Earnings Watch

HIKING SEASON COMETH

Payrolls Increased 161,000 in October; Wage Gains Jump Hiring by U.S. employers remained healthy in October as wage growth accelerated to its strongest pace since the recession.

• Hilsenrath: Stage Set for December Rate Rise

• “As the job market gets tighter, firms are responding to tougher competition for workers by raising pay. This is a big positive for income growth, consumer spending, and the overall economy.” —Stuart Hoffman, PNC Financial Services

• “The October jobs report was as good as an optimist dared hope for…With hourly earnings up 2.8% year-over-year, the fastest since the crisis, workers are sharing the benefits. If you wanted to show that the economy is still getting better for the typical voter, this report gives you what you needed.” —Jed Kolko, Indeed.com

For balance and objectivity, I often look at the other side of a consensus view. David Rosenberg did it for me on this latest NFP report. I summarize his main points for you:

• October’s 161k new jobs is not only much weaker than the 191k net addition posted in September, but nearly 30% below the 222k average of the past four months.
• The diffusion index jumped nicely to 59.2% from 57.1% in September but close to two-thirds of the October employment gain was concentrated in four
  areas:— government, health & education, hospitality & leisure and administration & waste services.
• Employment in the cyclically sensitive sectors of the economy (resources, durable goods manufacturing, transportation services, and construction)— eked out a meagre 15k increase, from +50k in September and just half the average of the past year.
• The manufacturing workweek expanded 0.2% to 40.8 hours but factory payrolls declined 9k and have fallen now for three months in a row. Cost cutting to boost productivity which helps explain how 71% of S&P 500 Industrial companies are beating Q3 EPS estimates while only 37% beat on revenues. Industrials’ earnings are up 3.7% in Q3 on a 1.7% revenue gain.
• Private sector services managed to post a 142k job gain, slower than the 158k average of the prior three months. Only 33% of industries added to the job rolls, down from 61% a year ago.
• Combining the Payroll and the Household surveys on the same methodological footing, employment sagged 83k in October and is down in two of the past three months and five of the past seven. Full-time employment fell 103k in October after a 5k decline in September.
• Average hourly earnings spiked 0.4% MoM in October and the YoY trend has clearly broken out to a new cycle high of 2.8% (best since June 2009). But the wage measure covering production & nonsupervisory workers showed a much slower 0.18% MoM increase, and is far from breaking out YoY (+2.4% from 2.65% in September)
• The fact is that 82% of the bulk of the workforce received a fractional wage advance in October, nothing remotely close to an acceleration in their earnings growth.

These last 2 points can be debated however. Here are Rosenberg’s charts to support his point (and basic thesis) that wages are not really accelerating when we exclude supervisors and only consider the larger cohort of production workers:

  

The fact is that inequality of wage trends is not apparent since 2009:

Rosenberg’s point that because staff wages did not rise as much as line wages last month, there is no significant acceleration in wages is not supported by other pertinent facts:

• one, staff and line wages tend to follow very similar trends over time.
• two, when using non-seasonally adjusted numbers, often preferable when looking at YoY trends, both cohorts are getting accelerating wage gains: +3.4% for line employees and +2.9% for staff employees in October. Given point one, we can anticipate that growth rates will converge in the not-too-distant future.

  

Also keep in mind that the Labor Department indicated that Hurricane Matthew “affected parts of the East Coast during the October reference period.” Given the above and the latest strong PMI surveys, my sense is that it would take very dismal retail trade data in coming weeks to prevent the Fed from finally hiking rates in December.

Worldwide PMI surveys show economic growth kicking higher in October

Global economic growth kicked higher at the start of the fourth quarter, according to PMI survey data, though inflationary pressures also intensified.

The JPMorgan Global PMI Composite Output Index, compiled by Markit from its various national surveys, rose from 51.7 in September to an 11-month high of 53.3 in October. The improvement points to annual global GDP growth (at market prices) accelerating above 2% at the start of the fourth quarter and pulling out of the malaise that had been evident through the second and third quarters.

Manufacturing grew at the sharpest rate for just over two years and services saw the largest monthly increase in business activity since November of last year, suggesting a broad-based improvement in the global economy. (…)

Germany helps drag down eurozone retail sales

Monthly sales dropped 0.2 per cent in September compared to August as Germany suffered a 1.4 per cent decline. The eurozone’s drop was the second consecutive month of contraction and matched the 0.2 per cent slip between July and August, according to figures from Eurostat.

