Positioning for a Year-End Rally

Our thoughts and prayers go out to the victims of the terrorist events in Paris.

It’s been a while since my last blog posting. We have been quite busy revamping our precious metals trading platform and are now running the hedge book for some of the largest precious metals recyclers in the country. Exciting opportunities indeed but we wanted to take the time to write about the current market conditions and our strategy heading in to the year end.

Third quarter earnings season is winding down and the results in my opinion haven’t been all that stellar. Earnings contracted almost 2% year over year and revenues declined 4% year over year which marks the second and third consecutive quarterly declines for those items, respectively. Analysts are expecting year over year declines for 4Q15 as well and will mark the first time for three consecutive quarters of year over year declines dating back to late 2008 and early 2009. Not exactly a bright picture but the market has largely brushed off this phenomenon.

As of the end of October, the S&P 500 twelve month forward earnings estimates are $125.32 according to Bloomberg consensus. The book value per share for the index is $742.99 and the cash flow per share figure is $183.62. If we run a value variance over the past business cycle we come up with differing price targets for the index using the three aggregated financial statements.

On the earnings front, the current earnings yield for the index is 6.1% compared to 7.2% over the past business cycle. This gives us a fair value of for the index of $1732 using the income statement. The current book value yield (using the trailing twelve months) is 3.6% compared to 4.1% over the past business cycle. This gives up a fair market value of $1794 for the index using the balance sheet. Cash flow yield for the index is 8.9% versus 10.9% over the past business cycle. This gives us a fair market value of $1691 using the statement of cash flows. When we weight each metric based upon its previous accuracy in predicting future prices we find the income statement and balance sheet analysis provided the most accurate pricing data but the statement of cash flows certainly provided value in the analysis. A weighted average of the future price targets based on prediction accuracy provides us with a twelve to eighteen month price target for the S&P 500 of $1740. This leads us to believe the market remains overvalued to the tune of roughly 15%.

Given the amount of negative earnings preannouncements we have seen this quarter (roughly 75% of all forward guidance has been negative) and expected earnings, book value and cash flow trends appear to be topping and heading lower, this gives us a cautionary stance towards the market in the intermediate and longer term.

There has been quite a bit of evidence that the earnings profile is one that generally happens during economic weakness and in many cases economic recessions. The following chart taken from Business Insider shows the comparison of year over year earnings projections compared to U.S. leading economic indicators. Notice the divergence between the two figures of late.

Given the state of financial engineering of corporate America, earnings growth have been rising faster than revenue growth and margins are starting to appear to return to the mean. There have been numerous warnings that margin contraction is a precursor to economic downturns and outright recessions. According to Barclay’s (via Business Insider), “What's worse: This could be signaling a recession. “The link between profit margins and recessions is strong," Barclays' Jonathan Glionna writes in a new note to clients. "We analyze the link between profit margins and recessions for the last seven business cycles, dating back to 1973. The results are not encouraging for the economy or the market. In every period except one, a 0.6% decline in margins in 12 months coincided with a recession."”

Additionally, trends in corporate earnings don’t seem to be accurately tracking U.S. GDP expectations. According to the Atlanta Fed’s GDPNow, “The forecast of real growth increased to 2.9 percent last Friday after the employment situation release from the U.S. Bureau of Labor Statistics. It has since retreated to 2.3 percent as the forecast for the contribution of inventory investment to fourth-quarter GDP growth fell from -0.3 to -0.8 percent after Tuesday's wholesale inventories release from the U.S. Census Bureau and this morning's retail inventories release (also from the Census).”

Monetary Policy and Earnings

The likelihood of an increase in the fed funds rate at the Fed December policy meeting has increased dramatically in my opinion largely due to the strong employment figures in November, although one could argue the retail debacle of last week (soft retail sales and miserable results from traditional retailers) could alter their thinking somewhat. Either way, it still appears the Fed is leaning hawkish on its policy view. This would most likely continue to fuel the U.S. dollar off its mid-October lows and likely further dampen earnings results from those multi-national corporations here in the U.S. The following graphic from FactSet illustrates just how impactful the stronger dollar has been on corporate results. One can see that those companies with the greatest exposure to overseas markets have had the most difficulty managing their earnings and revenue trends.

 We are taking the assumption that the Fed will raise rates this year. The current research shows that the market tends to rise after an initial rate hike. The following graphic taken from Business Insider explains the relationship between corporate earnings, stock prices, market multiples and fed funds rates.

The problem with this analysis is that traditionally the Fed is forced to raise rates to stem an overheated economy, when economic growth and corporate earnings are rising and the threat of inflation is the key reasoning behind the rate hike. This time around is a bit different. The Fed seems determined to get off the zero bound policy and a resumption to a more normalized monetary policy in order to replenish its own monetary capabilities in the future as opposed to cooling an overheated economy. On the surface inflation, economic growth and corporate profits do not seem to be sizzling on the grill, in fact one can argue that these metrics are barely warm.

