Tuesday, July 26, 2016

Apple Does it Again (and other yarns from the financial press)

Apple just released their much anticipated earnings for calendar Q2 (Apple's fiscal quarter Q3).  While the financial press heralded, "Apple Does it Again" , "Apple Beats" and other yarns, the data tells a very different story. The company reported Q3 revenue of $42.1 billion, a decline of a stunning $7.2 billion from the same quarter one year earlier.  The decline in net income was worse. Far worse.  

Apple's Q3 earning fell from $10.68 billion in the year ago period to just $7.8 billion in the current quarter - a decline of a whopping 27%. So much for analysts claiming the earnings recession is all energy related, by the way.  And so much for meaningful  reporting from the financial press.

Wednesday, July 20, 2016

Morgan Stanley Earnings Beat and Other Tall Tales of Wall Street

"Morgan Stanley Solidly Beats Earnings Expectations". That's the headline posted on the CNBC website this morning. Fox Business posted a similar headline reading "Morgan Stanley's 2Q Profit Tops Expectations". Nearly identical headlines ran yesterday when Goldman Sachs reported its 2Q results. The CNBC headline claimed "Bank Earnings on a Roll as Goldman Tops the Street". But drill down into the actual results and you'll uncover a far less bullish story than what the headlines would indicate.

Morgan Stanley, it turns out did beat analyst expectations on both the top and bottom line.  These were significantly lowered expectations, of course, based upon careful if not clever guidance of the company's CFO. But the numbers "beat" nonetheless. However, by all more traditional measures, Morgan Stanley had a terrible quarter. Top line revenues fell by $840 million from the same quarter a year earlier. A nearly 10% decline in revenue is hardly a reason to celebrate. Goldman's top line fell by $1.14 billion on a year over year basis, for a decline of 12.5%. The bottom line for Morgan Stanley was even worse than its revenue performance. Morgan's net income fell 12%, despite significant cost cutting. 

So how do stories like this get spun as "Morgan Stanley Solidly Beats Earnings Expectations"? Welcome to the new Wall Street. With investors trying to game the system in a through the looking glass economy, traders are solidly focused on earnings "beats" and misses. It's a desperate attempt to gain a trading advantage in markets that seldom make sense to anyone. The trouble is, an earnings beat tells us very little about the company's fundamental earnings performance or the growth trajectory of its business. It simply tells us about the skill of the CFO in managing earnings guidance. But year over year revenue and earnings performance tell us something very different. They tell us about the viability of the company's business plan, how customers are responding to the company's outreach and how the company is executing on its profit plan internally. Data points investors should be keenly aware of if they own the stock.

In the seven years following the Great Recession, CFOs have turned gaming earnings expectations into an art. They know that conservative guidance gives the company a lower bar to hurdle in reporting its results. And to the extent they "beat", well... Morgan Stanley stock is up 2% as of this writing.

Thursday, June 30, 2016

Brexit and the Markets

The surprising outcome of the British election over succession from the European Union rocked global financial markets on Friday. The selling continued into Monday, but markets quickly bounced back on Tuesday, Wednesday and Thursday. Now with Brexit a full week in the rear view mirror, most stock markets around the world have nearly or fully recovered their losses. But in bond markets, particularly in the US, the historic gains in prices (and drop in bond yields) remain largely intact. Moreover currency markets have also retained their post election gains (or losses).

Immediately following the large declines in world stock markets on Friday, investment advisors for major banks were all over the media advising investors of the bargains the stock market had provided. They cautioned investors that the markets were overreacting, throwing the proverbial baby out with the bathwater. Investment strategists were quick to point to beaten down US stocks, like Southwest Airlines with virtually no British of european exposure. The argument being, that these stocks were being unfairly punished by an indiscriminate market inclined to sell, sell, sell.

In reality, the market reaction to the Brexit vote had very little to do with the implications for corporate earnings or weakened economic activity in the UK. It had everything to do, first and foremost, with the excessive risk-on positioning of portfolio managers who were betting strongly on a remain vote. Many pointed to the odds at British bookie parlors, the "in the know" folks who were treating Brexit as a one in six probability. The torrid selling on Friday and into Monday was largely driven by fund managers scrambling to get back onside.

There is, however, a much more significant and lingering issue that underlies these moves. This, is the implication for currency markets. Friday saw the greatest one day selling of the Great Britain Pound (GBP) in history. While the Euro also sank, the US dollar rose. And, in far more dramatic fashion, the Japanese Yen soared.  

