Updated 11/3/17 – Big cap tech dominated the news with both their earnings and stock market performance this past week. To see AMZN, GOOG, INTC and MSFT add so much market capitalization in one day was a sight to behold. The 4 grew its combined market value by $146b Friday which compares with the entire market cap of IBM at $143b. Amazon in particularly was up by 13% where they reported a sharp earnings beat relative to expectations but the $.53 quarter vs the estimate of .04 was no different than last year’s eps figure. Also, that estimate was more than $1.00 per share 3 months ago. Amazon reported a sharp decline in its tax rate and a microscopic operating margin number. I love Amazon the company as it’s an incredible source of value for the consumer but the stock is a different story.
What was also very interesting about Friday’s incredible rally was that it was again very selective. Notwithstanding the sharp rally in the NASDAQ, there was actually a rise in the number of stocks hitting 52 week lows. Also, we are seeing lower highs in the number of stocks touching 52 week highs. From my friend Helene Meisler after Friday’s close said, “The number of stocks making new highs on both the NYSE and Nasdaq could not even reach 200 on either exchange. Back in early October Nasdaq had 367 new highs and the NYSE saw 304 new highs.”
The point is, the market is becoming a more selective and that is something worth paying attention to but I acknowledge the divergences can certainly persist.
The other noteworthy event from last week was the expected decision on the part of the ECB to cut in half their monthly QE purchases beginning in January. To cushion the potential market impact, Mario Draghi bathed himself in dovish talk by not committing to a firm end of QE by September 2018, by saying again that NIRP will remain in place until 2019 and by threatening more QE if needed. He thus remains addicted and truly believes in the effectiveness of the policies he has embarked on. By weeks end, European bonds had rallied, the euro fell and most European stocks were up (except Spain). If QE ends in September, the ECB will buy 450b euros less of assets vs the current run rate. Add in the reduction of the Fed balance sheet of $450b from now until the end of 2018 and you have about $1 Trillion less of liquidity. This is a really big deal.
I do want to emphasize that in 2018, Fed QT will soon be offsetting the shrinking ECB QE and thus the liquidity flow will slow to a drip. The BoJ will still remain at it but even they are in a subtle taper as mentioned here many times.
Also, don’t forget the context of this tightening. It is with extraordinarily inflated valuations in just about everything. Another 3% rally in the S&P 500 would put the price to sales ratio at same level as in March 2000.
The stock market also remains drunk on tax reform. Don’t get me wrong, I want lower taxes in order to make America competitive again. I do believe it’s important for American business to get both regulatory and tax relief, particularly small companies as I am one of them. I began the year believing that the market action would be a tug of war between these hopes for business friendly policy on one hand and monetary tightening on the other. It’s clear that the former has won out for now but do not count out the latter as we enter 2018.
There is no question that earnings growth is a key component in determining the direction of stock prices and a lower corporate rate for many will lead to higher earnings (all else equal but where all else is not equal). But, everyone must have perspective here and understand that stock prices have flown much faster than earnings growth in this bull market, especially beginning in 2013. This is also referred to as multiple expansion. Central bank easing of course has been the main factor here as they essentially created an at the money put for investors. To quantify, over the past 5 years, earnings have risen by 30% (and goosed by stock buybacks, lower tax rates and reduced interest expense) while the S&P 500 is higher by 80%.
Q3 earnings reports have seen the typical beat rate of around ¾ of companies exceeding expectations. The positive is the increase in those reporting revenue beats and that has been helped by the weaker dollar and better overseas economies.
I’m a broken record so I’m sorry here. With respect to your US equity exposure, it’s time to be taking chips off the table or at least putting in stops depending on one’s time horizon. A longer-term time horizon is an investors best friend but a short one is now fraught with risk. Is this the end of the bull market? I’ve been burned before trying to predict and I know it’s a fool’s game but I will say again, central bank largesse is turning the other way. Don’t forget what got us here. Bottom line, monetary tightening will be the big story in 2018 and historically it’s what ends the party.
