Thursday, September 27, 2012


So what is the correct P/E for the S&P 500? Our “Blue Angels” analysis of earnings momentum and valuation shows that 13 has been an unlucky number for the P/E for the past three years. The rallies of 2010 and 2011 were followed by nasty corrections after the P/E rose to 13. On September 14, the P/E was back just above this jinxed level. Now it is just a bit below it.

Then again, I’m hearing more folks in our business talking about the “Rule of 20.” Stocks are deemed to be cheap (expensive) when the sum of the P/E and the CPI inflation rate is below (above) 20. The CPI was up 1.7% y/y during August. Using the S&P 500’s forward P/E, the sum of the two was only 14.4 during August, suggesting plenty of upside for the valuation multiple. In my opinion, while the Rule seems to work at extremes, it isn’t a sure way to determine where the P/E is heading next most of the time.

I suppose that the actual implementation of open-ended quantitative easing by both the Fed and the ECB could lift the P/E above 13 to 14 by the end of the year. If forward earnings rises from 112 now to 115--equaling the current consensus forecast for next year (assuming that doesn’t change)--then the S&P 500 has the potential to rise to 1610 by the end of the year.

I think that’s not likely to happen until we see how the US elections play out. That will influence how Washington deals with the fiscal cliff, which will certainly result in a US recession early next year if Congress remains gridlocked. In addition, mounting social unrest in China and Europe are also weighing on the outlook for global economic growth next year. Oh, and then there is all the commotion in the Middle East. These uncertainties are likely to keep a lid on valuation for a while.

Today's Morning Briefing: Social Unrest & Valuation. (1) Plosser is skeptical about QE3. (2) Caterpillar is cautious about the global economy. (3) Remarkable resilience in earnings expectations. (4) The number 13 has been unlucky for P/E over the past couple of years. (5) The case for 14. (6) The case against the “Rule of 20.” (7) Lots of headlines about social unrest in China and Europe. (8) What’s the impact on valuation? (More for subscribers.)


Tuesday, September 25, 2012


Something Wicked This Way Comes is a 1962 novel by Ray Bradbury. It’s about two Midwestern 13-year-old boys, who have a nightmarish experience with a creepy traveling carnival that comes to their town in October. This is a month that has sometimes been a very scary one for stock investors too. But it has also been a good month for them on numerous occasions. The month ends with Halloween, the trick-or-treat holiday.  

If something wicked this way comes in October, it is most likely to be a war in the Persian Gulf. The next two full moons over Iran will be September 30 and October 29. Israeli drones will have more light at night to assess the damage done to Iran’s nuclear facilities. Of course, another possible scenario is that Iran’s wicked President Mahmoud Ahmadinejad will once again deliver a vile speech before the UN General Assembly in NYC on Wednesday (on Yom Kippur!), and the only response will be that some delegates walk out of the carnival, as they did last year when he called the 9/11 attacks "mysterious."
Iran's lunatic already started to rant and rave yesterday, according to a story in Reuters that might very well convince the Israelis to go to war. UN Secretary-General Ban Ki-moon met Ahmadinejad on Sunday and warned him of the dangers of incendiary rhetoric in the Middle East. Meeting with reporters yesterday, Iran’s provocateur said: "Iran has been around for the last seven, 10 thousand years. They [the Israelis] have been occupying those territories for the last 60 to 70 years, with the support and force of the Westerners. They have no roots there in history," referring to the founding of the modern state of Israel in 1948. He added, "We don't even count them as any part of any equation for Iran. During a historical phase, they [the Israelis] represent minimal disturbances that come into the picture and are then eliminated." Let’s see if he can top that act tomorrow in his speech before one of the creepiest carnivals on earth.

If war is coming to the Persian Gulf, why has the price of a barrel of Brent crude oil plunged by $6.79 from a recent peak of $117.19 on September 14 to $110.40 this morning? As I noted last week, the global crude oil demand-to-supply ratio is actually quite bearish. However, all the latest saber rattling between Israel and Iran should be adding a war premium to the price of oil.

Despite the recent weakness in the price, large speculators are once again holding near-record net long positions in both crude oil and gasoline. Maybe they know something. Or else, that could be a good signal for contrarians to short oil, especially if they figure that a war isn’t likely. Alternatively, if a war happens, it would cause a temporary spike in the price of oil that would send the global economy back into a recession and oil prices much lower. What will the central banks' carnival clowns do for an encore in that event?

Today's Morning Briefing: Wicked. (1) The carnival is back in town. (2) Trick or treat? (3) October is a typical month, but with more crashes. (4) Fed and ECB punish risk-averse investors. (5) Next full moon over Iran. (6) Wicked Wednesday at UN carnival. (7) The Mad Man’s speech. (8) Why are crude oil prices falling? (9) Won’t be surprising if Q3 earnings are disappointing. (10) Not much deleveraging in the Fed's latest flow of funds report. (More for subscribers.)

