2017 Stock and Bond Market Predictions - Part Two

The period following the November presidential election was, by many measures, extraordinary. Equities soared, bonds and interest rate sensitive stocks declined, while Dow leader Goldman Sachs saw its share price climb by 30% in just six weeks. By now, we're all familiar with the thesis: less regulation, lower taxes, greater fiscal spending on infrastructure, higher inflation and more rapid growth will all contribute to earnings growth in 2017. The ability of the new Trump administration to rapidly advance each of these themes, however, is at best uncertain. Nonetheless, each issue has likely contributed to the equity rally and bond market decline. 

Of these factors, the most likely new policy of the administration out of the box is widely believed to be some sort of a tax cut. And therein lies the rub, as we turn to 2017. In post-election 2016, higher stock prices were driven by greatly expanding p/e multiples. Whether new policies, if enacted, may contribute to earnings growth and thus, lower multiples over time, we can only guess. 

But one thing appears all but certain. The market is convinced that lower tax rates will prevail in 2017. In fact, this one single factor may have contributed the most to the post-election rally, and may now pose the greatest risk to 2017: a lack of selling in November-December if capital gains were deferred to 2017. With the New Year just days away, we'll soon find out whether this is in fact what has happened. That being said, it might be well worth putting stops in place, just in case.

The New Year will also see the ability of scheduled OPEC cuts to restore balance to the oil markets. The first quarter is typically a period of scaled-back production for Saudi Arabia and many other OPEC producers. It will be critical for oil markets to see some cuts in production over and above the normal seasonality to instill the confidence necessary to support prices. OPEC member production will also be monitored closely for cheating, as has been the case with prior OPEC agreements. To this, we add scaled up production by US shale producers and potential demand saturation in China as inventories, ramped by lower prices, are expected to fill. If the market loses confidence in the ability of OPEC to manage the oil glut, prices could fall swiftly and dramatically.

With the December Fed meeting now behind us, it's unlikely the Fed will do much for the next several months, as they await new information. Thus, bond markets will be driven by hard economic data, in short supply over the past several weeks. The strong dollar has already negatively impacted exports, raising the trade deficit, and thus weakening projected GDP. If fourth quarter consumer spending data is weak, bond yields will accelerate their descent of the past few sessions. In this environment, interest rate sensitive stocks will gradually rise, as we're now beginning to see in telcos, utilities and select REITs. 

The first quarter of 2016, following the Fed's December 2015 rate hike saw bank stocks decline, utility stocks rally, bond yields fall and gold rise. That was against the backdrop of a sharp selloff in stocks early in Q1. Nonetheless, gold, bonds, utilities are now all higher following the Fed's December 2016 rate hike. Financials are lower. Caution is advised.

2017 Stock and Bond Market Predictions

Regrets for taking so long between posts. I plan to be better about posting next year...get more exercise...and more sleep.

Before moving on to the 2017 forecast, let's take a look at what took place in various segments of the markets in 2016, including the impact of major political developments on those markets. The S&P currently stands at 2265, up 10.8% year to date. Fully 8.7% of these gains, however, occurred in the last five weeks following the US Presidential election. 

Equity markets fell sharply early in 2016, largely on China worries, falling commodity prices, a collapse in oil prices and record low bond yields. By mid-February, the S&P 500 would fall by nearly 10%, before snapping back to rally to new highs in mid-April. But by July the market was up just 5% on the year, and with some volatility, stayed in this range pretty much up until the November election. 

Major political events, unexpected and shocking to many like Brexit, the Trump victory and the Italian referendum would disrupt markets, but with ever shorter periods of recovery, before pushing to new highs. It's been said that the stock market took three days to recover from Brexit, three hours to recover from the Trump victory and three minutes following the Italian referendum. Amidst these recent, post-election gains, however, and with new infrastructure spending still years away (if at all) the rise in stock prices has been entirely attributable to price/earnings multiple expansion. The S&P 500 now stands at 26x 12-month trailing earnings, second only to historic peaks in 2000 and 2008.

