Wednesday, June 21, 2017

Drowning in Oil

OPEC oil producers continue to put a lid on their output in an effort to prop up prices. Yet the price of a barrel of Brent crude oil is back down to $45.89, below its recent high of $57.10 on January 6. That’s comfortably in the $40-$50 price range that I have been expecting for this year. Despite the 76% plunge in the price of oil from June 19, 2014 to January 20, 2016, US crude oil production fell just 12% from the week of June 5, 2015 through the week of July 1, 2016. Since then, it is up 10% to 9.3mbd.

Interestingly, weekly production held up relatively better in Texas and North Dakota than in the rest of the country when total output was declining. However, the rebound in US oil production has been led by the rest of the country, excluding Texas and North Dakota. Could it be that frackers figured out how to lower their costs in the two states where they’ve been most active, and taken their innovations to the other states? Maybe.

Meanwhile, the 52-week average of gasoline usage in the US is down 0.7% y/y. This may or may not be a sign of a slowing economy. It is undoubtedly a bearish development for oil prices.

Saudi Arabia, Russia, Iran, and other major oil producers, with large reserves of the stuff, should be awfully worried that they are sitting on a commodity that may become much less needed in the future. Elon Musk intends to harvest solar energy on the roofs of our homes, storing the electricity generated in large batteries while also charging up our electric cars. As long as the sun will come out tomorrow (as Little Orphan Annie predicted), solar energy is likely to get increasingly cheaper and fuel a growing fleet of electric passenger cars. Meanwhile, the frackers are using every frick in their book to reduce the cost of pumping more crude oil. Rather than propping up the price, maybe OPEC should sell as much of their oil as they can at lower prices to slow down the pace of technological innovation that may eventually put them out of business.

Thursday, June 15, 2017

Tech Now and Then

Is it 1999/2000 all over again for the S&P 500 Information Technology sector? Not so far. Consider the following:

(1) First vs third place. During the bull market from October 11, 1990 through March 24, 2000, the sector soared 1,697.2%, well ahead of the 417.0% gain in the S&P 500 and all the other sectors. During the current bull market, it is in third place with a gain of 379.8% through last Friday.

(2) Market-cap and earnings shares. At the tail end of the bull market of the 1990s, the S&P 500 IT sector’s share of the overall index’s market capitalization rose to a record 32.9% during March 2000. However, its earnings share peaked at only 17.6% during September 2000. This time, during May, the sector’s market-cap share rose to a cyclical high of 22.9%, while its earnings share, at a cyclical high of 22.0%, was much more supportive of the sector’s market-cap share. As a rule of thumb, I get nervous when a sector’s shares of either or both rise close to 33%. I’m not nervous yet about IT, though I am just a little twitchy.

(3) No contest on valuation basis. During the second half of the 1990s through the early 2000s, the forward P/E of the Tech sector soared relative to the broad index. The former peaked at a record 48.3 during March 2000. That same month, the forward P/E of the S&P 500 was 22.6. Both then proceeded to trend lower through 2008, when they finally converged. During the current bull market, the Tech sector’s forward P/E hasn’t diverged much at all from that of the overall index. Last month, the former was 18.1, while the latter was 17.3.

(4) Less irrational exuberance about long-term growth. I regularly monitor LTEG for the S&P 500 and its 11 sectors and 100+ industries. LTEG is analysts’ consensus long-term earnings growth expectations over the next five years at an annual rate. It soared to a record high of 18.7% during August 2000 for the S&P 500, up from 11.5% at the start of 1995. Keep in mind that the historical trend growth in the S&P 500 during economic expansions tends to be around 7%! The ascent in this growth expectation trend for the S&P 500 during the second half of the 1990s was led by an even more wildly irrational rerating of expected LTEG for the Tech sector from 16.6% at the start of 1995 to a record high of 28.7% during October 2000.

Since those peaks, both LTEGs have come back down closer to the Planet Earth. During April, they were 12.3% for the S&P 500 and 12.7% for the IT sector. Those are still more optimistic than what is likely to be delivered, but at least they are back to the rationally exuberant normal bias of analysts.

