March 2014

……………...Thoughts and Comments



The More Things Change…

There really hasn’t been much to comment on in the past two months beyond earnings, so this letter will be fairly short.  Yes, the markets dropped in January and then hit records in February and March.  Yes, there were emerging market crises and the Ukraine is likely to become part of Russia again before too long.  But really, nothing has changed.

The market is all about trading, and has been for some time – which is not an intelligent way to invest.  So after a huge rally in 2013 based on…um…we are still trying to figure that out…the markets decided things were overdone – at least according to the gurus at Goldman Sachs.

In November, Goldman Sachs was bullish on the U.S. market.  After a 6% rally in December alone, they changed their mind in mid- January as reported in Zero Hedge:  “S&P 500 valuation is lofty by almost any measure, both for the aggregate market (15.9x) as well as the median stock (16.8x). We believe S&P 500 trades close to fair value and the forward path will depend on profit growth rather than P/E expansion.”

Lo and behold, the markets were down about 5% in January and half of February, and suddenly, Argentina, Brazil, India, Russia, South Africa, Turkey, and Ukraine all became major concerns.  The dollar rallied, stocks dropped, bond yields dropped, even though the Fed said “all is well” and announced that they would continue to slowly taper their money-pumping.  Now, to be fair, with the Fed withdrawing $10 billion a month from their spending spree, some amount of pullback was to be expected since the markets are nothing but leveraged speculation.  But after a couple of weeks of this, apparently it was decided that everything was fine and so the S&P retraced all of its losses and hit new highs.

Then, in the past couple of weeks, the Ukraine crisis came to the fore. Riots – shootings – a government collapse (I bet most people couldn’t find the Ukraine on a map) – and Russia took over the Crimea (and you think the Ukraine is hard to find) and markets drop 168 points.  The next day, Russia said they wouldn’t attack the Ukraine for now, the U.S. thanked them for their kindness but promised severe economic retributions should they show any more aggression and the Russians responded by saying that any economic sanctions will be met with economic moves of their own which would not be “symmetrical.”   On this obviously wonderful news that we are all friends again the S&P jumped even more than it fell, rising 225 points.

But what does any of this have to do with investing?  That is a very good question.  Certainly, the Fed’s money printing at various levels of extreme have an impact.  Certainly earnings have an impact.  But by and large, none of that was ever discussed by anyone; they were too busy buying and selling and whipping up a frenzy.

But not to worry, because most investors will tell you that earning are terrific and the markets are not very expensive at all.  In addition, corporate balance sheets are stronger than at any time since 2008 and that there has been an under-investment in capital structures so earnings will continue to drive higher.


Q4 2013 Earnings – The Real Story

Let’s consider these items more closely.

1)    Earnings are growing nicely…

In the past two years, the median growth rate for S&P 500 companies has been slowing – from about 7% to about 4%.  While earnings per share (“EPS”) have shown increased growth this past year, the amount of share buybacks is up dramatically.  Close to 35% of the S&P companies have benefited from share buybacks.  A look at net income as opposed to EPS shows dramatically slower growth, especially in the past two quarters.

Given the large increases in inventories for the past eight months, the severe winter, and weakness in Asia, we would not be surprised to see revenues and net income to continue to slow into the next quarter.

Figure 1 – Revenue Growth (data provided by S&P Capital IQ)

Figure 2 – Earnings per Share vs Net Income (data provided by S&P Capital IQ)

Figure 3 – P/E Ratios – S&P 500 (data provided by S&P Capital IQ)


2)    Corporate debt levels are lower now than in 2008…

Total debt is up, not down.  Cash is also up, but on a net basis, debt is still much higher than in 2008.  At first debt was being refinanced, replacing higher cost debt with lower cost debt.  This lowered corporate interest expense – a positive – and increased earnings.  But for the past two years, new debt has been raised and used to fuel increases in dividends and to share repurchases.  Such leverage is dangerous if sales and earnings slow at all.

