The Best and Worst Things Going For the Markets Right Now
Dear Valued Clients and Friends,
November certainly started off with a bang as energy markets, stock markets, and most risk asset classes continued the October rally the first half of this week with continued price appreciation to the upside. We don’t see a lot of catalysts ahead for continued market rally between now and the end of the year but we never know what the next day may hold. This week’s commentary looks at earnings season, the Fed (what else is new), and a few other big-picture economic angles that are pertinent to our current positioning. It’s not a super-lengthy read this week so please take it all in if you’re so inclined, and reach out as always with questions or comments.
We have a six-to-eight-page white paper to be published shortly for your reading benefit on the 2016 Presidential election and its specific ramifications for the economy and your portfolio. In the meantime, off we go…
Earnings season is almost over and the results have been better than expectations; 72% of companies beat estimates of what their profits would be; 45% beat projections of what top-line revenue would be. The quarter was not outstanding, but was better than the “atrocious” many had been expecting, so stocks rallied dramatically. They moved higher than they normally would from positive earnings surprises.
Where do things stand with the Q3 earnings season?
We are complete enough now in terms of the number of companies (80%) that have reported results, that we will make this our final update on the matter for the quarter. 72% have beaten in earnings expectations and done so by an average of 4.7%; 45% have beaten expectations in top-line revenue. We would describe the results as “good enough” to have rallied the markets (and held the rally), but not enough to leave no doubt about the strength of markets. In other words, the “bad news” appears to have been overstated coming into the quarter, but the good news is not causing us to feel out of the woods when it comes to Q4 earnings results.
How has the market responded to earnings results this quarter?
Companies that have beaten expectations have seen their stock prices rise (on average) 2.2% in the four days surround the earnings results, and companies that have missed expectations have declined by 2%. The average stock price move around an earnings beat is 1.1%, meaning the results have doubled the norm for companies performing, showing once again how much bad news had been baked in coming into this season. I talk more about this in a CNBC interview I gave earlier this week.
It sounds like you are not very bullish on where markets go from here?
We believe the vast majority of this immediate recovery rally has obviously taken place – the lowest hanging fruit of price gains coming out of the August/September sell-off. China is largely out of the headlines for now, and for good reason, and earnings season is essentially over. Broadly speaking, the stock market is largely at “fair value” now. Certain pockets still look cheap, so if there were to be a continued risk-on environment, we would expect high yield bonds, emerging markets, and energy stocks to be the beneficiaries. However, the risk-on environment may very well cool down, and we could muddle through for a bit. To be totally honest with our clients, (and also for the sake of our non-client readers) it is our ethical and professional duty to also say this: Such short-term perspectives (next week, next month, next quarter) are of little to no use to anyone, and of little to no interest to us. We include this paragraph in the commentary to set a broader paradigm of expectation and to present the information that a lot of the “stuff” that had been beaten up in Q3 has already rallied dramatically. We think things may cool. We have no plans to change our allocations right now regardless.
What are the best and worst things going for the markets right now?
The best thing has been credit spreads coming down and oil prices coming off of lows. In other words, a couple indicators of big fear and risk aversion went away. (Credit spreads are the excess cost of borrowing for a given type of bond like a corporate bond or mortgage bond relative to “safe” treasuries.) The big fear signals have subsided (credit spreads, oil prices, but also earnings seasons and China – all in a better place than they were 45-75 days ago). The worst thing, though, is that valuations are now higher than they were 45-75 days ago. Careful stock picking is advisable when broad markets come back to the levels to which they’ve recently returned.
So have spreads coming in a bit helped us economically?
Tighter spreads is more of a reflection that anxiety in the economy has relaxed a bit, but yes, they have the effect of helping the economy fundamentally (lower borrowing costs), which then eases the anxiety, which then helps, which eases, etc. (a positive feedback loop). In other words, what really is an indication of a certain mood can become the cause of the mood, as well. And of course, this is true on the other side too – wider credit spreads indicate more fear in credit markets, and then cause more reason for fear in credit markets. Interestingly, the slight improvement in spreads we have seen the last five weeks has been in the high yield bond market. (It really has been slight. We were about 6.5% higher in high yield rates than treasuries. Now we are 5.9%. We wouldn’t view this as news until there is a 4-handle in front of that high yield spread – 650 basis points coming to 450 basis points would be meaningful; right now we are 590). One thing I will mention that we are watching, which is quite peculiar, is that as high yield spreads, emerging markets bond spreads, corporate bond spreads, etc. have all improved in the last five weeks, CMBS (commercial mortgage backed securities) spreads have not. We are curious but not yet concerned.
The above paragraph re-stated in English: There is a way we measure risk and fear in the economy, and that is the cost of borrowing money for certain entities (real estate, risky companies, etc.) compared to the cost of the U.S. government borrowing money. When that cost of borrowing goes higher compared to treasury levels, it can indicate fear, and create more reason for fear (and vice versa). Those numbers have modestly – very modestly – improved in the last five weeks. But they have not improved for commercial mortgage borrowing, which is interesting.
