Updated 6/12/17 – It was getting to the point that I never thought it would happen. Just a week after I wrote piece titled “The death of the value investor,” the biggest cap and very overvalued top stocks of the S&P 500 got slammed. Is this the bell ringing? Is the most overcrowded trade in many years to be long the largest names in the NDX about to unwind? We’ll see. But at a minimum, it should be a wake up call that gravity exists in the stock market and human nature will never change, no matter how much central bankers want to have it otherwise. At the end of the day, Google and Facebook are advertising/media companies, Netflix is a movie channel and Amazon is a retailer in an extraordinarily competitive space and that happens to have a cloud business that while fast growing, will see margins fall in perpetuity. As the US economy is really showing its age, no economically sensitive company is immune. Auto sales are slowing, capital spending remains punk, retail sales even ex auto’s remain mediocre and loan growth continues to slow, particularly in the important commercial and industrial loan category. Most of the economic upside is coming from outside our shores, particularly in Europe. There is also now growing worry that the Trump tax agenda may be a 2018 event instead of in 2017 which could paralyze corporate decision making as they hold off on major decisions until next year. The front page of the May 30th WSJ is titled “GOP Bid to Rewrite Tax Code Stalls Over How to Offset Cuts.”
The earnings for Q1 saw a nice rebound y/o/y for S&P 500 companies with almost a 15% gain. But it was mostly from the energy and financial sectors and the sales derived from overseas for US multinationals. Looking at the profit picture on a broader perspective as seen in the National Accounts data released with the Q1 GDP revision, after tax profits with adjustments were higher by only around 4%. The difference is a muted US domestic picture because profit margins continue to contract because of rising labor costs. I cannot emphasize enough what a peak in profit margins means for corporate earnings as they rose to record highs in this recovery with the helping hand of lowered interest expense and the lowest share of the profit pie going to labor since WWII. That latter point is ending as is the former for many companies that borrow LIBOR based.
The Fed will raise interest rates this week and Janet Yellen in her press conference will likely express her hopes for another hike in September to be followed by quantitative tightening beginning in December. The question though is the yield curve is expressing a view now that they are concerned with the US economy’s ability to handle more rate hikes at this late stage of the economic cycle. This can be seen in 2s/10s spread which is BELOW where it was on election day. It is today at 87 bps vs the 100 bps where it stood on the day Trump won. The good economic news out of Europe also means the pressure is growing on Mario Draghi to again taper his QE initiative which he will most likely announce this September. Last week he was uber dovishness because it’s becoming apparent that he is very afraid to pull the plug so soon on this monetary madness. Just look at the sitting ducks European bonds are after all.
To repeat what I said two weeks ago, therein lies the continued risk for stocks. The removal of the proverbial punch bowl. The liquidity spigot is being toned down and this has potentially dramatic implications for stocks that are wildly overvalued based on a variety of metrics. These worries haven’t mattered because of the QE still rolling out of the BoJ and the ECB but as stated many times, there is less coming out of this spigot. There is also of course the optimism over what Trumponomics will bring but there is now a growing question as to when and to what extent this fiscal stimulus/reform will take place. As the timing issue continues to be a concern, it will help to slow down corporate decision making.
I’ve been saying for a while that valuations don’t matter until they do which is not a revelation to market watchers and investors but important to acknowledge. The question is always searching for the catalysts that make them matter. Was Friday June 9th the beginning of the end of this bull market? Who knows but at the least, a case of acrophobia finally afflicted the names we all know so well that the whole world seems to have piled into. There is no room for error here in US stocks. Valuations are extreme, the Fed is tightening policy and US growth is slowing. WATCH YOUR BACK.
I’m going to repeat my view that investors should look overseas for better opportunities. Emerging markets such as Brazil (EWZ), India (INDA), and South Korea (EWY) I believe provide better equity valuation opportunities. Brazil has had a rocky few weeks as President Temer’s position of power is now in major question due to bribe allegations. Temer has been very effective so far in pushing a more liberalized and fiscally prudent agenda and now that is in question. That said, I do not believe the country can reverse itself and I’m confident that the desire to root out corruption in this very corrupt country will remain to its long term benefit. I hold out hope that if Temer resigns, his replacement will continue with the needed reforms.
I’ve been bullish on Europe and that has worked out. I’ve particularly liked Spain (EWP) and Italy (EWI). Raise your hand if you ever thought of investing in Spain and Italy. The European bank sector should also benefit from the inevitable end to negative interest rates and QE in Europe at some point in the 2nd half of 2017 and into 2018. Within EWP and EWI includes the largest Spanish and Italian banks that have had a tough go and would benefit from an end to ECB extremism. There is now a love affair with European stocks so I now have one foot out the door and will recommend selling these ETF’s on any further strength. In case you missed it, Barron’s ran a front page story on European stocks a few weeks ago highlighting their attractiveness. That’s usually a pretty good sell signal. France remains intriguing with the political earthquake that Emmanuel Macron and his wide support now in Parliament as a business friendly attitude in a the heart of a welfare state might be game changing.
