Saturday, November 29, 2014

What "Might" Happen When the Fed Raises Rates?, Why Buy Europe, A Global Economic Game-Changer, and Your Weekly Update...

Piggybacking on the work of Wells's Jim Paulsen, I have run some charts of my own confirming that price to earnings (P/E) multiples tend to contract measurably during Fed rate-tightening cycles---and that the stock market has historically run into trouble at the onset of such cycles. However, it is not unusual for the market to recover early and march higher as the Fed continues to raise rates (those are the charts the bulls are trotting out these days). 

Here's one of my charts (I apologize for its busy-ness). The dark blue line represents the P/E for the S&P 500, the light blue line represents earnings per share and the purple line represents profit margins: click the chart to enlarge

Fed tightening cycles
The declining P/E is warranted given higher interest rates. Accelerating profits during some of those cycles (when the market held or advanced) effectively offset the potential fallout from lower P/Es. During a Fed tightening cycle---when P/E's are declining---and profits aren't rising, stock prices will come down hard. My concern this go-round is that profit margins have been expanding, virtually non-stop (note the purple line and white arrows on the graph), for 5+ years and the Fed has yet to begin tightening. Which they generally in the past have done earlier in the profit cycle. On this observation, by itself, we should expect a significant correction to occur when the Fed begins raising rates.

However, there is a counter argument to be made that, by itself, may not avert a 10+% correction, but should provide some comfort to those who fear that the next great bear market lies just around the next turn. The U.S. economy has just begun to accelerate at a pace worthy of your typical expansion. Companies are holding large cash positions, commercial and industrial loan issuance looks healthy, commercial paper issuance is up off its low in March and commercial paper rates remain extremely low. The corporate financing gap (non-residential fixed investment vs corporate profits, i.e., the amount companies must finance for capex [capital expenditures... i.e., investing in plants and equipment]) sits ($87 billion) way below the long-term average of 2% of GDP ($350 billion). Which means there's plenty of room for capex spending going forward. Which leads to economic growth, jobs and future profits. This would be one (there's more) legitimate bull case amid the coming Fed tightening cycle.

All that said, my suspicion (a suspicion, mind you, is not a prediction) is that the Fed will induce a healthy 10-20% pull back in U.S. stocks, should they begin tightening, as expected, during the second half of 2015. But being that great bear markets are things of recessions, and that your conventional pre-recession warning signs in the U.S. are virtually nowhere to be seen, I would be surprised if the U.S. stock market begins a prolonged 20+% sell-off next year. But it absolutely could happen...

I don't anticipate taking any unusual measures, at this juncture, going into next year based on the above. I do, however---as I suggested last week---believe we would be well-served to take advantage of present dynamics in other parts of the world and rotate some of our portfolios away from the U.S.---and into places such as the Eurozone (assuming you're not sufficiently there already).

Here's more on the Eurozone's prospects:

While, granted, the Eurozone economy looks shaky at best, we are beginning to see a few tiny green shoots. Primarily from recent sentiment indicators. Back in March of this year Markit's Composite PMI showed the Eurozone economy growing at a 32-month high pace. Since then things have retrenched. I believe much of the early-year optimism was effectively squashed by the Russia-Ukraine conflict. Although, as I said, there are signs that sentiment is beginning to improve.

In terms of monetary policy, clearly, the ECB---unlike the U.S. Fed---is far from engaging in anything other than further easing in the year ahead. Making for a friendly stock market environment, barring a new recession.

In terms of profit cycles, the Eurozone---unlike the U.S.---is currently nowhere near peak profit margins. And while the S&P 500 Index is trading at 15.9 times next year's earnings (not, btw, scary) the MSCI Euro Index is trading at a P/E on next year's earnings of 13.5. The Eurozone also looks more attractive when we consider price to book value, 1.5 versus 2.7 for the S&P 500.

On the oil market (given last week's action, I have to comment):

Wow! If you had told me back in January that oil would be trading where it is today ($66/barrel for West Texas Crude, $70 for Brent), I bet I could've talked you out of it. And if you didn't buy my argument, I would've cited the predictions of the International Energy Agency, and a host of gurus.

