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

TRUMP CARDS

The Trump story has been remarkable, not really on its impact on the bull and bear population, but mainly on the denizens of the “correction camp” as these Yardeni charts illustrate. Bullish investors (per Investors Intelligence) are back at their usual high number of hopefuls but they have been joined by a significant number of short-term nervous willies who suddenly decided that the odds of a correction vanished the morning of November 9. That has left the few bears still growling with barely anybody to share any notion of cautiousness on the forthcoming renewal of American Greatness.

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Factset tells us that during the first two months of the fourth the Q4 bottom-up EPS estimate for the S&P 500 Index dropped by 2.0% (to $30.91 from $31.55).

During the past year (4 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.8%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.4%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.9%. (…)

One of the sectors contributing to the below average decline in the bottom-up EPS estimate for the S&P 500 over the past two months is the Information Technology sector. This sector has recorded an increase in the bottom-up EPS estimate of 0.8% (to $13.26 from $13.15) during the first two months of the quarter. This 0.8% increase is well above the average decline of 4.0% over the past year and the average decline of 3.6% over the past five years in the bottom-up EPS estimate for this sector during the first two months of the quarter. (…)

The Energy sector has recorded the largest increase in expected earnings growth since the start of the quarter (to 3.4% from -1.3%). (…)

Of the 108 companies that have issued EPS guidance for the third quarter, 73 have issued negative
EPS guidance and 35 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 68% (73 out of 108), which is below the 5-year average of 74%.

As a result of the downward revisions to earnings estimates, the estimated year-over-year earnings growth rate for Q4 2016 is 3.3% today. On September 30, the expected earnings growth rate was 5.3%. (…)

Analysts currently expect earnings and revenue growth to continue in 2017.
For Q1 2017, analysts are projecting earnings growth of 11.5% and revenue growth of 8.0%.
For Q2 2017, analysts are projecting earnings growth of 10.7% and revenue growth of 5.7%.
For all of 2017, analysts are projecting earnings growth of 11.4% and revenue growth of 5.7%.

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On the Rule of 20, the only positive is that the Rule of 20 “fair value”, which reflects trends in trailing earnings and inflation (yellow line below) has bounced back after reaching a 12-month low in July, thanks to a 2.9% rise in trailing EPS and stable inflation.

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Based on Q4’16 estimates, trailing earnings could reach $118.19 (TR) by mid-March. The Rule of 20 P/E is thus 20.8x trailing EPS three months hence. This elevated number leaves little room for a strong upward move unless investors get so giddy to venture higher into overvalued territory. There have been 17 major market peaks since the Great Depression. The average Rule of 20 P/E at these peaks has been 21.7 (median 22.0).

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Here are other ways to look at the risk/reward ratio at this point:

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With such poor odds, Mr. Market better have solid trump cards in his hand.

If you prefer more conventional valuation measures, Goldman has them lined up in this table:

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Corporate insiders don’t seem to trust their own hand as they see it.

(…) A total of 3,500 insiders at Russell 3000 companies have unloaded their own stock in the last three weeks, while 467 purchased shares, according to data from The Washington Service, a Bethesda, Maryland-based provider of insider trading data and news. The number of sellers was higher than the monthly average of 1,832 sellers this year through October. Sellers have also increased from the comparable year-ago period, and buyers have decreased. (…)

Insider buying and selling doesn’t necessarily presage gains or declines in a given firm’s shares, of course. But Wall Street watches the data because insiders are understood to have the best information about their companies’ prospects, and are also typically veterans of their industries with longer-term horizons.

While they have historically tended to sell more than buy, their behavior since the election diverges from investors, who have exhibited a rapid shift in sentiment and poured money into equities. (…)

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“The big increase in insider selling makes sense because we’ve been making all-time market highs,” said Aaron Jett, the Los Angeles-based vice president of global equity research at Bel Air Investment Advisors, which oversees about $8 billion. “A huge portion of their wealth could be tied up with that one stock so they could want to sell to diversify.”

It is normal for executives to sell into market strength, according to Mr. Jett. That said, a prolonged period of outsize selling by insiders would be concerning, he noted.

(…) in the last month, 891 insiders of U.S. financial companies sold shares, compared with 425 executives who added, data from The Washington Service show.

Both Mr. Clissold and Mr. Jett said it is more valuable to pay attention to a pickup in executive buying rather than selling, since sales can occur for personal, idiosyncratic reasons, while stock purchases tend to indicate confidence in the company. (…)

Punch Where the big increase in insider selling makes much less sense is that it is occurring at the end of 2016:

  1. why not wait just a few weeks to defer tax payments by 12 months to April 2018?
  2. why not wait just a few weeks to potentially avoid the 3.8% Obamacare’s net investment income tax which the Trump camp wants to eliminate?
  3. why not wait just a few weeks to potentially benefit from lower capital gains tax rates promised by Republicans?

Insiders’ use of the trading window following quarterly earnings reports has been rising as the year progressed. Sellers steadily increased while buyers became fewer and fewer. Note that the November data on the chart only includes trades after the election.

U.S. SERVICES PMI STEADY AT 54.6

U.S. service providers experienced a robust expansion of business activity in November, helped by the fastest rise in new work for one year. Greater workloads and resilient business confidence led to a further upturn in the pace of job creation from the three-and-a-half year low recorded in September. Meanwhile, input cost inflation eased slightly during November, which contributed to the slowest rise in average prices charged by service sector companies since April.

The seasonally adjusted final Markit U.S. Services Business Activity Index registered 54.6 in November, to remain above the 50.0 no-change value for the ninth consecutive month. Although the latest reading was fractionally lower than in October (54.8), the rate of growth remained stronger than at any time in the first half of 2016. Survey respondents noted that improved client confidence and a favourable domestic economic backdrop had helped to boost business activity in November.

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Latest survey data signalled a continued rebound in new business growth from the four-month low recorded in September. Moreover, the rate of expansion accelerated to its fastest since November 2015. Anecdotal evidence suggested that the launch of new projects and generally improving demand patterns had boosted new orders in November, alongside competitive pricing strategies.

Payroll numbers increased again in November, with the rate of job creation reaching its strongest since July. However, the latest upturn in staffing levels was still weaker than the average recorded since the jobs recovery began in early-2010. A number of firms commented on efforts to boost capacity in line with long-term expansion plans and hopes of a sustained improvement in economic conditions. This in turn contributed to a reduction in backlogs of work for the first time in five months during November.

There were signs of a squeeze on operating margins across the service economy in November, with input cost inflation close to the 15-month peak seen in October. Survey respondents attributed this to higher food prices and efforts by suppliers to pass on increased raw material costs. However, prices charged by service sector firms rose only slightly in November.

Service providers remain upbeat about their growth prospects for the next 12 months. The latest reading was one of the strongest since late-2015, but down slightly from October’s recent peak. Survey respondents cited the end of the election cycle and improved economic conditions as driving positive sentiment in November.

At 54.9 in November, the seasonally adjusted final Markit U.S. Composite PMI™ Output Index was unchanged from October’s 11-month high and therefore signalled a further robust expansion of private sector business activity. Manufacturing production picked up at a sharp and accelerated pace in November (output index: 56.3), but this was offset by a fractionally slower expansion of service sector activity than in October.

Chris Williamson, Chief Business Economist at IHS Markit:

Looked at together, the two PMI surveys point to the pace of economic growth holding steady on October’s 11-month high, indicating that GDP is set to rise by 0.6% (2.5% annualized) in the fourth quarter. Both sectors are benefitting primarily from stronger domestic demand.

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