Sunday, August 28, 2016

Q2 Earnings Review

We at YRI have updated all of our chart publications that track S&P 500 revenues, earnings, and margins with Q2 data. S&P compiles both revenues and reported (unadjusted GAAP) earnings for the S&P 500. The latter peaked at a record high of $27.47 per share during Q3-2014. It then fell 31.9% through Q4-2015. That five-quarter earnings recession coincided with the collapse in oil prices and in the S&P 500 Energy sector’s earnings.

Reported earnings rebounded 24.7% during the first two quarters of this year as the price of a barrel of Brent crude oil rose 33% during the first half of this year, suggesting that the Energy-led earnings recession is over. That’s confirmed by S&P 500 revenues, which was negative on a year-over-year basis from Q1-2015 through Q4-2015, falling by as much as 3.8% y/y during Q2-2015. During Q1 and Q2 of this year, this growth rate was 0.3% and 1.1%. So far, I can’t find too many devils in the details:

(1) Revenues. On an aggregate basis, rather than per-share, revenues growth remained slightly negative during Q2 for the sixth consecutive quarter, at -0.7%. This series is highly correlated with and often identical to the yearly percent change in manufacturing and trade sales, which was down 0.6% during Q2.

One can exclude Energy earnings from aggregate revenues (not per-share). On this basis, revenues rose 2.2% y/y during Q2. Furthermore, the growth in aggregate S&P 500 revenues excluding Energy remained in positive territory throughout the recent earnings recession. The weakest growth registered during this period was 0.2% during Q4-2015, which probably reflected the knock-on effects of the Energy recession on other sectors as well as the significant appreciation of the dollar.

(2) Earnings. Before turning to S&P 500 earnings per share, let’s follow our discussion of aggregate revenues with a discussion of aggregate earnings. The complication is that there are three aggregate measures of earnings that we at YRI track. They are earnings as reported by companies and operating earnings as compiled separately and differently by S&P and Thomson Reuters (TR). S&P derives its measure of operating earnings by excluding items that S&P deems to be non-recurring ones. TR’s composite is based on the operating estimates provided by industry analysts, who tend to be guided by company managements.

I favor the TR approach because I believe that the market reflects the estimates of industry analysts while recognizing their optimistic bias. Again, focusing on the aggregates, I find that TR earnings rose to $254 billion during Q2, only 6.1% below the record high in Q4-2014. Excluding Energy, TR’s aggregate earnings is back at last year’s record high after a brief dip during Q1.

The story is more or less the same for the S&P aggregate operating earnings composite. The bottom line is that excluding Energy, it has been a growth recession rather than an outright recession for earnings.

One can’t do the same kind of analysis for earnings on a per-share basis. In other words, I can’t show you this measure without Energy. However, the TR measure of total S&P 500 operating earnings per share didn’t fall much since mid-2014. It rebounded during Q2 to $29.31 per share, only 4.0% below the record high of $30.54 during Q4-2014.

(3) Margins. Calculating the S&P 500 profit margin using the TR data for earnings per share and the S&P data for revenues per share, I can report that it edged back up to 10.3% during Q2. In other words, it continues to hover in record-high territory around 10%, as it has been since Q1-2014. So far, it has refused to revert back to the proverbial mean, as widely expected by the bears.

(4) Forward aggregates. I track forward earnings, forward revenues, and the implied forward profit margin on a weekly basis; these tend to be good leading indicators of their respective quarterly series. All three have remained relatively flat in record-high territory since mid-2014. Forward earnings and forward revenues seem to be on the verge of achieving new highs. (See our S&P vs. Thomson Reuters.)

During the week of August 11, forward earnings was $127.99 per share. That’s a time-weighted average of analysts’ latest estimate for this year ($117.86) and next year ($134.42). I am using $119 for this year and $129 for next year. I raised my S&P 500 target for next year from 2200-2300 to 2300-2400 on July 20. So far so good, especially if the market is agreeing with me that the earnings recession wasn’t much of a recession and that it is over, in any case.

(5) Leading indicators. By the way, S&P 500 forward earnings isn’t one of the 10 components of the Index of Leading Economic Indicators (LEI), but perhaps it should be. It is highly correlated with the LEI. It tends to lead the Index of Coincident Economic Indicators (CEI). July’s LEI was within 1.3% of the record high during March 2006, while the CEI rose to a new record high last month. There’s certainly no recession in either of these economic indicators.