Here's a chart, taken from the International Energy Forum's January 22, 2014 publication "A Comparison of Recent IEA and OPEC Outlooks": click chart to enlarge

IEA oil price estimate

The case I was making for energy at the beginning of the year had to do with my guess that where we sit in terms of the U.S. business cycle and the potential for a pickup in global economic growth would support the price of oil against increased North American production. And I was feeling pretty smart around mid-year, as the energy index ETF we use was up two-times the broader market. Today, alas, not so much.

To my, the IEA's, gurus galore and some very unhappy hedge fund managers surprise, the Saudi's aren't doing what the Saudi's do. That is, they're not supporting a falling price by cutting production. In fact, they're doing precisely the opposite: They're pulling it out of the ground at a pace that keeps the price far below their fiscal breakeven number (the number at which oil revenues support their national budget), $106/barrel in 2015. It appears that the Saudi's are hell-bent on gaining back market share by plummeting the price and maintaining it long enough to put the skids on all that North American production (Thursday's decision among OPEC members not to cut production led to a 10% rout of oil prices and a 6+% drubbing of our ETF on Friday). And they're, for now anyway, willing to run a deficit until they achieve their goal. How long can they do it? Well, technically, all things (current pace of production, price, and Saudi foreign reserves) remaining equal, I calculate somewhere between seven and eight years. Would they stick it out that long? I'd say no way. But a year or two could, at a minimum, do a number on future investment in North American oil production.

So should we scream bloody murder? Well, as investors in energy stocks, sure. But as investors in transportation, industrial and consumer cyclical stocks---and as consumers of oil---we should send them a big fat thank you letter! No kidding...

Now that last sentence suggests that what we're experiencing is a global economic game-changer, in a phenomenally good sense. But of course, if the above story is correct, a game-changer this ain't. If the Saudi's truly have the power to price the competition out of the market, ultimately we'll see prices shoot back up as all that production begins to leave the scene. No long-term game-changer there, just a game.

But there's another story to tell that indeed says we're experiencing a global game-changer. Perhaps this isn't about the Saudi's strengthening their grip on world oil, perhaps it's about the Saudi's losing their grip. Truly, given the huge increase in North American production capacity, OPEC doesn't have quite the influence on the price of a barrel of oil that it used to. As Nigeria's Oil Minister, Diezani Alison-Madueke, said after the OPEC meeting last Thursday:
“It’s a toss of the coin as to whether, if we had cut anything at this point in time, we would have seen higher prices.”

Business Insider's Tomas Hirst makes the case and illustrates the pain other less-wealthy OPEC nations are experiencing due to plummeting prices. Here's a snippet:
Previously, OPEC members would agree to cut oil production if falling prices posed a threat. That may now have changed because of the shale oil boom in the US, which has dramatically increased supply.
As Goldman Sachs wrote in a recent note (emphasis added):

"[There is a] realisation that the OPEC reaction function has changed and that the US shale barrel is now likely the first swing barrel ... When Saudi Arabia cut prices to Asia for November delivery it was interpreted as a shift in the Saudi reaction function to a focus on market share. This should have not been a surprise in the new world of shale that has flattened the supply curve, as economic game theory suggests that they should not be the first mover and that the US shale barrel should be the new swing barrel given how easily it can be scaled up and down."

This may explain Saudi Arabia's unusual hints that it is now comfortable with sub-$90-a-barrel oil prices — it doesn't want to admit that its power to shift the price is drying up.

Here's another:
Already this year Venezuela, Nigeria and Russia have burnt through billions of dollars in efforts to support collapsing currencies and flagging economies.

Russian international reserves have plummeted by $90 billion since the start of the year spent mostly in foreign exchange markets trying to prop up the rouble. Despite decades of commitments to diversify its economy, oil still accounts for 10% of the country's GDP and around 50% of federal budget revenue.

Morgan Stanley estimates that "every $10 fall in the oil price means a $32.4 billion fall in oil and gas exports, which is equivalent to about 1.6% of GDP" and around a $19 billion fall in government budget revenues.