Oil played a major role in markets in 2016, with WTI falling below $27 per barrel in January. Soon thereafter rumors of planned price collusion of OPEC began to swirl, first at Doha, then Algiers and finally Vienna. By the time a deal had been struck, it was early December, with oil prices artfully manipulated for the entire year. Despite the recovery in prices and the alleged OPEC deal, however, oil remains vastly oversupplied.  US EIA data indicates that average daily global oil storage builds in 2016 are expected to average 700 million barrels, dropping to 400 million barrels per day in 2017 (presumably on the OPEC cuts). Oil in storage in the US is just below 500 million barrels (and well above five-year historical averages for this time of year) while oil stored at Cushing, Oklahoma is rapidly nearing capacity.

The UST 10-year bond yield would begin the year at 2.27%, approximately 26 basis below its current level. For all the drama about soaring bond yields, the 10-year is at levels of June 2015 and 50 basis points below its levels of January 2014. That being said, the sell-off in bonds in the latter part of this year, was swift and severe. The 10-year hit a low of 1.46% in July 2016. While yields crept higher thereafter, the 10-year would still be trading at just 1.56% at the end of September. 

What followed for bonds was increasing concern about the Fed, on hold for the entirety of 2016, but widely expected to hike the fed funds rate this past fall. After numerous false starts in June, July, August and September, the Fed would finally hike, but not until mid-December (and then, by just 0.25%). In it's forecast for 2017, the Fed indicated that it would likely hike rates another three times, which spooked a market that had been predicting two hikes for 2017. Turns out, the Fed actually dialed back its hawkishness from the four rate hikes it predicted for 2016 (again, only to raise just once).

But it was the Trump victory in November that greatly accelerated the sell-off in bonds, and with it, interest rate sensitive stocks like utilities, REITs, Telcos and other dividend plays. In moments following the election, investors became rapidly convinced that a Trump Administration, supported by a Republican House and Senate would move swiftly to implement tax cuts, infrastructure spending and financial deregulation. Markets quickly concluded that lowered tax revenue, coupled with greater fiscal spending could only mean greater deficits and, with them, a rapid acceleration of inflation. Long-term interest rates promptly reacted. Yields on the UST 10-year would jump by 70 basis points in just five weeks. But what does all this imply for 2017? Perhaps not what many are thinking.

Part 2, a forecast for 2017 will follow in the next few days...I promise.

Bank Earnings Blowout (Reprise)

JP Morgan, Citi and the tarnished Wells Fargo all reported third quarter earnings this morning. The press was ecstatic. CNBC's original headline "J P Morgan Crushes Expectations", was quickly revised to read "JP Morgan Profit and Revenue Easily Tops Forecasts". At Business Insider, the headline was even more bold: "JP Morgan Smashed it out of the Park". The headline for Citigroup's release at CNBC was "Citigroup Tops Wall Street Expectations for Earnings and Revenue".  

But none of these titles accurately captures what is going on with bank top line revenue or profits. Reading past the headline, here's what we actually learn. JP Morgan saw its earnings decline by 7.5% year over year and its top line revenue climb back to just above where it was in the third quarter of 2014, two years earlier. And this is the report from the nation's top performing bank. The news at Citibank was no better, with top line revenue falling 4.8 % year over year and profits falling by 5.3%. 

These results confirm a trend of now greater than four years of declining bank revenue and earnings, as previously reported here for 2016 Q2. The major US banks are effectively shrinking, based upon poor top line revenue growth and profitability.

The Trump Campaign Struggles with the Real America

Poor, poor Trump. As successful as he may have been in the business world, he’s clearly out of his league when it comes to Washington. Try as he might, he’ll never be as polished, his record never as scrubbed, his views never as focus-group tested as it takes to win a major election. He’ll fail to cut the back room deals that build support within his own party, fail to carefully cultivate the media that so expertly shapes public opinion, nor will he promise the favors of access sought by powerful special interest donors. 