One last thing here. Sentiment is again extreme. According to Investors Intelligence, the Bull/Bear spread in its survey is at the highest level since 1987. Also, within the UoM consumer confidence index, on the question of whether the US stock market will be higher in 12 months (has been asked since 2002), a record amount said yes. The two previous highs were in June 2015 right before the August mini crash of the Chinese yuan devaluation and July 2007 before you know what.
I’m going to repeat my commentary on EM which thankfully has been a great investment over the past 2 years. While I completely understand that emerging markets will not be immune to any selloff in developed markets driven by central bank tightening, I remain a bull on many of these markets such as Brazil (EWZ) and India (INDA). I also like Vietnam (VNM). Emerging markets have had a great run this year, better than US markets but I expect outperformance for years to come both from a growth and valuation perspective. US stock markets have just pulled forward so much in terms of future returns.
India remains an exciting long term story as the benefits of Modinomics takes hold. There was big news this past week that took the Sensex to a record high and that was India announced its own version of TARP where $32b will be injected into the state banks as a recap of their balance sheets which suffer from high levels of non performing loans.
I remain bullish on Brazil and EWZ is trading at the best level in almost 3 years. Michel Temer has successfully passed two of the important three key legislative goals when he took office. The first one was limiting government spending to the rate of inflation in order to slow the excessive rises in debts and deficits. Just two weeks ago labor market reform passed and this is a major step in liberalizing the Brazilian labor market. Within the bill, companies would be able to more freely negotiate with employees directly instead of thru collective bargaining. Also, union members would not be forced to pay union dues which instead would be voluntary. Having the ability to more freely fire an employee for cause without major repercussions makes companies more inclined to hire which results in a net improvement in job creation. The third key piece of needed change is reform to the pension system by extending out retirement ages. It remains to be seen if Temer has enough political capital to get this done but he does keep avoiding every accusation thrown at him. The country is coming out of its two worst recession years since the Great Depression in the early 1930’s and many are still down on the Brazilian market. The Brazilian economy in Q2 grew on a y/o/y basis for the first time since Q1 2014.
I think we are beginning to witness a major change in gold stocks and something that has been prevalent in equity markets in general. That is buying on the dip. Gold traded back below $1300 the last few weeks as the US dollar got a bid on the very dovish stance of the ECB. I do though believe there is a new bull market underway here people and it’s time to get on board if you are not. If you have ridden thru a tough couple of years, the worst is now over. I expect gold prices to resume its upward path because of low real rates and continued poor performance of the US dollar. I’m hoping we are on the cusp of the next leg higher in the precious metals because it seems that the fundamentals are coming together. I remain very bullish on gold and silver.
Keep in mind, central bankers will tighten us right into the next recession and bear market and will quickly halt and then reverse the process. That is when gold and silver really explode higher. In the last 13 rate hike cycles by the Fed since WWII, 10 put us into a recession. The gold idea can be played via PHYS, SLV and the miner etf GDX. As for the individual miners, I like GG, AEM and NGD in particular. All three reported good Q3 earnings reports this past week. If I am correct that a bull market in precious metals is now getting into gear, I expect them to take out the 2011 highs in the few years to come. That’s what bull markets do.
I continue to like agriculture and am playing it via POT, MOS and the broader MOO. What I thought was a possible trend change last month in agriculture prices, particularly wheat, corn and soybeans turned out for now to be a head fake as prices have since come back down again on better weather and more overseas supply. After closing at a one year high, the CRB food price index has pulled back about 10% but has since bounced. I still believe we are potentially seeing the beginning of the next bull market after 6 years of a bear as pieces are falling into place. The global demand for food is on a perpetual rise so it’s always the supply side that helps to drive prices. Also, ending stocks for corn and soybeans have fallen recently as demand is beginning to ‘eat’ into the supply of robust harvests seen over the past 5 years. The 2017/2018 harvest may result in the first fall in ending stocks for corn since 2010 and 2011.