Monday, September 24, 2012

NZIRP Forever

Why can’t they all get along and leave well enough alone? The members of the Federal Open Mouth Committee (FOMC) are already yapping away about what they should or should not do after implementing “QE3 Forever” less than two weeks ago on September 13. A few are already pushing for “NZIRP Forever.” (NZIRP = near-zero interest rate policy.)

On September 20, FRB Minneapolis President Narayana Kocherlakota said the Fed should target the federal funds near zero until unemployment falls below 5.5% as long as inflation doesn’t exceed 2.25%. Previously, he tended to side with the FOMC’s hawks. Now he is even more liberal than FRB Chicago President Charles Evans, a super-dove who has been advocating NZIRP until the jobless rate falls below 7%. Evans can declare victory since that seems to be the new policy implied in the 9/13 FOMC statement, though Fed Chairman Bernanke denied during his 9/13 press conference that there is a specific unemployment rate that is being targeted.

FRB Dallas President Richard Fisher, an outspoken critic of the Fed’s unconventional monetary policy easing programs, is not a voting member of the FOMC this year. However, he undoubtedly lashed out at QE3 Forever during the latest meeting of the Fed’s policy-setting committee. He shared his dissident's views with the public on last Wednesday, September 19, in a speech before the Harvard Club of NYC.

His most sarcastic punch line: “We are blessed at the Fed with sophisticated econometric models and superb analysts. … The truth, however, is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 Banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course.” It was a not-too-subtle dig at Fed Chairman Ben Bernanke’s recent Jackson Hole speech, in which he claimed that the Fed’s econometric models confirmed that the Fed’s previous unconventional policy measures had worked to boost economic growth and lower the unemployment rate, though the jobless situation remained “grave” by his own admission.

Fisher went on to observe that small and medium-sized businesses, “the wellsprings of job creation,” are hesitant to expand their payrolls at a more normal faster pace because of regulatory and fiscal uncertainty, not tight credit. Big business, which accounts for much of capital spending, is also stymied by the same concerns and is using NZIRP as an opportunity to borrow cheaply in the bond market to buy back stock rather than to expand. The positive wealth effect on stocks is more than offset by the weakness in capital spending, in Fisher’s opinion. I agree.

Movie. “Trouble with the Curve" (+) (link) stars Clint Eastwood as an aging baseball scout for the Atlanta Braves. He doesn’t talk to any empty chairs, though he is losing his eyesight in the movie. But at the same time, he is finding out how to get closer to his daughter, whom he neglected when she was growing up. One of the messages of the film is that computer models can’t beat common sense. I hope Ben Bernanke goes to see the film and gets this point.

Today's Morning Briefing: Leading & Misleading Indicators: (1) Fed chatter never ends. (2) Fisher vs. Bernanke, Evans, and Kocherlakota. (3) Despite high-powered models, Fed is clueless. (4) A shortage of money isn’t the problem for employers. (5) ECRI: There they go again seeing a recession. (6) False alarms and top secrets. (7) Composite indicators can go rogue. (8) Our own formula is no secret. (9) Bad geopolitical vibes and bad global economic indicators. (10) The case for sector neutrality. (11) “Trouble with the Curve” (+). (More for subscribers.)

Saturday, September 22, 2012

QE3: A Brief History

It was only a week ago that the Fed's FOMC formally implemented its latest and most radical version of quantitative easing on September 13. While the details surprised the markets, the concept of an open-ended QE3 was first floated by John Williams, president of the Federal Reserve Bank of San Francisco, in a July 23 interview in the FT. He is a voting member of the FOMC.
In the interview, Williams warned of significant downside risks to the US economy from the fiscal cliff, the euro zone crisis, and the global slowdown. He favored QE3 with the Fed buying mortgage-backed securities. He proposed that it be open-ended without specifying how much the Fed would purchase and when the program would end. That’s exactly what the Fed implemented last week. (I highlighted this story in our Morning Briefing the very same day it appeared in the FT.)

Williams floated the idea again in an interview reported in the 8/10 issue of the San Francisco Chronicle. When he was asked whether QE3 should be saved to cushion the fall off the cliff early next year, if necessary, he responded: "We want to position the economy to be strong in advance of that. If you are really worried about running out of ammunition, you want to act more aggressively, more quickly and better prepare yourself for that eventuality." (I believe the question was inspired by a conversation I had with the reporter who asked me what I would ask Mr. Williams.)

