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

BEWARE: CAMEL CROSSING

The Q2 earnings season has nearly come to an end. The media and most strategists are emphasizing the facts that companies keep beating estimates and that ex-Energy, corporate America continues to lift margins even in the face of tepid top line growth.

Below the surface, however, results are not that great:

  • The beat rate, at 73% per Factset, is below the 1-year average (74%) and in line with the 5-year average.
  • The surprise percentage (+4.5% above expectations) is in line with the 1-year average and below the 5-year average of +5.0%.
  • Earnings surprises declined as the season progressed, averaging 68% for the last 258 companies to report.
  • Revenue beats, at 51%, was well below the 1-year and 5-year averages (both 57%).
  • The surprise percentage (+0.9%) is equal to the 1-year average but above the 5-year average (+0.7%).
  • Thus, given the expectations game corporations play, this last season was average, at best.

But beyond the beats and the surprises, the actual Q2’15 results are displaying a sharp deceleration in revenue and earnings growth rates even when excluding oil as Zacks Research shows:

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More importantly, averages are very deceiving in Q2 and are far from providing a realistic picture:

  • 46% of S&P 500 companies reported negative EPS growth in Q2 with a median decline of –18.9%.
  • The median growth for the 54% of companies with positive EPS growth was +16.2%.
  • Ex-Energy, 43% of companies reported negative EPS growth in Q2 with a median decline of –14.6%.
  • The two-hump camel is replicated in every sector:

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Essentially, half the market has positive EPS growth and half has negative growth, whether you include or exclude Energy.

Zacks Research has a tally for the small-cap Russell 2000 Index:

For the small-cap Russell 2000 index, we have seen results from 1691 index members that combined account for 86.9% of the index’s total market capitalization. Total earnings for these 1691 Russell 2000 members are down from the same period last year -8.1% on +2.6% higher revenues, with 50.7% beating EPS estimates and only 35.7% beating sales estimates.

Russell 2000 Index earnings were up 14.8% YoY in Q1 on revenues up 5.6%. They dropped 8.1% in Q2!

The other problem is raised by Standard & Poors which is the “official” aggregator for the S&P 500 Index earnings database under the leadership of Howard Silverblatt. Howard updates the database as companies report. He subsequently reviews the results after receiving the 10Q reports to make sure that each company results is consistent with S&P’s methodology to ensure uniformity and comparability by company, sector and over time. This is especially critical with respect to special items which companies can define as operating or not but which S&P may classify differently under its own consistent methodology.

S&P’s latest tally dated August 13 puts Q2 operating EPS at $26.22, down $2.24 (7.7%) from the July 30th tally and down 10.6% YoY. In effect, it seems like S&P had to reclassify et recalculate results from many companies in Q2 in order to maintain the integrity of its database from a comparability stand point. Intentionally or not, companies can categorize special items as “operating” or “non-operating” differently than what investors would generally do. S&P tries to ensure consistency.

Interestingly, “operating” EPS were 7.7% above “as reported” EPS during the 7 quarters between Q1’13 and Q3’14. That ratio rose to 17.2% in Q4’14 and 18.3% in Q1’15. We do not have the final number for Q2’15 but we know that 300 of the 458 companies having reported so far had higher “operating” than “as reported” EPS. S&P’s significant downward revisions during the last 2 weeks suggest that more “games” might have been played in the most recent quarter.

Many observers blame energy companies for the more difficult Q2 earnings season. S&P data does not really concur. Among the largest 20 earnings surprises (in terms of their impact on Index earnings), only 3 were positive (+$0.38) and 17 were negative (-$3.43). Five Energy companies account for 47% of the negative surprises but 53% comes from 20 non-energy companies as diverse as Home Depot, Allergan, Wal-Mart, Hewlett-Packard, Medtronic,FedEx, Goldman Sachs, Berkshire Hathaway and Google.

Only four of the 10 largest capitalizations in the S&P 500 Index had positive YoY EPS growth in Q2 and the earnings of the 10 largest companies averaged a 9.4% drop which worsens to –12.6% if we exclude the two outliers (AAPL: +44% and XOM: –51%). Exxon is the only Energy company among this diversified group.

Of the 58 largest S&P companies by revenues ($10B+), 36 (including 3 Energy companies) had positive EPS growth in Q2 with a median gain of 15.3%. Twenty-two companies (including 2 energy companies) had negative growth with a median of –25.0%.

At the other extreme, of the 106 companies with revenues below $1 billion, 51 had positive EPS growth in Q2 with a median growth rate of 17.4%. The other 55 companies had  a median EPS decline of –17.9%.