The sales of non-food products suffered the biggest drop, falling 1 per cent, while food, drinks and tobacco rose 0.6 per cent.

Compared to September 2015, sales were up 1.1 per cent in the 19-country bloc. The quarterly figures, which rose 0.3 per cent “suggests consumer spending likely made a modest positive contribution to third quarter eurozone GDP growth”, said Howard Archer at IHS Global. (…)

Still soft and somewhat erratic, but less so than before:

OPEC Chief Says Russia on Board With Deal to Limit Output

(…) “We as OPEC remain committed to the Algiers accord,” Barkindo said. “I have heard from the highest quarters in Moscow that Russia is on board.” (…)

Energy Minister Alexander Novak indicated that Russia was willing to freeze production for six months or more, rather than cut, and only if OPEC reached an agreement first. (…)

Freeze at what level?

China’s Debt Addiction Could Lead to a Financial Crisis China’s borrowing spree could end badly, with dangerous repercussions for the rest of the world.

Barron’s feature this week:

(…) How much of the current $30 trillion in Chinese debt [on a $10T economy] and other impaired financial assets in the financial system is nonproductive, or yielding no net return? For an informed answer, we turned to Charlene Chu in Hong Kong, a widely respected Chinese credit analyst who cut her teeth at Fitch before joining the research shop Autonomous Research Asia. Chu estimates that about 22% of this pile will be nonperforming by year end. And of this troubled paper, totaling $6.6 trillion, actual losses after recoveries are likely to weigh in at more than $4 trillion. (…)

In June, Torsten Slok, chief international economist at Deutsche Bank Securities, published a chart showing that China’s credit bubble exceeded even that of the U.S. in 2007, on the cusp of the subprime mortgage meltdown that set off the global credit crisis. (…)

Deleveraging, or allowing credit growth to go negative, would unleash the baleful forces of widespread business bankruptcies, soaring unemployment, negative economic growth, and, ultimately, massive social unrest.

(…) In a speech delivered last spring in New York at the Asia Society, [George Soros] asserted that what’s unfolding in China bears an “eerie resemblance” to what happened during the financial crisis in the U.S. in 2007-08, which was “similarly fueled by credit growth.…Most of the money that banks are supplying is needed to keep bad debt and loss-making enterprises alive.”

In a September interview with the BBC, Kenneth Rogoff, a professor of economics at Harvard University, opined that China’s “credit fueled” economy, as the postcrisis “engine of global growth,” is rapidly losing velocity and constitutes a major threat to the world economy. Forget Brexit and other issues. “There is no question. China is the biggest risk,” he said.

Likewise, the Bank for International Settlements issued a review in September showing that China’s banking-system credit had blasted off in the first quarter to a level 30 percentage points above long-run trend levels. The report further warned that even a 10 percentage-point deviation from the trend is “a reliable early-warning indicator of banking crises or severe distress.” Trouble typically arrives “in any of the next three years,” according to the report. (…)

Complacency vis-à-vis China reigns. Most of its debt is domestically owned and therefore not vulnerable to foreign capital flight. The Chinese are prodigious savers, with a gross savings rate of nearly 50% of GDP, compared with 18% in the U.S., according to the latest World Bank data. Bank deposits tend to be sticky. Like Las Vegas, what happens in China is expected to stay there, or so many global investors apparently believe. (…)

Most of the dodgy paper sits in China’s fast-growing shadow banking system, whose assets now amount to nearly $8 trillion, according to a Moody’s estimate this summer. The shadow institutions—trust companies, brokers, wealth managers, and insurance companies—derive most of their funds from investors looking for higher yields and not directly from bank depositors.

The shadow players, in turn, invest in all manner of assets, from corporate bonds and stocks and loans to local governments for infrastructure projects, to loans to less-creditworthy corporate credits, which are packaged as high-yielding wealth-management products, or WMPs.

Chinese banks also use the shadow market to get nonperforming loans off their balance sheets by injecting the bad loans into WMPs and then buying the WMPs, transmogrifying the bad debt into what they depict as “investment receivables.” 

These WMPs are starkly reminiscent of the bad mortgage-backed paper in the U.S. that metastasized in 2008 into a full-blown global credit crisis. The primary problem in the shadow sector, as cited in an International Monetary Fund report this summer, is interconnectedness. In the mosh pit of China’s current financial system, banks invest in a wide variety of WMPs, and WMPs invest in one another. Layers of liabilities accrete on the very same loans and other damaged paper. Therefore, any debt defaults have the potential to create a full-fledged contagion.

