The Fed Won’t Raise Rates Until Deflationary Trends Reverse

We all love to say “I told you so,” but gloating is difficult when the news is this bad. Back in March 2015, I published an article entitled Deflation is the Main Reason the Fed Will Raise Rates Later Rather than Sooner. As the exhibits below will confirm, deflationary pressures persist, thus the Fed will most likely not be raising rates in December 2015, either. The mainstream media is high on hopium when it asserts that raising rates is the default decision for December. Unless there is a significant turnaround in the trends presented below, rates will remain at current levels until at least April 2016.


Corn and cocoa are the only two major agricultural commodities to finish the trailing 12 month period at slightly higher average prices. Oats, wheat and cotton prices declined modestly, and soybeans and coffee are both down over 35% from a year ago.


The story is worse for physical commodities. Aluminum, copper, nickel, zinc and lead have suffered price declines of -10% to -30% in the past year.


A one-year history of Bloomberg’s commodities index confirms the trend. The global economy has been experiencing widespread declines in the prices of both agricultural and physical commodities for several years. These trends are not consistent with global growth and prosperity. Every central bank in the world is easing its monetary policy except the U.S. Federal Reserve. The Bank of China has recently announced new monetary stimulus efforts on consecutive days. The Bank of Japan openly admits it has extended quantitative easing to include the outright purchases of equity securities (which is more of a monetary madness than a policy). The European Central Bank also laid out plans for another massive round of quantitative easing recently (although Mario Draghi is fast becoming known as the boy who cried “QE”).

It is not plausible that the U.S. Fed will act against these trends. As reported by Bloomberg, Janet Yellen managed to obtain near unanimity (9-1, with only Lacker dissenting) from the FOMC to continue monitoring the situation and reconsider raising rates at its December meeting.

One last exhibit below — the Baltic Dry Index (also from Bloomberg), a measure of global shipping activity, managed to show some improvement from June-August. But the index has trended down for the past 2 months, as the global market selloff quickly dampened business confidence.


And before you get too excited about that November 2014 “high” in the Baltic Dry, examine the chart below. Global shipping activity has been in a downtrend for at least the past 5 years:


The world is not only a long way from “normalized” interest rates, we are a long way from the kind of robust business environment under which any central banker would seriously consider so much as starting the normalization process. Here is the question we should be asking: How weak can the domestic and global economy be if most major central banks are easing further, and a 0.25% increase in the Federal Funds rate is unthinkable?

Categories: Market Commentary

Sector Analysis Reveals Investors’ Waning Appetite for Risk

Analyzing returns to stocks by sector can reveal information about investors’ desire to either take on or avoid additional risk exposure. The chart below shows that the top-performing S&P 500 sectors since May 2015 include defensive sectors such as Utilities, Consumer Staples and Health Care. Investors typically rotate into these safer sectors when they anticipate increased market volatility and sluggish economic conditions, which turned out to be a good call. It’s definitely been a “sell in May and go away” summer thus far.


The worst-performing S&P 500 sectors include Industrials, Information Technology, Materials and Energy stocks. Investors typically rotate into these stocks when they anticipate lower market volatility and brisk economic activity. The continued decline in Materials and Energy raises the possibility that these sectors are now somewhat oversold, with the chance for a potential “relief rally” later in the year.


The chart below shows the CBOE’s implied volatility index (VIX), sometimes called the “fear index,” although when volatility languishes as it has for most of the past 4-year rally in stocks, it can also be thought of as a “complacency index.” The spike in volatility from August 24 rivals those from early 2010 and late 2011, but is still much lower than the volatility observed in late 2008 and early 2009, during the heart of the financial crisis. If the VIX quickly returns to a sub-20% reading, it would signal a return to more of a “risk-on” mentality in Q3. On the other hand, stocks are unlikely to begin a significant uptrend if the VIX remains elevated.


Overall, sector activity shows that investors had been positioning themselves for a steep correction since May. Whether or not the selling continues into bear territory or remains confined to a quick correction likely depends on the Federal Reserve’s September interest rate decision. If the Fed hesitates and postpones their long-telegraphed rate increase, expect stocks to rally sharply this fall — especially the most beaten-down sectors. If the Fed proceeds and raises rates in September, however, the recent increase in volatility is likely to continue, and a sustained market rally is much more unlikely.

Data from S&P’s Capital IQ.


