X-factor Report 17 November 2014
by Lance Roberts, StreetTalk Live
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer at the bottom of this report.
This past week in the daily blog posts I did a good bit on macro analysis on the markets that I thought were worth repeating this weekend. I am only reprinting a portion of the work, but I have provided the links to the full pieces if you wish to read them in their entirety.
However, before I get into the macro analysis, let’s discuss the recently rebound surge in the markets over the last four weeks.
First, after breaking numerous technical supports the markets staged an immense short-covering rally that has taken markets back to new highs. While the move itself is not that abnormal, the extreme elevation of the move is. As you can see in the chart below, this is the sharpest move up in the markets since the turn of the century.
Secondly, the move has occurred against the backdrop of a drop in volume and a narrowing of participation. The chart below shows the number of stocks in the S&P 500 that are above their 200-day moving average. The downtrend in the index shows the deterioration in leadership of the market. Furthermore, the rollover in the rate-of-change in the lower part of the chart has been coincident with short to intermediate corrections in the markets.
As Mebane Faber recently wrote in reference to one of the investing legends of our time, Paul Tudor Jones;
“One principle for sure would be to get out of anything that falls below the 200-day moving average. ”
That simple piece of advice would save investors an immense amount of heartache and wealth if they would only tune out the media and pay attention to the trend.
The point is that the recent advance, as sharp as it has been, has not been a healthy one. HOWEVER, the overall TREND remains BULLISH so portfolios must remain tilted towards risk. During the recent correction, I reduced the allocation model by 25% which brought equities down to 45% exposure and increased cash to 20%. That is the current allocation as it exists today.
During the first couple of weeks of December mutual funds will begin distributing their capital gains and income for the year to shareholders. Historically, there is almost always a decent correction during that period.
With some cash on hand to buy with, I will look for a healthy entry point to reallocate the model back to full exposure in anticipation of the year end/New Year rally.
Okay, on to the macro.
Stock Market Detached From Real Economy
Think about this for a moment. The stock market is comprised of thousands of companies doing business in the economy. Therefore, it only makes sense that the value of the stock market should be a reflection of the economy. As the economy ebbs and flows, so should the values of the companies that are operating within it. This idea can be demonstrated by looking at the real, inflation-adjusted, price of the S&P 500 as a percentage of real GDP.
Another way to look at this phenomenon is by using the inflation-adjusted market capitalization of the S&P 500 Index (price times the number of shares outstanding) as a percentage of real GDP.
[Note: It has been clearly stated by the majority of mainstream economists and analysts that the market is currently “NOT” in a bubble. While that may be the case, it is worth remembering that is what was also said at the peak of the last two major market cycles that were eventually called “bubbles” in hindsight.]
Over the last decade in particular, financial engineering has distorted the relationship between the financial markets and the underlying economy. Corporations have resorted to a host of tools to maintain asset prices in the face of weak economic growth. To wit:
“In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools creates a mirage of corporate profitability.”
Why CapEx Ain’t Reviving
That last point was reiterated recently by Goldman Sachs in a recent report where they estimated that cash spending by companies in the S&P 500 index will increase by 12% to $2.3 Trillion in 2015. Of that increase in spending 51% will be used for spending and 49% will be returned to shareholders.
The analysts estimate that S&P 500 companies will put around $740 billion into capital expenditures next year alone. This is roughly a 6% growth rate in Capex down from 8% in 2014. This decline in the rate of capex spending is going to disappoint market bulls who have been anxiously awaiting the revival of massive capex spending as companies ramp up to meet burgeoning consumer demand.
The problem, however, continues to be a lack of demand follow through to justify further increases in capital expenditures. With oil prices falling due to global demand pressures, the resurgence in capex will likely be put on hold for another year as the energy sector makes up roughly one-quarter of the total S&P 500 capex and R&D spending.
The problem for the “economic growth is coming” crowd is that corporations are indeed spending their cash, but not in ways that directly impact economic growth like capex and R&D does.