Thursday, August 18, 2016

Record-High Global Production

While the central bankers are increasingly getting most of the credit for the current bull market in stocks, let’s not forget that workers are still going to work and managers are still managing their businesses every day. Central banks have responded to slow global economic growth by flooding the global economy with liquidity. Business managers have responded by working harder to bolster their revenues, to cut their costs, to increase their productivity, to boost their profit margins, and to grow their earnings. A recession is always a good excuse for not doing any of these things beyond slashing costs. In a slow-growing business environment, there are no good excuses for not at least trying to do better.

On a global basis, all these efforts continue to pay off in growth, albeit slow growth. However, it is mostly slow growth to record-high territory. Consider the following:

(1) Global industrial production. Global industrial production (excluding construction) rose 2.0% y/y to a new record high during May. That’s not much growth, but it has a positive sign rather than a negative one, and it is happening in record-high territory.

(2) Advanced vs. emerging economies. I am not as pleased by the industrial production index for advanced economies. It has been flat-lining for the past couple of years roughly 5.5% below its record high during January 2008.

On the other hand, the index for emerging economies jumped 4.2% y/y during May to a new record high. Production is at or near a record high for the following EMs: Indonesia (up 6.4% y/y through June), China (6.0%, July), Poland (6.0%, June), Malaysia (4.6%, June), Czech Republic (4.6%, June), India (2.3%, June), and Mexico (0.3%, June).

Wednesday, August 10, 2016

Productivity Puzzle

There are lots of questions raised by the weak productivity numbers that were released on Monday. Nonfarm business productivity declined 0.5% (saar) as output (1.2%) increased at a slower pace than hours worked (1.8). That followed an unrevised 0.6% decline during Q1. On a y/y basis, productivity was down 0.4%, the first negative reading in three years. Annual revisions show productivity growth for 2015 was only 0.9% (up from 0.7%), while 2014’s was unrevised at 0.8% and 2013’s edged up 0.3% (up from zero). Those are all pathetic growth rates.

Why are companies hiring so many unproductive workers? Why aren’t they investing more to increase productivity? Why isn’t weak productivity boosting price inflation more? Why are profit margins so high if productivity is so lackluster? Could it be that output is being underestimated? Should high-tech freebies, such as free apps, be reflected in output? If companies are using more automation, robotics, and artificial intelligence, why aren’t these technologies boosting productivity? Might the aging of the Baby Boomers explain the productivity puzzle? Are the Millennials spending too much time playing video games?

The easy answer is that output is being underestimated. The fastest-growing areas of the economy are in services, which are hard to measure. What is the output of a hospital, for example? When I commuted to work on Wall Street from my home on Long Island, I wasted about two hours getting there and back. Now I work at my home office during those two hours thanks to the Amazon Cloud, which has dramatically lowered our IT costs and increased the reliability of our systems, requiring less IT support. Our charts are automatically updated, eliminating the need for lots of grunt work.

On the other hand, productivity in the services economy continues to lag productivity in manufacturing, which has been much easier to automate. That may be starting to change, but most of the employment gains have been in services for many years, and the lackluster pace of productivity may simply reflect that most service industries still rely on workers more than automation to deliver their services.

Another possible explanation is that, from a supply-side, companies are highly productive. The problem is that in a world of secular stagnant demand growth, their unit sales aren’t strong enough to show off their productivity. You may have the most efficient widget factory in the world, but if no one wants widgets, your productivity is zero. Consider the following:

(1) Lots of capacity. There are lots of industries and companies with too much unproductive capacity. Some have expanded too much with the help of cheap credit. Some have been disrupted by competitors using new technologies. I just can’t find too many industries that haven’t spent enough money on plant, equipment, and technology. Indeed, the industrial capacity utilization rate has dropped to 75.4% during June from a recent peak of 78.9% in November 2014. What’s puzzling is that the employment rate (which is the flip side of the official unemployment rate) has risen to 95.1% from 94.2% over this same period.

