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 But if you've been trading stocks for less than ten years, this perspective might appear archaic, outdated, downright foolish.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

Up In Smoke Free Promotion

Up In Smoke: How the Retirement Crisis Shattered the American Dream will be available for free download in its entirety to Kindle users from August 1 through August 5, 2016 by following the link below: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com. 

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?