Fall 2016 – Newsletter
Last month I dropped my son off at college, and like most parents, wondered where all the time went and why it was in such a hurry to leave. Times have indeed changed since the fall of 1984, but the parting words of wisdom in the doorways of austere dorm rooms remain constant: I know I sound like a broken record, but you’ll be what you think you are and the lazy man works twice and the most important decision you’ll ever make in life is the company you keep and study for 4 hours every day and do not waste my money because I am not your plan B.
When I was done, having heard it all before, my son asked what I meant by a “broken record”. After all these years he had no idea that I was analogizing how a scratched record played the same part of the song over and over until we put a quarter on the needle to add enough weight that we could listen to Earth Wind and Fire in its entirety.
There’s something rewarding about coming up with a quick fix. In the wake of the Brexit announcement, when Britain’s middle class voted to leave the European Union, equity prices initially declined, at least until the market realized the Fed couldn’t raise interest rates and there was a rebound. What’s good for the goose is great for the gander – any hint that rates could go up sends the market in a tail spin, even if there is no reasonable case to increase them in this economic environment.
In fact, things were sort of humming along in our low interest rate never mind the slow growth stocks never go down fantasy land until Eric Rosengren of the Federal Reserve suggested that he may vote to raise interest rates(i). Based on his comments alone, the market had a temper tantrum and declined by 2.4% that day. The reaction had nothing to do with any material change in the value of companies, only a hint that the Fed might tighten the screws. The next day a different Fed official said rates wouldn’t go up and the market jumped a full percent(ii). Go figure.
There must come a time when a man reflects back and begins to feel old, and in the spirit of nostalgia S&P 500 companies have reported their 2nd quarter earnings and they have declined by 2.1% on a year over year basis(iii). In fact, earnings have declined for five consecutive quarters on a year-over year basis(iv). It is not even debatable whether or not the economy is slowing, that we are at the end of a business cycle or that the only thing keeping a floor on equity prices is low interest rates and financial engineering.
I mentor kids in underserved neighborhoods several days a week because my dad’s advice wasn’t just the source of entertaining stories – they kept me alive. There were stolen cars I didn’t get into, wrong places at any time I stayed away from and habits that I can now pass down to my own child. And since many of these young men lack role models and come from challenging backgrounds, they have been told what they cannot do or be at an early age by a wide range of adults who are either part of a collaborative penal system or educators who don’t know any better.
All of us will be exactly what we think we are and there comes a point when either you believe in what you’re doing or you do not, and absent that internal belief, you become subject to somebody else’s objective. There is no reasonable basis to think a slowing economy can support a rising market any more than an inflated market could survive a rate hike by the Fed. Fortunately, either outcome would elicit a similar strategy.
Let’s assume for a moment that the Federal Reserve increases interest rates. First, the market will likely behave like any organism does when an artificial stimulant is taken away. The low interest rate environment that allowed companies to borrow record amounts of money(v) to spend on stock buybacks will slow significantly, and with it, a portion of the $161.39 billion of demand from S&P 500 companies during the first three months of the year(vi). Additionally, the value of the dollar gets stronger and any profits earned overseas are worth less when they bring it home. A stronger dollar is also deflationary, because you need fewer dollars to buy the same loaf of bread and companies won’t invest money if they’ll have to sell their products at a lower price. None of these things make stocks go up.
Should the Fed continue to send mixed messages on whether or not they’ll actually raise rates, the state of affairs will become apparent one way or another. Aside from a decline in the growth of earnings, profits have also declined(vii), so has the manufacturing index(viii). The small business loan index is collapsing(ix), non-farm payrolls are in a downward trendx and existing home sales (which are ninety percent of the market) are falling(xi).
We can do this all day. Industrial production on a year over year basis is in reverse(xii), producer price index under pressure(xiii), and GDP grew at an annual 1.2% rate(xiv), and like everything else, is slowing on a rate of change basis. In the face of all of this, random members of the Federal Reserve expect us to believe that based on the data there is a case for raising interest rates to cool our strong economy. Sooner or later the market won’t be able to deny that there is no growth and it will act accordingly. And it’s not as though I’m cherry picking one or two statistics or that any of this is new. There is deep confirmation and it’s been happening for some time.
Even if the Fed does nothing, how does that improve a lethargic economy? Investors would have no expectations of growth or inflation, and when that happens, slow and steady companies that look like a bond have historically held their own. Many businesses cannot raise their prices during a recession or deflationary environment, but utility companies will keep hiking prices. Finally, the idea that central banks have a handle on things is seemingly going by the waste side, which makes gold attractive.