His campaign will struggle with finances, raising only $94 million by July 1, 2016, versus the $386 million raised by his Democratic opponent. A pathetic $5 million of his funding will come from Super-PACs, compared with the $121 million raised by Hillary Clinton. He won’t get the $1 million donations given each by JP Morgan, Citigroup, Goldman Sachs and Morgan Stanley to Clinton, nor the $1.2 million given by the taxpayer-funded institution, the University of California (note, Obama’s former head of Homeland Security, Janet Napolitano, is now the President of UC). His paltry $2,000 in funding from the hedge fund industry will be dwarfed by the $25 million received by Ms. Clinton’s campaign. He’ll lack the two-faced, deceptive, partisan skills of successful members of the US Congress, a body that now enjoys an approval rating by the American people of just 11%.

In the end, he’ll likely be returned by the electorate to his role as real estate developer, never to amass the 400% gain in personal wealth of Barack Obama during his tenure in the White House, nor the $111 million fortune built by the Clintons through their public service. Washington will go on as it has, an ever escalating arms race of special interest donations, with never a serious effort at campaign reform. We’ll fail to meaningfully attack the federal deficit, perhaps allowing the US national debt to double once again, as it has over the past eight years. We’ll fail to fix social security, disability insurance and medicare, leaving a ticking time bomb at the doorstep of an aging population. We’ll continue to shift the ever-increasing burden of health care costs to middle and upper-middle income consumers, compromising the quality of their health care while devastating disposable incomes. We’ll become even more polarized in our wealth as a society, as we have undeniably become over the past eight years. All the while, Congress’ day to day activities will stall in senseless, immature partisan bickering to form, what President Obama so aptly characterized in 2014 as, “the least productive Congress in modern history.” And, we the American people will be left wondering, is this really all we can expect from government?

No one can defend Trump. All the same, it would be interesting to see someone who thumbs their nose at both the Republican and Democratic parties stumble their way into the White House. Paul Ryan would suffer irritable bowel syndrome for four years. But here's the real concern: a binary political system we Americans have somehow come to accept. If it it's not this, then it's that. If you're not a liberal, then you're a tee-bagger. If you oppose illegal immigration, then you're a racist (by the way, notice the word "illegal" in that sentence). We demonize the opposition. And it's all designed to foster the interests of the two parities who only fein attention to what benefits our country when focus groups show voter support. Once that nonsense is out of the way, the politicians can return to the actual business of government, addressing the concerns of special interests and Super-PACs. Sorry Mr. Trump, but we live in a post-democratic technocracy, where the parties only exist to perpetuate their incumbency.

Understanding Dividend Yields

The search for high dividend yielding stocks continues as investors seek alternatives to the abysmal yields on fixed income securities. A stock yielding 3% in the context of a US Treasury 10-year yield of 1.55%, definitely looks attractive. Well, maybe.

Dividend yield is the projected annual dividend per share of a particular stock, divided by the price. So if General Motors, for instance, is paying an annual dividend of $1.52 per share and the stock is trading at $32, the dividend yield is 4.75%. Far better than the 10 year Treasury.

But there are three important points to remember for those investors buying high dividend yielding stocks. The first consideration is that dividends are declared each quarter by the board of directors and, therefore, can be cut or suspended at any time. We've all seen this happen to stocks like Conocophillips (COP) that announce a dividend cut earlier this year. After entering 2016 with a dividend rate of $0.95, the company cut its dividend in Q2 to $0.79, and in Q3 to $0.49.  The stock now trades at $41, fully 25% off its recent November 2015 high of $55.  Meanwhile, other large integrated oils, not cutting their dividends, have risen considerably over this period.

Second, the dividend yield is an annual number. In other words, if you purchase the stock, hold it for a year and the dividend rate does not change you earn a dividend yield, in the case of GM, above, of 4.75%. Now, of course, what is important to investors is not the annual dividend yield, but rather the total return in holding the stock. For instance, taking this same example, if you buy GM today at $32 and it closes one year from today at $30.5, just one and one-half point lower, your total return for the year is exactly zero - quite a bit less than the yield on that US Treasury.

These two considerations are fairly obvious, but there is one more point for dividend investors that's often overlooked. The dividend yield when you purchase a stock is only the projected yield you are to receive (assuming no cut to the dividend rate) at the price at which you acquire the stock. In the example above, the dividend yield for GM purchased at a share price of $32 today is projected to be 4.75%. 