Elsewhere Nigeria finally conceded defeat in defending its currency, with the central bank devaluing the naira by 8% and increasing rates sharply on Wednesday. Investors have turned against the currency as Nigeria imports around 80% of the goods it consumers with 95% of its foreign currency earning coming through oil exports. Falling oil prices means the cost of those imports has become a lot steeper.

And for Venezuela the situation is simply dire. According to state-run oil company Petroleos de Venezuela the country looses $700 million for each $1 a barrel decline in oil prices, a cost that the ailing state can ill afford. Adjusted for inflation the country's real GDP remains 2% below its 1970 level and, according to US academics Carmen Reinhart and Kenneth Rogoff, it is now all-but-certain to default on its foreign-currency debt.

Iraq and Iran are also vulnerable to sharp price drops. Production in the former at risk due to the threat of Islamic State militants seizing additional territory, including key oil infrastructure. In November forces loyal to the Iraqi government succeeded in forcing IS militants out of the Baiji refinery in northern Iraq, which the had earlier captured. These risks mean the cost of extraction and refining is high.

Again, lower energy prices---while they haven't helped our portfolio's relative returns this year (at all!)---are, save for the countries who rely heavily on oil exports, a boon to the global economy. As for the beaten up energy exposure in our portfolios, as long as we remain around 10% of equities (it's down to that after the drubbing), I'm not inclined to go chasing this falling knife. Sure, there may be an opportunity here, but 10% in my view is ample under the circumstances.

Here are last week's (US) highlights from my economic journal:

NOVEMBER 24, 2014

THE CHICAGO FED NATIONAL ACTIVITY INDEX came in below expectations, .14 vs .40. An index reading of 0 represents trend. Therefore, a positive reading represents growth above trend. October's disappointment lies in the rate of growth coming in below consensus expectations. The production component, specifically, with regard to a sharp decline in both mining and utility production, accounted for the lion's share of the disappointment. The employment component declined as well as payroll growth came in at 214k in October versus September's 256k.

MARKIT'S FLASH SERVICES PMI came in at a positive 56.3 (above 50 denotes expansion), however that's down from October's 57.1 final reading, and estimates of 57.8. The positives within the survey were employment growth and the business outlook, both at 5-month highs. Weighing on the number was growth in incoming work, now at a 7-month low. However, backlog accumulation remains strong.

DALLAS FED MANUFACTURING SURVEY'S BUSINESS ACTIVITY INDEX came in strong at 10.5, ahead of estimates of 9.0 and matching October's 10.5. THE PRODUCTION INDEX, however, came in noticeably lower than last month's reading, 6.0 versus 13.7. The continued strength in employment [amid mixed yet improving responses to other key components] among the majority of these anecdotal indicators supports my view that the U.S. economy is moving its way toward a better growth trajectory in the coming months. Here's the summary from the Dallas Fed :
Texas factory activity increased again in November, according to business executives responding to the Texas Manufacturing Outlook Survey. The production index, a key measure of state manufacturing conditions, fell from 13.7 to 6, indicating output growth slowed in November.

Other measures of current manufacturing activity also reflected slower growth during the month. The capacity utilization index fell sharply from 18.1 to 9.8. The new orders index also declined notably from 14.2 to 5.6, although more than a quarter of firms continued to note increases in new orders over October levels. The shipments index was 12.1, nearly unchanged from its October reading.

Perceptions of broader business conditions remained positive this month, while outlooks were less optimistic. The general business activity index held steady at a solid reading of 10.5. The company outlook index dropped from 18.2 to 8.8, due to a smaller share of firms noting an improved outlook in November than in October.
Labor market indicators reflected continued employment growth and longer workweeks. The November employment index posted a sixth robust reading, coming in at 9.6. Twenty-one percent of firms reported net hiring, compared with 11 percent reporting net layoffs. The hours worked index slipped from 8.3 to 5.7, indicating a smaller increase in hours worked than last month.

Upward pressures on wages and prices were mixed. The raw materials prices index fell from 19.7 to 15.3, its lowest reading in seven months. The finished goods prices index edged up from 7.1 to 9.7. The wages and benefits index was little changed, at a reading of 23.9, with 76 percent of manufacturers noting no change in wages and benefits this month.