In all, this two-hump camel is just about everywhere in the stock universe whether in large or small caps, energy or not. No wonder U.S. equity averages have been marking time all year long. The half going forward is offset by the half going backward.

As it stands now, S&P trailing earnings are $108.38, down 2.8% from their level after Q1’15 and down 3.1% YoY. Based on S&P’s tally of consensus EPS for Q3, trailing EPS will decline to $107.69 by November before potentially bouncing back to $111.88 after Q4 results are in next March, assuming current Q4 estimates of $30.94, +15.7% YoY, hold.

Will they? BCE Research has a grim view on that:

There is still a dearth of evidence pointing to a reacceleration in global economic growth, despite easy policies abroad. The deflationary weight of deleveraging in Europe and China’s moribund economy are offsetting policymaker’s efforts to stimulate growth.

Although global trade has expanded at roughly twice the rate of world GDP for several decades, the value of exported goods has plunged, warning that corporate sector sales will deteriorate further.

This BCA comment was before China devalued its currency. More volatility and more uncertainty are in store as a result, all things which generally tend to reduce valuations.

More charts to keep you alert:

(The Fiscal Times)

(Ed Yardeni)

Yet, many pundits continue to try to justify current equity valuations using forward earnings and arguing that

a 16x multiple on 2016 estimated earnings is actually not that unreasonable (and at the lowest level in four years: maybe analysts are smoking something powerful, but on the chance it is correct then we are not talking about an expensive market at all but one with forward price-to-earnings ratios that are trending down to their lowest level in four years… not to mention below the average of the past three decades). (David Rosenberg)

These past three decades, it must be said, because it should be known to all strategists, included two of the greatest bubble periods in history…

Rosenberg is using 2016 estimates right when the 2015 figure is under severe pressure, conveniently excluding energy from the current results and adding rising energy contributions in 2016 even though oil prices continue to decline.

Why anybody would want to justify buying equities using 2016 estimates at this time is beyond any common sense. Is there one economist who can predict how the world economy will behave in the next 18 months with any degree of confidence?

Even the most well equipped and sophisticated forecasters can hardly predict the next quarter:

Evolution of Atlanta Fed GDPNow real GDP forecast

The Rule of 20 only uses trailing EPS and trailing inflation. No forecast, no assumptions, no crystal ball. It has proven to be the best and most dependable tool to properly assess the risk/reward equation, not only throughout the current bull market but also throughout the last century.

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The Rule of 20 P/E, currently at 20.8, last January finally crossed the “20” line which is the demarcation between undervalued and overvalued stocks. In the past, stocks have had a tendency to rise firmly into the overvalued area after crossing 20, reaching 22-24 on the Rule of 20, suggesting further upside potential but with ever rising risk.

Given the macro headwinds swirling, the growing deflation risks and the increasing evidence that central banks are in a free-for-all mode, it seems appropriate to manage risk down another notch. Recession risks may be low, but “things are getting very complicated” as Ed Hyman recently acknowledged. Overall earnings will not be providing much support for a while and economic growth is erring more toward slower than stronger. In this context, upside potential is no more than 10% (a bubbly 23 on the Rule of 20 with inflation at 1.8% and EPS of $108) while downside is 10-20% (17-19 on the Rule of 20).

Technically, the S&P 500 keeps finding support on its still rising 200-day moving average (2075) and on its 2012-2015 trend line. One should not rest too comfortably on such support, however. Here’s how the trend line provided precious little help in 1987 after confidence suddenly evaporated:

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Let’s face it, when valuations are as high as they are, confidence is crucial. Throughout this bull market, central banks were the only sources of confidence for investors. For most of the period, central bankers over the world pushed the pedal to the metal, only to bring world economic growth barely at 2% with deflation still lurking just about everywhere.

Now, each central bank is clearly beating its own drum. The PBoC tried to keep quiet while other Asian and Latin American bankers merrily devalued. Last week, it yelled a loud “enough”, effectively triggering a frightening free-for-all.

The Fed and Super Mario can’t really do much more, can they?

In fact, pressure will build on the Fed NOT to raise rates as the strong USD keeps hurting commodities and emerging markets.

(…) crossborder US dollar-denominated credit to non-banks has risen from $6T to $9T since 2008. Roughly $4.5T of that crossborder USD-denominated credit has been extended to firms in emerging markets, largely via international bond issuance. As a result, the rising US dollar is a margin call on increasingly burdened emerging market borrowers. (Evergreen Gavekal)

Not only burdened by the rising USD, but also by the continuing decline in commodity prices, making the servicing of such debt, never mind its eventual repayment, impossible. The reality is that the lenders are getting increasingly shaky, threatening to morph into huge black swans of diverse nationality since, back in 2010-1013, just about everybody with loose change wanted to get on the ever swelling Chinese bandwagon.

