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

NEW$ & VIEW$ (19 JULY 2016)

Thumbs up Thumbs down Confused smile Fed Officials Gain Confidence They Can Raise Rates This Year Federal Reserve officials are looking more confidently toward a rate increase before year-end, possibly as early as September, now that financial markets have stabilized after the Brexit vote and the economy shows signs of picking up.

Officials are almost certain to leave rates unchanged when they meet July 26-27, according to their public comments and interviews with officials. But the message in their postmeeting policy statement could be that the economy is on a more solid footing than appeared to be the case when they last gathered in June, setting the stage for raising rates if the data hold up in the months ahead. (…)

U.S. Home Builders Index Dips

The Composite Housing Market Index from the National Association of Home Builders-Wells Fargo eased to 59 in July from an unrevised 60 in June. The NAHB figures are seasonally adjusted. During the last ten years there has been an 72% correlation between the y/y change in the home builders index and the y/y change in housing starts.

The index of present conditions in the housing market fell to 63 from 64 while the index for the next six months declined to 66 from 69. Both readings have been falling since their Q4’15 peaks.

Home builders reported that the traffic index also eased to 45 from 46, and remained below the Q4’15 high.

China GDP data show services growth flagging

China’s gross domestic product growth may have come in on-target in the second quarter at 6.7 per cent, but its composition deserves a second look now that more detailed figures are out on each sector’s contribution. (…)

Yet services GDP did grow on a quarter-to-quarter basis, rising by 25 per cent from the first quarter in constant-price terms while secondary sector GDP fell by nearly 22 per cent.

The catch is that much of that likely came from state-owned firms at the expense of private-sector expansion, as NBS figures from May show private companies’ fixed-asset investment contracting for a fifth straight month compared to continued investment growth from state-owned firms. (…)

China’s government spending continues to rise in order to cushion the slowdown in the private sector activity. (Via The Daily Shot)

EARNINGS WATCH
  • 44 companies (12.3% of the S&P 500’s market cap) have reported. Earnings are beating by 4.6% while revenues are surprising by 0.6%.
  • Expectations are for a decline in revenue, earnings, and EPS of -1.3%, -6.2%, and -3.8%.
  • EPS is on pace for 0.3% (-0.6% yesterday), assuming the current beat rate for the remainder of the season. This would be +4.5% (+3.8%) excluding Energy and the Big-5 Banks.
CETERIS NON PARIBUS

Fed actions having unintended consequences:

BofA Targets Lower Costs Bank of America said it would deliver another $5 billion in annual cost cuts by 2018 as part of its strategy to deal with persistently low interest rates that are eating away at lenders’ profitability.

(…) Much of the cost-cutting burden is falling on the bank’s staff. Bank of America has shed about 25% of its jobs since Mr. Moynihan became CEO in 2010, with employment falling to about 210,000 from nearly 284,000. The bank slashed about 6,000 jobs over the past 12 months, or 3% of its work force, and in January it let retention packages for some of its longtime Merrill Lynch brokers expire.

“We’re down 2,600 people quarter over quarter,” Mr. Moynihan said. “It’s a constant reduction in personnel through hard work and automation.”

(…) the firm has invested in automated trading platforms that cut down on the need for well-paid traders. Mr. Moynihan said last month that he planned to keep cutting jobs at the trading unit, which already lost 10% of its workforce over the previous year and increased its revenue this quarter by 12%. (…)

More unintended consequences of low interest rates:

One group of electronics suppliers could get squeezed to help pay for the largest proposed technology takeover by market value. Suppliers to EMC Corp. are in the line of fire as Dell Inc. completes its acquisition of the data storage company, the WSJ’s Samuel Goldfarb and Rachael King report. EMC shareholders were to vote today on the $60 billion sale, which comes as Dell seeks to overcome persistent declines in world-wide computer sales by creating a one-stop shop for corporate information technology. Dell is highly aggressive at delaying payments to help finance operations, and the scale of the acquisition presents an inviting target for Dell’s leverage. One expert says companies Increasingly are using their supply chains not just to obtain goods but to “fund the organization and to fund the growth opportunities.” Worries over ongoing payment terms is a common one for suppliers caught up in acquisitions, and the size of the Dell-EMC deal will only make those concerns bigger. (WSJ)

BTW, Dell’s 107 average days in accounts payable in its most recent quarter compare to 87 days three years ago and EMC’s average of 42 days.