Chu, the credit analyst, estimates that by next year these opaque, off-balance sheet wealth-management products will be double the size of the mortgage-structured investment vehicles and conduits that brought the U.S. banking system to its knees. (…)

But the bubble of all bubbles is unfolding in the housing market, as gobs of new credit are being lavished on developers and home buyers alike.

The market has been on fire, with prices in September soaring year over year by 34.1% in Shenzhen, 32.7% in Shanghai, and 27.8% in Beijing, according to the National Bureau of Statistics of China. Even some secondary cities have seen solid price gains, despite sky-high unsold inventories. Chinese real estate billionaire Wang Jianlin said in a September interview with CNNMoney that the Chinese residential real estate market is now “the biggest bubble in history.”

(…) Credit directly tied to housing sits at about a third of GDP. Much household wealth would be vaporized. These days, mortgage borrowing accounts for much of the acceleration in household debt levels, which have soared from just over 10% of GDP in 2006 to 40% now.

A substantial dent in household wealth would also play havoc with the nation’s ambition to transform its economy from an industrial export powerhouse to one emphasizing consumption and services. (…)

(Charts from Fitch Ratings via The Daily Shot)

• Is China Making the Same Mistakes That Crushed Japan’s Economy?

• China Adopts Cybersecurity Law Despite Foreign Opposition

EARNINGS WATCH

From Factset:

Overall, 85% of the companies in the S&P 500 have reported earnings to date for the third quarter. Of these companies, 71% have reported actual EPS above the mean EPS estimate, 7% have reported actual EPS equal to the mean EPS estimate, and 21% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (70%) average and above the 5-year (67%) average.

In aggregate, companies are reporting earnings that are 6.6% above expectations. This surprise percentage is above the 1-year (+4.8%) average and above the 5-year (+4.4%) average.

In terms of revenues, 54% of companies have reported actual sales above estimated sales and 46% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is above the 1-year average (50%) and equal to the 5-year average (54%).

In aggregate, companies are reporting sales that are 0.5% above expectations. This surprise percentage is above the 1-year (0.0%) average but below the 5-year (+0.6%) average.

The blended earnings growth rate for the third quarter is 2.7% this week, which is above the blended earnings growth rate of 1.6% last week and above the estimated decline of -2.2% at the end of the third quarter (September 30).

If the Energy sector is excluded, the blended earnings growth rate for the S&P 500 would improve to 6.0% from 2.7%.

The blended revenue growth rate for Q3 2016 is 2.6%. If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would improve to 4.4% from 2.6%.

To me, the surprise comes mainly from the revenue growth rates in the non-resource related sectors amid very low inflation rates. a strong dollar and rather subdued economic conditions. Ex-Energy, operating margins actually rose in Q3. This is the first positive revenue growth quarter since Q1’15 for the S&P 500 Index.

Domestic companies are recording revenue growth of 4.2% compared with +0.4% for globally-oriented companies.

At this point in time, 78 companies in the index have issued EPS guidance for Q4 2016. Of these 78 companies, 53 have issued negative EPS guidance and 25 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 68%, which is below the 5-year average of 74%.

This compares with 75% negative guidance at the same time last year and 72% at the same time after Q2’16. Which probably explains that:

During the month of October, analysts lowered earnings estimates for companies in the S&P 500 for the fourth quarter. The Q4 bottom-up EPS estimate (which is an aggregation of the EPS estimates for all the companies in the index) dropped by 1.2% (to $31.17 from $31.54) during this period.

During the past year (4 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.6%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.4%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has also been 2.4%.

S&P 500 Falls for Ninth Session in Longest Losing Streak Since 1980

(…) Tightening polls in the presidential election have dragged down stocks and pushed Wall Street’s “fear gauge” to its longest-ever stretch of gains. Investors also are grappling with a possible rise in U.S. interest rates next month and a renewed fall in oil prices.

The S&P 500 fell 3.48 points, or 0.2%, to 2085.18 on Friday, putting its nine-session decline at 3.1%. The last time the S&P 500 index fell for nine days in a row was the period ended Dec. 11, 1980—when it lost 9.4%. (…)

The last time the index fell for nine days in a row was the period that ended in late-1980, a time of high inflation that preceded a recession, when the Federal Reserve was raising interest rates toward 20%.

