U.S. profit margins appear to be rolling over or topping near record levels and earnings estimates for 2015 have moved lower as 2014 has progressed. Corporations have been buying back stock at a high rate to manage EPS damage, while many executives are selling large chunks of personal holdings. IBM has been a prime example for years of a company with sluggish revenue growth coupled with a big shrinkage in its shares outstanding, boosting EPS. That combination worked well until it finally became quite apparent last quarter that that it can only mask its difficulties for so long. The Fed will not be making IBM shareholders whole and QE did not prevent losses. We will be seeing more stories like IBM’s because many corporations have relied on the same strategy.
Markets away from stocks do not paint a rosy picture. Longer-term bond yields and commodity prices are still pretty clear in their expressions of growth doubts. Copper and iron ore prices point to the still weakening Chinese real estate market. Credit spreads indicate much more caution in corporate bond land. Most economic data is not at all inspiring. Our third quarter GDP growth owed its surface strength to a major increase in defense spending and slowing imports. We may be adding jobs at a nice clip, but the quality is poor and labor force participation is still alarmingly low especially when one considers that this was supposedly what the Fed was trying to ameliorate. Once again, in spite of robust soft surveys like the ISM, actual U.S. industrial production printed at -0.1% for October as auto production is now slowing after the sub-prime lending induced binge earlier in the year.
After all of the money printing, real final demand at the consumer level is still so demonstrably weak if one listens to any major retailer’s quarterly conference call. Macy’s, Dillards, Kohl’s, Sears, J.C. Penney, and TJX are all telling the same basic story if one bothers to listen: a lot of people are living paycheck to paycheck. Even Amazon, the retail growth darling (with a hugely overvalued stock), saw weaker performance than its investors had expected. However, in a clear sign of the speculative nature of the current environment, a number of retailers’ stocks rallied strongly after guiding lower for coming quarters. You gotta love the Fed!
The U.S. has obviously been riding an energy production boom in recent years thanks to hydraulic fracturing (fracking). We encourage you to think of energy production as the housing construction industry of this cycle. Like the home building bubble created by the central planners and the Fed from 2003-2008, fracking is another endeavor granted favor by the deciders who also crushed the coal market to give it a boost. An enormous amount of debt has been raised to fund the undertaking including a major portion in the junk bond market. Wall Street profited handsomely in the capital raising process, of course. Sound familiar?
In recent months, oil prices have been crushed to four-year lows because demand is just not able to match the massive increase in domestic supply. Too much cheap money was thrown at the energy sector and predictable imbalances have occurred. In recent weeks, the equities of many producers have been decimated. Capital spending budgets for next year are being trimmed as a result. These capacity gluts will hit suppliers and other sectors as well. When many capital expenditures decisions in energy were based on the unnaturally low hurdle rates derived from a zero-bound monetary policy and printed dollars, you got entirely too much capacity. Because the energy industry was a significant contributor to our GDP in recent years, oil below $80/barrel will have a meaningful dampening effect on the industrial production side here in coming quarters, which will likely not be overcome by any relief for consumers at the pump.
The oil industry is likely just the first crack to become apparent. We go back to what we discussed last month. Six years into an ill-advised effort at escaping the crash from the bursting of the last bubble it created, the Fed has gotten the world even more totally addicted to cheap dollars. Now, by supplying a world that is short dollars even fewer of them by ending QE, the Fed is creating a gigantic margin call. Current dollar strength is a crushing blow to many global borrowers. Trillions of dollars have been borrowed across the globe for all kinds of purposes. Businesses in emerging economies that were drowning in dollars and spending like mad are being forced into a more scarce dollar environment. Sustainable growth has not arrived and it is difficult to know what has been organic economic activity and what has not. We think that the pricing of treasury bonds, oil, many commodities, and precious metals markets are reflecting the end of the QE sugar high, while stock indices have yet to discount reality.
If we are wrong on stock valuations being historically extremely overvalued and are cautious as result, then why must a central banker somewhere open his or her mouth to jawbone equities higher every time we have the sort of correction that used to be natural until the closing level of the S&P 500 became the determinant of job performance for the Fed and other central planners? This will work as an index prop until it does not. Regardless, the IBM-effect will likely overtake enough stocks that investors no longer view the indices as a no-lose proposition.
Though the chorus of QE doubters and dissenters inside and outside the central banks and governments seems to be growing louder, equity investors have renewed their faith and commitment for now. With speculation being the dominant force driving stock markets and fundamentals pushed aside, we have mostly remained on the sidelines from a trading perspective in recent weeks. Does anyone besides us question the pundits who advocate aggressive allocations to equities at the same time a monetary policy that would have been considered the work of the lunatic fringe is enacted in a major global economy that will likely only slow its demise? Do many of these pundits discuss that stock valuations are twice normal price/sales and price/GDP measures and that bullish market sentiment is also off the charts?
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.