Boston Fed President Eric Rosengren, who is a non-voting member of the FOMC, seconded Williams’ motion for open-ended QE3 in an interview reported in the 8/7 WSJ. According to the minutes of the July 31-August 1 FOMC meeting, released yesterday, "Many participants expected that such a [QE] program could provide additional support for the economic recovery both by putting downward pressure on longer-term interest rates and by contributing to easier financial conditions more broadly."

On August 23, I made the following prediction about Fed Chairman Ben Bernanke’s next big speech: “I think there’s a chance that he might announce during his August 31 speech at Jackson Hole that the Fed will launch an open-ended QE3 program with the hope of turbocharging the economy so that it can leap over the cliff.” He didn’t do so explicitly, but he certainly set the stage for the FOMC decision on September 13 by expressing his “grave concern” about the unemployment problem.

For quite some time, I’ve sided with the FOMC’s hawks, who have been critical of QE. I wasn’t a fan of QE2. I think it backfired, reducing the purchasing power of consumers by boosting food and fuel prices. I wasn’t rooting for QE3. There are lots of other critics of the Fed's latest unconventional easing program. However, now that it’s a done deal, I’m willing to be open-minded about open-ended QE3.

As I previously noted, Bernanke & Co. were very clever to focus QE3 on purchasing mortgage-backed securities since the housing market was starting to recover without any additional assistance from the Fed. If it continues to do so, they can take credit for it!

Sure enough, the latest data for new and existing home sales and for housing starts all look quite good. The most current series, available for September, are based on a monthly survey of members of the National Association of Home Builders. Their overall Housing Market Index rose this month to 40, up from 14 a year ago and the best reading since June 2006. August was a very good month for existing home sales, which jumped 7.8% m/m.

If QE3 boosts US economic growth by giving the housing industry an extra lift, that would be good for earnings. If it weakens the dollar, that would be good for earnings. The JP Morgan trade-weighted dollar index was up as much as 9.3% y/y this year on July 24. It is now flat y/y. As a very rough rule of thumb for the S&P 500, I reckon that a 10% increase in the dollar will depress profits from overseas by 20% and total profits by 10%.

Thursday, September 20, 2012

Euro Mess

On July 26th, ECB President Mario Draghi promised to do “whatever it takes” to defend the euro. It may take a lot, especially to keep Spain in the euro zone. The latest data compiled from original central bank sources, show that non-performing Spanish bank loans rose to a record 9.9% during July. Spanish bank deposits continued to fall sharply in July, down €74.2 billion m/m and €207 billion y/y. The ECB lent Spain €411.7 billion through August, mostly through the LTRO facility. Pour another glass of sangria for Mr. Draghi.

The TARGET2 imbalances continued to worsen in August as capital flowed from the south to the north of the euro zone. Last month, Spain had a record debit balance of €434.4 billion. Italy’s debit balance was a record €289.3 billion. Germany’s credit balance rose to a record €751.4 billion. The M2 monetary aggregates continued to fall y/y during July in Greece (-15.0%), Spain (-6.8), and Portugal (-6.1 in June). M2 was up in Germany (9.0), France (5.1), and Italy (3.8).

Today's Morning Briefing: QE3: A Very Brief History. (1) John Williams told us all about QE3 on 7/23. (2) QE3 boosted bullish sentiment and thinned out the correction camp. (3) Junk thrives in QE3 sunshine. (4) Demand/supply ratio bearish for oil. (5) Open-minded on open-ended. (6) Fed cleverly positioned to get credit for housing recovery. (7) How QE3 could boost earnings. (8) Time for another glass of sangria. (More for subscribers.)


Wednesday, September 19, 2012


The Chinese government is picking fights with some of its neighbors over several islands in the South China Sea. These issues have been simmering for a very long time. Why are they coming to a boil now? One possibility is that the Chinese government is stirring up nationalist sentiments to distract the locals from some serious homegrown problems, and doesn't believe that the US will side with Japan and other Asian nations disputing China's territorial claims.

China’s Communist leadership change isn’t going smoothly at the same time that the economy is slowing significantly. For example, electricity output during the three months through August rose only 1.4% y/y. Crude oil demand has flattened out around 9.5mbd over the past six months through August. Fred Smith, the head of FedEx, warned on Tuesday that China watchers may be “completely underestimating” that the export slowdown is more than offsetting attempts by the government to boost growth.

The recent widespread protests in China against Japan’s claims to some of the disputed islands in the South China Sea are already harming the economy. Japanese companies are temporarily closing their manufacturing facilities and retail outlets in China. Trade between China and Japan totaled $323 billion (saar) during August, with China’s exports to Japan at $147 billion and imports from Japan at $176 billion.

China’s Shanghai-Shenzhen 300 stock price index rallied late last week, but now seems to be resuming the downward trend of the past year. The price of copper rebounded smartly last week on news that China will spend to build subways and roads, but could weaken if tensions between China and Japan don’t abate soon. Japan’s Nikkei is also vulnerable to the dispute between the two countries.