Expectations regarding future business conditions remained optimistic in November. The index of future general business activity rose 5 points to 18.3, while the index of future company outlook held steady at 23.1. Indexes for future manufacturing activity held steady or improved in November.

NOVEMBER 25, 2014

THE ICSC RETAIL REPORT showed a pickup measurably last week. +2.2% vs the previous week. As I stressed, I fully expect retail results to come in very good this season. This indicator supports that view.

THE JOHNSON REDBOOK RETAIL REPORT showed a year-on-year increase of 4.2%, vs 3.9% the previous week.

THE FIRST REVISION OF Q3 GDP came in surprisingly better than anticipated. It was revised up to 3.9%, thanks to consumer spending and non-residential investment (among other things) , from the 3.5% preliminary reading. The consensus expected a revision downward to 3.3% (so did I)... Here's the BEA release:
Real gross domestic product -- the value of the production of goods and services in the United
States, adjusted for price changes -- increased at an annual rate of 3.9 percent in the third quarter of
2014, according to the "second" estimate released by the Bureau of Economic Analysis. In the second
quarter, real GDP increased 4.6 percent.

The GDP estimate released today is based on more complete source data than were available for
the "advance" estimate issued last month. In the advance estimate, the increase in real GDP was 3.5
percent. With the second estimate for the third quarter, private inventory investment decreased less than
previously estimated, and both personal consumption expenditures (PCE) and nonresidential fixed
investment increased more. In contrast, exports increased less than previously estimated (see
"Revisions" on page 3).

The increase in real GDP in the third quarter reflected positive contributions from PCE,
nonresidential fixed investment, federal government spending, exports, residential fixed investment, and
state and local government spending that were partly offset by a negative contribution from private
inventory investment. Imports, which are a subtraction in the calculation of GDP, decreased.

The deceleration in the percent change in real GDP reflected a downturn in private inventory
investment and decelerations in exports, in nonresidential fixed investment, in state and local
government spending, in PCE, and in residential fixed investment that were partly offset by a downturn
in imports and an upturn in federal government spending.

The price index for gross domestic purchases, which measures prices paid by U.S. residents,
increased 1.4 percent in the third quarter, 0.1 percentage point more than in the advance estimate; this
index increased 2.0 percent in the second quarter. Excluding food and energy prices, the price index for
gross domestic purchases increased 1.6 percent in the third quarter, compared with an increase of 1.7
percent in the second.

THE FHFA HOUSE PRICE INDEX showed price appreciation slowing in September, at 0% vs .4% estimate and .4% prior. Year-on-year prices are up 4.3%.

THE CASE-SHILLER HOME PRICE INDEX showed a little strength in September, up .3% versus a decline of .1% in August.

THE CONFERENCE BOARD'S CONSUMER CONFIDENCE INDEX disappointed in November. Coming in at 88.7 vs and estimate of 96.5 and a prior reading of 94.1. My view has been that the consumer, based on lower gas prices and an improving jobs market, not to mention recent equity market action, would continue to drive optimism higher. This reading contrasts, albeit slightly, with that view. Here's Lynn Franco, Director of Economic Indicators at The Conference Board, followed by Econoday's commentary:
Consumer confidence retreated in November, primarily due to reduced optimism in the short-term outlook. Consumers were somewhat less positive about current business conditions and the present state of the job market; moreover, their optimism in the short-term outlook in both areas has waned. However, income expectations were virtually unchanged and gas prices remain low, which should help boost holiday sales.

Positive trends are still intact despite an otherwise weak looking 88.7 November reading for the consumer confidence composite index, down from a downward revised but still a 7-year, recovery best of 94.1 in October. A hidden positive in today's report is little change in jobs-hard-to-get, at 29.2 percent which is historically low for this reading and up only a marginal 2 tenths from October. This reading, which is closely watched, points to steady and favorable conditions for the November labor market.

The jobs-hard-to-get reading is a subcomponent of the present situation component which in total, pulled down mostly by monthly declines in business conditions, fell 3.1 points to 91.3 to indicate month-to-month weakness in consumer activity -- not welcome news for the nation's retailers going into Black Friday.

