S&P Earnings – A Safer Market Commentary

With 95% of S&P 500 companies reporting Q3 earnings, year-over-year earnings are down 6%. It was the largest decline since Q4-2015.

 

 

So, why is the S&P 500 making new all-time highs as earnings decline?  One reason is that traders focused on the short term compare the earnings numbers to analyst projections. And analysts tend to set a low bar that leads to positive market responses.

In Q3-2018, quarterly Operating S&P 500 earnings were $41.38 and Reported earnings were $36.36. In other words, over the last year operating earnings have declined by -3.21% and reported earnings fell by -5.58%. At the same time the S&P 500 index has advanced by 7.08%.

It’s actually worse.

Despite the rise in the S&P 500 index, both Operating and Reported earnings have fallen despite the effect of substantially lower tax rates and massive corporate share repurchases, which reduce the denominator of the EPS calculation.

Steve Goldstein recently penned for MarketWatch

“Research published by the French bank Societe Generale shows that S&P 500 companies have bought back the equivalent of 22% of the index’s market capitalization since 2010, with more than 80% of the companies having a program in place.

The low cost of debt is one reason for the surge, with interest rates not that far above zero, and President Trump’s package of tax cuts in 2017 further triggered a big repatriation of cash held abroad. Since the passage of the Tax Cuts and Jobs Act, non-financial U.S. companies have reduced their foreign earnings held abroad by $601 billion.

This repatriation may have run its course, and stock buybacks should decline from here, but they will still be substantial.”

The problem with this, of course, is that stock buybacks create an illusion of profitability. However, for investors, the real issue is that almost 100% of the net purchases of equities has come from corporations.

Here is the important point – when markets grow faster than profitability, which it can do for a while; eventually a reversion occurs.

 

 

Stock Valuations Are Very High

With the S&P 500 making new all-time highs, it is getting harder and harder to find stocks selling at reasonable prices. That is especially true in the technology sector. This chart from Bespoke Investment Group shows that the current price-to-earnings (P/E) ratio—the most common measure of stock valuation—of the tech sector is in the 99th percentile of all P/E ratios over the last 10 years.

 

 

CAPE-5 is a modified version of Dr. Robert Shiller’s smoothed 10-year average. By using a 5-year average of CAPE (Cyclically Adjusted Price Earnings) ratio, it becomes more sensitive to market movements. Historically, deviations above +40% have preceded secular bear markets, while deviations exceeding (-40%) preceded secular bull markets.

 

 

Regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

 

Warren Buffet

What is Warren Buffet Buying?  Nothing….

Of course, if you are an investor looking for value opportunities in today’s markets, you may want to take a cue from Warren Buffett—founder, chairman, and CEO of Berkshire Hathaway. Buffett is considered the king of value investing, and his company is sitting on $128 billion in cash.

 

 

Buffett has been adding to his cash war-chest for over a decade. The company’s pile of cash is so big, there is enough money to buy all but the 50 largest public companies in the U.S. But the father of value investing clearly doesn’t see many good bargains in today’s markets. Of course, there probably are companies out there that offer good value, but they are just too small to make it onto Berkshire Hathaway’s radar.

Investors are advised – Be like Warren Buffett and his crew: You know, he’s buy and hold, he never sells! Oh, please. 

From The Motley Fool:

Here’s what Berkshire sold in the third quarter of this year:

During the third quarter, Berkshire sold some or all of five stock positions in its portfolio:

• 750,650 shares of Apple
  
• 31,434,755 shares of Wells Fargo. 
• 1,640,000 shares of Sirius XM. 
• 370,078 shares of Phillips 66. 
• 5,171,890 shares of Red Hat.

 

Slump in Global Trade

 

 

Good News for the Markets

• The Markit Manufacturing PMI showed further improvement in factory activity.
• Residential construction spending has been improving.
• Cyber Monday online sales hit a new record, rising almost 20% from a year ago.
• US households are saving more and reducing their debt.

Bad News for the Markets

• The inventories-to-shipments ratio remains elevated.
• The ISM Manufacturing PMI report was surprisingly bad, with key sub-indices coming in below market expectations (PMI below 50 means contraction).