This morning, Reuters reports that the mass protests could backfire on China’s Communist leaders. Ultra-nationalists are going bonkers that Beijing isn’t being tough enough on Japan. Many demonstrators held up portraits of Mao Zedong. Last week, Gen. Xu Caihou, vice chairman of the Central Military Commission, considered the most senior military political commissar, said that military forces should be “prepared for any possible military combat,” according to the state-run Xinhua news agency.

Today's Morning Briefing: King of Hearts. (1) The lunatics have escaped. (2) Lots of angry people. (3) Uncle Sam has left the building. (4) China’s economy threatened by anti-Japanese protests. (5) Iran’s loony leader is ranting again. (6) Exercises in the Persian Gulf. (7) The world needs a warden. (8) They are mad in Europe and the US too. (9) Oil price rollercoaster. (10) Saudis want to pump it up. (11) Energy stocks and Dramamine. (More for subscribers.)

Tuesday, September 18, 2012

Stocks & QE

The Fed’s QEs and Operation Twist all seemed to be responses to falling inflationary expectations. So far, they all successfully boosted those expectations. The inflation rate embedded in the spread between the 10-year Treasury yield and the comparable TIPS yield jumped by 39bps from 2.25% on August 31, when Bernanke spoke at Jackson Hole this year, to 2.64% on Friday. That matches QE2’s peak on April 8, 2011.

The S&P 500 has been highly correlated with the 10-year Treasury market’s expected inflation rate. Rising inflation tends to be bullish for stocks because it boosts revenues and earnings as long as prices are rising faster than costs. In the past, inflation was only bearish when the Fed tightened monetary policy to bring down inflation. Since the financial crisis started in 2008, the Fed’s goal has been to avert deflation with unconventional monetary easing.

Today's Morning Briefing: Stocks & QE3. (1) “What’s not to like?” (2) Eight reasons why QE is bullish for stocks. (3) Don’t fight the Chairman. (4) Encore, encore! (5) NZIRP is purgatory for conservatives. (6) It might work this time. (7) Basking in the warm glow of inflation. (8) A weaker dollar may be boosting earnings already. (9) No more Lehmans! (10) Lenders of last resort to everyone. (More for subscribers.)

Monday, September 17, 2012

QE & Stock Prices

There they go again. Last Thursday, the FOMC voted to implement open-ended QE3. Last Wednesday, the German Constitutional Court cleared the way for the establishment of the European Stability Mechanism. That will allow the ECB to proceed with its plan for unlimited QE in the euro zone.

So happy days are here again! The central banks will do whatever it takes to avert another Lehman Moment. For now that trumps concerns about the US Fiscal Cliff, the Euro Mess, and the China Landing. On the geopolitical front, there is a new worry, i.e., the “Arab Winter”--in addition to push coming to shove in both the Persian Gulf and the South China Sea. However, as I wrote last Wednesday, the bull has been charging to new high ground on performance-enhancing drugs provided by the Fed and the ECB. Instead of a meltdown, we have yet another melt-up relief rally:

(1) The S&P 500 jumped to 1466, up 1.9% w/w and 16.1% ytd. It is only 6.7% below its record high of 1,565 on October 9, 2007. The S&P 500’s forward P/E jumped to 13.1 last week, the highest since June 2008.

(2) The Wilshire 5000 rose to a new cyclical high of 15,354, only 2.9% below its record high on October 9, 2007.

(3) The S&P 400 MidCap index rose 2.2% w/w and 16.8% ytd, exceeding its previous record high on April 29, 2011. The S&P 600 SmallCap index is up 2.5% w/w and 17.0% ytd to a new record high.

(4) Dow Theory followers should be happy to see that the 2.2% increase in the DJIA was confirmed by the 2.8% increase in the DJTA.

(5) The central banks have certainly succeeded in turning investors into QE junkies. The S&P 500 rose 36.4% during QE1, 24.1% during QE2 (starting with Fed Chairman Ben Bernanke’s speech at Jackson Hole on August 27, 2010), and 4.2% so far since Bernanke’s speech at Jackson Hole on August 31, 2012. The S&P 500 is up 18.1% since the ECB’s LTRO1 was implemented on December 20, 2011, and 7.8% since ECB President Mario Draghi’s “whatever it takes” speech on July 26 of this year.

The question is how quickly will the latest injections of performance-enhancing drugs wear off?

Today's Morning Briefing: Feddie. (1) The game that never ends. (2) There they go again. (3) QE addiction. (4) Stomping on the tail. (5) QE-3.5 might work if QE-3.0 doesn’t. (6) Good for our Second Recovery scenario for 2013. (7) The Fed’s latest QE cleverly targets housing, which is improving already. (8) What if QE enables reckless fiscal policy, which worsens joblessness? (9) Schumer begged, so Bernanke delivered. (10) Melting up to a double top? (11) Retailers charging ahead. (12) “The Queen of Versailles” (+). (More for subscribers.)