But what happens to your yield over time, is of equal importance. Let's say that you find GM an attractive investment at the prices and yields mentioned. Now, let's say that you hold GM for a year and the price rises to $35. Well, you've done quite well on the investment. Your total return for the year would be $14.12% (9.375% in price, plus a 4.75% dividend). But at this point, assuming no increase in dividend rate, your projected dividend yield has fallen to 4.34%. Still a very impressive yield. But for stocks that have risen appreciably, the current estimated dividend yield may be far less than when the investor purchased the stock. As such, investors should periodically reconsider why they are holding the stock and its estimated dividend yield on capital currently deployed.

Is a Fed Rate Hike Good for Bank Stocks?

With talk of a Fed rate hike at its September meeting increasing, following comments of Stanley Fischer and other Fed governors at Jackson Hole, bank stocks are enjoying quite a run. Bank of America is currently trading at $16.14, a nearly 45% gain from its February 2016 lows.  Citigroup is up 38% and JP Morgan +28.5% (a nice game for Mr. Dimon who publicly purchased $26 million of its shares on February 12). The financial services ETF, "XLF" is up an impressive 27.5%.

Some of this gain was a bounce off the February lows, but a healthy share of the return has been produced over the past 30 days as focus turned toward the Fed's Jackson Hole Symposium. Rightly or wrongly, the market thoroughly believes that higher rates are good for banks, as long-suffering bank net interest margins profit by a higher interest rate lending environment.

Truth be known, a hike in the Fed funds rate, in and of itself, is negative for bank earnings. Such a rise in short term rates has to be accompanied by a far larger increase in term lending rates to produce net interest income benefit to the banks. Part of this disconnect has to do with the mystery surrounding the Fed. Despite the Fed's noble efforts at transparency, market participants remain convinced that the Fed has secret data insights, not otherwise available to the markets at large. If the Fed is moving on rates, the economy must be heating up and with it the UST 10-year, or so the thinking goes.

Of course, the Fed is not privy to some covert set of data, but rather is looking at the same economic data as everyone else. In fact, their prolonged hesitation over the most minor of (and nearly insignificant) rate increases should be ample evidence that the data on the economy is more confusing than it is compelling. Nonetheless, as the chatter rises, bank stocks head higher while utility stocks, bonds and gold - each of which thrive in a low interest rate environment - drift lower.

This being said, it's probably worth taking a look at how markets actually reacted in the days and weeks following the Fed's 25 basis point rate hike last December.  As discussed in a previous post, in the several weeks following the Fed's December 15, 2015 rate hike, the 10-year UST actually fell in yield (bad for bank earnings, by the way) while utility stocks and gold posted some of their best gains in recent memory. 

The XLF shows a similar phenomena, rising to a close of $24.44 on the day following the Fed decision, up nearly 32% from its August 2015 lows. But in the days that followed, the XLF quickly began to fade, falling nearly 5% the very next day. By the time of the February 2016 lows, the XLF had fallen nearly 20%. Eerily, the XLF today, as we approach the September Fed meeting stands at precisely the same level, $24.56, as it did on the day prior to the December Fed meeting. 

The Fed, Bonds, REITs and Utility Stocks

The Fed is hosting its 2016 annual academic conference in Jackson Hole, Wyoming this weekend.  Fed Chair, Janet Yellen is scheduled to speak. While no interest rate decision will be announced, markets nonetheless are fixated on developments. With little real economic data or interest to move stock and bond prices, traders eagerly await some insight into future rate policy, in hopes of gaining some direction for markets.

We see the impact of Jackson Hole on bond and utility stock prices, and prices for REITs.  Each of these instruments trade as fixed income securities and are, therefore, rightly influenced by trends in interest rates. But, it's actually long term interest rates that impact these instruments over time, not the short end of the curve that the Fed sets.

Utility stocks have performed extraordinarily well over the past six months, as we first pointed out in this blog in April 2016, Investing in Utility Stocks.  Utility stocks as measured by the return on the ETF, XLU, were up 18.8% through August 10 of this year (see Returns on Selected Assets Year to Date).  It's also worth reading our 2016 market predications posted on December 30, 2015 and What's Working in this Market Correction from January 7, 2016.