A prolonged period of declines isn’t necessarily indicative of how the index will perform going forward. In previous nine-day or longer stretches of losses, stocks were nearly as likely to end the next month higher as they were to fall, according to Birinyi Associates Inc. (…)

BTW, Barron’s adds this info as Americans go to the polls, possibly making history in more than one way:

(…) the last 10-day slump was in July 1975, when the S&P 500 dropped 7.8%. The record is 12 straight losing sessions in April 1966, when the index lost 6.6%.

These stats make for good conversation but are practically useless without the context of salient market data around these losing stretches:

S&P 500 earnings were declining at the end of 1980. From their earlier March peak, they dropped 4.6% until their March 1981 trough. Inflation was slowing rapidly from 14.8% in March 1980  (yes, four-teen-per-cent!) to 12.5% in December 1980. The market’s P/E was 9.2 then! If that sounds cheap to you, it’s because you are much younger than me and still don’t fully appreciate the impact of inflation on P/E ratios. 

Equities went on to dive 21.3% through July 1982 when the market P/E reached 7.6. People using the Rule of 20 were not fooled by the low absolute P/Es. The Rule of 20 P/E was 21.7 in December 1980. It reached its cyclical low of 14.1 (now, that is cheap!) in July 1982.

FYI, Ronal Reagan the maverick became president in November 1980…

In July 1975, 3 months after I got my first job as a financial analyst, earnings were also in a downtrend after peaking in September 1974. They troughed 14.8% lower in September 1975. Inflation was declining, from +12.0% in September 1974 to +9.5% in July 1975. The absolute P/E was 11.2 in July 1975 but the Rule of 20 P/E was high at 20.8.

Equities retreated 11.6% between June and September 1975 bringing the Rule of 20 P/E down to 18.7. Rising EPS and declining inflation combined to boost equities 27% during the ensuing 15 months.

In April 1966, earnings were rising along with inflation. The absolute P/E was 17.0 and the Rule of 20 P/E was 19.8. The S&P 500 Index, up 8% over the previous 10 months, tanked 15% during the next 4 months during which inflation accelerated sharply from 2.4% to 3.6%.

The Rule of 20 P/E declined to 17.5 in September 1966, just before equities roared back 26% during the following 12 months which saw a 1% drop in inflation more than offset flat earnings. The Nifty-Fifties did the sentimental job, taking equities 11% higher and the Rule of 20 P/E to a 23.3 extreme. The S&P 500 Index cratered 32% after that.

High valuations, per the Rule of 20 to account for inflation, can be treacherous, especially when inflation is rising, even more so if earnings are also declining.

At this time, the Rule of 20 P/E is right at its 20.0 fair value mark and earnings are stabilizing. The Fed wants higher inflation and is willing to let it exceed its target for a while. Better have strong earnings…

Want more election-related stats?

• Don’t Worry When the Stock Market Goes Crazy After Election

(…) regardless of how prices react on Nov. 9, next-day moves in the S&P 500 Index are useless in telling what comes after. While the index swings an average 1.5 percent the day after the vote, gains or losses over the first 24 hours predict the market’s direction 12 months later less than half the time.

This matters because the compulsion to act in the vote’s aftermath is often very strong — stocks swing twice as violently as normal those days, data compiled by Bloomberg show. They plummeted 5 percent just after Barack Obama beat John McCain in 2008. But while nothing says Wednesday’s reaction won’t be a harbinger for the year, nothing says it will, either, and investors should think before doing anything rash. (…)

In the 22 elections going back to 1928, the S&P 500 has fallen 15 times the day after polls close, for an average loss of 1.8 percent. Stocks reversed course and moved higher over the next 12 months in nine of those instances, according to data compiled by Bloomberg. (…)

• What Does History Indicate about the Final Two Months of Election Years?

Looking at the final two months of presidential election years going back to 1928, the S&P 500 index gained in value 64% of the time (14 out of 22 years). The average price increase was 1.9%, which trailed the 2.1% average increase in the final two months of all years.

When a Democrat was elected as president, the S&P 500 posted an average price gain of 0.6% (during the final two months of election years), which was well-below the 3.6% average gain when a Republican was elected. (…)

Looking at the first year after the presidential election (going back to 1928), the S&P 500 index has increased in value 55% of the time (12 out of 22 years), with the average price gain amounting to 5.1%.