Thursday, September 13, 2012

S&P 1500

Time sure does fly. Summer started on June 21. It will end next Friday, on September 21. It’s been a great summer rally. The S&P 500 is up 12.2% since June 1, and 14.2% ytd. The S&P 500 is only 8.2% below its record high on October 9, 2007. The S&P 400 MidCap index is up 14.3% ytd and just 1.0% below its record high on April 29, 2011. The S&P 600 SmallCap index is up 14.5% to a record high.

The bull markets in all three S&P market cap indexes have been led by their forward earnings, which are at record highs. Their valuation multiples are more or less even with where they were when stocks started to rebound from the bear market during March 2009.

Maybe we should consider going away and coming back after the November 6 elections, assuming there will be a yearend rally too. That will depend on the results of the election and whether they lead to more or less gridlock in Washington. If there is more gridlock, there is a greater risk that the economy could fall off the fiscal cliff early next year. In this case, there might not be a yearend rally. It’s getting harder to get charged up about the near-term prospects for stocks.

Today's Morning Briefing: A Change of Seasons. (1) Will summer rally be followed by yearend rally? (2) Many stocks at or near record highs. (3) Record high forward earnings. (4) No QE4 after QE3. (5) Not much growth here or there. (6) No jolt in JOLTS jobs report. (7) Not much spice in China’s tax revenues, money supply, and loans. (More for subscribers.)

Wednesday, September 12, 2012

Earnings Guidance

Monday’s FT reported that “[d]uring the latest reporting season S&P 500 groups were three times more likely to say they would miss analysts’ expectations of third-quarter earnings than beat them. That was the worst guidance ratio since the final quarter of 2008, immediately after the collapse of Lehman Brothers.”

Intel on Friday cut its previous third-quarter sales forecast, citing weaker demand for its microchips amid the softening worldwide market for personal computers. The company supplies about 80% of PC microprocessors. Dell and Hewlett-Packard both recently lowered their earnings outlook for the next few months. Worldwide sales of PCs are expected to grow less than 1% this year, marking the second consecutive year of growth below 2%, according to International Data Corp.

Semiconductor industry analysts have been mostly lowering their 2012 and 2013 estimates, and forward earnings has been flat-lining since late 2009 following a dramatic rebound earlier that year. Even estimates for the Computer Hardware industry (which includes Apple) have been trimmed recently.

The same goes for Air Freight & Logistics, especially after FedEx management warned last week that the global slowdown is depressing the company’s revenues and profits. In fact, the industry's Net Earnings Revisions Index has been negative every month since August 2011.

Today's Morning Briefing: Bull on Steroids. (1) September is a good month so far. (2) October could be trouble. (3) The next two full moons over Iran. (4) Performance-enhancing central banks. (5) Stocks near five-year high despite bad economic and earnings news. (6) The worst earnings guidance since Q4-2008. (7) Intel and FedEx seeing global slowdown. (8) Flattening exports. (9) Obama will meet with Letterman, not Netanyahu. (10) Israel’s jumbo drones. (11) Now for a little good news. (12) Après QE, le déluge? (13) A broad bull market for now. (More for subscribers.)

Tuesday, September 11, 2012

Global Economy

While China’s latest batch of economic indicators was uniformly weak, there were some upside surprises in the US and Germany. Let’s review:

(1) China. Exports, which represent about 25% of the Chinese economy and account for millions of jobs, slowed sharply in recent months. They rose just 2.7% y/y during August. Growth has been depressed by Europe’s recession and the anemic recovery in the US. An unexpectedly sharp slump in imports to China showed that domestic demand, too, had weakened. Imports fell 2.6% y/y in August.

(2) United States. Of course, Friday’s payroll employment release for August was disappointing. However, ISM’s non-manufacturing PMI rose from 52.6 in July to 53.7 in August led by a jump in its employment component from 49.3 to 53.8.

(3) Germany. Most surprising was Germany’s industrial production, which jumped 1.3% in July. It was led by a 3.8% increase in capital goods output, back toward previous record highs. On the other hand, Germany factory orders remained stalled during July, as they have been for the past year.

Today's Morning Briefing: Is China Shovel Ready? (1) Corruption and concrete. (2) Cave-ins and collapses. (3) High speed, high risk. (4) Xi is missing. (5) China and Japan have some disputes. (6) China’s trade data confirm global slump. (7) Are there any limits to unlimited QE? (8) Capital markets are the Fed’s casino. (9) Will Spain and Italy say thanks, but no thanks to ECB? (10) Latest US and European indicators: Not so bad. (More for subscibers.)