And herein lies the problem for US stock markets. The Bank of England announced earlier today that they will be likely adding to QE to stimulate the post-Brexit economy. As one might expect, the GBP is down another 1.5% against the dollar on the news. Further QE by the ECB would predictably have a similar reaction in currency markets. This being said, it is the Yen and the Chinese Yuan that pose the greatest risk to devaluation and the greatest implications for a further rise in the dollar, as these countries desperately struggle to invigorate their own exports. A stronger dollar would pressure sales and earnings of US multinational companies, already suffering not insignificant profit declines and poses a great challenge to US stock prices going forward.  

Thursday, June 23, 2016

The National Debt Problem

Despite what the title above may imply, there are many that do not see the dramatic rise in government debt as a problem. In fact, very few nations see their sovereign debt as an issue, despite the unprecedented rise in borrowings over the past several years. Most recently China, whose total debt has now risen to eye-popping levels, was quick to dismiss their levels of indebtedness as a reason for concern.

Let's put this in perspective for China. According to a recent study published by McKinsey & Co, in 2000, total China debt was roughly $2 trillion. By 2007, China debt had risen to $7 trillion and by 2014 to a whopping $28 trillion. In fourteen years, China's debt has grown by 600%. Yet, Chinese officials are eager to dispel any concern by claiming just earlier today that there is no problem with the debt, as long as GDP continues to grow.  

This has always been the rationale, hasn't it, or at least for the past ten years when debt in China, the US and around the world has exploded higher? The argument is supported by the primary metric for evaluating sovereign debt, the ratio of debt to GDP. China's total debt is currently 250% of GDP and, as shown from the chart to the rights, is expanding at an alarming rate. 

US debt, both total and US federal direct borrowing is also a key problem, however, and here's why. First, let's look at the US national debt and it's growth over the past ten years. Total US government debt in September 2015 was $18.1 trillion, according to official records of the US Treasury Department. In 2007, or eight years prior, the national debt was $9 trillion, representing growth of roughly 100% over this period. Eight years prior to this, or 1999, US government debt was $5.6 trillion, implying a growth rate of 60%. So clearly, the rate of growth is accelerating, in this case, by a factor of 2/3rd.  But let's leave this aside and return to the argument that it is only the ratio of debt to GDP that is relevant in quantifying the level of debt burden of the American people.

This ratio, as well, paints a fairly stark picture as can be seen from this graph of the Federal Reserve Bank of St. Louis.  But this chart shows Federal debt at just over 105%, a level that the government would argue is manageable given the breadth of the US economy. 

But is this metric of debt to GDP even meaningful? Let's remember that the government's ability to pay the interest (and principal) on the national debt is derived from tax revenue. Now while taxes are collected on economic activity, or GDP, it follows that the greater the GDP, the greater the tax revenue, etc.  But is this reasonable if US tax revenue represents a fairly small share of total US economic activity?

According to the Tax Policy Institute, total US tax revenue currently represents just 17% of GDP. With the national debt at $18 trillion and 2015 tax revenue of $3.2 trillion, the ratio of debt to tax revenue (or the portion of GDP that relates to the Federal government) was 562% at the end of last year! Now what other corporation or individual borrower in the United States has a debt to income ratio of 562%? Exxon, one of America's largest companies and with substantial capital investment, had total debt in 2015 of $20 billion. With annual revenues of $51 billion, however, a debt to income ratio of 562% would support debt of $286 billion (it would also make them insolvent to the tune of $116 billion). Perhaps the board of Exxon has considerably more common sense in its judicious use of debt than the US Congress, in its unwillingness to take cover in this questionable metric of debt burden.

Thursday, May 5, 2016

Valuing Stocks in a World Gone Mad

An abundant supply of capital sloshing around the global markets in search of return. The idea has been discussed extensively over the past few years. The argument was first made that excesses found their way into mortgages and mortgage backed securities, then US and Japanese bonds and ultimately, US and foreign equities. In times of bubbles or "irrational exuberance" as Fed Chairman Greenspan was fond of saying, investors tend to find rationales that fit otherwise irrational investment decisions, thus allowing bubbles to form. This may be true of stock valuation metrics, as well.