The damage has already begun in the energy complex…

The Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. are telling banks that a large number of loans they have issued to these companies are substandard, said people familiar with the matter, as they issue preliminary results of a joint national examination of major loan portfolios.

The substandard designation indicates regulators doubt a borrower’s ability to repay or question the value of the assets that back a loan. The designation typically limits banks’ ability to extend additional credit to the borrowers. (…)

A number of energy companies already have filed for bankruptcy protection, and others are exploring options to raise capital or restructure their debt loads.

So far, the suffering hasn’t been as widespread as was initially feared when prices plummeted last year.

That’s because many rushed to issue equity early in 2015 and because hedges are still in effect at high prices, but not for much longer…

The suffering has also begun in mining…

 bhp Glencore data vale

…and in the high yield debt market…

hyg

…and the hedge fund universe…

…potentially eventually reaching banks caught in this currency-commodity collapse, exacerbated by the Fed’s next move.

One thing is certain: there will be blood!

Recall that the Fed’s mandate includes nothing related to foreigners. The Bundesbank said the same to Treasury Secretary James Baker on October 17, 1987. Baker was then imploring the Germans to let the Deutschmark weaken, even threatening to devalue the USD in order to narrow the U.S. widening trade deficit. After the Bundesbank politely told Baker to take a walk, investors lost confidence in central banks willingness to coordinate policies in order tackle global issues.

This is happening now. Draghi engineered the devaluation of the euro with the blessing of the Fed. What was good for Europe was good for the U.S. and the world. Then Abe did it with the Yen. What was good for Japan was good for the U.S. and the world… But it was not that good for China which had been silently watching the yuan appreciate since 2010 bringing its exports into negative growth in 2015. 

Real Effective Exchange Rate and Export Growth

For much of the past 4 years, China’s manufacturing PMI has been in contraction territory but that was offset by its strong Services sector. This is not happening in 2015, forcing Beijing to become much more self-centered.

What is good for China may not be all that good for the U.S. and the rest of the world if it means deflation and a race to the bottom in this currency zero-sum game.

Exactly one month from now, the FOMC will decide whether to start raising rates or not. What is best for the U.S.? And how good will it be for the rest of the world?

Investors bought QE1, QE2 and QE3. They bought Draghi’s “whatever it takes”. They bought Abe’s arrows. These were all confidence boosters. Whatever was happening at the political levels, the central banks were there for financial markets. Confidence is so high now that volatility has almost disappeared from an inherently volatile market.

vix

Since 2010, confidence was shaken three times, each time exploding the Vix and cratering the Rule of 20 multiple: –3.8 points in 2010 to 15.4, –2.4 points in 2011 to 16.3 and –1.8 points to 18.0 in mid-October 2014 when, after the S&P 500 Index dropped nearly 10% in 4 weeks, James Bullard restored confidence by hinting at QE4 if necessary (“We could react with more QE if we wanted to.”)

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When the Rule of 20 fair index value is declining (yellow line on chart, reflecting trends in trailing earnings and inflation), equities have no sustained tailwind to keep advancing. Only higher P/Es can propel equity markets higher. With inflation as low as it is now and all central banks focused on boosting prices, confidence is crucial to transform excess liquidity into higher stock prices.

When we are left hoping that technical indicators will hold, it is time to walk away and leave our camel alone for a while.

NEW$ & VIEW$ (20 AUGUST 2015): Fed Up, Fed Not?

Divided Fed Puts Yellen on Hot Seat Central bank chief faces cliffhanger decision as rate call comes down to wire
  • “Most [officials] judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point,” the minutes said.
  • “Some participants expressed the view that the incoming information had not yet provided grounds for reasonable confidence that inflation would move back to 2 percent over the medium term,” the minutes said.
  • Some officials worried about moving prematurely and lacking tools to respond if unanticipated events caused the economy to falter, and also about risks from developments abroad, particularly slowing growth in China.
  • Staff economists advising Fed officials on the outlook lowered their forecasts for economic growth and inflation.
  • A number of officials argued that a rate increase could convey confidence to the world about the economic outlook and that the Fed needed to move in acknowledgment of the economy’s progress toward full health.
  • “Some participants expressed the view that, in light of their current outlook, it likely would be appropriate to adjust the federal funds rate gradually after the first increase to help ensure that the economy would be able to absorb higher interest rates and that inflation was moving toward the committee’s objective,” the minutes said.
  • “the possibility of adverse spillovers from slower economic growth in China raised some concerns.”
  • The central bank cautioned a “material” slowdown in the world’s second-largest economy could pose risks to the U.S. outlook. But it downplayed China’s stock market plunge this summer, saying it seemed to have had a limited impact on Chinese growth so far…at least through the end of July.
  • “the committee’s communications around the time of the first rate increase should emphasise that the expected path for policy, not the initial increase, would be the most important determinant of financial conditions and should acknowledge that policy would continue to be accommodative,”
Citi: The Markets Read the Minutes Wrong, and the Fed Will Hike in September

