlook is still facing “considerable uncertainty” related to “geopolitical developments and trade policies.” (…)

Indeed, much of the Bank of Canada’s statement highlighted positives for the economy, including “above potential” second-half GDP growth, “very strong” job gains, “robust” consumer spending and October’s resumption in export growth.

Even inflation, which has remained stubbornly below the central bank’s 2-per-cent target for years, is showing signs of life amid “diminishing” labour-market slack, according to the statement.

“Inflation has been slightly higher than anticipated and will continue to be boosted in the short term by temporary factors, particularly gasoline prices,” the bank said.

Another outlier in the otherwise bullish outlook is the slowing housing market. But a cool down of the hottest housing markets in Toronto and Vancouver is exactly what the central bank wants in the face of record household debt. Canadians owe $1.68 (Canadian) for every dollar of disposable income. (…)

  • The BoC remains complacent about labour market slack

The Bank of Canada (BoC) kept its overnight rate at 1% today but recognized that the recent uptrend in core inflation reflects “the continued absorption of economic slack” on the back of “very strong” employment growth and “improving wages” that supported “robust consumer spending in the third quarter”. We already know that the jobless rate fell to a 40-year low in November, that hourly wage inflation accelerated to a two-year high, and that core inflation moved higher. So surely, more capacity was absorbed in the fourth quarter.

Yet, the BoC still claims that its in-house measure of labour market tightness shows slack. As argued in our most recent special report, the BoC’s indicator understates labour market tightness because it is skewed by two components. Correct for this anomaly as we did and Canadian labour markets are just as tight as they were a decade ago. If we are right, wage inflation will continue to percolate and force our central bank to raise rates perhaps as early as January 2018. NAFTA-related uncertainty, not labour market slack, is the only reasonable argument left for keeping interest rates below inflation at this point in the economic cycle. Be wary of our data-dependent central bank’s foot dragging. (NBF)

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Weak revenues set to temper US banks’ optimism Fourth-quarter results likely to douse some cheer over prospects for looser regulation

(…) John Gerspach, chief financial officer at Citigroup, told a Goldman Sachs-sponsored conference this week that revenues from trading would be down in “the high teens” from a year earlier. In response, analysts at Credit Suisse cut forecast profits for the bank as a whole by about 4 per cent for the final three months of the year. Elsewhere, top executives at Bank of America and JPMorgan Chase said trading revenues were likely to drop about 15 per cent.  “The environment hasn’t really changed. Volatility remains pretty low across the spectrum,” said Marianne Lake, JPMorgan’s chief financial officer. (…)

Citigroup CFO Sees $20 Billion Hit If Senate Tax Bill Signed

Citigroup Inc. expects to take a noncash charge to earnings of about $20 billion if the U.S. Senate’s version of the tax reform bill is enacted, Chief Financial Officer John Gerspach said.

The hit to profit would mostly stem from the bank writing down its deferred tax assets in the period the bill is signed, Gerspach said Wednesday at an investor conference in New York. About $3 billion to $4 billion of the charge would come from the taxation of unremitted foreign earnings.

JPMorgan Chase & Co. said Tuesday it expects a charge of as much as $2 billion, largely driven by foreign earnings facing taxation, while Capital One Financial Corp. said Wednesday it would expect a $1.8 billion adjustment to its deferred tax assets. (…)

Much of the DTAs are excluded from counting as regulatory capital, so the writedowns won’t have a large impact on those ratios. Gerspach said the reduction to regulatory capital would be about $4 billion and that means the amount it has planned to return to shareholders through dividends and stock buybacks over the coming years won’t change.

Still, it’s a larger reduction to regulatory capital than the bank’s illustration in July, which had assumed a $2 billion cut. (…)

That is a $7.55 hit (9.2%) to book value per share. C now trades at about the new BVPS with expected ROE of 8.0% in 2018. By comparison, BAC is at 1.2x BVPS with a 9.3% ROE. JPM: 1.6x with 11.3% ROE.

Money Speaking of banks, here’s a research piece unlike what you are used to read from brokerage analysts:

Draft letter to US regulators says financial system ill-prepared for cryptocurrencies

Ray Dalio:

Watch Out for the Effects of Tax Reform on Tax Migration, the Fiscal Conditions of Affected States and Cities, and Polarity in America