What prompts me to get into this topic was an episode from earlier in the week of Mad Money, where TV persona Jim Cramer, ever the bull, argued that the drop in stock prices over the last few days was a "blip" presenting a trading opportunity for smart investors. His choice sector for the next rotation of our sloshing mound of capital: consumer staple stocks. This on a day, most interestingly, when leading hedge fund manager Stan Druckenmiller advised investors at the Sohn Conference to sell stocks and head into gold. Given Druckenmiller's stellar investment performance, it's a notion we can hardly dismiss.

But let's look at a few names Cramer threw out as investment ideas, raising the much larger question of how and when the metrics for stock valuation had changed so dramatically. The first name Cramer offered was Clorox (CLX). Clorox trades at a trailing price/earnings multiple of 25.33x. Higher than the broad market multiple, and significantly greater than the historical trading average of the S&P, but not stratospheric. But at $129, Clorox is trading above its five year average multiple, of a still aggressive 21x.  If Clorox were to simply trade at its historic multiple, the price would drop to around $111.

Let's take another example. Colgate Palmolive (CL) at $71.88 is trading at 47.5x trailing 12 month earnings, well above its lofty 5-year average of nearly 26x.  Proponents of the stock, however, will make two arguments. First with interest rates as low as they are, they would argue, stocks "deserve" a higher multiple (as if companies have an inherent right to the higher stock price). Hmm. They will also point to the far more reasonable forward p/e projection to justify the price - and this is the fundamental point to be made here.  

The forward multiple for Colgate is now just under 26x, wholly in line with the company's historic 5-year multiple. But here's the point. To roughly halve the multiple on a forward basis (i.e., from from 47.5 to 26) requires earnings to grow over the next 12 months at roughly double the level of the past 12 months, or by 100%. More specifically to Colgate, for the company's annual earnings to align with a 26 p/e at the current stock price would require earnings to climb from the roughly $1.3 billion they made in 2015 to $2.6 b in 2016!

Now, here's the rub. That basic math would be true, but only if the share count outstanding remained fixed. But Colgate, as true of many consumer staple and industrial companies in this environment, is buying back shares, reducing the number of shares outstanding by some 15 million per year. They've done this at the expense of adding leverage, or debt, to the balance sheet, but we'll leave that issue aside for now.

But even with the adjustment, or on a constant share basis, Colgate would need to grow its earnings by 80% in 2016 to achieve a 26x multiple at the current stock price. All this, for a company whose net income has declined sequentially in each of the past five years. I can't help feeling that Druckenmiller might be right.  With these kind of metrics, how will we ever get the toothpaste back in the tube?

Wednesday, April 27, 2016

Investing in Utility Stocks

Those who read my post from early January, "What's Working in this Market Correction", will know I favor utility stocks in the current market.  In fact, the utility ETF, XLU rose from 43 on January 4 to 50 on March 28, or a gain of 16% in 12 weeks.  It's since backed off, now trading at 48.  I'll explain why in a moment.  First, why I like utility stocks and what their performance this year says about the economy.


Utility stocks essentially trade like bonds.  Known for consistent and high dividends, investors buy utility stocks as they would fixed income securities, for their predictable level of dividend payments.  The dividend yield, or the relationship between the annual dividend and the stock price, is often equated to a bond yield for more traditional fixed income securities.  Utility stocks are not pure dividend plays, though, and we'll get to this issue in a moment, as well.

Trading like bonds, of course, means that price and yield vary inversely.  As interest rates rise, the price of bonds and utility stocks decline.  As rates decline, utility stocks tend to appreciate. Over the past two months, since the lows of the stock market in February, stocks have rallied following a risk on momentum trade.  Bonds have weakened.  The US 10-year has traded as low as 1.63% and as high as a 1.97% over this period.  

If this risk on rally that has been leading momentum into the least favored sectors of the market is about to turn once again, however, the focus will shift back to the continued weakness in GDP, consumer spending, capital investment, durable goods orders, commodity prices and corporate earnings.  This perceived weakness will damage stocks, but boost fixed income securities that rally in the face of low growth and inflation.

This being said, while factors favor utility stocks, I don't prefer the ETF alternatives, and here's why.  Utility stocks largely trade like bonds, but not entirely.  Their values also swing based upon forecasted revenue on energy sales to their customer base.  In some regions of the country, that customer base can be heavily industrial, for instance Texas, Oklahoma and much of the mid-west.  If the economy is in fact slowing, industries in these regions will likely reduce their consumption of power, impacting utility revenues.

