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 SITTING BULL

From its January 26 high of 2866 to Friday’s close of 2580, the S&P 500 has corrected exactly 10.0%. Just a normal correction within a bull market or the beginning of the end? Let’s look at the evidence systematically and objectively.

EARNINGS

Earnings are the lifeblood of equities, “the indispensable factor or influence that gives something its strength and vitality”. Earnings are strong, tanks to

  • a good economy that provides healthy revenue growth,
  • continued corporate focus on cost control that provides rising operating margins and to
  • tax reform which provides an automatic boost to 2018 net profits, contributing about one third of the expected 19.6% EPS growth for S&P 500 companies.

The evidence on the economy remains good near the end of the first quarter. There are no serious signs of recession for 2018 (per even the most cautious economists and strategists and per the Leading Economic Indicators) and the recent PMI surveys all point to rising new orders in both manufacturing and services sectors in North America, Europe and Asia.

The main risk lies with the U.S. consumer who has seemingly pre-spent the 2018 tax savings and finds himself with virtually no savings to absorb any setback, right when the Fed is rising interest rates, the price of oil is up 70% from its June 2017 low and overall inflation is threatening to squeeze real incomes.

There has never been a recession without the LEI turning negative. That said, Steve Blumenthal reminds us that “there have been 13 Fed interest raising cycles in the last 70 years and 10 of them landed us in recession. The other three were mild economic slowdowns, but we weren’t then in this much debt.”

Rising interest rates generally have their most significant and immediate impact on the housing and automobile sectors. They have both lost momentum in early 2016, right after the first FOMC rate hike.

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Nonetheless, total business sales remain healthy against 2% inflation while inventories have been kept under control.

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S&P 500 companies grew revenues 7.3% YoY in Q4’17, a sharp acceleration from +4.5% in the previous 4 quarters (with all 11 sectors accelerating). These trends are currently expected to continue in 2018. However, the consumer (28% of direct S&P 500 revenues) could decide to restore its savings and Tech revenues (12%) could slow much more than forecast during a trade war with China.

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The leadership from Financials and Technology companies is particularly strong during 2018. These 2 sectors account for 40% of the S&P 500 Index, 42% of total earnings and 46% of the expected growth in S&P 500 earnings in 2018.

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The risk to 2018 earnings is limited thanks to tax reform but margins could get squeezed by slower revenue growth, accelerating wages and other costs (e.g. transportation) which generally lurk up so late in the cycle.

In all, the environment remains earnings positive with little, if any, current evidence pointing to a meaningful slowdown in S&P 500 earnings growth. The first quarter is coming to an end and corporate guidance remains upbeat, giving credibility to the expected huge 18.4% gain in EPS with the first releases starting in about 2 weeks.

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VALUATIONS

It is generally best to measure equities based on the hard facts of trailing earnings. Tax reform is changing this for 2018 and it makes good sense to adjust trailing EPS by the expected tax savings provided by the new tax law. Working with the widely accepted 7% accretion, trailing EPS are currently $142.30 on which analysts are presently adding 11% more earnings on a 6.6% revenue growth forecast for the year. Interestingly, and perhaps worryingly, this expected scorecard of +6.6% revenue growth leading to +11.0% EPS growth ex-tax reform is a copy/paste of 2017 results.

At 2580, the S&P 500 Index is selling at 18.1x adjusted trailing earnings. Some pundits will see this as quite reasonable against the 18.5 average and median of the last 25 years. But this ratio is significantly boosted by the 1998-2002 period when P/Es averaged 26.1.

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The more stable Rule of 20 P/E (actual P/E + inflation) has corrected back to its “20” long-term median using adjusted trailing earnings of $142.30 which means that equities are currently fairly valued on a risk/reward basis: the 15% upside potential from valuation to 23.0 is equal to the downside from valuation to 17.0, give or take one or two valuation points on either side at the extremes.

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There are 2 components to the Rule of 20 multiple: earnings and inflation.

When inflation rises, the fair P/E decreases proportionately and vice versa. The jury is still out on inflation in 2018 but recent evidence is pointing to upward pressures from extended resource utilization 9 years into the cycle. As 2018 progresses, the race will be between growth in profits and growth in consumer prices. If profits meet the current full year bottom-up forecasts of $158.00, the S&P 500 index sells at 16.3x forward EPS. For the Rule of 20 P/E to be at the 20.0 fair value, inflation could rise to 3.7%, double its current reading! If inflation is 2.5% by year-end, fair P/E would be 17.5 which would mean 2765 on the S&P 500 Index assuming $158 in EPS.