Oil is now above the midpoint of the $45-55. Oil stocks finally have lifted with XLE bouncing off the lowest level since April 2016. The aftermath of Hurricane Harvey in addition to pretty solid global demand for oil and falling inventory levels have been the main catalysts. As I don’t see much more downside as I truly believe that progress is being made on the supply side, I am holding on to COP and HP as two individual companies. Both pay good dividends and have had good rallies off recent levels. I added a new recommendation in early July, Williams (WMB), the large natural gas pipeline, gathering, processing and storage company last month. They own a large stake in the MLP Williams Partners which generates almost all of its revenues from fee based, toll booth type activity. Natural gas continues to take market share from coal and exports of LNG are becoming a large business. A few insiders, including the CEO, recently bought stock and I love that as an endorsement of current levels. Williams also pays a dividend of almost 4.5%. If there is a down and out sector outside of ag, it is energy.
As for individual industry themes, I continue to like the cruise line stocks as a play on an aging population globally and an emerging market (particularly in China) that is getting wealthier and who want to see the world. CCL and RCL are the best way to play this. The cruise line stocks saw a pullback because of the aftermath of Hurricane Irma where some business was lost. There is also some fear that terrorist concerns are impacting travel plans. These are short term concerns that shouldn’t impact at all the long term positive secular trends and the stocks have bounced back. Carnival in particular had a great quarter announced a few weeks ago but lowered guidance in response to the hurricane as was expected.
I remain positive on Las Vegas Sands (LVS) and Wynn Resorts (WYNN) as a great way to play the rebound in Macau and the rise of the Las Vegas of Asia.
I still like Cameco. Cameco (CCJ) is the world’s largest private miner of uranium. They reported a disappointing earnings report this week but the industry right now sucks. It is very challenged and that should surprise no one. CCJ still is able to generate free cash flow and the stock is paying a dividend yield above 3%. They will have huge upside leverage when this cycle turns, which it will. The uranium market has been in a tailspin since Japan shut down every single one of their reactors after the Fukushima disaster a few years ago but some Japanese plants are coming back online with about 9 expected to be operating by year end with 5 currently open. Why like this stock now? The entire industry is underwater in that it costs more to dig it out of the ground than it can be sold for. Production is being cut and very slowly Japan is beginning to bring on more reactors online. At the same time, China and India are voracious builders of nuclear power because it’s safe, clean and a great source of stable power in big size. In total worldwide there are 57 plants under construction on top of about 450 on line.
General Electric reported an earnings report that dramatically reset expectations lower and they put on the block up to $20b of assets including their transportation business (locomotives, rail). This company remains very challenged and the new CEO seems very intent on right sizing this conglomerate to further focus its businesses. The earnings bar has been lowered sharply, the dividend is now in question and the terrible action in the stock certainly reflects this. I remain positive on GE for those with a long term time horizon. They have dominant positions in aviation, oil and gas, energy (natural gas turbines and wind), and healthcare equipment.
I added a new recommendation not long ago, Johnson Controls (JCI). It is an industrial company that is mostly focused on commercial building management. They provide everything from HVAC products and services, to fire, safety and security. The stock trades at 15x earnings with a 2.5% dividend yield. An earlier than expected CEO change helped to boost the stock over the past few weeks but the potential cash flow turnaround is large and the new CEO is the man to deliver. We also have the higher likelihood that the company spins out its Power Solutions business which is a division that produces car batteries. This is a very consistent business but doesn’t fit strategically with building management.
I added AES, the global utility company, to my buy list last month. It is global because they currently do business in 17 different countries via regulated units and independent power producers. They have revenue of $15b and back in February announced the acquisition of sPower, the largest independent owner, operator and developer of utility scale solar assets in the US. The US utility group is trading a historical high P/E ratios near 20x. AES instead is trading at about 11x with a 4% dividend yield. It is a value play for a company that is shifting its focus on natural gas, wind and solar as the predominant forms of energy production. They have and will continue to cut debt in hopes of achieving investment grade status in the next 3 years.