Residential demand for power, on the other hand, is highly stable and far less impacted by economic cycles.  For this reason, better opportunities present themselves in utilities with higher residential customer profiles, than what might be achievable with the XLU.  A few large utilities that fit this profile and should be considered are Duke (DUK) with 6.2 million of its total customer base of 7.2 million being residential, Southern (S0) and Exelon (EXC).

Thursday, April 7, 2016

San Bernardino's Pension Fiasco

New details emerged this week on the City of San Bernardino's bankruptcy recovery plan. Reuters reported a proposed settlement with two of the creditors of the city's 2005 pension obligation bonds. That plan calls for bondholders to write off as much as 60%, or $30 million of their original $50 million investment. 

The bonds in question were originally issued by the City back in 2005 to help shore up the city's struggling public employee pension fund, held by the California Public Employee Retirement System, or CalPERS.  Unable to come up with the funds to fulfill its commitment to retirees, the city turned to the public bond markets, selling bonds and using the proceeds to pay CalPERS. In being granted authorization under law to issue the pension bonds in 2005, the city obtained a court ruling confirming that the city wasn't issuing new debt, per se, but rather refinancing debt it owed to the CalPERS pension fund.

By July 2012, though, soon after it filed for bankruptcy, the city failed to make required semi-annual payments on the bonds, throwing the bonds into default.  Interestingly, in its bankruptcy filing, the city blamed the high costs of its fire and police labor contracts, including pensions as the main issue forcing the bankruptcy filing. Now in bankruptcy, the city failed to make payments on the bonds funding that pension liability, as well.

The two principal holders/guarantors of the bonds sued the city soon thereafter, arguing that the bonds should be paid on an equal basis with the city's continuing obligations to fund its pension account at CalPERS.  But in the end, the powerful, $300 billion CalPERS prevailed in court. In May 2015, a bankruptcy judge threw out the bondholder suit, allowing the city to proceed with its plan to make pension payments to retirees in full, while forcing bondholders to suffer significant losses on their loan to the city.

Now let's step back here a moment and take a look at what has actually transpired.  The city, through negotiation with its employee unions, had agreed to make a certain level of lifetime pension payments to retired city employees. Unable to come up with the funds from tax revenues and other sources to do so, the city borrowed $50 million from investors. It deposited these funds with CalPERS, the pension trustee, on the city's behalf.  

Now, in cramming down a loss of $30 million (or 60%) to bondholders, the city is arguing that it doesn't have the funds to make full repayment. However, it actually does. The full $50 million that the city borrowed, plus interest, remains on deposit in the city's pension account with CalPERS. So, in effect, what has happened is that the city effectively stole $30 million from investors (the difference between the original borrowing and the amount to be repaid) using the money to make whole on its pension commitment to employees.

Now, here is where this gets truly galling. As reported in our blog from May 2015, a study of salaries of the 120 highest paid firefighters in San Bernardino reported by Bloomberg shows the top one-third drawing an average salary of $190,000 per year; the next third $166,000 (this is in a city where the median household income is $52,112 per year). In retirement, as early as age 50, these firefighters may be eligible for annual pensions of up to $171,000 per year, an obligation the city will need to pay for many years to come. This might, in part, explain the types of management decisions that led up to the city's bankruptcy and its nearly unconscionable deal with its bondholders.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com

Thursday, March 17, 2016

The Dash For Trash in Stocks

Following an unusually rough start to 2016, the last four weeks have seen a dramatic turn of events in stocks, oil and commodity prices. The question we ask is "what has changed?" Unfortunately, not very much. Our concerns entering 2016 are still with us: record low commodity prices, weak oil, widening junk bond yields, declining corporate profits and a less accommodative Fed.  These concerns are superimposed upon a bleak macroeconomic picture, with many starlets of the emerging markets stumbling, including China, and others falling hard, like Brazil.

Amidst this backdrop the rally in stocks has been puzzling. Driving these gains, in part, was a race to hastily cover short positions in oil, as a rumored OPEC alumnae reunion quickly sent the price of oil up by 50%.  Oil analysts, though, shrug off the effect of a plan to freeze production at today's record levels (even assuming parties would hold to it) as having little impact on ever-growing inventories.  However, as weak shorts run to cover in oil and beaten down oil stocks, hedge funds and algorithmic traders have been quick to ride the tailcoats of all the buying.

