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

THE DAILY EDGE (21 November 2017)

Leading Economic Indicators Index Rises An economic index that measures business trends increased in October as impacts from a string of catastrophic hurricanes dissipated.

The Conference Board Leading Economic Index rose 1.2% to 130.4. Economists polled by The Wall Street Journal were expecting the index to rise by 0.9%.

Metrics including average weekly manufacturing hours, building permits and stock prices rose. The only negative contributor was manufacturers’ new orders for nondefense capital goods excluding aircraft. (…)

The board’s coincident index—designed to reflect current economic conditions—rose 0.3% in October from September.

The lagging index increased by 0.2% in October, following no change in September and a 0.2% increase in August.

As usual, Doug Short provides the best charts on the LEI. Recession not in sight from these charts.

Conference Board's LEI

Smoothed LEI

Tech Boom Creates New Order for World Markets Shares in technology companies are outpacing other sectors this year by the widest margin since the height of the dot-com era, with a handful of key players dictating how markets are performing around the world.

Just eight companies—Facebook Inc., Apple Inc., Amazon.com Inc., Netflix Inc., Alphabet Inc., Baidu Inc., Alibaba Group Holding and Tencent Holdings Ltd.—have increased by $1.4 trillion in market cap in 2017, a sum roughly equivalent to the combined annual GDP of Spain and Portugal.

As the tech sector has become bigger and more influential within global stock indexes, its ascent has helped take U.S. and Asian emerging stock markets to record highs—but left behind the less tech-heavy bourses of Europe, Canada and Australia. (…)

Global tech stocks are up 41% this year, roughly double the gains of the broad-based MSCI AC World Index. So far in 2017, the tech sector is up 20.5 percentage points more than the next best sector, materials—leading by the widest margin of any sector since 1999, according to analysis by Morgan Stanley.

The U.S. tech sector alone now has a combined market capitalization of $5.4 trillion, bigger than the $5.2 trillion in the entire MSCI Emerging Markets index or the roughly $4.8 trillion of its eurozone counterpart, according to Bank of America Merrill Lynch. (…)

Just four companies—Samsung Electronics, Tencent Holdings, Alibaba Group Holding and Taiwan Semiconductor Manufacturing Co.—now make up a combined 17.4% of the MSCI Emerging Market Index, even more influential than Facebook, Apple, Netflix and Alphabet are within the S&P 500. (…)

Tech valuations in the U.S. are just a fraction of where they were during that era. In early 2000, the S&P 500 tech sector traded at a forward price-to-earnings ratio of 52.2, according to FactSet. Today, that PE is around 19.1, compared with 18 for the S&P 500 as a whole. (…)

“In 1999 [tech companies] were incredibly expensive and didn’t yet have a lot of earnings, “ said Mark Phelps, an equities chief at AllianceBernstein. But today, not only are their earnings keeping up, “they’ve got more data, more processing power, and they’re giving the consumer a really good product,” he said.

IT equities actually trade at 28x trailing EPS and 20x trailing cashflow. Their margins are very impressive and are showing no signs of slowing. (Charts from Morningstar/CPMS)

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China Steps Up the Fight Against a Mountain of Debt
A Specter Is Haunting Europe’s Recovery: Zombie Companies Hundreds of these staggering firms, kept alive by banks, undercut healthy rivals, tie up capital and stunt the continent’s recovery

(…) The Bank for International Settlements, the Basel-based central bank for central banks, defines a zombie as any firm which is at least 10 years old, publicly traded and has interest expenses that exceed the company’s earnings before interest and taxes. Other organizations use different criteria.

About 10% of the companies in six eurozone countries, including France, Germany, Italy and Spain are zombies, according to the central bank’s latest data. The percentage is up sharply from 5.5% in 2007.

In Italy and Spain, the percentage of zombie companies has tripled since 2007, the Organization for Economic Cooperation and Development estimated in January. Italy’s zombies employed about 10% of all workers and gobbled up nearly 20% of all the capital invested in 2013, the latest year for which figures are available. (…)

THAT LOUSY TRUMP BULL (an update)

Last September 25, I wrote about Lowry’s Research surprisingly upbeat reading of so-called market internals. I explained why I was not buying Lowry’s analysis that

a crossing of the Buying Power and Selling Pressure Indexes, with Buying Power rising to the dominant position, would qualify as a major buy signal (…) and would provide important confirmation of a robust bull market that is actually showing signs of strengthening.

As I said then, yes, “the crossing of the Buying Power and Selling Pressure Indexes may be happening, but really only because the selling has dried up so much that it is crawling itself under the Buying Power Index. There is no real demand here. We will see in a few months which of the starved bear or that lousy Trump bull can rise to the dominant position.”

Almost 2 months (and +0.35% on the S&P 500 Index) have passed and Lowry’s has become more cautious. Its analysis shows that its Selling Pressure Index has moved back to the dominant position above its Buying Power Index. Selling has risen but there also has been a small drop in Demand. Steady demand is crucial to allow the market to withstand periodic bouts of selling (buying the dips). Recently, Down Volume on down days has outpaced Up Volume on rally days.

It is rather interesting to note that, using Lowry’s methodology, Buy Volume jumped after the November 2016 elections but has remained fairly constant at a low level since mid-December. On the other hand, Sell Volume has been declining relentlessly throughout the last 12 months, until mid-October.

Given that total volume has been declining since late 2016, we can assert that the 21% gain in the S&P 500 Index since the elections was not the result of enthusiastic buying but was rather due to investors merely staying in to see what will happen with this new President and his tax reform.

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This would also explain why valuations (black line below) have not exploded as they normally do so late in the cycle given the strong earnings, a Goldilock economy and a fairly quiet Fed amid low inflation.

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Mind you, while the Rule of 20 P/E has increased 7% from 20.4 to 21.8 since October 2016, the actual P/E on trailing EPS has risen 10.4% from 18.2 to 20.1 to reach pretty scary levels, however one looks at it. 

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The decline in inflation has kept the Rule of 20 P/E (and, importantly, interest rates) from rising even more. But the odds keep stacking up against us. Has anyone noticed that 2-year Treasury rates have tripled since July 2016 and jumped from 1.3% in early September to their current 1.72%? Some day, investors will realize that they can now park money for 2 years without losing much, if any, buying power to inflation, and watch this not so calm and simple world evolve one way or the other from the sidelines with precious dry powder.

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This is a game of probabilities. Let’s not get fooled by the low volatility which, when accompanied by rising valuations, only increases the potential damage when it returns. Because it will return.

TINA (There Is No Alternative) is weakening. Prospective returns must be contrasted with the rising 2-year returns on cash.

  • The actual trailing P/E is 20.1:

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  • The Rule of 20 P/E is 21.8:

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  • Yes Virginia, you can end up losing money:

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The complementarity between the “120 Yield Spread” and the Rule of 20 is clear, significant and fundamentally sound. The Rule of 20 valuation analysis provides the fundamental risk/reward equation while the 120 Yield Spread adds the momentum input from the economic and monetary trends. With simple, objective readings, investors can manage their equity exposure on the basis of both value and momentum according to their own individual risk profile.

(…) the only period when both gauges failed simultaneously was between December 1976 and February 1978 when equities lost nearly 20% while the Rule of 20 P/E was in the 15-16 range and the yield spread averaged 212. Only one miss out of 21 cycles is pretty remarkable.

Hmmm…

BTW, I have been able to subscribe to Lowry’s Research thanks to your donations. In over 40 years in the business, the only technical analysis service I have been willing to pay for is Lowry’s Research for its simple, sensible, down-to-earth, yet smart analysis.