I’m going to add another recommendation, Hewlett Packard (HPQ). What attracts me to this story is their growing 3D printing and graphics printing business. 3D is a potentially transformational technology in so many different ways that could literally upend manufacturing techniques. I expect HPQ to be a major player here. The PC business is challenged from a secular standpoint but as the biggest manufacture, it generates a large amount of cash as does the conventional printing business. The stock trades at just 12x earnings and pays a dividend yield of about 2.5%.
Updated 11/3/17 – I’m going to repeat something I said last August/September. I believe the lows in global bond yields seen last summer after Brexit will never be seen again in our lifetimes. You will never see a 7 bps 40 yr JGB yield. You will never see a -.20% German 10 yr bund yield and you will most likely not see a 1.35% US 10 yr yield. Thus, I believe the 35 year bond bull market ended in July 2016. The only question is what happens from here as this could be a multi year and maybe a multi decade process and rise in rates.
I say this again after the ECB announced a 50% cut in its QE purchases beginning in January at the same time the Fed will keep on raising rates and get deeper into QT. Also of note, the CRB commodity index is trading at a 5 month high.
After a 10 year low in the yield spread between US 2s/10s, the yield curve did steepen a bit over the past few weeks but in the face of all the optimism about global growth we still have to wonder why It’s as flat as it is.
As I’ve said many times, the European bond market, both sovereign and corporates, are in an epic bubble and as goes European yields, as might go US yields. Throw in of course Japanese JGB’s and we’re all in this bubble together. I’ll call right here AGAIN that the next Big Short is the European bond market. European bonds got a reprieve this week after Mario Draghi’s dovish tapering announcement. But, I believe this is only a temporary reprieve.
The Bank of England will hike rates by 25 bps on Thursday. It’s time to at least take back the emergency rate cut they initiated after the Brexit vote. Falling real wages because of 3% inflation is making UK citizens poorer because wage growth remains modest. If wages rise in line with inflation, that is tolerable. If inflation rises without a commensurate rise in wages at the same time savers are earning zero on the savings, that is a destruction in people’s standard of living. The BoE is paralyzed by Brexit and has now a stagflation problem on their hands. Retail sales plunged in October and the BoE should continue to raise rates until inflation starts dropping. That is their mandate and low/stable inflation is the precursor to healthy growth.
With respect to the Fed, QT is underway. As stated before, the sucking sound of liquidity leaving the financial system will be modest at first but will get louder as the quarters progress. The Fed seems to believe that QT will be a smooth, boring, ‘watching paint dry’ type process. I think they are delusional but it’s that belief that will cause them to move forward. I want to be clear, this process must take place. The Fed must remove themselves from bullying and manipulating our markets but this will be highly disruptive to asset prices and the economy. A recession will most likely follow. As for when the next rate hike might come, it’s looking highly likely to be in December. The Fed still expects another 3 in 2018 but the fed funds futures is only pricing in about 1 ½ more (which happens to be an increase from ½ of one).
Sovereign bonds, particularly in Europe should be sold. This is where I’m the most bearish as stated and have been as I believe European sovereigns are a train wreck waiting to happen. Corporate bonds are also vulnerable in the Euro Zone. The yields on European junk bonds are about the same as the US 10 yr Treasury note. Let that sink in for a moment. US corporates are very expensive with corporate debt levels relative to cash flow at historic highs. Spreads are very tight with little room for error. Stay short HYG. Further monetary tightening on top of a slowing US economy is not a good combination for high yield. As for investment grade, the yield spread to Treasuries is now down to 100 bps. Tight!!!
As for US Treasuries, they got pushed around this week by the rally in European bonds (US yields lower) and the decent economic data reported with durable goods improving and Q3 GDP surprising to the upside (although there were holes in this report with a sharp drop in the savings rate and big rise in inventories).
Stay short BNDX. It’s the Vanguard Total International Bond ETF. I reiterate my call two weeks ago to get short TLT or buy TBT or TBF.