(5) Less air in this bubble so far. All of the above suggests that the Tech sector is trading much closer to realistic expectations for fundamentals than during the bubble of the 1990s. The S&P 500 IT stock index nearly exceeded its March 27, 2000 high for the first time just last week on June 8. The sector’s forward earnings rose to a record high at the start of June, exceeding the 2000 peak by 168.6%.

(6) Fat margins. The sector has the highest forward profit margins among the S&P 500 sectors. It has been at a record high around 20% since late last year, up from a cyclical low of around 12% at the start of 2009.

Thursday, June 8, 2017

Hannibal Spirits: S&P 500 Climbing Mountains

Hannibal, the Carthaginian general, was one of the greatest military strategists of all times. The city of Carthage in ancient Roman times was in the spot of modern-day Tunis, in Tunisia. Hannibal was so feared by the Romans that a common Latin expression to express anxiety about an impending calamity was “Hannibal ante portas!,” which means “Hannibal is at the gates!” He studied his opponents’ strengths and weaknesses, winning battles by playing to their weaknesses and to his strengths.

One of Hannibal’s most remembered achievements was marching an army that included war elephants over the Pyrenees and the Alps to invade Italy at the outbreak of the Second Punic War. He occupied much of Italy for 15 years but was unable to conquer Rome. A Roman general, Scipio Africanus, counter-attacked in North Africa, forcing Hannibal to return to Carthage, where he was decisively defeated by at the Battle of Zama. Scipio had studied Hannibal’s tactics and devised some of his own to defeat his nemesis.

So far, the current bull market has marched impressively forward despite 56 anxiety attacks, by my count. They were false alarms. I remain bullish. My long-held concern is that the bull market might end with a melt-up that sets the stage for a meltdown. The latest valuation and flow-of-funds data certainly suggest that the melt-up scenario may be imminent, or underway. Consider the following:

(1) Valuation melt-up. The Buffett Ratio is back near its record high of 1.81 during Q1-2000. It is simply the US equity market capitalization excluding foreign issues divided by nominal GDP. It rose to 1.69 during Q4-2016. It is highly correlated with the ratio of the S&P 500 market cap to the aggregate revenues of the composite. This alternative Buffett Ratio rose to 2.00 during Q1 of this year, matching the record high during Q4-1999. It is also highly correlated with the ratios of the S&P 500 to both forward revenues per share and forward earnings per share. All these valuation measures are flashing red.

(2) ETF melt-up. The net fund flows into US equity ETFs certainly confirms that a melt-up might be underway. Over the past 12 months through April, a record $314.8 billion has poured into these funds. That was led by funds that invest only in US equities, with net inflows of $236.4 billion, while US-based ETFs that invest in equities around the world attracted $78.4 billion in net new money over the 12 months through April.

Some of the money that went into equity ETFs came out of equity mutual funds. Over the past 12 months through April, net outflows from all US-based equity mutual funds totaled $155.3 billion, with $163.7 billion coming out of US mutual funds that invest just in the US and $8.4 billion going into those that invest worldwide.

So the net inflows into all US-based equity mutual and indexed funds totaled $159.4 billion over the past 12 months, $72.7 billion going into domestic funds and $86.7 billion into global ones. These totals don’t seem to be big enough to fuel a melt-up. However, the shift of funds from actively managed funds to passive index funds is significant and could be contributing to the melt-up. That’s especially likely since money is pouring into S&P 500 index funds, which are market-cap weighted. This may partly explain why big cap stocks, like the FAANGs, are outperforming assuming that money is coming out of mutual funds that are underweight the outperforming FAANGs.

(3) FAANG-led melt-up. The market cap of the FAANGs is up 41.4% y/y to a record $2.49 trillion, while the market cap of the S&P 500 is up 14.3% to $20.95 trillion over the same period. The FAANGs account for 27.8% of the $2.6 trillion increase in the value of the S&P 500 over the past year. The FAANG stocks now account for 11.9% of the S&P 500’s market capitalization, up from 5.8% on April 26, 2013. Collectively, over this period, they’ve accounted for $1.6 trillion of the $6.9 trillion increase in the S&P 500! Their collective forward P/E is now 27.1 and 42.8 with and without Apple, respectively. The S&P 500’s forward P/E is 17.7 and 16.9 with and without the FAANGs. These elephants continue to sprint up mountains, leading the market’s bulls, even though the air is getting thinner.