The second component of the composite index, expectations, fell an even steeper 6.8 points to 87.0 which is the lowest reading since June. The decline here reflects declining confidence in future business conditions and some erosion in the jobs outlook. A positive, however, is strength in the key subcomponent for expectations which is future income. Optimism here held nearly steady. Income expectations turn mostly on the jobs outlook but also on the outlook for the stock market and the housing market.

The ongoing burst lower in gasoline prices is driving down inflation expectations which fell 1 tenth to 5.2 percent, a level that is very low for this particular reading and which will get the attention of Fed policy makers who have been voicing concern that inflation right now needs to turn higher.

This report, due to jobs-hard-to-get as well as future income, is not as bad as it looks, especially given the hard comparisons in the prior spike. The Dow is moving to opening lows following today's report. Watch for the twice monthly consumer sentiment report to be released tomorrow and whether it too will show a fall off from recovery highs.

THE RICHMOND FED MANUFACTURING INDEX showed a softening of manufacturing activity in the fifth region compared to October. Coming in at 4 versus an estimate of 16 and October reading of 20. The last sentence of Econoday's summary below accurately characterizes the recent indicators coming from the manufacturing sector:
Early indications on the November manufacturing sector, on net, point to monthly softness compared to October. The Richmond Fed's index is down very sharply this month, at 4 vs 20. Order readings are very weak with new orders essentially flat compared to October, at plus 1, and with backlogs in contraction, at minus 2. Shipments are also basically flat at 1 while vendor delays eased which is another sign of softness. But manufacturers in the region are still hiring, at 10 though down from 14 in October. Inventories are rising on plan and price pressures are mostly moderating especially for inputs. Recent data from the manufacturing sector have been no better than up and down, much like this report today.

THE STATE STREET INVESTOR CONFIDENCE INDEX declined slightly to 114, from 115.8 prior. The European component is up big time to a record 141.9, although the strength was centered only in the UK. Relatively weak North American and Asian sentiment effectively offset the strength in the European component.

NOVEMBER 26, 2014

THE MBA PURCHASE APPLICATIONS INDEX has been the definition of volatile of late. After a 12% surge in this index tracking new purchase mortgage apps the prior week, it dropped 10% last week. The 4-week average shows a negative trend.

REFINANCE APPS dropped .4%, after a .6% decline the prior week...

DURABLE GOODS ORDERS, while looking good on the headline number, showed underlying weakness in several key areas. If I had to zero in on one component as being key going forward it would be capital goods, ex-defense. Which showed a contracting of .8% for shipments and .1% for new orders. Year-on-year, however, showed increases of 5.0% and 9.7% respectively. In the aggregate, the month-on-month result, ex-transportation, was -.9%, year-over-year +6.4%... Transportation and defense orders are what essentially created the positive headline number. As I type, industrials ore off .23% on the day, while transports are up .04% --- the overall market's flat on the day.

WEEKLY UNEMPLOYMENT CLAIMS came in at 313k. The first reading above 300k in several weeks. There were no special factors cited in the report. The 4-week moving average (the metric to watch in this volatile series) is at its highest level since September, yet remains at an historically comfortable 294k. A positive was a decline in continuing claims which fell 17,000 to 2.316 million. The 4-week continuing claims number dropped 18k to 2.352 million. Lastly, and positively, the unemployment rate for insured workers dropped 1 tenth to 1.7%, the lowest level since 11/2000.

The consumer's situation continues to, albeit slightly, improve. THE BEA'S PERSONAL INCOME AND OUTLAYS REPORT for October shows personal income growing .2% month-on-month, 4.1% year-on-year... As for outlays, consumer spending grew .2% over September, 3.6% over the past year. And as for inflation, the Fed's favored indicator, the PERSONAL CONSUMPTION EXPENDITURS (OR PCE) PRICE DEFLATOR shows a core (ex-food and energy) increase of 1.6% over the past year. With food and energy inflation running at a 1.4% year-on-year rate. I wonder what the naysayers (I've been one myself) who complain about the core number understating inflation because it omits food and energy are saying now?? I should add, being that clients are now privy to these notes, that we should remain watchful with regard to inflation in the years to come---as global central banks continue to follow ultra-easy monetary policy... As for the moment, however, clearly, inflation is not a worry...