Monday, September 10, 2012


China’s transition from export-led growth to domestic-led growth might not be easy and could be disrupted by major social unrest. This is a very big concern among our London accounts (with whom I met with last week), particularly those who frequently visit China. They told me that Chinese officials expected to have plenty of time to make the transition. However, the sudden slowdown in China’s exports--mostly attributable to the recession in Europe--is forcing China’s leaders to scramble to boost domestic growth. Their immediate reaction over the past two years has been to raise minimum wages. That’s crushing profit margins, which tend to be razor thin even when all is going well.

So now companies are scaling back their hiring. China’s industrial production rose 9.0% y/y during August, but that’s the lowest pace since May 2009. Railway freight traffic plunged 12.4% over the past four months through July to the slowest pace since February 2011. All these developments certainly explain why the Shanghai-Shenzhen 300 stock price index dropped last Wednesday to the lowest readings since March 3, 2009. On Friday, it rebounded by 5.3% on news that the government approved 25 new subway and inter-city rail projects worth $126 billion.

That’s not much, really. Why aren’t China’s leaders spending much more as they did in late 2008 and 2009 to boost economic growth? It might be because much of what they built was defective as a result of widespread corruption. The 8/4 issue of the London Times reported there were 99 road cave-ins in Beijing between July 21 and August 21 of this year. Roads and bridges are collapsing in other cities as well. Most are relatively new including a bridge that was built just 10 months ago.

The country's former railway minister, Liu Zhijun, was expelled from the Communist Party of China for corruption in May following the high-speed train collision that left 40 people dead and 172 injured near the eastern city of Wenzhou last year. In March of this year, part of a high-speed railway line due to open in May between the Yangtze river cities of Wuhan and Yichang collapsed after heavy rain. Engineers working on some projects have complained of problems with contractors using inferior concrete or inadequate steel support bars. Consider this excerpt from the 2/17/11 issue of the NYT:

“The statement underscored concerns in some quarters that Mr. Liu cut corners in his all-out push to extend the rail system and to keep the project on schedule and within its budget. No accidents have been reported on the high-speed rail network, but reports suggest that construction quality may at times have been shoddy. A person with ties to the ministry said that the concrete bases for the system’s tracks were so cheaply made, with inadequate use of chemical hardening agents, that trains would be unable to maintain their current speeds of about 217 miles per hour for more than a few years. In as little as five years, lower speeds, possibly below about 186 miles per hour, could be required as the rails become less straight, the expert said. Strong concrete pillars require a large dose of high-quality fly ash, the byproduct of burning coal. But the speed of construction has far exceeded the available supply, according to a 2008 study by a Chinese railway design institute.”

Today's Morning Briefing: All’s Well, But Will It End Well? (1) Life is good in London. (2) Pessimistic undertone. (3) Four concerns. (4) US wages and salaries on the edge. (5) Global growth is on the 50-yard line. (6) China’s Big Dig. (7) War talk in the Middle East. (8) Any upside left for stocks between now and the elections? (9) A few positive employment indicators.(More for subscribers.)

Saturday, September 8, 2012

Fiscal Fiasco

I met with our accounts in London this past week. The number one concern among investors here is the US fiscal cliff at the beginning of next year. That seems to be a bigger worry than a breakup of the euro zone. There is a great deal of interest in the upcoming US presidential elections, and a sense that the fiscal cliff is more likely to be averted if Mitt Romney wins. If Barack Obama wins, the fear is that political gridlock will thwart any attempts at a bipartisan compromise on fiscal policy.

I tend to agree with this assessment. However, in either case, I expect that right after the November 6 elections, Congress will pass legislation that will delay the fiscal cliff until mid-2013. That doesn’t guarantee that this problem will be resolved by then even if Romney wins. There is already a big debate about Romney’s fiscal plan.

In the 8/28 WSJ, Martin Feldstein wrote an op-ed titled “Romney's Tax Plan Can Raise Revenue.” It’s no surprise that Feldstein is defending the Romney plan since it reflects some of his suggestions, especially capping the amount that an individual taxpayer can benefit from tax loopholes. It’s a great idea. The Simpson-Bowles deficit reduction plan also targets eliminating lots of the loopholes. The problem is that all those high-priced and high-powered lobbyists in Washington will fight tooth-and-nail to keep the loopholes they worked so hard to stick into the tax code for their special-interest clients. Leaving the loopholes alone but limiting their use by individual taxpayers would certainly help to call off the attack dogs.