And this ballooning problem:

U.S. Pension Funding Levels to Deteriorate, Moody’s Says

U.S. multiemployer pension plans, already short on cash, are likely to see funding levels deteriorate due to aging constituents, low interest rates and a sluggish global equity market, Moody’s Investors Service said in a report on Wednesday.

The credit rating company examined 124 multiemployer pension plans, finding the group was short by $337 billion at the end of 2014. While strong investment returns helped boost plan assets 4.5% to $302 billion in 2014, obligations rose 5% to $639 billion.

Moody’s said the situation may have deteriorated even further last year, as interest rates remained low. Those figures have yet to be released. (…)

More trouble is on the horizon. The Pension Benefit Guaranty Corporation needs $15 billion over the next decade to protect multiemployer pension plans against default, CFO Journal reported in June. The pension insurer projected that its multiemployer pension insurance program will have a deficit of $53.4 billion in today’s dollars by 2025, if it cannot raise the money needed. (…)

(…) Under accounting rules, the declining rates triggered an increase in pension obligations for companies with defined-benefit plans, which offer retirees a set payout.

Now, those companies are pursuing a variety of tactics as they struggle to close the resulting gap in pension funding and to avoid steep increases in premium payments to the nation’s pension insurer.

The combined pension deficit for S&P 1500 companies ballooned to $568 billion at the end of June, a $164 billion increase from the end of 2015, according to Mercer, a benefits consulting firm.

And companies could have large holes to plug by the end of year, when they typically complete their funding calculations.

“It’s brutal,” said Alan Glickstein, senior retirement consultant at Willis Towers Watson.

But the market’s turmoil could help fatten the coffers of the U.S. Pension Benefit Guaranty Corp., which backstops the private-sector pensions that cover about 40 million Americans.

The federal agency collects a fixed fee for each person enrolled in private-sector pension plans and a separate fee, or variable premium, for every dollar that pension plans are in deficit.

So, there could be a fee windfall heading its way in coming months and years as pension deficits balloon.

Those fees were already on the rise. Congress passed increases in the Bipartisan Budget Act of 2015, mandating a 25% increase in the fixed fee between 2016 and 2019 for plans sponsored by single employers. Variable rates will rise roughly 37% over that period.

Last year, the agency received some $4.1 billion in premium revenue from those plans, up 8.5% from 2014, reflecting prior premium increases.

Many consultants and plan managers say the PBGC’s premium revenue, all of which comes out of corporate pockets, will jump again this year.

As they scramble to close their pension funding gaps, some companies are exploiting low interest rates to borrow cheaply in bond markets.

Others could step up plans to transfer pensions off their books entirely by paying insurance companies to take over those obligations, said Caitlin Long, a pension expert.

Newspaper publisher McClatchy Co. said in February it would contribute $47 million of real-estate assets to its pension plan to boost funding and reduce fees.

In February, General Motors Co. sold $2 billion of bonds, and pumped the money into its pension plan. One investment banker at a major bank said he expects similar deals to come to market as the year progresses.

Chemical maker Chemtura Corp. shifted part of its pension plan to an insurer earlier this year, citing rising PBGC fees as a reason.

Pittsburgh-based specialty-material manufacturer Allegheny Technologies Inc. is considering doing the same with some of its pension, said Patrick DeCourcy, the chief financial officer, in an earnings call in April.

The potential pension deal would “help to lower the burden of significantly escalating premium charges from the PBGC,” said Mr. DeCourcy, according to a transcript of the call.

Such deals are expensive, however, and take a lot of time to put together, said Ms. Long.