But let's look at one non-oil, non-mining blue chip stock to see what has happened to valuations over the past several weeks. Boeing Corp (BA) bounded off its mid-February lows of 108, to now trade at a robust 130.  Little has actually changed at the company over this period. In fact, the company announced in late February that it would be laying off employees, including highly paid engineers, as it faces stiff competitive market pressures, principally from Airbus. This news followed a downbeat earnings report for 2015 Q2, released on January 27, in which the company lowered forward earnings guidance on an expectation of slower 2016 sales. Boeing's net in 2015 Q4, it turns out, was $1.03 billion, down from $1.47 billion in the same quarter a year earlier. 

Yet despite this 29% drop in Q4 earnings and lowered guidance for 2016, Boeing stock is up a stunning 20% from its February 11 low.  So how is this possible?  Multiple expansion. Today, BA trades at 17.15x twelve month trailing earnings, above its 5-year historical range of 16.19x. But with earnings projected to decline, even if not nearly to the degree the company experienced in 2015 Q4, this TTM multiple will jump significantly, without any further gain in the price of its stock.

Now this isn't to say that Boeing is a weak or troubled company. It is an outstanding company, with excellent long term prospects. But these prospects must be set against global macroeconomic conditions that support, or in this case, limit growth. This issue, in fact, is precisely what the company warned in its Q4 earnings statement.

Meanwhile far trashier stocks, like Chesapeake Energy (CHK) are up 201% over the past four weeks, while Freeport McMoran (FXC) is up 187%.  It's much more difficult to value these stocks on a TTM p/e basis, because these stocks do not have earnings.  Not by a long shot. FXC lost $12.2 billion in fiscal 2015. If you think this might give pause to the reasonableness of a 187% rise in FXC's stock price, you might want to consider treading cautiously in this newfound market rally.

Monday, February 29, 2016

The Rising Mountain of New Jersey Pension Debt

This week, the Supreme Court of the United States moved to uphold a 2015 ruling of the New Jersey Supreme Court, thereby defeating a challenge to the state's plan of pension funding brought by public employee labor unions. The unions sued the state over the underfunding of the state's staggering employee pension deficit. The unions alleged that in 2014 Governor Christie failed to fund the plan at an agreed upon level, per a deal negotiated by state legislators and the unions in 2011.

To understand where this story begins, or just how dire the circumstances are surrounding the New Jersey Public Employees Pension Fund, a bit of background is required. In 2014, the State of New Jersey deposited roughly $700 million of taxpayer dollars into its employee pension fund. The State spent an additional $2.8 billion of public monies to fund retiree health care benefits. Yet, despite these significant investments in shoring up the retirement plan of its past and current employees, the State actually underfunded its statutory funding obligations by nearly $3 billion.

To understand how this is possible, we need to delve into the murky world of state and local government accounting. To fully fund the state's requirements, simply to keep pace with current pension costs - with no effort to catch up on past underfunding - would have required the State of New Jersey to contribute $6.5 billion of taxpayer funds, or 20% of the entire state budget to its pension funds. So the state "saved" $3 billion by underfunding in 2014. But year after year of these kinds of "savings" or deferrals, simply builds one heck of a mountain of debt, or pension liabilities, for the state (or more specifically, taxpayers) to climb in the future. In fact, by 2015, New Jersey's total benefits liabilities had reached a staggering $90 billion - $37 billion in unfunded pension liabilities and $53 billion in unfunded health benefits.

Now back to the Supreme Court. The case revolved around the agreement negotiated in 2011. In order to gain concessions from the unions on greater employee pension contributions, the state agreed to gradually increase its funding of pension contributions in each year, until reaching the required annual level. And in fact, things proceeded just this way in 2012 and 2013.  But in 2014, in an effort to pass a strained budget, the state reduced its annual pension contribution by the aforementioned $3 billion. Governor Christie claimed financial hardship. The unions sued saying the stated had breached its 2011 deal. The Supreme Court has now sided with the state, allowing the State of New Jersey further leeway in kicking the can down the road on its pension obligations.

Looking ahead, for the state's fiscal year 2017 beginning on July 1, the Governor has proposed $1.86 billion in pension contribution, or just 40% of its required annual contribution. And while this may help the state balance its 2017 budget, the state's pension mountain continues to rise before New Jersey public employees and cast an ever-greater shadow over its taxpayers.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com