 

 

 

• Investors who held German bank shares for 30 years have lost money.

 

 

• The seasonally-adjusted initial jobless claims declined more than expected.

 

 

• Household spending tumbled after the sales tax hike. Forecasters see a sharp GDP contraction this quarter.

 

 

Debt – Stansberry Article

Problems often appear in the credit markets before the stock market. Problems in the credit markets are contagious. Their problems spread to all parts of the economy. In this case, I’m talking about the corporate bond market… where the debt of corporate America is traded.

$10 trillion in corporate debt is at an all-time high…

It’s a high both nominally and as a percentage of gross domestic product (“GDP”). The next bear market will be triggered when the corporate credit bubble pops.

It’s a matter of when, not if…

The chart shows how many U.S. companies can’t pay their debt (the high-yield default rate) versus total corporate debt. Total debt is measured against U.S. GDP. The shaded areas show bear markets.

 

 

As you can see, the default rate (black line) normally rises and falls with levels of corporate debt (blue line), only on a slight lag.

That makes sense. As debt levels balloon, interest costs rise and many companies struggle to repay their loans. The most leveraged companies begin to default.

First debt rises, then the default rate rises. Notice that during credit crises, the default rate spikes higher than 10% and triggers recessions and bear markets (shaded areas).

But that normal relationship has broken down following the last financial crisis.

Corporate debt has ballooned to all-time highs. But the default rate hasn’t followed it higher. It’s still near historic lows. Except for a brief spike back in 2016 when oil and gas prices cratered, it’s held steady in the 1.5% to 3% range. Today it’s at 2.4%.

The central bank’s easy-money policies forced interest rates lower. Companies borrowed like never before. Their balance sheets are now bloated with debt. Ultra-low interest rates have kept defaults at bay.

But this disconnect simply can’t last. All the Fed has done is delay the day of reckoning for corporate America.

There’s only two ways this can end. Corporate debt must fall, or defaults must rise.

If you think companies will be able to pay down their debt on their own, you’re sadly mistaken. Except for a few tech giants, corporate America doesn’t have the cash to pay down its debt. The only logical way this can end is with defaults rising.

The debt’s credit quality is the lowest it’s ever been. Many “zombie” companies can barely afford their interest. They’re being kept alive by lenders willing to refinance their debt as it comes due.

These zombies can only pay off maturing debt by borrowing more. They’re completely dependent on the credit market. The willingness of lenders to extend credit to dubious borrowers is the only thing keeping this bubble from popping.

It’s important to understand that fear can take hold of the markets incredibly fast. Fear causes investors to sell without asking questions. Fear causes banks to tighten credit – a process that I’ll get into below – and it causes the credit market to dry up.

Fear can bring the entire “house of cards” down.

We saw a brief glimpse of what can happen last December. Investors worried that the Fed was raising interest rates too fast. Fear suddenly gripped the credit markets. Lenders started tightening credit. Not a single high-yield bond was issued that month.

Including investment-grade bonds, the number of new bonds issued was 92% lower than average.

 

 

The Fed saw what was happening and acted quickly. It quelled the fear by reversing its interest rate policy. Instead of hiking rates, it began lowering them. Since then, it has lowered rates three times from 2.5% to 1.75%.

It worked.

Sure, defaults are low today. But don’t be fooled.

The best way to see where the default rate is headed is by looking at the number of credit downgrades. Companies’ credit ratings are downgraded before they default. So the number of downgrades is a good leading indicator of the health of the credit market.

And this metric is telling us that trouble is right around the corner.

So far this year, credit ratings agency Standard & Poor’s (“S&P”) has downgraded 875 North American companies. That’s on pace for the most since 2009. It’s nearly double the number of downgrades in 2007 leading up to the last financial crisis. We estimate there will be 1,100 downgrades by the end of the year. Take a look:

 

 

In 2016, most of the downgrades were in the oil and gas sector. This time, it’s spread much more among all industries.

But it’s not just the rising number of downgrades that’s a concern.  Banks are tightening credit again.  That means they are demanding higher interest payments, greater credit protection, or worse, cutting off some companies’ credit completely.

