Wall of Worry

We've all heard this expression, to refer to stocks clawing gains to new highs amidst a market of doubters. It's contrarian logic. Buy when others are selling, when skies are at their most foreboding.

Recent reports have highlighted significant equity mutual fund and ETF outflows of both domestic and international equities, suggesting at least retail investors may be worried indeed. An article in Barron's indicates that fund outflows from U. S. equities in July deepened to a six-year low. International stocks followed suit. ISI Evercore Research reports that fund flows out of equity mutual fund and ETFs last week alone totalled $6 billion, bringing the year to date fund flows to negative $95 billion, a near record.

Now, to those of the contrarian view, the data argues for bullishness with the market soon to drive ever higher. Well, maybe. While markets have been known to climb a wall of worry, just as often investor uneasiness plays out as expected in future events. The herd isn't always wrong.

Take a look at the chart above. It shows the historical pattern of U.S. domestic equity fund flows paired with the S&P 500. While retail investors were seemingly caught off guard in the 2001 tech wreck, only to pull money from equity funds as the market fell to new lows, the stock market crash of 2008 paints a very different picture. While markets pushed ever higher throughout the fall of 2007, equities began to see negative fund flows as early as April, with money being pulled out of the market in increasing volume throughout the year, before the market began to topple in early 2008.

Today's negative fund flows from US domestic and international equities could be just the contrary signal that bulls are looking for, or this time, the herd could simply be right.

Warning Signs in Consumer Product Company Revenues

President Obama recently spoke about the economy, pushing back against nagging naysayers who point to disappointing growth, arguing that his detractors are attempting to make the US recovery look less robust than it really is. He pointed to job growth, a falling unemployment rate, rising wages and, did I mention job growth? Truth is, President Obama shouldn't take it so personally. An $18 trillion economy is more that the doing of one man.

On closer examination, though, there's no denying that something is downright fishy about the economy. Corporate profits for the S&P 500 have now declined for five straight quarters. More disturbing, and to our point about economic growth, top line revenues of S&P 500 companies have fallen for the past six.

It's not just struggling energy companies, or retailers shouldering these declines, both of whom it could be argued are not representative of the broader economy. In the former case, bulls would point to the nearly unprecedented fall in the price of oil, in the latter the shift to online shopping. But truth be told, the poor sales and earnings of major retailers like Macy's, Nordstrom, Walmart, Kohls, Ralph Lauren and Apple all take into account their online sales. So it's not just a shift to online shopping. There is something wrong with the consumer.

The issue is manifest in top line revenue of major banks like Citibank, JPMorgan and Bank of America. While their customer base is as corporate and institutional as consumer, top line revenues for each of these banks has fallen sequentially for the past five years. The banks are in effect shrinking themselves through expenditure reductions to keep cash flow positive.

But it's the consumer brands, like Colgate that are the most disturbing and highlight the structural weakness in the economy. Net sales for Colgate's products fell 7% last year - now bear in mind this is a company that makes consumer staples like toothpaste, mouthwash, soap, deodorant and household cleaners. Assuming for a moment that inflation is zero (if you buy that argument) the world's population is unquestionably growing. How can a company that markets consumer staples see shrinking sales in a growing world? And it's not that Colgate is somehow falling behind its competitors. After all, the stock trades at 47x trailing earnings and is at the top end of its 52-week trading range. Clearly, investors value the franchise.

As dreary as this picture might be, Colgate is not doing nearly as badly as America's largest consumer products company, Procter & Gamble. P&G has seen declining annual revenues, sequentially, for each of the past five years. Its revenues were fully 20% lower in 2015 than in 2012. P&G saw its sales decline last year alone by $10.9 billion. Pepsico's revenue fell by 5.4% last year, and came in $2.5 billion below its sales level of 2012. General Mills, another leading consumer products company, saw revenue decline last year by 6% vs. 2014. How is this all possible in a healthy economy?

Maybe this is what Bill Gross, Stan Druckenmiller, George Soros, Carl Icahn and other billionaire investors see that scares them so terribly about the economy and the stock market. After all, for revenues of major consumer brands to see continuing sales declines, something has definitely gone off track with the economy.

Earnings Beats Continue to Drive Markets Higher

When it comes to investing, I guess I'm old fashioned. There, I said it. I still dream of owning shares of companies that are growing, building businesses, expanding production, services, facilities and markets. But if you've been trading stocks for less than ten years, this perspective might appear archaic, outdated, downright foolish.

Gina Martin Adams, Equity Strategist for Wells Fargo was on Bloomberg TV yesterday touting renewed bullishness on US equities. Her enthusiasm was driven by the "75% of companies reporting earnings this quarter that exceeded analyst estimates". You can watch the full interview here. Tom Keene, the venerable host, for whom I have great respect, failed to ask the most compelling question: what percentage of companies reported earnings that actually exceeded prior year's results. After all, as old-fashioned as I may be, I still like the idea of owning shares of companies that are growing their businesses, not companies that are failing, but a little less badly than analysts had predicted.

We've discussed this topic elsewhere in this blog, in respect of US banks like Morgan Stanley and Goldman Sachs, then in a blog post just after Apple reported a stunning 27% decline in year over year quarterly earnings (the stock popped on the news, by the way). We saw yet more of this silliness yesterday as Polo Ralph Lauren reported a same store sales decline of 9%, with its stock up roughly the same percentage on the day. Today's pop is over at Macy's up 17% as of this writing on news of an earnings beat. Nevermind the fact that revenue declined by $230 million on a year over year basis, that the retail giant is shuttering 100 stores or that the company is forecasting a full year decline in comp sales of 3-4%.

But markets are markets and the market is never wrong, so what's going on here? My guess is that computer algorithms run by investment banks, hedge funds and other institutions are now programed to spot earnings beats, irrespective of overall company performance, and buy shares on the news. A beat is not always sufficient to drive a stock higher, but if it works in 90% of the cases, the odds are quite favorable for an institution trading hundreds of thousands of shares per day.

For the retail investor, however, this poses a great challenge. Do you seek out growing companies with rich stock prices, or beaten down companies hoping they'll fail a little less spectacularly? If you choose the latter, and I'm not arguing you shouldn't, bear in mind the risks of a miss on the stock performance of a downtrodden company as can be seen from market action following Macy's 2015 Q3 results.

Returns on Selected Assets 2016 Year to Date

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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.

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.

Global Stock Market Performance

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.  

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.