Categories: Market Commentary

Deflation is the Main Reason the Fed Will Raise Rates Later Rather Than Sooner

Like many, I have been perplexed by what can only be described as the complete cluelessness of the U.S. Federal Reserve. Chairwoman Yellen may speak more plainly than Greenspan or Bernanke, but like her obscure-talking predecessors, her statements are circular and contradictory. In her most recent statement last week, in virtually the same breath Ms. Yellen told us that 1.) “economic conditions have moderated” — which any objective observer can confirm — but also that 2.) “the economy continues growing above-trend.” With 2014 Q4 GDP coming in at another disappointing reading of +2.2%, Ms. Yellen must be referring to imaginary, rather than historical, trends. Neutral outsiders can clearly see that the Fed a.) is biased toward interpreting macro data in a way that conforms to their oversimplified academic theories, and even worse b.) reflexively parrots propaganda to markets that serves the interests of the financial services sector. The main problem, of course, is that the Fed stubbornly insists on implementing policies that increasingly diverge from basic common sense. Their recent “threats” to raise interest rates are, I believe, nothing more than a subterfuge being perpetrated on financial markets. They are merely flicking a few jabs to see how markets would react to actual action on interest rates later this year.

I offer two charts to illustrate why I believe the Fed is merely jawboning about imminent hikes in interest rates. The first chart shows the cumulative percentage change in the price of key agricultural commodities over the past year: Corn, wheat, soybeans, oats, cotton, coffee and cocoa. The average 1-year price decline is -25%. Every single commodity in the chart has declined in price. This is known as deflation, pure and simple, which results from economic weakness. When we look at direct measures of changes in price in this manner, instead of the hedonically- and seasonally-manipulated CPI, PPI, PCE, etc., one simple, common-sense truth is clear — the U.S. is being affected by the global deflationary episode that has persisted for at least the past year. The U.S. economy may be stronger than Japan’s or the Eurozone, but it is still so weak that the prices of key agricultural commodities can decline for an extended period of time. And such price behavior is in no way consistent with “an economy growing above trend.”


The second chart shows the cumulative 1-year percentage price change in gold, crude oil, coal, heating oil, natural gas and copper. Every single physical commodity in the chart has declined in price, with an average 1-year price decline of -27%. Once again, we call this phenomenon deflation — a sign of profound economic weakness.

The Fed is jawboning the market the may Floyd Mayweather uses his jab. They are feeling out markets, which they have never seemed to fully understand in the first place. The Fed is observing the effect of merely talking about higher rates, in case they continue losing their collective mind and would be so stupid as to actually raise rates any time in 2015. The relatively minor volatility we’ve seen in reaction to their jawboning would be many times worse, probably resulting in a “correction” in equities that would approach the -20% threshold for an official bear market. And I don’t think they have the nerve to pull the trigger.

It increasingly appears that Janet Yellen and crew are playing with their monetary policy levers like teenagers addicted to a video game. In a market suffering from numerous unpriced risks, the Fed’s utter cluelessness may be the biggest unpriced risk of all.

Categories: Market Commentary

Sector Performance Mixed as Stocks Search For a Catalyst

U.S. stocks were in the negative for January, a signal that often predicts how the rest of the year will go. Analyzing the performance of stock market sectors, known as “sector rotation,” can provide additional clues about the market’s next move. For example, when “risk-on” sectors such as Consumer Discretionary, Energy and Information Technology lead the market on the way up, it often signals the beginning of a broader, sustained rally. When “risk-off” sectors such as Utilities and Consumer Staples lead the market, however, it often signals a period of sideways consolidation or correction.

The 4th quarter of 2014 was characterized by the largest correction in equities in 3 years (-9% in October), after which stocks soared into a period of high-volatility consolidation that has lasted almost 2 months.


Despite the October 2014 mini-correction, 8 out of 10 S&P 500 sectors finished higher in Q4, and did so in an unusually tight range of performance. There are two risk-on sectors among the top performers (Industrials and Consumer Discretionary, suggesting investor bullishness) as well as two risk-off sectors (Utilities and Consumer Staples, suggesting caution and a possible flight-to-safety as investors reached for higher yields while interest rates fell). Utilities declined by the least amount during the October correction, and Staples stocks benefitted from falling energy prices.


The mid-performing sectors in Q4 were also mixed, with a defensive sector (Health Care) leading risk-on sectors like Financials and Information Technology.


The worst performers in Q4 were Energy (decimated by the decline in oil and gas prices) and Materials stocks, reeling from declines in commodity prices and a slowdown in global construction.


Equities remained in the negative overall in early 2015, although 2 defensive sectors (Health Care and Consumer Discretionary) posted modest gains, along with 2 risk-on sectors (Materials and Consumer Staples). Continuing the theme from 2014, there is no clear signal from this type of sector performance.


Sectors earning approximately zero returns in early 2015 include Energy, which recovered from additional losses in mid-January, along with Information Technology and Industrials. If the market was mounting a serious advance, we would expect more leadership from these sectors.


Rounding out the back of the pack in early 2015 were Utilities (risk-off) and Financials (risk-on). Financial stocks seem particularly affected by news that regulators might actually regulate banks a bit in 2015 — shocking.


Despite Q4’s gains, the market’s overall lack of direction is reflected in this type of mixed sector performance. It will be important to continue watching stocks’ reaction to geopolitical and macro news (and the implications of the news narrative) to determine if 2015 is shaping up to be a positive or negative year.