I will repeat this commentary on gold from my last Ideas piece with some changes: There is this persistent belief that gold is a safety play and I need to reiterate that it is not. It is just a currency that happens to be yellow, weighs more than paper and is really tough to get out of the ground. So, after the French election and the easing of worries that resulted, gold sold off. I told you to “Please ignore this reaction.” That was the right response as gold has broken above $1250 as the dollar trades poorly and many are questioning the health of the US economy. The gold/silver bear market ended in December 2015 when the Fed finally raised rates for the first time in 10 years. Gold was then $1050. Investors should be watching REAL yields, not nominal. The 5 yr REAL yield is around zero but still remains well below the +.43% when the Fed first hiked rates back in December 2015. The US dollar doesn’t trade well and I keep finding holes in the bull case. 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. 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. Earnings from AEM were excellent and the stock had a nice move higher last week. GG and NGD were fine but investors sold them off as they didn’t beat the estimates. Only algo’s would trade gold mining stocks on whether a company beats or misses earnings expectations as this is one tough business.
I continue to like agriculture and am playing it via POT, MOS and the broader MOO. POT reported much better than expected earnings last month and these two fertilizer stocks are really washed out. Demand is good and supply is getting under control. Mosaic took it on the chin after their earnings report but I believe many of the issues were only short term in nature. Two insiders believe the same thing as we saw some insider buying which is always a good sign. See my comments below on oil and oil stocks which I included under the ‘commodity’ section. Deere is a big component within MOO and they reported a much better than expected Q1 because of sharply higher demand from South America. Too many only focused on their North American business. In case you missed it, corn last week touched its highest level in a year and the CRB food stuff index closed saw its highest level since August.
The energy stocks are very interesting right now after getting crushed over the past few months. Until proven otherwise, oil remains in a $45-55 range while the stocks are assuming much lower prices. I like the oil services etf XES and COP and HP as two individual companies.
I stated this two weeks ago but will again. Here are some more statistics that I believe will eventually buoy corn and soybean prices which in turn will boost the ag stocks. The International Grains Council (IGC) has downgraded its expectations for global grain stocks at the end of the 2017/18 crop year by 12 million to a three-year low of 479 million tons. Relative to last year, stocks are expected to decline by 34 million tons, mostly due to a large supply shortfall in corn. This deficit might total 28 million tons after the IGC raised its estimate for global corn demand by 8 million tons but left its forecast for the global corn crop the same. According to the IGC, the increased corn demand is due mainly to the growing industrial use of corn to make ethanol in the US and starch in China. Also, China has implemented incentives to stimulate the industrial use of corn to reduce the country’s high inventory levels. The result of these factors the IGC forecasts will lower global corn stocks to under 200 million tons by the end of 2017/18.
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 and RCL reported great earnings last week and the stocks were up sharply. 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 believe all four reported good earnings and the stocks have performed well. As I never like to chase things, I’d wait for pullbacks to add but that pullback may only come with a broader market selloff.
I still like Cameco. Cameco (CCJ) is the world’s largest private miner of uranium. 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. 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. The CEO said this a few weeks ago in the midst of the tough conditions, “Six years is a long time to be in a down market. But that’s where it’s at. We can’t control the market; all we can control is how the company operates in it … We’re going to work our way through this.” Successful investing long term is buying things when the news is bad and there is light at the end of the tunnel. Chasing what everyone else loves is not investing, it is just momentum driven speculation.
Updated 6/12/17 – The rally in long end bonds is sending a clear message to investors. If the market could talk it is saying “The Fed rate hikes are slowing the US economy and will continue to.” Quantifying this, the US Citi Surprise Index this past week fell to a one year low. While Q1 GDP was revised up to a gain of 1.2% vs the initial print of .7%, Q2 GDP estimates have fallen. The Atlanta Fed GDPNow estimate is down to 3%. Should the Fed back off then from raising rates? I want to emphasize that the interest rate normalization process needs to happen because doing otherwise would just be repeating the mistakes of Japan but the timing of a more aggressive rate hike cycle could not have come at a worse time. The Fed is behaving this way because of their rear-view mirror obsession of two lagging indicators, employment and inflation.