Over the past few weeks, though, bonds, REITs and utility stocks have given back some of their gains as investors eye a potential rate hike by the Fed.  Let's take a look at how bonds are priced and why I treat utility stocks as the equivalent. Utility stocks generally trade with a high level of dividend yield. Because utility revenues are quite stable, the dividend is therefore predictable and protected, as much as possible, from swings in the economy.  Therefore, as with bonds that pay a fixed level of interest, the value of the utility stock is tied to the discounted future value of the dividend stream. If the dividend is stable, the stock value will rise as the discount rate falls and decline as the discount rate rises.

Markets, of course, are forward looking, which explains why utility stocks are weakening, while no interest hike has actually been scheduled. The Fed also does not directly impact longer term interest rates that are the basis by which utility dividend and bond interest would be discounted. Nonetheless, the markets are fragile and investors anxious.  

If we look at the last Fed hike on December 15, 2015, however, we see a very different picture emerge. The US 10-year rose by 2 basis points to 2.30% in the day following the announcement, eventually rising to a high of 2.32% on December 29.  But the yield began immediate falling thereafter, to 2.00% on January 28, and 1.63% by February 11, 2016. The 10-year yield now sits at 1.55%. The XLU utility ETF, by the way closed on the day of the December Fed hike at 42.33, climbing to 53 on July 6, 2016 (a gain of 25%).

This points to the most interesting aspect of how bonds and utility stocks trade, not on forecasted Federal Funds rates, or perhaps even the US 10-year, but on the forecast of inflation in the economy, as inflation erodes the value of fixed income securities. The point of all this is that if a Fed hike acts to curb growth (and therefore inflation) a rise in the Fed Funds rate could actually act to lower the US-10 year and raise, not lower, the price of bonds and utility stocks. This is precisely what happened following the Fed's December rate hike. There's no reason to believe that this would play out any differently in the months following the next rate increase.

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.

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?

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.

XLU

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).

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. 

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.

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. 

Retail Spending and the Consumer

I had lunch recently with a friend in a fashionable urban restaurant. When the conversation came around to the economy he said, just look around. Everywhere I go restaurants and retail shops are crowded with people eager to spend. From Fifth Avenue to Rodeo Drive. From San Francisco to Miami Beach, restaurants are crowded and consumers are spending, spending, spending.

The problem with this image, of course, is consumer behavior in these tony high end locations tells us very little about the overall health of the American consumer. How little, may be just 1%. 

For the month of January, total retail sales grew by 0.2% over the prior month. These weak results were at least partially due to falling gas prices - a good thing for consumers. Retail sales ex-auto, gasoline, building materials and food services (i.e., core retail sales) were up 0.6%. While not stellar, the January report followed an outright decline in core retail sales of 0.3% in December. Not great, but certainly not recessionary. Bear in mind also that retail sales figures are not adjusted for inflation. So 2% sales growth in an economy with 2% inflation, would mean essentially flat unit sales. 

Against this backdrop, consider that four states are already officially in a downturn, as reported by Bloomberg News: Alaska, North Dakota, West Virginia and Wyoming. Likewise, other states are threatened, as well, including Louisiana, New Mexico and Oklahoma, according to Moody’s Investors Service. And of course there is Texas, which is also struggling with plunging oil prices, layoffs and reduced consumer spending.

So what's going on? Fortunately, the Commerce Department, in its monthly report of consumer spending, gives us a broader view of how people are spending, or not spending. If we drill down into the January Retail Sales Report, here's what we find beneath the headlines. On a year over year basis, food and beverage store sales were up just 1% (the CPI in January on a year over year basis was up 1.4% so sales grew by an amount less than inflation). But sales at bars and restaurants were up a solid 5.4%, indicating a preference for meals out to those at home for many consumers. Yet, furniture and home furnishings grew by just 1.4% (about the rate of inflation) while clothing stores were flat (no increase in sales, before inflation). And department store sales fell 4.5%, while electronics stores were off 5.4%.

So while the anecdotal evidence of a healthy consumer eating out more often and buying lavish clothes may be what some of us see, others see a far more bleak picture of retail spending, lending yet further support to the case for an impending recession.