(…) The minutes were from a meeting that took place three weeks ago, when recent economic data points had been disappointing. Since then, data has come in stronger, with retail sales getting revised higher and housing and construction coming in strong. Furthermore, Citi saw something specific in the minutes which it interpreted as hawkish. 

The increased prominence of financial stability considerations in the FOMC discussion is a very hawkish signal that markets apparently ignored with the release of the July minutes.

Adding to that, while the Fed did cite concerns over inflation, Citi sees the recent uptick in the Consumer Price Index as reason to lessen the concern, even though the markets seemed to interpret the inflation worries as dovish. The latest CPI readings were low in July, but core inflation has picked up in the past six months. Citi views a number of the factors leading to downward pressure on inflation as temporary, which the Fed has said it will look past. (…)

Lastly, the minutes noted concerns over worldwide economies such as Greece and China, but that it did not merit changing the baseline view for the U.S.  (…)

U.S. Consumer Prices Rise for Sixth Straight Month U.S. consumer prices rose 0.1% in July, marking the sixth-straight monthly increase and suggesting mild inflation pressure is stirring.

From a year earlier, prices are up a very mild 0.2%, but when excluding volatile food and energy categories, the gain in the so-called core index was a more solid 1.8%.

From a year earlier, shelter prices were up 3.1% in July, the largest annual increase since early 2008. Shelter is the largest component of the consumer-price index, accounting for about a third of the overall measure.

Prices for some goods that are typically imported fell last month. For example, toy prices fell 0.5% from June, and home furnishing prices fell 0.2%. However, apparel and footwear prices rose in July.

Cleveland Fed calculations keep median core CPI at 2.4% a.r.

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IMF Decision Rattles Yuan China’s yuan fell after the International Monetary Fund dealt a setback to the currency’s role on the global stage, breaking a streak of stability earlier this week.

The International Monetary Fund late Wednesday signaled that China’s currency won’t be added to its influential basket of reserve currencies for at least a year, after the executive board approved an extension for the current basket of currencies that includes the U.S. dollar, Japanese yen, pound and euro. The decision confirms an earlier proposal to delay the five-year reshuffling of the basket, which doesn’t include the yuan. (…)

“It is hard to have a high degree of conviction in anticipating the increasingly fitful reactions of the Chinese policy makers, and by extension the near-term direction of the [yuan],” analysts from Goldman Sachs wrote in a note earlier this week. (…)

China export woes mirrored across Asia Renminbi move of little help amid global demand slump

Chart: Emerging Asia export growthChina’s export problem is not simply one of increased international competition — it is also a case of lacklustre global demand. Despite improving economic activity in the US and Europe, exports from across Asia have yet to see a long-awaited lift, leaving policymakers with scant tools to respond.

China and its neighbours share many of the same challenges. Japan’s poor second-quarter gross domestic product figures were partly due to weak trade, while South Korean exports have been shrinking for the past five months. Shipments from Thailand, Taiwan, the Philippines and Malaysia have all been disappointing this year. (…)

The slowdown in China’s economy has also helped push down global commodity prices, especially those used in heavy industry such as iron ore, copper and oil. That, in turn, has undermined growth in the resource-rich emerging markets that export to China, including Brazil and Russia, both of which are now in recession.

The knock-on effects of the commodity slide have been felt in Asia’s high-end manufacturing economies, notably South Korea and Japan, where cuts to investment by miners and energy producers have hit the large engineering companies that supply drilling platforms and gas storage units used in resource extraction.

Chart: Emerging Asia bank credit

Li & Fung Profit Falls 20% Amid Weak Demand in U.S., Europe

Li & Fung Ltd., the world’s largest supplier of clothes and toys to retailers, reported first-half core operating profit slumped 20 percent amid weak demand from its customers in the U.S. and Europe.

Li & Fung gets about 60 percent of its revenue from the U.S., where consumer confidence fell in July as a stock market slump amid weakness in China may have damped Americans’ views of the domestic economy. The rapid decline in the euro due to political uncertainty around Greece, and the slowing Chinese economy also affected the company’s business, it said Thursday.