I still believe the 35 yr bull market in bonds ended in July when a panic low in yields was reached right after the Brits voted to leave the EU. Levels were reached globally in yields that we may never see again in our lifetimes. I’ll argue that we’ll never see a 7 bps yield in the Japanese 40 yr. Today it’s around 1%. But, the path to higher rates will still be a lumpy one as the global deflationary trends of too much debt face and the progress of technology face off against the inflationary desires of central banks. My main worry with global bonds is the upward pull in yields due to central bank activity (or a reduction thereof) but acknowledge that a slow economy will be a natural suppressant to yields. Thus, stay in short term maturities. I don’t believe the reward of slightly higher longer term yields is worth the large potentially downside as central banks are less influential in the market.
Sovereign bonds, particularly in Europe should be sold. This is where I’m the most bearish as I believe European sovereigns are a train wreck waiting to happen. Corporate bonds are also vulnerable in the Euro Zone and in the UK as QE eventually ends there and these bonds trade at egregiously tight spreads. 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.
Updated 6/12/17 – As stated above, I remain a bull on some commodities. I remain on the sidelines with industrial metals until we get better clarity on the now shaky situation in China. OPEC agreed to a 9 month extension of its production cuts but I still think $45-$55 will remain the range in oil for now but which I think inevitably will be taken out on the upside as a result of the still large amount of capital expenditures being taken off line over the past few years. The news that OPEC and Russia will extend production cuts most likely protects the downside of that range. I like COP, HP, and XES (the oil service etf) as stated above. Energy stocks have certainly been a big laggard this year but there hasn’t been much change to the price of oil itself.
Gold and silver are currencies not commodities but I’ll refer to them in this section again (see equities). I continue to remain a huge bull and with the continued flattening of the US yield curve and poor performance in the US dollar, gold and silver have again perked their heads up. We are at a point that if the Fed keeps tightening policy, which they seem intent on doing, the US economy is headed for a recession as that is typically the end result of these cycles. To quote my good friend David Rosenberg, in the last 13 rate hike cycles, 10 put the US economy into a recession. This scenario should be great for the precious metals. If on the other hand the Fed either before this or during, backs off and then reverses themselves, that will be great for gold and silver as well.
Agriculture has lagged badly over the past 5 years on robust harvests but the demand side has been strong. I do think we might be on the cusp of upside in corn prices if the most recent USDA report is any indication as well as the IGC data I discussed above. To add to the IGC news, the USDA said “The global coarse grain outlook for 2017/2018 is for lower production, increased use and sharply reduced ending stocks…Global corn ending stocks are down from last year’s record high and if realized would be the lowest since 2013/14.” I like DBA and added CORN, the etf to my buy list two weeks ago. With respect to China’s voracious appetite for commodities but with worries about their debt bubble, I worry too on the demand side but belief the supply side has responded enough over the past year that any declines in prices will be muted. Corn has broken out to a one year high and the CRB food stuff index is at the highest level since August. Not many are paying attention.
Updated 6/12/17 – A month ago I said, “I’m sorry but the dollar just does not trade well.” It continues to trade badly. We have Trump slamming it only to have his Treasury Secretary give it a boost. We have Fed rate hikes this year but real rates are basically zero. And now the yield curve is really flattening which is a market indictment of how the US Treasury market thinks the US economy can handle those rate hikes. The BoJ, BoE and ECB are still dovish, albeit a bit less so, and the dollar still can’t rally. I’m still a seller of the dollar BUT with one caveat, the sentiment has gotten very anti dollar so we may be on the cusp of a contra trend rally. On any pullbacks though, I’m still a buyer of the euro (FXE) as the ECB takes its first step toward the exit door and the European economy right now is growing faster than the US. Mario Draghi is still very dovish but is finally beginning to acknowledge that inflation trends are moving up, the downside risks are basically gone and there is now even a discussion about when negative rates will start going up.
Two weeks ago I said this: “The BoE is done with expanding their balance sheet and will now only be maintaining its size but I’m going to take my chips off the table on my long pound trade (FXB) after nice move that took the pound from about $1.20 to $1.30. The UK economy seems very vulnerable here as inflation damages real wage gains and businesses lack visibility on what Brexit will look like.” We can now add the huge unknown with the UK economy and the Brexit process post election where Theresa May’s gambit to call an early election has backfired.
I still like Asian currencies, particularly the South Korean Won where the EWY stock etf will benefit from. I of course assume no war with North Korea which continues to be a nuisance. I also like the Singapore dollar (FXSG) as its cheap relative to the US dollar. The Chinese seem to be backtracking on its move to liberalize the trading of the yuan and the yuan has rallied sharply in response as they added ‘counter cyclical measures’ as a factor in determining its daily reference rate. At least for now, the Chinese have had enough with yuan weakness.