Banks are the key to keeping the house of cards from falling. They are the foundation of most companies’ capital structure. They get paid first if a company goes bankrupt. And their loans are secured by company assets. So they don’t have to worry as much about enormous credit losses when a company defaults. They recover far more of their investments than most debt investors.

When banks tighten credit, they are protecting themselves. Everyone else suffers.

If a bank will no longer lend money to a company, no one else will.

The best way to gauge the level of fear about the credit conditions in our economy is to look at banks’ lending standards. Every quarter, the Fed surveys U.S. banks and asks how their credit standards have changed over the last three months. The central bank wants to know if they’ve tightened standards or have eased them, or if they’ve stayed the same.

All of this can be boiled down into a single number… the difference between the percentage of banks tightening credit and the percentage easing credit. If the percentage of banks tightening is higher than the percentage easing, the net score is positive. If the number of banks easing is greater, the score is negative.

In the latest survey for the third quarter, the score was 5%. That means banks are tightening once again. Banks started tightening in the fourth quarter of last year, but when the Fed started cutting rates this year as opposed to raising them last year, banks began easing credit.

But not any longer.

The latest Fed survey shows that despite the interest rate cuts, banks are worried again. That spells trouble. If banks are tightening when the Fed is dovish and lowering interest rates, that’s a bad sign. When banks tighten, defaults rise. And when defaults rise, stocks fall.

The chart below shows banks’ lending standards over the last 20 years as well as the default rate. Again, the shaded areas are bear markets.

 

 

You can see that when banks begin tightening – when the black line rises above 0% – bear markets often follow. That’s why it’s important to keep a close eye on this trend.

We’re already seeing rising defaults. The number of high-yield defaults is up 66% this year. There have been 58 so far in 2019 compared to only 35 defaults last year.

If this trend of tighter lending standards by banks continues, it will likely cause the corporate-credit bubble to pop.

I expect the trend to continue. There’s a new tailwind that will force banks to keep tightening credit. And it’s something that few people are talking about.

A new accounting rule is about to go into effect that will radically change the way banks account for loan losses.

Under the accounting rules in effect today, banks only record credit losses when it looks likely that loans will go bad. But starting next year, banks will have to record all expected future credit losses on their loans at the time they are made. They won’t be able to wait for loans to go bad.

This is a big deal.

It will mean many banks have to significantly increase their loan loss reserves, starting next year.

One major accounting firm called it “the biggest change to bank accounting – ever.”

The new rule will cause banks to tighten credit on the least creditworthy companies… those in the most need of credit lifelines. Many companies will be hung out to dry.

The ironic part of all of this is that the new accounting standard was born from lessons learned during the last financial crisis. It’s likely to be responsible for ushering in the next one.

 

2020 Stock Market Forecasts

 

 

Economists Expectations for the Timing of the Next US Recession

 

 

US Energy Independence

The U.S. has posted its first full month as a net exporter of crude oil and petroleum products since government records began in 1949. The nation exported 89K barrels a day more than it imported in September, according to data from the Energy Information Administration. Analysts at Rystad Energy predict the U.S. is only months away from achieving total energy independence, citing surging oil and gas output, and the growth of renewables.

Market Data

• Bad banks. The widely-watched BKX index of banking shares suffered a negative outside reversal day after hitting a high on Monday.
• Higher volatility. The S&P 500 futures had enjoyed a very long period of calm, going almost 2 months without even a 1% intraday dip. That ended on Monday (and continued on Tuesday).
• 4 months of contraction. Corporate insiders of varying stations are not very optimism on their prospects. Purchasing managers have indicated a contraction for four straight months, something we normally see during recessions or bear markets, not when stocks are hitting all-time highs.
• Fewer than 45% of stocks in the S&P 500 held above their 10-day average for the first time in more than 30 days.
• The ISM survey of purchasing managers continues to hover near its lowest level in years, even while the gain in stocks over the past 12 months is among its best in years. That is an unusual disconnect, with bulls and bears arguing about what it means.
• Different parts of the bond market are seeing vastly different treatment from investors. Riskier, lower-credit parts of the market are seeing low demand and heavy selling pressure while higher-rated bonds are being bid up to a record degree. This level of disparity has occurred only 3 other times in 25 years.