THE CHICAGO PURCHASING MANAGERS INDEX continues to signal a nice rate of expansion. Econoday sums it up nicely:
Chicago purchasers continue to report outsized rates of monthly growth, at a composite index of 60.8 this month vs an even greater outsized 66.2 in October. New orders fell 11.7 but are still at 61.9. Production also slowed but still remains robust while inventory growth slowed after October's 41-year high. One clear negative is a slowing in employment to its lowest level since March. It's hard to make much of this report where the readings are so high. Note that this report covers all sectors of the Chicago economy.

While Conference Board's Consumer Confidence Index (released yesterday) reflected a bit of waning optimism, THE BLOOMBERG CONSUMER COMFORT index climbed last week to its highest level since 12/2007. Which is much more consistent with my view with regard to the consumer going forward. Here's Bloomberg:
Consumer sentiment in the U.S. climbed last week to the highest level since December 2007 as Americans grew more upbeat about the state of the economy, their financial well-being and the buying climate.

The Bloomberg Comfort Index advanced to 40.7 for the period ended Nov. 23 from 38.5, according to a report today. All three components improved last week, with the gauge of views on whether it's a good time to shop rising to a seven-year high.
Labor market gains, record stock values and gas prices at four-year lows are boosting household sentiment in time for the holiday-shopping season. Fatter paychecks for lower-income earners would help households across all income brackets to make more purchases.

Another reading indicating that the consumer is feeling pretty good about life is today's release of THE UNIVERSITY OF MICHIGAN CONSUMER CONFIDENCE INDEX which increased to 88.8, its highest level since July 2007. Basically the same obvious drivers---stronger job growth, cheaper fuel, a rising stock market---are influencing consumer attitudes heading into the shopping season.

NEW HOME SALES disappointed in October, coming in at 458k, vs an estimate of 470k. September's reading was revised to 467k. As Econoday states below, this is a volatile series:
New home sales are soft but sellers are getting their prices, at least in October. New home sales came in at a lower-than-expected 458,000 pace vs 455,000 in September which has been revised 12,000 lower. August, which was originally reported at 504,000, has been revised down a second time, 13,000 lower in today's report to 453,000. The combined 25,000 in today's downward revisions paint a weaker-than-expected picture of the new home market.

This report is often volatile and volatility really appears in price data which show a 16.5 percent surge in the median price to a record $305,000. The year-on-year rate, which had dipped into the negative column in September, is suddenly at plus 15.4 percent. More thorough but less timely data on home prices in yesterday's Case-Shiller and FHFA reports offer no hint of a sudden acceleration in pricing power.

THE PENDING HOME SALES INDEX, like the new home index, was generally uninspiring for October. Pending home sales fell 1.1% after rising .6% in September.

THE EIA PETROLEUM STATUS REPORT shows inventories rising for crude oil and gasoline, +1.9 million barrels and 1.8 mill respctively. While distillates inventories declined by 2.1 million barrels.


  1. […] number coming in at 321,000, and September and October revisions adding another 44,000 jobs. Last week I shared with you my view of what we might expect from the stock market when the Fed begins […]

  2. […] begins its long-awaited tightening, or, as the Fed prefers, “normalizing” cycle— I’ve made the case that the profit cycle is a bit more mature today than it was during past fed-tightening cycles. […]

  3. […] fact, I recently offered up a detailed chart, along with some data that suggested that today’s market could suffer a greater than your garden variety recession […]

  4. […] them by selling their bonds—and the Fed gets off the dime. Which, to validate your fear—as I’ve previously addressed—spells potential (short-term at least) trouble for the stock […]

  5. […] be the year they start “normalizing” interest rates. As I’ve shared with you, and charted, it’s my view that—contrary to what many of the pundits seem to expect—U.S. […]

  6. […] create them by selling their bonds—and the Fed gets off the dime. Which, to validate your fear—as I’ve previously addressed—spells potential (short-term at least) trouble for the stock […]