In the interim, many companies could simply tap bond markets for a loan.

Not only are interest rates low, but interest payments on bonds are tax deductible, and companies don’t have to pay additional fees to the PBGC. “I would think this is an environment that companies would find compelling,” one banker said.

But companies are continuing to offload their pension burdens. Paint manufacturer PPG Corp. decided to transfer some of its pension plan to Massachusetts Mutual Life Insurance and Metropolitan Life Insurance Co. partly to avoid the rise in PBGC premiums, according to finance chief Frank Sklarsky.

Congress approved an increase in PBGC fees as part of an accounting maneuver that allowed it to fund the 2015 federal budget. Any fees that go to the PBGC count as revenue for the federal government, helping to offset total spending.

One PBGC official said the agency would rather see companies fully fund their pensions than pay big fees.

“We prefer if people fund up their plans,” the official said. “It’s in the participants’ interests for the plans to be fully funded.”

NEW$ & VIEW$ (18 JULY 2016)

U.S. Data Point to Stronger Economy Confident consumers and a stabilizing factory sector put the wind at the U.S. economy’s back as it entered the second half of the year.

(…) Sales at retail stores and restaurants rose 0.6% in June from the prior month to a seasonally adjusted $456.98 billion, the Commerce Department said Friday. Sales had climbed 0.2% in May, revised down from an earlier estimate of 0.5% growth. (…)

Excluding autos, retail sales last month rose 0.7% from May. Excluding both autos and gasoline, sales also climbed 0.7%. (…) Total retail sales rose 2.7% in June from a year earlier, up from annual growth of 2.2% in May. (…)

In the second quarter, total retail sales were up 1.4% compared with the first quarter—providing a tailwind for the overall U.S. economy. (…)

Most retail categories saw sales grow last month, led by a 3.9% jump in sales at building-supply stores. That was the largest one-month increase in the sector since April 2010 and followed a 2.5% drop the prior month and a 1.6% decline in April. (…)

Sales of motor vehicles and automotive parts were up 0.1% last month after falling 0.5% in May. (…) Sales at restaurants and bars were down 0.3% from May and clothing-store sales fell 1.0% in June. More broadly, restaurant sales were up 1% in the second quarter compared with the first three months of 2016. (…)

In the first six months of 2016, overall U.S. retail and food services sales were up 3.1% compared with a year earlier. The data weren’t adjusted for price changes, but sales growth comfortably exceeded the recent rate of inflation.

Sales in the retail control group, which excludes gasoline, building supplies and food services, rose 0.5% (4.1% YoY) and is up a huge 8.7% annualized in the last 3 months as this Haver Analytics chart shows. This figure is used in the computation of the GDP.

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Hopefully, this will help that:

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There is a bit of a mystery with these retail sales data. The huge +8.7% annualized growth rate in control sales during the last 3 months has received little echo from retailers and consumer surveys. As well, the most recent Beige Book contained no mention of a retail resurgence.

For example, the 9 S&P 500 Consumer Discretionary companies that have reported Q2 so far showed revenues up 3.3% YoY. Only 22% beat on revenues with a revenue surprise factor of –0.3%. The 7 Staples companies that have reported showed revenues up 0.6%, a 29% beat rate and a –0.5% revenue surprise factor.

Evercore ISI Retailers Sales Surveys did bounce back from the very weak spring but shows no meaningful upturn so far this year and is down 3.9% YoY.

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Recall that April has been the big bounce month in total retail sales, +1.2% MoM after very slow sales early in the year. May was originally reported up 0.5% but that has been revised down to +0.2%. We shall see what will happen to June’s +0.6% initial release.

Consumer Prices Begin to Percolate

The consumer-price index, which measures what Americans pay for everything from shelter to sweets, increased a seasonally adjusted 0.2% in June from the prior month, the Labor Department said Friday. It had climbed 0.2% in May and 0.4% in April.