Wednesday, May 31, 2017

A Memorable Earnings Season

Q1 revenues, earnings, and margins are now available for the S&P 500. Revenues per share dropped 2.7% q/q during Q1. Earnings per share, based on Thomson Reuters I/B/E/S (TR) data, fell 1.3% q/q. So in what sense was the Q1 reporting season “memorable,” as stated in the title of today’s commentary?

For starters, the S&P 500 rose to a new record high of 2415.82 on May 26. The S&P 400 and S&P 600 stock price indexes continued to mark time at their recent record highs. Industry analysts remained upbeat about earnings for this year and next year, as reflected by the record highs in the S&P 500/400/600 forward earnings.

This all happened despite a growing realization that President Trump’s economic agenda is likely to be slowed by Washington’s swampy ways. I came to that epiphany on May 18 and adjusted my earnings estimates accordingly, pushing the corporate tax cut into 2018 from 2017. Without a tax cut, I estimate that S&P 500 earnings per share will be $130.00 this year and $136.75 next year. With the tax cut in 2018, my estimate for next year gets raised to $150.00. Let’s have a closer look at the results of the latest reporting season:

(1) Good growth. Of course, the apparent weakness in Q1’s revenues and earnings on a q/q basis is mostly seasonal in nature. The first quarter of the year tends to be the weakest one of the year. On a y/y basis, revenues per share rose 6.9%, the fastest since Q4-2011. Earnings per share rose 14.5% y/y, the best growth since Q3-2011.

I argued that the S&P 500 revenues recession during 2015—when y/y growth rates were down each quarter—was mostly attributable to the plunge in the revenues of the energy sector. The revenue growth rates, which turned slightly positive during Q1-2016, have been increasing since then. It was last summer that I declared the end of the earnings recession. The y/y growth rate of earnings turned positive during Q3-2016 at 4.2%, rose to 5.9% during Q4-2016, and chalked up 14.5% at the start of this year.

(2) High & stable margin. The profit margin of the S&P 500, based on TR data, rebounded sharply from a record low of 2.4% during Q4-2008 back to its previous cyclical peak of 9.6% during Q3-2011. There was lots of growling by the perma-bears that it would soon revert to its mean. Instead, it continued to rise to a new record high of 10.7% during Q3-2016. It has remained around there since then, registering 10.5% during Q1.

I argued that following the Trauma of 2008, company managements would do whatever they could to raise and maintain their profit margins by remaining conservative in their spending plans despite record profits. I’m not saying that the profit margin will never revert again. It will do so come the next recession. But that downturn may not come for a while because companies are being conservative.

In the past, the profit margin would often peak before recessions as companies went on hiring and capacity expansion sprees. The resulting boom would create the borrowing and inflationary excesses that set the stage for the inevitable bust. This time, the economy isn’t booming the way it often has at this late stage of an expansion. No boom, no boost … at least not in the foreseeable future.

(3) Correlations. I’m not surprised by the solid rebound in S&P 500 revenues because its y/y growth rate tends to be nearly the same as the comparable growth rate for manufacturing and trade sales, even though this series is limited to goods and does not include services. Aggregate (not per-share) revenues was up 5.2% y/y during Q1, while business sales rose 6.4% through March. Revenues per share on a y/y basis tends to lag the US M-PMI. The latter remains relatively high and consistent with revenue growth around 5%. Not surprisingly, there is a decent correlation between the y/y growth rate in nominal GDP and aggregate S&P 500 revenues.