Our view is that the stock market will rally on the news of a 25bp hike in interest rates along with an exceptionally dovish statement by the fed. This will eliminate an uncertainty that has been hanging over the market for the past six to eight months and put this ridiculous 25bp concern to bed.  

Broader Economy

The two items I’m looking at last week is retail sales and transportation. Retail sales figures were soft and year-over-year the figures continue to decline.

The back to back earnings disaster which was Macy’s and Nordstrom drove retail stocks down to levels last seen in the market swoon earlier this year.

The Nordstrom earnings raised red flags for a few analysts. According to Business Insider, “And while weakness in retail seen over the past several years has been chalked up, among other things, to the shift in consumer habits from shopping in-store to online, Nordstrom's results are the ones that have analysts across Wall Street worried that something is wrong with the US economy.

"Tourism weakness, warm weather, a focus on experiences/entertainment, consumers purchasing big ticket items (autos/furniture), and the Amazon effect have all been excuses for weakness across retail over the past few weeks," analysts at Deutsche Bank wrote in a note to clients on Thursday.

But the firm noted that none of these excuses were used by Nordstrom, with the company "instead highlighting a meaningful slowdown in transactions across all formats, across all categories, and across all geographies beginning in August that has yet to recover."

Deutsche Bank added: "With a superior business model, in our view, that is half high-end dept. store, 30% off-price, and 20% online, this level of deceleration is a potential cautionary tale of the US consumer's health."”

Taken from the same article, “In its own note to clients, analysts at KeyBanc wrote, "We think we are either seeing the impact of one of the warmest fall selling seasons in recent history (more likely) or we are teetering on the precipice of a recession."”

Coinciding with the consumer spending concern has been the spike in the inventory to sales ratio.

The question always arises when looking at this figure, is the increase in inventory representative of slowing demand or a calculated increase in supply on improving demand assumptions. Given where we are within the retail space, my guess would be the former. This is further confirmed by the Cass Freight Index.

According to their analysis,

 

“Third quarter GDP growth was indicative of the economic headwinds facing the economy caused by the strong U.S. dollar (making U.S. goods 

less competitive abroad) and the weakening world economy. However, the consumer sector is rising to the occasion and continues to improve, 
providing the missing element to a full recovery from the Great Recession. Consumer spending has been bolstered by low inflation, 
especially with fuel prices; improving jobs creation; and stronger household purchasing power. In October, the Labor Department reported that 
271,000 jobs were added and the unemployment rate dipped to 5 percent. A report from the Labor Department showed new applications for 
unemployment benefits last week hovering near levels last seen in late 1973. Growth in durable goods spending (for long-lasting items such as washing machines and automobiles) continued strong, rising 6.7% in the third quarter. Inventory levels remain a looming 
problem as the Federal Reserve has been actively hinting that an interest rate hike is very possible in December. The combination of record 
inventory levels  and an interest rate increase will cause a significant hike in inventory carrying costs. This will most likely drive a drawdown 
much like the one we saw in 2009 and 2010. Expect freight to continue to trail off through year’s end. Retailers and wholesalers have ample 
supply for the holiday season, so imports and freight shipments should not strengthen considerably.” 
(Emphasis added).

So weakening corporate earnings and slowing economic growth continue to concern us as we press forward. Longer-term charts on the SPX are quite concerning. We are seeing a negative divergence between equity prices and the RSI (14) as we did in the prior two major bear markets. The MACD line (20, 35, 10) has passed through the signal line to the downside as in past bear market beginnings and the market seems to be in a topping process. We have been able to hold the 20 month moving average. A downside break from that level and a failed retest would surely be a bad signal for the market.

Short-term Trade

This past week we had sold (for profits) most of our existing short positions in the market. We have been largely outperforming the major indices in November after a softer than expected October. We took a more aggressive long position as the market sold off on Friday. While we are concerned about the long-term prospects for the U.S. equities, we do believe the market is now oversold and is due for a bounce into year end. While QE is off the table in the U.S., the rest of the world is utilizing it quite aggressively and we continue to believe that could be a tailwind for equities. We also believe, given the volatility of the market in the second half of the year, many large funds are underperforming their benchmarks. We do believe there will be a strong bout of window dressing on the part of larger funds and an ensuing “Santa Clause rally”.  We will use any weakness in the market from this point on to increase our long exposure in anticipation of a strong year-end rally.

Bottom Line: While we continue to believe that a U.S. economic recession isn’t on the horizon, we do anticipate continued slowing within our economy. Our longer-term view in the stock market remains cautionary and we expect to be active in both upside and downside trading throughout 2016. That said, we are taking an aggressive long stance into the end of the year in anticipation of a strong year-end rally.

 

Joseph S. Kalinowski, CFA

 

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