Excluding the often-volatile categories of food and energy, consumer prices also rose 0.2% in June. (…) Prices excluding food and energy climbed 2.3% from a year earlier, matching the highest level since May 2012.

While energy prices remain well below their levels from last June, costs for shelter, medical care, transportation services and clothing all have risen sharply. Shelter costs, which account for about one-third of CPI, are up 3.5% from a year earlier, the strongest rise since September 2007. (…)

In a separate report on Friday, the Labor Department said inflation-adjusted average weekly earnings fell 0.1% in June from the prior month. Average hourly earnings climbed 0.1% while prices climbed 0.2% and the average workweek was unchanged.

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Good thing food-flation and goods-flation are declining fast because the consumer is getting squeezed just about everywhere else, primarily from Services (charts from Haver Analytics). The Cleveland Fed data shows core inflation rising at a sustained 2.4% rate this year:

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Industrial Production Up 0.6% in June

Industrial production, a measure of everything made by factories, mines and utilities, rose a seasonally adjusted 0.6% in June, the Federal Reserve said Friday. Economists surveyed by The Wall Street Journal had forecast a 0.4% rise.

The last time it jumped at that rate was nearly a year ago, in July 2015, and the last time it increased by more was November 2014. (…)

June saw a rise in motor vehicle and parts production, a volatile category that had dipped in May. Mining, which includes energy production, registered a small increase for the second straight month, welcome news for the beleaguered sector.

The headline index was in part lifted by a 2.4% monthly rise in utilities output, as June’s warmer-than-usual weather had Americans turning up the air conditioning. (…)

Overall manufacturing output rose 0.4% in June, led by a jump in the production of motor vehicles and parts. However, other non-auto output was unchanged from May. (…)

Capacity use, a measure of how much industries are making as a share of potential output, rose 0.5-percentage point to 75.4%. The rate is 4.6 percentage points below the historical average, suggesting there is still room for the economy to ramp up, should firms feel more confidence in future demand.

Overall industrial production was down 0.7% in the 12 months through June. Manufacturing output is 0.4% above its June year-ago level, but on a quarterly basis has fallen 1% in the second quarter from the same period a year ago. Utility output is up 0.5%. Mining output is still on the path to recovery, down 10.5% from June 2015. (…)

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(Haver Analytics)

Empire State Factory Sector Activity Index Deteriorates

The Empire State Factory Index of General Business Conditions declined during July to 0.55 and reversed much of its June improvement. Expectations had been for 5.0 in the Action Economics Forecast Survey. The data are reported by the Federal Reserve Bank of New York and reflect business conditions in New York, northern New Jersey and southern Connecticut.

Based on these figures, Haver Analytics calculates a seasonally adjusted index that is comparable to the ISM series. The adjusted figure declined to 48.9 from 50.3. Since inception in 2001, the business conditions index has had a 64% correlation with the change in real GDP.

A weaker new orders reading accounted for much of the decline in the overall index as it fell to -1.82 from 10.90. (…) employment moved lower to -4.40 from 0.00. During the last ten years there has been a 68% correlation between the index level and the m/m change in factory sector payrolls.

Major cities drive China property price gains

Property prices in large Chinese cities grew in more locations last month compared to a year earlier, with prices in higher-tier cities again leading the charge upwards – but fewer saw month-on-month prices rise compared to May.

Annualised prices for new residential homes rose in 57 out of 70 cities surveyed and fell in 12, while in monthly terms prices rose in 55 cities and fell in 10, according to data from the National Bureau of Statistics on property prices across large and mid-sized cities.

The same ten first- and second-tier cities led gains over the previous year, with Shenzhen far ahead of the pack thanks to year-on-year growth of 46 per cent. However, other first-tier cities like Shanghai (up 27.7) and Beijing (up 20.3) were pushed to fifth and sixth place, respectively by the second-tier likes of Xiamen, Nanjing and Hefei (up 33.6, 29.7 and 29, respectively).

Overall prices of new residential buildings rose 7.3 per cent year-on-year in June, according to Reuters calculations based on the official data, the highest since April 2014.