Updated 11/3/17 – As stated above, I remain a bull on some commodities. I’ve recently been on the sidelines with industrial metals until we get better clarity on the economic situation in China. I did catch much of the industrial metal move off the 2015. I’m particularly intrigued by copper again as demand is now coming from new emerging sources. I do think there is progress being made on the supply side and One Belt, One Road initiative will result in voracious buying of industrial metals in coming decades.
Oil is now at the upper end of the multi month range of $45-55. See above for more comments. Longer term, I’m no fan of oil as the rate of growth in its global usage should continue to slow as alternatives gain greater share. In the median term (1-3 years) however, there is a lot of long term supply that is being taken out of the market and I believe oil has one last bull run left in it in coming years. Bottom line, below $40 I’m a buyer of oil, above $60 I’m a seller.
Gold and silver are currencies not commodities but I’ll refer to them in this section again (see equities for more color). I continue to remain a huge bull and you can see my arguments above. Gold and silver prices were awoken from their stupor and gold is now at a one year high. It was nice to see gold back above $1300 earlier this month which again put it above its 50, 100 and 200 day moving averages but has since dropped back again in response to the US dollar bounce. I believe the gold/silver bear market ended in December 2015.
Agriculture has lagged badly over the past 5 years on robust harvests but the demand side has been strong. As stated above, wheat, corn and soybean prices spiked a few months ago and have since moved lower again. I still believe though that a trend change might be upon us. I like DBA and added CORN, the etf to my buy two months ago. In July I added SOYB, the soybean etf. China has recently ramped up their imports of soybeans and demand for soybeans are at a record. The global demand for food is on a one way trip higher. The CRB food stuff index has corrected and the space remains frustrating but I believe this is part of a major bottoming process.
With my bull case for Cameco listed in the equity section, I also like uranium but that is just easier to play via CCJ.
Updated 11/3/17 – The US dollar has bounced a touch, mostly vs the euro after Mario Draghi’s press conference on Thursday. The euro definitely has its challenges, especially in light of the problems in Spain with the Catalonia region wanting its independence that resulted in Rajoy stepping in to rid Catalonia of its government. We also have the issue of policy divergence where the Fed is shrinking its balance sheet and will be still hiking rates while the ECB clings to NIRP and is still buying assets. I’ve been bullish on FXE for a while but has pulled back this week. Let’s put a $110 stop on it to lock in a profit if it gets there. I’m a secular bear on the dollar but have acknowledged over the past month the possibility of a contra trend bounce.
We’ve also had 4 rate hikes from the Fed, a 5th one likely in December and quantitative tightening is underway and even this can’t boost the US dollar much as REAL rates are still subdued. I too believe the market is getting worried about US economic mediocrity at the same time we are seeing this tightening along with the uncertain political situation. If growth accelerates due to tax reform and Fed tightening speeds up, I’ll reevaluate. But, while the BoJ and ECB are still dovish, they are a bit less so with a subtle tapering going on with the former and the announcement from the ECB that QE will be cut in half. I expect the US dollar to trade much lower from here against a broad basket in coming years.
I still like Asian currencies, and have been a particular bull on the South Korean Won which has traded well this year. With my recommendation a few months ago to sell EWY, I’ll also say to sell the Won and take profits. I still like the Singapore dollar (FXSG). The yuan is particularly tricky here as while I’m hugely bullish long term on China, I still am worried about the short term implications of their large debt build up that they are so desperately trying to deal with but at the same time not wanting it to impact growth. The 19th Party Congress ended with leaving no doubt as to who is in charge.
I still like the Canadian dollar (FXC) as its benefiting from the rise in commodity prices and the BoC had the guts to at least take back the two emergency rate cuts they implemented after oil prices collapsed in 2014 and 2015. Also, the BoC never fell for the drug that was QE. Kudos to them. The Canadian dollar did lose momentum this week after the BoC expectedly did not hike again and basically said they are on hold for now but the rise in commodity prices which I think will continue, will be a boost.