Wednesday, May 24, 2017

Valuation: A Less Miserable Measure

Almost all valuation multiples are flashing that stocks are dangerously overvalued. Are there any valuation models suggesting that the danger signals might be false alarms? There is one. It shows the inverse relationship since 1979 between the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. Let’s have a look at it and compare it to a few of the other valuation indicators:

(1) Misery Index very bullish. During April, the Misery Index was down to 6.6%, near previous cyclical lows. That’s down 6.3ppts from its most recent cyclical peak of 12.9% during September 2011. Over this same period, the forward P/E has risen from roughly 10 to 17, well above its average of 13.8 since September 1978.

The theory is that less misery should justify a higher P/E. A low unemployment rate should be bullish for stocks unless it is accompanied by rising inflation, which could cause the Fed to tighten to the point of triggering a recession and driving the jobless rate higher. Nirvana should be a low unemployment rate with low inflation, which seems to be the current situation. In this happy state, a recession is nowhere to be seen, which should justify a higher valuation multiple.

I construct a “misery-adjusted” P/E simply by summing the S&P 500 forward P/E and the misery index. It has been trendless and highly cyclical since September 1978, with an average of 23.9. Its low was 18.5 during November 2008, and its high was 33.0 during March 2000. During April, it was 24.3, in line with its average. That’s somewhat comforting.

(2) Rule of 20 no longer a buy signal. Less comforting is the Rule of 20, which tracks the sum of the S&P forward P/E plus the CPI inflation rate. So it is the same as the misery-adjusted P/E less the unemployment rate. I moved to CJ Lawrence in 1991. My mentor there was Jim Moltz, who devised the Rule of 20, which states that the stock market is fairly valued when the sum of the P/E and the inflation rate equal 20. Above that level, stocks are overvalued; below it, they are undervalued.

The rule was bearish just prior to the bear market at the start of the 1980s. It was wildly bullish for stocks in the first half of the 1980s. It turned very bearish in the late 1990s and bullish again a couple of years later in mid-2002. Those were all good calls. However, like most other valuation models, it didn’t signal the bear market that lasted from October 9, 2007 through March 9, 2009. At the end of 2008, the Rule of 20 was as bullish as it was in the early 1980s. That was another very good call. By early 2017, it was signaling that stocks were slightly overvalued for the first time since May 2002.

(3) Buffett ratio sees no bargains. Another valuation gauge I follow is the price-to-sales (P/S). The S&P 500 stock price index can be divided by forward revenues instead of forward earnings. However, the forward P/S ratio is very highly correlated with the forward P/E ratio. So it doesn’t add much to the assessment of valuation.

A variant of the P/S ratio is one that Warren Buffett said he favors. It is the ratio of the value of all stocks traded in the US to nominal GDP. The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags behind the GDP report, which is available a couple of weeks after the end of a quarter on a preliminary basis. Needless to say, it isn’t exactly timely data.

However, the forward P/S ratio, which is available weekly, has been tracking Buffett’s ratio very closely. In an interview he did with Fortune in December 2001, Buffett said, “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.” That’s sage advice from the Sage of Omaha. His ratio was at 1.69 during Q4, while the P/S was 1.90 in mid-May, suggesting that we are playing with fire.

On the other hand, a year ago in a 5/2 CNBC interview, Buffett said, “If you had zero interest rates and you knew you were going to have them forever, stocks should sell at, you know, 100 times earnings or 200 times earnings.” He was speaking hypothetically, of course. More recently, this year in a 2/27 CNBC interview, Buffett said that US stock prices are “on the cheap side,” and added, “We are not in a bubble territory.” He also announced at the time that he had more than doubled his stake in Apple since the new year and before the tech giant reported earnings on January 31.

(4) Fed model still bullish. To round out the discussion, I should mention that the Fed’s Stock Valuation Model showed that the S&P 500 was undervalued during April by 61.9% using the US Treasury 10-year bond yield and 24.9% using a corporate bond yield composite. This confirms Buffett’s assessment that stocks are relatively cheap compared to bonds. If more investors conclude that economic growth (with low unemployment) and inflation may remain subdued for a long while, then they should conclude that economic growth and inflation may remain historically low. That’s a Nirvana scenario for stocks, and would be consistent with valuation multiples remaining high.