I remember putting a life saver in the butterfly of a carburetor to keep it open when cold weather froze the condensation and wouldn’t allow the gas to start the engine. I also recall studying Paul Volcker, Federal Reserve chairman in the 1980’s, who famously raised interest rates in the face of high inflation. We learned things in college like capital asset pricing model, price earnings ratio and matters that impacted stock prices. Regardless of the things will be different this time narrative, these things still matter, even if they do not subscribe to any schedule. As was the case in previous times of volatility, when the dust settles, the experts will eulogize about how they should have known better.
I described earlier how companies were borrowing record amounts of money to buy their own stocks back. This manipulates the stock price because it increases demand for shares, reduces supply of shares and boosts the earnings per share calculation, which is equal to net income minus dividends divided by shares outstanding. The fewer the shares, the bigger the earnings per share.
That, however, is really only half the story because they reported those earnings using a method that allows them to ignore expenses and pretend that they didn’t happen. Generally Accepted Accounting Principles (GAAP) was the sole method used by over forty percent of all public companies as late as 1996; today only 5.7% do so. Slowly but surely more firms began to report with what’s called the Pro-Forma method that allows them to back out certain one-time expenses and paint a better picture, inflating income by an average of forty-four percent(xv).
Moreover, many of the shares companies have bought back are given to employees as compensation, which is an expense under Generally Accepted Accounting Principles and reduces profits. Under pro- forma, however, it can be backed out. When Microsoft announced earnings of .69 a share, the stock price jumped 6.8%. The GAAP earnings received far less attention, likely because they were .39 cents a share. Adding insult to injury, companies have a habit of nudging Wall Street analysts to lower their expectations(xvi) because nothing makes a stock go up like the words “beat expectations”. I always wondered how seventy five percent of companies in
the S&P 500 index met or exceeded analysts’ earnings forecasts quarter after quarter in both good times and bad.
In the final analysis, raising rates would be the equivalent of removing a load bearing wall in a house of cards – not even the Fed is that stupid. Right now bad news is good news for the market because it reduces the odds that the Fed will raise rates. What will likely come to pass is the bad news of slow growth will be acknowledged and treated as such unless they can think of another gimmick. I’ve named three or four in this newsletter alone; who knows what else they have up their sleeve.
When I came home from college, my father told me not to hang out with some of my old friends, guys who did sleepovers in my house as kids telling fart jokes before we went to bed. He told me everybody doesn’t live to be an adult and that life is a full contact sport. Years went by, but he was proven right time and time again. Stocks should have corrected months ago, but it’s not the first time that train has been late to the station. Fortunately for us the Fed’s waffling back and forth doesn’t change the strategy. On one hand, the numbers will become unmistakable. On the other hand, the Fed could actually makes a mess of things and slows the economy down even more. It’s one or the other, which suggests a single response: buy things that benefit from slow growth, hunker down and wait.
Because as my dad would say – son, everything happens when it’s supposed to.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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i Increasingly risky to delay US rate hike, Fed’s Rosengren says; CNBC.com; 9/9/16
ii Stocks close more than 1% higher after Fed’s Brainard speaks; telecoms jump 2%; CNBC.com; 9/12/16
iv June Quarter To Tie The Great Recession’s Earnings Decline; Forbes; 6/20/16
v Corporate debt seen ballooning to $75 trillion: S&P; CNBC; 7/20/16
vi Buybacks Pump Up Stock Rally; Wall Street Journal; 7/12/16
vii Corporate Profits Set to Shrink for Fourth Consecutive Quarter; Wall Street Journal; 7/17/16
viii ISM Manufacturing Index Fell to 52.6 in July – WSJ; Wall Street Journal; 8/1/16
ix Thomson Reuters/Paynet Small Business Lending Index
x US created 151,000 jobs in August vs. 180,000 jobs expected; CNBC.com; 9/2/16
xii Federal Reserve
xiii US Producer Price Index down 0.4% in July vs. 0.1% increase expected; CNBC.com; 8/12/16
xiv U.S. Economy Grew Less-Than-Forecast 1.2% in Second Quarter; Bloomberg; 7/29/15
xv Accounting Choices Blur Profit Picture; Wall Street Journal; 6/28/16
xvi Companies Routinely Steer Analysts to Deliver Earnings Surprises; Wall Street Journal; 8/6/16