So we have the Rule of 20 P/E sitting on its long-term “20” fair value level, right when the S&P 500 Index is, once again, sitting on its 200-day moving average which is still rising smartly.

Valuation-wise, probabilities of upside are now balanced with downside risk with a pretty strong earnings backwind which could get further validated when the Q2’18 earnings season begins in mid-April.

That said, further upward moves in inflation and interest rates would complicate the outlook given the weak consumer and poor balance sheets.

It is true that bull markets don’t die of old age. Yet, this bull seems more and more worried about its deteriorating environment. Thanks to strong earnings and tax reform, it may have enough vitality to keep going, but its repeated sitting sessions are a warning of accumulating fatigue and increasing anxiety. Portfolios should be constructed with lower beta companies sporting above average balance sheets and free cash flows.

THE DAILY EDGE (23 March 2018): “The art of the deal” vs “The art of war”

China Fires Warning Shot at U.S. Over Import Tariffs China unveiled plans for tariffs against $3 billion in American goods and said it is readying more actions against the U.S.

A Commerce Ministry spokesman accused the U.S. of “setting a vile precedent” and warned that China was prepared to defend its interests.

“If somebody imposes a trade war on China, we’ll fight to the end,” Chinese Ambassador to the U.S. Cui Tiankai said on state television.

Measures the Chinese Commerce Ministry rolled out Friday target $3 billion in U.S. goods, from fruit and pork to recycled aluminum and steel pipes that would be subject to higher tariffs. The ministry said the penalties are being imposed in response to new U.S. tariffs on Chinese steel and aluminum products, which the Trump administration announced earlier and which took effect Friday.

Missing from Friday’s list are big-ticket U.S. exports to China such as soybeans, sorghum and Boeing airplanes. The absence of those key goods showed that the Chinese government is leaving itself room to escalate—or negotiate. (…)

Specific actions won’t occur for at least one month, as U.S. officials compile a formal list of proposed tariffs and American businesses then get 30 days to comment on the measures. During that time, the Trump administration hopes China will make concessions to avoid a substantial cutoff in trade.

Similarly, China’s response is calibrated. In announcing its response Friday prior to the U.S. actions on steel and aluminum, the Commerce Ministry didn’t give a specific time for imposing the tariffs on U.S. goods and said Chinese companies have until the end of the month to make comments.

(…) “the Chinese side hopes not to fight a trade war, but is definitely not afraid of fighting one.” (…)

  • China Started the Trade War, Not Trump President Trump’s China crackdown is risky, but it’s on firmer legal, political and economic ground than many of his other trade complaints, Greg Ip writes.

(…) the collateral damage of a trade war, and thus the risks of Mr. Trump’s strategy, are also much greater. The breadth of his action elevates the potential harm to American consumers, supply chains and exporters.

Mr. Irwin says it isn’t clear that Mr. Trump’s strategy is right. Taking China to the WTO might be a less dangerous approach. But he adds: “No one is saying we shouldn’t do anything.”

(…) China ignored the U.S.’s latest move. Instead, it focused on previously announced U.S. steel and aluminum tariffs coming into effect Friday. Chinese data shows steel and aluminum product exports to the U.S. have been $3-4 billion annually over the last two years: accordingly, China announced it is targeting $3 billion of U.S. agricultural and miscellaneous other exports.

In other words, China is providing exactly what President Trump says he wants: reciprocity. China, which now depends far less on U.S. trade for growth than in the mid-2000s, will likely take a similar approach to the planned tariffs on $50 billion of its exports to the U.S.—respond in kind, but not escalate.

So it’s “the art of the deal” against “the art of war”. Good grief!

Going to war against its main lender may have unintended consequences:

Money Markets Are Messed Up, With Real Consequences Banks are paying more to borrow money now than during the 2012 euro crisis, a sign of trouble ahead

(…) The danger signals at the moment are coming from the money markets, where banks are having to pay a bigger premium to borrow than during the 2012 euro crisis. Savers are directing their money to the U.S. Treasury rather than the banks, just as they did in the past two major crises.