It is estimated that in 2015 companies will increase cash used for acquisitions by 37%, which generally results in layoffs and consolidations, 31% of the budgeted cash will be used for “stock buybacks,” up from 29.4% in 2014, and 17.6% will be distributed to shareholders as dividends which is down from 18.2% in 2014.
Since dividends flow primarily to the top 20% of the country that have assets invested in the markets, there will be very little impact from the distribution of dividends to shareholders on economic growth. Stock buybacks boost earnings per share reports which supports assets prices, but again has very little impact on the 80% of the economy has little or no money invested in the financial markets. (Read: For 90% of America, There Has Been No Recovery for supporting evidence to the statement above.)
The Never Foreseen Danger
First, it is important to understand that capital expenditures by corporations can not offset any significant drag in personal consumption expenditures which comprises almost 70% of economic growth. Secondly, capital expenditures are a function of aggregate end demand. Therefore, if the personal consumption expenditures slow the demand for increased levels of capital expenditures by businesses will also wane.
Lastly, topline revenue growth remains extremely weak since the end of the last recession. As shown in the chart below revenue per share has increased by a total of 32% from 2009 through the second quarter of 2014 while reported earnings per share has exploded by 261%. This has been due to the near record level of companies buying back shares to artificially boost profitability.
The problem with this activity, along with cost cutting, employment reductions and other measures to increase profitability, is that they are all finite in nature. Eventually, either revenue growth must accelerate or earnings are at risk of a significant disappointment.
As shown in the chart below, earnings have never attained the currently expected growth rate…ever.
The risk to the markets currently is that the wave of deflationary pressures engulfing the globe have only begun to wash back on the domestic economy. The drag on exports, combined with the potential for extremely cold winter weather, puts both economic and earnings growth rate projections at risk. With the markets in extremely overvalued territory, the risks to investors clearly outweigh the rewards over the long-term. (Read The Full Piece Here)
Mean Reverting Profits
The problem with the chart above is that historically earnings have grown 6% peak-to-peak before a reversion. Notice, I said peak-to-peak. The issue is that the majority of analysts now estimate that earnings will rise unabated for the next five years.
However, this also applies to corporate profit margins as well. As Jeremy Grantham once stated:
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.”
Grantham is correct. As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP we see a clear process of mean reverting activity over time.
Reversions occur both from peaks and troughs, therefore, when profits-to-GDP have exceeded their long-term average to a significant degree (1 or 2 standard deviations) that has been a subsequent reversion. (Note: if I use nominal corporate profits the ratio is near 2-standard deviations from the mean)
Corporate profit margins have physical constraints. Out of each dollar of revenue created there are costs such as infrastructure, R&D, wages, etc. Currently, one of the biggest beneficiaries to expanding profit margins has been the suppression of employment and wage growth and artificially suppressed interest rates that have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.
However, there is one more fascinating tale that the inflation-adjusted profits-to-GDP ratio tells us. The chart below shows the ratio overlaid against the S&P 500 index.
I have highlighted peaks in the profits-to-GDP ratio with the blue vertical bars. As you can see the peaks, and subsequent reversions, in the ratio have been a leading indicator or more severe reversions in investment markets over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability. However, since asset prices are driven by emotion, rather than logic, this accounts for the lag between the fundamentals and the realization by investors that “this time is NOT different.” (Read The Full Piece Here)
As I wrote at the beginning of this missive, the markets are still in a bullish trend which suggests that portfolios remain tilted towards equity exposure. However, it is quite clear that this will eventually NOT BE THE CASE. What will be important to your long-term investment goal is understanding when that time has come and acting accordingly.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. At times, the positions of Mr. Roberts will be contrary to the positions that STA Wealth Management recommends and implements for its clients’ accounts. All information provided is strictly for informational and educational purposes and should not be construed to be a solicitation to buy or sell any securities.
It is highly recommended that you read the full website disclaimer and utilize any information provided on this site at your own risk. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and applicable laws, the content may no longer be reflective of current opinions or positions of Mr. Roberts. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing
Have a great week.
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