Why do you believe the need for economic growth transcends its implication on the job market?
There is no question that an improved economy helps create more jobs, and helps grow wages of those who already have jobs. However, the $18 trillion national debt and large annual budget deficits mean something else in the battle for economic growth: Without it, our debt will suffocate us. The key issue when analyzing debt is always and forever the debt in proportion to the assets and the income which must service it. We often use the analogy of someone with an $18,000/year job and $10,000 of credit card debt being far worse off than someone with $100,000 of credit card debt but a $1 million/year job. Ultimately, the only way we will control our $18 trillion national debt is by reducing it in proportion to the size of our economy. Put differently, growing our economy is the number one debt management strategy we can or ever will have. The debt-to-GDP ratio as shown below is at a place we have not seen since World War II. The level of debt is not likely to be reduced for the foreseeable future. Economic growth alone can reduce to debt-to-GDP ratio, and economic growth alone can maintain our ability to service its debt.
Do you follow auto sales at all as a sort of indication about the overall U.S. economy?
We follow auto sales closely, but mostly as just an additional data point in a wide assortment of considerations of which we want to take note. There is no question that the post-2009 recovery in the auto sector has been a sight to behold (see chart below). However, we also question the data’s relative information to past cycles because of: a) lower household formation, and b) Dealer incentives that brought so much activity forward. Thus far, though, auto industry skeptics have been wrong. We use auto sales data more to confirm different interpretations than to set them.
What do you think the jobs number will have to be to warrant a Fed rate hike in December?
Keep in mind that by the time you read this, the October jobs number has come out. We are writing this 24 hours before the report. Many pundits think that 140,000-150,000 new jobs will be enough to get the Fed to act (assuming it is repeated in the November report next month). The reliable strategist, David Rosenberg of Gluskin Sheff Research, who we read daily, has pointed out that the three-month average job growth was 230,000 a couple years ago when they tapered off QE3. We suspect that they are at no more than a 50% chance of raising rates in December no matter what the jobs number, but we think for the odds to increase towards a rate increase the number will need to be north of 180,000, and more importantly, some positive movement around wage growth, less part-time workers, and an improvement in the labor participation force will be desired.
The truth is that our guiding principles have been for a long, long time now that the Fed was highly biased for continued accommodation (low rates) regardless of any particular data, and that remains my guiding principle now. However, Chairwoman Yellen and the Fed are suffering a credibility crisis like we have never seen. That is a factor that must be considered in handicapping December lift-off likelihood.
Why do you think the zero interest rate policy of the Fed has failed to create more economic growth and activity?
It is very simple: Zero interest rates do indeed to create more incentive to BORROW, but they also take away all sorts of incentive to LEND. Credit expansion goes the OTHER WAY at these low rates, so essentially those who can get money easy get it at artificially low rates, and those who need it can’t get it anyways to create a stimulative effect because lenders tighten credit expansion as their profit motive is diminished.
Crude oil prices could go lower or stay low. Aren’t you worried about pipelines not having anything to run through them?
We don’t believe for a second crude oil prices will “stay low”, and we certainly don’t believe low prices mean low volumes. We think people like more of “stuff” when the prices are low (and the producers seem plenty capable of getting their production costs in line, don’t they?). But that is not the story of MLP pipelines – crude oil volumes. It is the media’s story, and the short seller’s story, but it is not the entire economic story. Natural gas, and natural gas liquids are the story, and will be for years to come in our humble opinions. Just take one natural gas liquid – propane – and look at its volume growth in the last five years. How does that propane get exported? The answer: Pipelines transport it to export facilities out of production spots. MLP pipelines.
Do you have fears about residential real estate?
Not for those buying well-priced homes and planning to live in them for a long time. But for the 5% of homes in Q3/2015 – yep, 5% – that were “flipped” (up front 1% in Q3/2012, but nowhere near the 11% from Q3/2006), we would not be so sanguine. The “flipping” phenomena at a 5% of volume level is not indicative of a healthy market. We are paying attention.
Quote of the Week
“Fear has a greater grasp on human action than does the impressive weight of historical evidence.”
– Peter Bernstein
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The above quote from Bernstein is not so much a criticism but a reality. We have tried to use this commentary more and more over the years to focus on the behavioral realities of finance. Behavioral economics matters because your own behavioral decisions affect your portfolio outcome, but also because other people’s behavioral decisions affect your portfolio. We cannot ever ignore this reality, and we work really hard to make sure the implications of it are factored into what we are doing on behalf of our clients. Our philosophy is un-phased by noise, unaffected by headlines, and unconcerned with hysteria.
If my opportunities continue to grow in various press outlets, my agenda will be to always share the unvarnished truth – an investment philosophy rooted in immutable truths – and never to generate emotional responses out of short-term and highly fallible market outlooks.
We wish you all the very best week. May USC take care of business with Arizona, and may you enjoy the recent time change as much as I do. (I am a morning guy, and also, we can now put our kids to bed earlier and lie to them about that time it is.) =)
Originally posted on HighTowerAdvisors.
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