When a Democrat was elected president, the S&P 500 was in the positive during the first post-election year 75% of the time (nine out of 12 years), with the average price increase equaling 11.7%. When a Republican was elected president, the index was in the positive only 30% of the time (three out of 10 years), with the average price change amounting to -2.8%. (…)

Interesting…but still useless without the context.

Big Hit on Drug Stocks Caps $26 Billion Decline for John Paulson

(…) Mr. Paulson’s hedge-fund firm, Paulson & Co., is suffering painful losses this year, extending a period of uneven performance that has left the firm managing about $12 billion, down from $38 billion in 2011. (…)

Six of Paulson & Co.’s 10 largest holdings as of June 30 were pharmaceutical companies, the most recent securities filings show, including the firm’s four largest positions. (…)

Shares of the firm’s largest investment, U.K. pharmaceutical company Shire PLC, are down 19% so far in 2016. The holding, worth about $864 million at current share prices, represented 9.1% of Paulson & Co.’s portfolio at the end of June, according to FactSet Research Systems Inc. The next three biggest Paulson investments, Mylan NV, Allergan PLC and , are down 37%, 40% and 40% this year, respectively. (…)

Paulson held more than 19 million shares, or about 5.5% of Valeant’s shares outstanding, at the end of June, after adding about 5.8 million shares this year.

(…) the Paulson Advantage fund was down 18.5% through September, Paulson Partners fund was down 22.3% and the Paulson Special Situations fund was down 29%, investors say. (…)

Some (apparently intelligent) people accept to pay 2/20% to be run by such poor judgement. Who do you think gets Paulson’s vote Tuesday?

FINALLY…

(…) Nearly half the country will therefore wake up deeply disappointed on the morning of Nov. 9, and many members of the losing side will think that America is doomed. Those on the winning side will feel relieved, but many will be shocked and disgusted that nearly half of their fellow citizens voted for the moral equivalent of the devil. (…)

In short, the day after this election is likely to be darker and more foreboding than the day after just about any U.S. election since 1860. Is it possible for Americans to forgive, accept and carry on working and living together? (…)

Democracy requires trust and cooperation as well as competition. A healthy democracy features flexible and shifting coalitions. We must find a way to see citizens on the other side as cousins who are sometimes opponents but who share most of our values and interests and are never our mortal enemies. (…)

This has been a frightening year for many Americans. Questions about the durability, legitimacy and wisdom of our democracy have been raised, both here and abroad. But the true test of our democracy—and our love of country—will come on the day after the election. Starting next Wednesday, each of us must decide what kind of person we want to be and what kind of relationship we want to have with our politically estranged cousins.

“Me against my brother, my brothers and me against my cousins, then my cousins and me against strangers.” —Bedouin saying

That was from How to Get Beyond Our Tribal Politics in Saturday’s WSJ.

COMING UP NEXT:

Italy Approaches a Constitutional Reckoning

(…) Despite subsequent reforms to the voting system designed to facilitate the election of single-party majority governments, the constitution had come to be seen as the main obstacle to meaningful reforms.

Yet now this pro-reform consensus has collapsed, just four weeks ahead of a Dec. 4 referendum Mr. Renzi has called to endorse a package of reforms to address these perceived deficiencies by reducing the size and powers of the Senate; that, alongside an overhaul of the electoral system, is designed to ensure governments with working majorities. Mr. Renzi is confronted by a coalition of political forces, including much of the left wing of his own Democratic Party; former Prime Minister Silvio Berlusconi and his allies on the center right; the right-wing separatist Northern League; and the antiestablishment, euroskeptic 5 Star Movement. The latest polls show Mr. Renzi behind by 49% to 51% among voters who have made up their minds, with up to a quarter of voters still undecided. (…)

This strategy isn’t without risks. One is that Mr. Renzi might refuse to stay on as prime minister if voters opt to destroy his political project. That could plunge the country into a period of political instability, reviving market fears about the sustainability of the country’s debts and the stability of its banking system.

A second risk is a perception that Italy’s elites are colluding to keep antiestablishment parties from power. That could backfire, even more so particularly if the result is more weak and unstable governments unable to deliver the structural reforms needed to revive Italy’s long-term potential growth. If a failed referendum undermines efforts to attract private capital into the banking system, as seems likely, thereby forcing banks to impose politically explosive losses on savers.