(2) Productivity cycles. While productivity growth in services has tended to lag behind that in fast-growing manufacturing, the latter is no longer fast growing. Indeed, during the current economic expansion, manufacturing productivity has been almost flat. The official manufacturing productivity data start during 1987. I have constructed a proxy for it that starts much earlier. Focusing on the long cycle in the data, I find that the 60-month growth rate is currently near zero and the weakest on record.

In the past, my manufacturing productivity proxy almost always grew significantly faster than nonfarm business productivity. During the current expansion, the two growth rates have been closer and declining in tandem. Again, it’s hard to believe that manufacturing has lost its productivity mojo. It’s possible, we suppose, that most factories are so productive that they can’t get much more so. More likely is that the demand for their products isn’t growing fast enough to boost their realized productivity. (See our new Productivity Cycles.)

(3) Margin for error. Given all of the above, why is the corporate profit margin still in record-high territory? For now, I have more questions than answers. But stay tuned, I am working on them.

Saturday, August 6, 2016

Japan Leads the Way

It’s all a matter of perspective. Here in the US, the day ends when the sun sets in the West. At the same time in Japan, a new day is beginning as the sun rises from the East. From an economic and financial perspective, Japan has been a leading indicator for the rest of the world, particularly the large developed industrial economies.

Japan may be leading the way again with a massive fiscal spending program, which may be starting to push bond yields higher over there. Contributing to the upswing in yields is talk that officials of the Bank of Japan (BOJ) are reassessing whether their ultra-easy monetary policies have lost their effectiveness. At the same time, there is some chatter about “helicopter money,” which would mean that the BOJ would directly finance fiscal spending.

Japan’s Great Recession and great financial crisis occurred in the early 1990s. The country’s real estate and stock market bubbles both burst simultaneously back then. The Nikkei (in yen) plunged 63.2% from a record high of 38915 on December 29, 1989 to a low of 14309 on August 18, 1992. It then traded in a volatile range roughly between 15000 and 20000 through the end of the 1990s before resuming its decline through April 28, 2003, when it fell to 7607. Then it rallied 140.0% through July 9, 2007 and dropped 61.4% through March 10, 2009. It consolidated just north of this level through late 2012, when the introduction of Abenomics sparked a 144.5% rally through June 24, 2015. It is currently down 21.5% from that recent peak, and down 57.8% from the record high in late 1989.

The BOJ led all other central banks by more than a decade with its zero-interest-rate policy (ZIRP), when the official rate was lowered to zero for the first time during March 1999. The BOJ lagged behind the ECB by nearly 20 months, introducing its negative-interest-rate policy (NIRP) on January 29 of this year. The central bank was early with QE (quantitative easing) when it expanded its reserves balances starting during November 2001 through January 2006. That was just a warm-up act for the dramatic expansion of these reserves that started in early 2011, and then went vertical since late 2012.

Yet the Nikkei remains significantly below its record high. There have been numerous fiscal spending programs since the early 1990s that built lots of bridges and roads to nowhere. How do you say in Japanese “If at first you don’t succeed, try, try again”? W.C. Fields added the following to that saying: “Then quit. There’s no point in being a fool about it.” Let’s review what the Japanese are doing now:

(1) Less negative. At the end of July, the BOJ said it would buy ¥6 trillion ($57 billion) worth of exchange-traded stock funds annually, up from ¥3.3 trillion previously. It didn’t change its target for purchasing Japanese government bonds or reduce its main interest rate--already in negative territory. The BOJ’s official rate was lowered to -0.10% on January 29 and kept there at last week’s policy committee meeting.

The central bank has been getting lots of pushback from financial institutions and depositors on its NIRP. As a result, Governor Haruhiko Kuroda may be having second thoughts about going further into negative territory. The 8/2 WSJ reported:
“Japanese government-bond prices have been falling since Friday, when the central bank announced what amounted to modest policy tweaks--dashing expectations of an interest-rate cut further into negative territory and an expansion of asset purchases. The central bank’s easing program has fueled the fantastic run in bond prices since it started three years ago, so any hints the BOJ might be losing its punch has spooked bond investors. Selling accelerated on Tuesday in the run-up to a government auction of 10-year bonds, and continued when results showed that demand remains weak.”
(2) Financial stability. The BOJ already owns more than a third of all outstanding Japanese government bonds. There is mounting concern that expanding its bond purchases much further would cause instability in the market.