The Hong Kong-based company, whose customers include Wal-Mart Stores Inc. and Target Corp., reported net income rose 33 percent to $149 million, while sales climbed 1 percent to $8.63 billion.

Lower oil prices weren’t able to offset the general economic softness and retail sales in the U.S. remain lackluster as Americans use their savings from lower oil prices partly to pay down their debts and save the money instead, the company said.

The retail demand in the U.S. was largely boosted by heavy promotions, hitting Li & Fung’s customers and weighing on margins, the company said.

Sales in the U.S were flat, while those in Europe and Asia, which each accounted for 16 percent of the total, dropped 13 percent and grew 8 percent, it said. Li & Fung’s margin fell 1 percent during the period.

Wal-Mart, the world’s largest retailer, said in May it pulled some of its goods sourcing business from Li & Fung, while Kate Spade & Co. will take sourcing for accessories in-house starting spring 2016.

Canadian Oil-Sands Producers Struggle Canada’s high-cost oil-sands producers are struggling as oil prices sink to fresh six-year lows, and even the most efficient drillers are losing money on every barrel they produce at current prices.

Benchmark West Texas Intermediate oil cost less than $41 a barrel in Wednesday trading, which although at multiyear lows was still well above the Western Canadian Select average of around $24 a barrel.

More than half of current oil-sands production can’t break even unless WTI crude-oil prices rise above $44 a barrel, according to a TD Securities Inc. report published Wednesday. (…)

“Every single SAGD/CSS player [is] bleeding cash on every barrel of bitumen produced at the current WTI” spot prices, TD Securities said. (…)

Despite lower prices, the Canadian Association of Petroleum Producers expects oil-sands output to continue to grow another 30% through 2020 as multibillion-dollar projects already under construction start producing. CAPP forecasts oil-sands volumes will grow by 130,000 barrels a day over 2014 levels to 2.29 million barrels a day this year as major producers such as Suncor and Exxon Mobil Corp.’s Imperial Oil Ltd. subsidiary increase their output.

Pointing up All the oil-sands crude—most of which is exported to the U.S.—is forcing rival heavy-crude producers like Venezuela, Mexico and Colombia to lower their prices to compete. (…)

Bulls Walk Away From U.S. Options Market as Put-Call Ratio Jumps

Confused smile Time to End Quarterly Reports, Law Firm Says Influential law firm Wachtell, Lipton, Rosen & Katz says quarterly earnings reports distract companies from long-term goals and the SEC should think about no longer requiring them.

(…) In a memo to its clients Tuesday afternoon, Wachtell noted a letter recently sent by U.K. investing giant Legal & General Investment Management Ltd. to the boards of the London Stock Exchange’s 350 biggest companies supporting an end in many cases to quarterly reporting.

The memo cited a move late last year to eliminate quarterly reporting requirements in the U.K. Regulators there found that “rigid quarterly reporting requirements can promote an excessively short-term focus by companies, investors and market intermediaries and impose unnecessary regulatory burdens on companies, without providing useful or meaningful information for investors.” (…)

In 1934, amid a wave of Depression-era regulations, the SEC forced U.S. companies to file annual reports and disclose more information to investors. In 1955, the mandate became semiannual and in 1970, quarterly. (…)

Academics have found evidence that increased reporting leads to short-term thinking by managers. In a paper last April, professors from the City University of London and Duke University found that firms that increased their reporting frequency reduced their spending on long-term assets.

“The decline in investments, for the most part, reflects the effect of managerial myopia induced by increased reporting frequency,” the paper concluded. It said it couldn’t determine whether the costs of more reporting outweigh the benefits of the information.

Still, other academic studies have weighed in on the benefits of increased reporting, noting that by reporting quarterly instead of semiannually, companies are able to reduce their cost of equity because shareholders will be more willing to take additional risk with more information. One study found more frequent disclosures led to higher price/earnings ratios.

Mr. Berenson doesn’t think the solution is scrapping quarterly reports, which he said he doesn’t see as an obstacle to long-term focus. He pointed to Amazon.com Inc., which has frequently failed to turn a profit and yet has kept investors focused on its long-term future.

“I don’t think that getting rid of them is a good idea,” Mr. Berenson said. “They are a source of information for investors.”

Actually, the problem really started in the early 1980’s with the increasing influence that investment consultants won over institutional investors. Consultants advised and often encouraged their pension fund clients to switch managers more regularly in order to improve investment returns. Investment managers passed their paranoia on to corporations as they began to trade more actively in order to maximize their returns by shedding poor performers more rapidly. Then came stock options and yaddi, yaddi, yadda…