The cause this time isn’t a panicked flight to safety. Yet, the money-market stress comes amid a transition to a new phase of the financial and economic cycle. It is a time when those who fail to prepare can be exposed—and in the past such shifts have led to the collapse of hedge funds and banks, and even sovereign defaults.

(…) the money markets are being distorted by a combination of vast U.S. government borrowing needed for the deficit-financed tax cut and companies shifting offshore money from corporate bonds into cash ready to spend. Regulatory restrictions on balance sheets limit banks’ ability to step in and even out the distortions. (…)

The U.S. Treasury is crowding out short-term financing for the private sector, while the huge cash piles that companies built up are no longer available to finance other companies’ bonds.

The result is that the trillions of dollars of loans tied to Libor cost more than they otherwise would, while high-quality, short-term corporate bond yields are up, albeit from low levels. The effect is similar to the Fed having raised rates twice this week, rather than once. (…)

The change in the regime is big: from dovish to hawkish, midcycle to late cycle, fearing deflation to fearing inflation. Hopefully the victims of the shift this time won’t be big enough to shake the entire system.

Known unknowns…or unknown knowns! Thankfully, the Ted Spread is quiet.

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Bond Investors See Air Coming Out of the Inflation Trade Yield on 10-year Treasury note remains below 3% as wagers of a sharp pickup in inflation moderate

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(…) Yet recent data have suggested inflationary pressures are still relatively muted—something that could help cap a rise in bond yields for now. A gauge of consumer prices rose less than expected in February, while wage growth slowed from the previous month and the annual wage gain in January—one element behind the selling in stocks and bonds earlier in the year—was revised downward. (…)

Hmmm…

Again, the facts:

  • Total CPI: Last 7 months annualized: +3.8%. Last 4 months a.r.: +3.6%. Last 3 months a.r.: +3.6%. Last 2 months a.r.: +4.3%.
  • Core CPI: Last 7 months annualized: +2.2%. Last 4 months a.r.: +2.4%. Last 3 months a.r.: +2.8%. Last 2 months a.r.: +3.0%.

  • 16% trimmed-mean CPI: last 3 months annualized: +2.4% vs +2.0% during the previous 3 months. Median CPI: +2.8% vs +2.8%.

  • U.S. Producer Prices Continue Upward Trend Core PPI rose 0.4% in each of the last 2 months and is up 2.7% YoY. Core Goods PPI has gained 0.2% in each of the last 3 months (+2.1% YoY). Prices for intermediate demand goods strengthened 0.7% (4.8% y/y). This is the seventh consecutive month of gains of 0.5% or greater. Goods have been in deflation for years but seem clearly set to add to inflation in 2018.

  • U.S. import prices rise more than expected in February Import prices ex-petroleum jumped 0.5% in each of the last 2 months.

  • And now this:

The White House is putting together a package of 25% tariffs on Chinese imports, and Mr. Trump’s advisers said they had targeted 1,300 product categories. The president said that action could affect imports of “about $60 billion,” but his advisers, speaking earlier, said that it was more likely to be $50 billion, or roughly 10% of the more than $500 billion the U.S. imported from China last year.

Leading Economic Indicators Index Rose in February

The Conference Board Leading Economic Index rose 0.6% to 108.7. (…) The index rose 0.8% in January and 0.7% in December.

The index rose despite a downturn in the stock market and weakness in February housing construction metrics. (…)

The board’s coincident index, designed to reflect current economic conditions, rose 0.3%. The lagging index increased by 0.4%.

The 6 and 12-month rates of change have usually been declining prior to recessions as the Doug Short charts illustrate.

Smoothed LEI

SENTIMENT WATCH

Bespoke’s charts reveal that the crowd suddenly got a lot less bullish…but not more bearish, going neutral instead which means “dunno!”:

The S&P 500 closed yesterday right on its 100-day m.a. and 2.1% above its still rising 200-d m.a. (2582) which was successfully tested on Feb. 9. At 2582, the S&P 500 would sell at 20.5 on the Rule of 20 (using pro forma Q1’18 EPS to reflect tax reform after Q1).

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The earnings backwind will remain strong in April-May as we get into the Q1’18 earnings season with forecasts for +18.3% EPS growth. We are almost at quarter end and pre-announcements remain quite positive.

The risks to valuations are thus inflation and interest rates. The risk to sentiment is Trump vs China.