(3) More of the same. This past week, Japan’s government announced $45 billion in extra spending for the current fiscal year. Prime Minister Shinzo Abe has been seeking to revive economic growth since he took office for a second time during December 2012 with various programs. More spending, totaling $273 billion, is scheduled for the next couple of years.

A 7/31 Bloomberg analysis reports that “this marks the 26th dose of fiscal stimulus since the country’s epic markets crash in 1990.” Bloomberg observes:
“And if previous episodes are any guide, an initial sugar hit to markets and growth will quickly fade amid a realization that extra spending does little to cure the economy’s underlying problems. A Goldman Sachs Inc. study found that markets gave up their gains in the first month after the cabinet approved the stimulus in 18 of the 25 packages it studied since 1990.”
Most of the latest program won’t be spending but lending. Some of the headline announcement of new spending actually includes existing spending pledges that have been repackaged. Abe’s decision to introduce a sales tax increase during April 2014 aimed at raising government revenues triggered a recession instead. Plans for another increase have been postponed to 2019.

(4) Structural problems. When Abe announced his program in 2013, it consisted of the “three arrows.” These were fiscal stimulus, monetary easing, and structural reforms. The first two were implemented rapidly, but were offset by the tax hike in 2014. Meanwhile, structural reforms have been slow in coming. Tackling areas like employment regulation has fallen short of expectations.

(5) Poor performance. How do you say in Japanese, “The proof is in the pudding”? Abenomics’ lack of success is evidenced by the government’s try-try-again routine. Japan’s nominal GDP has been essentially flat since the early 1990s. Real GDP has been increased at a subpar pace during the current economic expansion. Despite the massive 24% depreciation of the yen since late 2012, Japanese exports (in yen) are down 10% y/y. Reflecting weak domestic demand, imports (in yen) are down 22% over the past two years.

(6) Bottom line. Japan’s economy continues to stagnate and remains on the edge of deflation. The fear is that the BOJ has run out of NIRP and QE bullets.

Wednesday, July 27, 2016

Elections, Recessions, & the Fed

Several of our accounts have asked me to look at the relationships between the presidential election cycle and the business cycle, the Fed cycle, and the cycle in stock prices. I put together a chart publication titled Presidential Election Cycles. On balance, these elections tend to coincide with recessions and bear markets. However, there have been exceptions, and I remain bullish about the current outlook for the economy and the stock market. That’s partly because Fed officials are likely to postpone another rate hike until after the election, as they often have in the past. Here are my quick takeaways:

(1) Recessions. Since 1947, when quarterly GDP was first compiled, there have been 17 presidential elections. There were 11 recessions over this period, and almost all of them either coincided with elections or occurred shortly thereafter. There were only five instances when there was no recession between elections.

The political cycle suggests a high probability of a recession next year. I’m not sure what Hillary might do to cause one, though I’m sure she can think of something. It’s not hard to foresee a recession next year if the Donald wins and immediately declares that our trade treaties are null and void, slaps tariffs on imports from Mexico and China, and penalizes US companies that he views as having sent US jobs abroad. On the other hand, either one of them might not venture far from the status quo of the past several years, which has been a bullish environment for stocks.

(2) Fed rate hikes. As was demonstrated by the FOMC’s statement today, the Fed is in no rush to hike the federal funds rate again. The committee decided to pass on a rate hike, though the statement indicated that the economy and labor markets are doing well, inflation is likely to move closer to 2% “over the medium term as the transitory effects of past declines in energy and import prices dissipate,” and “[n]ear-term risks to the economic outlook have diminished.”

The next three meetings of the FOMC are scheduled for September 20-21, November 1-2, and December 13-14. After the statement was released, the bond market rallied and the spread between the 12-month ahead and the nearby federal funds future narrowed.

My analysis of the federal funds rate since 1954 shows that the Fed has on several occasions held off on raising this rate until after the presidential elections. The same is likely to happen this year. I am still thinking that none-and-done is more likely than one-and-done this year. However, a rate hike during the last meeting of the year is possible. If the “gradual” normalization of monetary policy means a 25bps increase once a year for the foreseeable future, then rates will remain awfully low for a while.

(3) Bear markets. Since 1961, there have been nine bear markets in the S&P 500. Five of them coincided with the elections, and they were among the longest of the lot.