However, Republican legislators who signed Grover Norquist’s no-new-taxes pledge might baulk at capping loopholes even if one of their own is in the Oval Office. Norquist, who is president of Americans for Tax Reform, recently claimed that his pledge is more popular than ever. The 6/21 WSJ reported: “As evidence, he says, the pledge is growing in popularity among congressional candidates. In all, 449 incumbents and challengers signed the pledge in 2010, including 241 challengers and 208 incumbents. This time around, 534 have signed the pledge, including 255 challengers and 279 incumbents, he said.”

In his op-ed, Feldstein wrote: “Mitt Romney's plan to cut taxes and offset the resulting revenue loss by limiting tax breaks has been attacked as ‘mathematically impossible.’ He would reduce all individual income-tax rates by 20%, eliminate the Alternative Minimum Tax and the estate tax, and limit tax deductions and loopholes that allow high-income taxpayers to reduce their tax payments. All this, say critics, would require a large tax increase on the middle-class to avoid raising the deficit. Careful analysis shows this is not the case.”

The question is whether the no-new-taxes crowd would accept a cap on loopholes in exchange for lower marginal tax rates. I think it is a very fair trade. I am especially fond of the Simpson-Bowles plan, which would eliminate all if not most tax loopholes and use the money to slash marginal tax rates and still put us on a path towards significant deficit reduction. Feldstein’s approach may increase the chances of implementing a lite-version of Simpson-Bowles. That would be better than no plan, which remains a possibility if political gridlock prevails no matter who wins in November.

In his 8/23 NYT column, David Brooks blamed Republican VP-nominee Paul Ryan for scuttling the Simpson-Bowles plan. Ryan was a member of this commission and voted against the plan: “Ryan voted no for intellectually coherent reasons. He argued that the single biggest contributing factor to public debt is the unsustainable growth of Medicare. Yet the Simpson-Bowles plan did nothing to restructure Medicare, and it sidestepped health care issues generally. Ryan said that it was silly to come up with a debt-reduction proposal that didn’t fix the single biggest driver of the nation’s debt.”

Brooks claims that “[i]f Ryan and the other House Republicans had voted for the Simpson-Bowles proposal, it would have gone to Congress for up-or-down votes, regardless of how President Obama reacted. We would have had national action on debt reduction.” That’s a stretch, to say the least. The Democrats weren’t blameless, and the President showed no interest in pushing for the plan whatsoever. Here are the facts:

(1) The original bipartisan legislation proposing the commission would have required Congress to vote on its recommendations as presented, without any amendment.

(2) In January 2010, that bill failed in the Senate by a vote of 53-46, when six Republicans who had co-sponsored it nevertheless voted against it. Thereafter, Obama established the Commission by Executive Order 13531.

(3) The Simpson-Bowles report was released on December 1, 2010, but failed a vote on December 3. Eleven of 18 votes were in favor, with a supermajority of 14 votes needed to formally endorse the blueprint. Among the seven dissenters were four Democrats. A curse on both their Houses!

On the other hand, in his acceptance speech in Tampa, Ryan failed to mention that he was a member of the commission and voted against its proposal. Instead, he noted that President Obama “created a bipartisan debt commission.” He said, “They came back with an urgent report. He thanked them, sent them on their way, and then did exactly nothing. Republicans stepped up with good-faith reforms and solutions equal to the problems. How did the president respond? By doing nothing--nothing except to dodge and demagogue the issue.”

A curse on both their Houses!

Finally, for now, here’s one more item on this subject from last week’s news: On Tuesday, Gene Sperling, the influential head of President Obama's National Economic Council, said that if the President is re-elected he will seek a sweeping deficit reduction agreement with Congress based on the “basic framework” of the Simpson-Bowles commission report. Sperling said he expects aggressive budget talks to begin after the November 6 election to avoid taking the nation over the fiscal cliff. Sperling said Obama would like to negotiate a deficit reduction accord similar to the deal he was discussing with House Speaker John Boehner last year. However, he made it clear that Obama would insist on a deficit reduction deal that includes additional revenues and did not have spending cuts that are as deep as those proposed by congressional Republicans led by House Budget Committee Chairman Paul Ryan.


Wednesday, September 5, 2012

Dow Theory

It was a summer to remember: Nothing special happened. However, it was one of the few summers in recent years that stock investors wouldn’t prefer to forget. The summers of 2007, 2008, 2010, and 2011 were all worth forgetting. The summer of 2009 was the previous good one for stocks, but it wasn’t worry-free. Neither was this summer, but there was nothing really new to worry about. Just the same old, same old.

Actually, there is something new to worry about. A Dow Theory divergence has developed between the Dow Jones Industrials and the Dow Jones Transportation indexes. The former rose to a new cyclical high of 13279 on May 1, slightly exceeding the previous cyclical high at the start of this year. So far, it’s failed to move higher, raising fears of the dreaded “double top.”

