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.  

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).

What's Working in this Market Correction

The New Year starts with a bang, with hundred points swings in the Dow Jones Industrial Average each day this week. Unfortunately, the swings have all been to the downside, with the S&P falling nearly 5.0% this week. In this environment, investors may be tempted to throw up their hands and sell everything, or watch from the sidelines like a deer in the headlights as portfolio values head ever lower. Let's look at what's actually working.

First, while some portion of the selloff was likely initiated by the Fed's modest rate hike in December, the 0.25% increase has all been directed at the short end of the yield curve. Bonds, especially long-dated bonds have performed quite well, with the yield on the 30-year UST falling below 3% (2.93% as of this writing) from a level of 3.04% just last week. Eleven basis points of declining yield has the price of the US Treasury 2x ETF (UBT) rising from $73 to $76 over the same period. That's a 4% gain for the week, while everything else seems to be swimming furiously in a sea of red.

This leads us to our first trade for the New Year, bonds, and specifically UBT as an ETF play available to retail investors. UBT is levered 2x which means that a rise in long term interest rates would also cause this instrument to fall disproportionately in value. But if your view is that the economy may be hitting a rough patch, where stocks are susceptible, then bonds may provide a safe port in the storm. This is especially true if you believe economic growth and inflation, the principal enemies of bonds, will continue to be subdued. It's also worth noting that UBT traded as high as 97 back in February 2015, when the long bond traded at 2.25%. Not to say this is where things are headed, but with the softness we're seeing in global markets, difficult to rule it out either.

Oil continues its rapid decline, now bordering on a free-fall. The inverse leveraged ETF, SCO, has done especially well over this period, rising from $80 in the beginning of November to its present level of $160. How much lower oil can go is anyone's guess, but WTI is now roughly where it was during the 2009 recession (along with other commodity prices). Hard to believe it falls much further, yet SCO may still form a reasonable hedge against long positions, certainly in energy and perhaps, also, industrial stocks.

SKF, the inverse leveraged ETF on financial services stocks, also has our attention. This instrument can not only provide a hedge against other long equity positions, but highlight the risks specific to the financial services sector. Some concern with financial services profits may be warranted following the poor performance of markets in the latter part of 2015 and the disastrous 4th quarter results posted by Jefferies on December 15. Customarily a harbinger of things to come at the larger Wall Street names, our concern can only be amplified by the exposures of these firms to deteriorating credits in the oil patch.

On the long side, defensive sectors like healthcare and utilities may prove a good place to hide, collecting dividends and waiting for markets to sort themselves out. As to cash, which investment advisors tend to dismiss, it's beating stocks by 4.89% this year.