Currently, the median debt/capital ratio of the S&P 500 is about 38.8%, very close to the highs back in 2008-2009.  If revenues were to actually contract, the added leverage could be a strain on cash flows and potentially on dividend distributions, not to mention the fact that investor money will have been wasted buying back expensive stock just for the benefit of management (stock buybacks make earnings look better than reality and help justify large management bonuses).

Figure 4 – Total Debt (data provided by S&P Capital IQ)

Figure 5 – Total Debt to Revenues (data provided by S&P Capital IQ)

Figure 6 – Debt to Total Capital (data provided by S&P Capital IQ)


3)    Companies will have to increase their capex as they have underfunded it for several years…

This simply is not true.  Capex did initially drop coming out of the 2008 financial crisis, but it has been rising every since 2010 and is higher than at any time since 2008.  Furthermore, with debt to revenues so high (see chart 5), consumers spending less and slowing growth in many parts of the world, it would seem unlikely that most companies will expand their capex at the current time.

Figure 7 – Capex to Revenues (data provided by S&P Capital IQ)


2014 Plans and Expectations

Given the weakness of many of the economic numbers and the severe winter, we would not be surprised to see GDP weaken in the next quarter, or to see that first quarter earnings will be even weaker than the last two quarters.  Given that the stock markets are, at the very least, very fully valued (a nice way of saying expensive), with many stocks priced like 1999 when valuations were (and are) based on hope rather than economic reality, and that there has not been a correction in over two years — a correction from current highs would certainly be reasonable.

Add on to this that China has experienced a number of defaults in the past several months – several were bailed out by the governments, but several have not been.  While not large in size (several billion Yuan), this is a bad sign for their economy although it will be better for them in the long run.  However, a slow down in China is likely to have repercussions around the world.

If this happens, we expect that Fed Chairman Janet Yellen will open the spigot even more.  This will probably send stocks back up and continue us down a very, very dangerous path.

Of course, the one thing I can guarantee about the stock markets is that they are often not reasonable, especially when there is so much freshly printed currency floating around in the system.

So let’s look a little closer.

1)    We would not be fully invested in stocks.  The Fed has pushed investors into taking excessive risk, and this will come back to haunt investors.  It is important to remember the risk part of the equation.  Wealth is created through long-term growth in economic value, not in speculation.

Investors should maintain an exposure in most asset classes: stocks, fixed income and commodities/real estate.  This does not mean, however, an equal weighting in all of the asset classes.

2)    While we believe the overall markets are expensive, this does not mean that there are not individual issues that are very attractive.  We have been adding to stocks that are actually growing, both revenues and net income, where they are not buying back stock as a way to manipulate earnings, where their debt levels are low, their cash flow is high and where multiples are lower than their growth rates.

If strong, reasonably priced stocks drop in value because the stock market sells off, this is when we would add to them.  So yes, we would hold them through the downturn in most circumstances.  But if that were to happen, that is when our fixed income positions would do well, helping to offset the losses in stocks. This would then provide a source of cash for adding to stocks later.  And when Yellen announces the next version of QE, it will likely to be good for precious metals.

3)    Speaking of precious metals, gold is starting to act much stronger after a terrible 2013.  The gold mining stocks have outperformed all other industry groups so far this year.  We are starting to see a number of smart investors beginning to nibble on gold again while the headlines still show the major broker-dealers projecting bigger losses.   Other positive signs include reports that companies have started writing down distressed assets and are starting to announce acquisitions.  This is usually a good sign as well.

Finally, the demand for gold internationally is very strong and may continue to rise.  India has an important national election in May and may well allow the purchase of gold again (it was restricted last year) as part of political maneuvering.  In China, they continue to purchase record amount of gold even while the West was selling.

The Bottom Line…

The stock markets are pricey and economies are showing very mixed results more recently.  There are, none-the-less, some great companies that are very attractively priced.  At the same time, by keeping a equal weighting in fixed income of short maturities and a smaller percentage in precious metals, we should benefit from any short term pull backs and still protect portfolios from a large portion of any volatility.

Alan E. Rosenfield                                                                                                                     Managing Director

March 2014


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