Contributing to the concern is that the DJ Transportation index hasn’t even bothered to retest the year’s February 3 high, let alone last year’s cyclical high, which also happened to be a record high. The theory is that if the transportation stocks aren’t confirming the strength in the stocks of industrials companies, then look out below.

I also like to compare the S&P 500 Industrials Composite index to the S&P 500 Transportation index. The former excludes Transportation, Financial, and Utility stocks. On August 17, it actually rose to a 12-year high. However, the latter has been flat-lining since the start of the year just below its record high of July 7, 2011.

I don’t see a major divergence here. It wouldn’t take much for both indexes to converge in a more bullish fashion. Besides, when we have a closer look at the S&P 500 Transportation index, we see a very interesting and somewhat unusual divergence between the two major industries in this index:

(1) The Railroads index, which accounts for 46% of the market capitalization of the S&P 500 Transportation index, rose to a record high in late August. It is up 8.2% ytd. The forward earnings of this industry rose to a record high in mid-August. The 2012 and 2013 consensus earnings estimates have held up well at record highs too.

(2) The Air Freight & Logistics index, which accounts for 50% of the S&P 500 Transportation index, has been weak this year. It is down 1.2% ytd. The forward earnings of this industry also rose to a record high in July, but has declined recently along with the estimates for 2012 and 2013.

The internal divergence within the S&P 500 Transportation Index between the Railroads and the Air Freight & Logistics stock price indexes as well as between the recent earnings estimates for the two makes sense. The US economy is chugging along relatively well. Rail car loadings of intermodal containers rose to a record high in August. On the other hand, global economic activity is slowing, and so is business for Air Freight & Logistics companies.

Today's Morning Briefing: Fiscal Fiascos. (1) What are they worrying about in London? (2) The future of gridlock. (3) Will the cliff be delayed until mid-2013? (4) Martin Feldstein wants to cap loopholes. (5) Washington’s attack dogs defend their special interests. (6) Norquist’s no-new-taxes pledge. (7) Did Ryan single-handedly scuttle Simpson-Bowles? (8) Ryan’s omission. (9) A curse on both their Houses! (10) Sperling’s spin. (11) Global manufacturing weakening. (More for subscribers.)

Tuesday, September 4, 2012


I’ve been bullish on the earnings-led bull market in stocks since March 2009 because I believed that it would continue to be led by earnings. So far, so good. However, as I’ve been noting lately, the bull is running out of earnings power. Consider the following:

(1) S&P 500 Earnings Per Share. I regularly focus on weekly S&P 500 forward consensus expected operating earnings, which has stalled around $111 per share since May. The quarterly data for S&P 500 operating earnings per share also has lost its upward momentum recently.

(2) After-Tax Net Income. Also running out of steam is the aggregate net income of the S&P 500. It is highly correlated with the after-tax corporate profits measures reported along with GDP in the National Income & Product Accounts (NIPA).

(3) Pre-Tax Profits by Source. The Bureau of Economic Analysis disaggregates the components of NIPA profits on a pre-tax basis. The data show that the domestic profits of nonfinancial corporations rose to a record high of $1.1 trillion (saar) during Q2, up 7.0% y/y. However, profits of financial corporations have stalled in a zigzag fashion over the past three years, while profits from the rest of the world have fallen from a recent peak of $451 billion during Q4-2011 to $422 billion during Q2-2012.

(4) Financial Corporate Profits. The S&P, NIPA, and FDIC measures of financial corporate profits are looking especially toppy. The FDIC data show that commercial banks have been reducing their provisions for loan losses from a peak of $71 billion during Q4-2008 to $14 billion during Q2-2012. That has boosted earnings. However, charge-offs for bad loans have exceeded provisions since Q1-2010, which is a drag on earnings.

(5) Profits from Abroad. I’ve been arguing that despite the global slowdown, US corporations would find enough business opportunities overseas to offset slower growth in the US. The latest data show I got that exactly backwards so far. Domestic profits rose to a record high, as noted above. Profit receipts from abroad, which account for 33.4% of pre-tax corporate profits, declined 3.2% y/y, the weakest growth rate since Q3-2009. The problem is that the y/y growth in profit receipts from abroad tends to be inversely correlated with the trade-weighted dollar on a 2-for-1 basis. The dollar is up 8.8% y/y through July, implying a decline twice as much for overseas profits.

Today's Morning Briefing: Back to School. (1) September is just another month. (2) Let’s not ask Clint Eastwood. (3) More upside for P/E than E. (4) Nonfinancial corporate domestic profits still strong. (5) Financial profits have stalled. (6) Weak global growth and strong dollar weighing on profits from abroad. (7) Ben and Mario are two wild and crazy guys. (8) Ben proudly injects steroids into the bull. (9) Mario wants to fix blockages. (10) “The Bourne Legacy” (-). (More for subscribers.)