But the statistics bureau noted that annualised price growth had softened from previous months in an explanatory note published alongside the new data, indicating overall prices were up only 0.5 percentage points year-on-year by its own reckoning, compared to 1.2 percentage points the month prior.

Gains in monthly terms were notably less impressive, as five fewer cities saw prices grow in June, while six more saw them fall.

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Yuan Weakens Past 6.7 Versus Dollar for First Time in Five Years

(…) China’s policy makers are trying to balance the need for a weaker yuan to help exports with efforts to avoid igniting depreciation pressures that would lead to surging capital outflows. Overseas shipments declined for the third month in a row in June, even as the yuan dropped 2.2 percent against an index of trading peers. (…)

Oil Producers Prepare for Second-Half Slump

After surviving two years of low prices, they’re gearing up for a third by buying protection against a renewed downturn. Laredo Petroleum Inc. said July 14 that it hedged more than 2 million barrels of 2017 output earlier this month. Drillers have increased bets on falling prices by 29 percent this year. (…)

“The producers have sold the hell out of this rally,” said Stephen Schork, president of Schork Group Inc., a consulting firm in Villanova, Pennsylvania. “The companies that did survive, they’ve been hedging into this rally. And they’re counting their blessings.” (…)

Producers increased bets on falling prices for a third consecutive week in the seven days ended July 12, according to data from the Commodity Futures Trading Commission. Short wagers rose by 8,566 futures and options combined, or 1.6 percent. 

Drillers are also taking advantage of the rally to tap the capital markets. U.S. oil and gas producers have been selling shares at record speed, using the cash to repay debt or buy oil and gas prospects, bolstering the asset side of the balance sheet. So far this year, companies have raised more than $16 billion in equity, according to data compiled by Bloomberg. (…)

Gasoline inventories are so swollen that at least five sea tankers hauling the fuel to New York were turned away over the past few weeks, according to traders and ship-tracking data compiled by Bloomberg. U.S gasoline stockpiles rose 0.5 percent to 240.1 million barrels, an all-time seasonal high, in the week ended July 8, the Energy Information Administration reported last week.

The peak-driving season in the U.S. has so far failed to erode those stockpiles, which may send crude tumbling below $40 a barrel again, according to Schork. 

“Demand is strong, but supply is even stronger,” he said. (…)

EARNINGS WATCH

Facset’s weekly summary:

Overall, 7% of the companies in the S&P 500 have reported earnings to date for the second quarter. Of these companies, 66% have reported actual EPS above the mean EPS estimate, 14% have reported actual EPS equal to the mean EPS estimate, and 20% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is below both the 1-year (70%) average and the 5-year (67%) average.

In aggregate, companies are reporting earnings that are 3.9% above expectations. This surprise percentage is below both the 1-year (+4.2%) average and the 5-year (+4.2%) average.

If the Energy sector is excluded, the estimated earnings decline for the S&P 500 would improve to -2.0% from -5.5%.

In terms of revenues, 51% of companies have reported actual sales above estimated sales and 49% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is above the 1- year average (49%) but below the 5-year average (55%).

In aggregate, companies are reporting sales that are 0.4% above expectations. This surprise percentage is above the 1-year (0.0%) average but below the 5-year (+0.6%) average.

If the Energy sector is excluded, the estimated revenue decline for the S&P 500 would improve to 2.3% from -0.6%.

The blended earnings decline for the second quarter is -5.5% this week, which is slightly smaller than the blended earnings decline of -5.9% last week. Upside earnings surprises reported by companies in the Financials sector were mainly responsible for the small decrease in the overall earnings decline for the index during the past week.

In the Financials sector, the upside earnings surprises reported by JPMorgan Chase ($1.55 vs. $1.42) and Citigroup ($1.24 vs. $1.10) were the largest contributors to the small decrease in the overall earnings decline for the index during the past week. As a result, the blended earnings decline for the Financials sector decreased to -4.6% from -5.8% during this period.

Five sectors have recorded a decrease in earnings growth since the end of the quarter due to downside earnings surprises and downward revisions to earnings estimates, led by the Utilities (to 2.6% from 3.5%) sector. Four sectors have recorded an increase in earnings growth during this time due to upward revisions to estimates and upside earnings surprises, led by the Materials (to -11.6% from -12.5%) sector. The Health Care sector (2.2%) has the same earnings growth rate today as it did on June 30.

RBC Capital’s tally is a little more up-to-date with Friday’s data:

  • Thirty-six companies (9.9% of the S&P 500’s market cap) have reported. Earnings are beating by 3.8% while revenues are surprising by 0.4%.
  • Expectations are for declines in revenue, earnings, and EPS of -1.3%, -6.4%, and -4.0%, respectively.
  • EPS is on pace for -0.6%, assuming the current beat rate for the remainder of the season. This would be +3.8% excluding Energy and the Big-5 Banks.

The recent better economic data have been well received by investors as these Yaredeni Research charts illustrate:

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The Bulls population has jumped materially as a result, not really because the bears have disappeared but rather because the correction camp has declined…

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…Investment managers have pushed their clients (equity accounts) to be nearly fully allocated to stocks (via The Daily Shot)…

…just as the conditions for a correction are rising.

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Transportation stocks have followed the crowd but keep lagging.

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Q2 EPS estimates have not stabilized yet:

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If Q2 EPS meet the current consensus, trailing EPS will drop a little more to the $114 range from $117.46 at the end of 2015 (per Thomson Reuters).

Meanwhile, core CPI is quietly climbing its way into the 2.0-2.5% range from 1.6% in December 2014 to 2.1% in December 2015 to 2.3% in June. Unless oil prices drop much from here, oil deflation will be behind us by the autumn months and total CPI will ramp up from its current 1.0% towards core CPI.

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The S&P 500 Index is now trading at 18.9 times trailing EPS:

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And 21,2 on the Rule of 20 P/E which accounts for inflation. The heat is rising. We either need better earnings and/or slower inflation, soon!

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SENTIMENT WATCH
What Next for Stocks? Financial Pros Weigh In Before jumping in or cashing out of a U.S. stock market that is in record territory, investors would do well to consider whether the best of the bull market is in the past or whether there is room to run. There are cases to be made on both sides, financial advisers and fund managers say.

On one hand, stocks are richly valued by some metrics such as price-to-sales ratios. On the other, market professionals are generally cautiously optimistic that the U.S. bull market, not having shown the signs typically associated with a peak and retreat, is primed for an extended run. (…)

“Markets aren’t cheap right now; that is a fact,” Mr. Hickey said. “That being said, bull markets don’t end when markets are cheap. They usually end when markets are excessive, and in many cases, they’ve been more excessive than they are now.”

How far can this bull market go?

(…) Today’s never-say-die bull market — now the second-longest at seven years and counting — has longevity genes, too. (…)

This bull, despite expensive stocks, slowing global growth, a wobbly Chinese economy, less profitable U.S. companies and fallout from Britain’s vote to exit the European Union, continues to defy skeptics.

“I can’t say that it will, but I will say that it could,” Scott Wren, senior global equity strategist at Wells Fargo Investment Institute, said of the current bull’s chance to outlast the nearly 10-year run from Oct. 11, 1990 to March 24, 2000. (…)

But this bull, despite the naysayers, could continue to exceed expectations.

“It has a chance if it doesn’t become over-loved,” said Ann Miletti, lead portfolio manager at Wells Capital Management. She gives the current bull a “better than 60% chance” of one day becoming the longest bull ever. “It has been a slow growth market for a long time and a bumpy ride along the way. But that has also meant that expectations have remained tempered and valuations have been kept in check, which is a good setup for longevity.” (…)

Nerd smile The run could go another eight to 13 years, said Brian Belski, chief investment strategist at BMO Capital Markets. (…)