Data from S&P’s Capital IQ. Disclosures: None.

Categories: Market Commentary

NetFlix: Great Company, Overvalued Stock

This article will review NetFlix from a fundamental and technical perspective. Investors liked NetFlix’s results from Q4 2014, focusing on the company’s ability to grow the global subscriber base. The stock had a big move after hours Wednesday, trading above $400 for the first time since October. Although it continues trading like a nineties dot-com darling, NetFlix’s stock remains considerably overvalued vs. any reasonable future growth and profitability assumptions the company may achieve.

Below we see that NetFlix (compared with the S&P 500 and Amazon) has alternated between beating and lagging the S&P 500 for the past 12 months. Yesterday’s sharp price spike stands out in the chart.


The table below shows the 3-year compound average growth rates for NetFlix’s key income statement, balance sheet and value creation drivers. Although the average revenue growth is strong at 26.5%, accounting profits (EPS), free cash flow and economic profit (EVA) have all contracted over the past 3 years. (Quiz: When you grow fast and are less profitable and your stock price rises anyway, you’re just like . . . Amazon, very good.)


NetFlix’s deteriorating profitability is shown from various perspectives in the following table. Operating margins have collapsed into the low single digits, free cash flow margin is negative, and 2013 profits are lower than 2009-2011.


NetFlix’s negative free cash flow per share (shown below) is similar to the long-term deterioration displayed by Amazon.


At least Amazon has been on a CAPEX spending spree, which eats up their free cash flow. NetFlix has yet to make a big move in CAPEX spending compared with Amazon (see below).


Both stocks also struggle to create economic profit.


I projected NetFlix’s financial statements using generous modeling assumptions. I grew future revenues 22% for 2014, tapering down to a long-term growth rate of 5.0% in perpetuity (that is an exceptionally high growth rate for valuation modeling). Even though profit margins have been contracting, I set NetFlix’s pro forma operating margin at 9% and their net margin at 7%, much higher than the company has achieved in recent years.


NetFlix’s cost of capital calculation is shown below, containing several more generous assumptions, including using the current 10-year yield (only 1.85%), and lowering their beta from a historical 1.04 to 0.90. NetFlix’s discount rate of 7.161% is extremely low, which benefits their discounted free cash flow (DCF) valuation.


The discounted free cash flow model is shown below. Even with the generous modeling assumptions (continued fast growth, profit margin expansion and lower risk), the best DCF value I can obtain for NetFlix is $336, vs. their recent price of $409 after hours on Wednesday. The stock remains overvalued by at least 17% ($73 per share), based on a best-case scenario estimate.


A long-term (weekly prices) technical chart of NetFlix shows that yesterday’s closing price of $409 puts the stock right at its 50-week moving average. Although the MACD is still indicating negative price momentum, this breakout above the 50-week moving average could signal the start of a new long-term uptrend. The Wall Street Journal’s Moneybeat blog is already predicting that the next stop for this stock is $500 a share, which is possible (especially with a little help from the ECB, and occasional QE4 hints from Jim (The Mouthpiece) Bullard). Other brokerages, including Stifel, have also set a new price target of $500 for the stock.


Conclusions: NetFlix continues to find a way to grow the subscriber base, which is certainly good news. But the stock price of $409 reflects unrealistic growth and profitability targets the company is unlikely to achieve. If you’re a technical trader, or looking to fill a spot in a growth/momentum portfolio, NetFlix may fit the bill. But if you’re a fundamental investor, the stock is significantly overvalued at $409.

 The author holds no stock in NetFlix or Amazon. Data from S&P’s Capital IQ.

Categories: Market Commentary

Eurozone Banks Ready to Implode, Part 2: In Search of Solvency

This article represents Part 2 on the comparative performance of the 20 largest U.S. and European commercial banks since 2001. (The full paper is available for download from the Social Science Research Network: SSRN.) In yesterday’s post I showed how European banks were lagging U.S. banks in terms of revenue and loan growth, and how both sets of banks had not increased their allowance for loan loss accounts proportionately in the post-crisis period, despite much higher levels of impaired loans.

Today’s post will compare these banks’ profitability, capital ratios, effective tax rates, payouts to shareholders and overall solvency. The graph below depicts the average net profit margin for both sets of banks 2001-2013. Margins trend higher every year through 2006, plunge during the crisis years, and begin recovering through 2010. Afterwards, U.S. banks’ average margins trend back up to their pre-crisis levels, but European banks’ margins trend down for the next 4 years, all the way to a vapor-thin 7% by fiscal 2013.


If we measure profitability as return on equity (ROE), the results are similar. U.S. banks’ average ROE post-crisis has been higher than its pre-crisis average, while European banks’ steadily contracting ROE (2.5% in fiscal 2013) reflects just how desperate their situation really is.


With U.S. banks’ average profit margins back to their pre-crisis levels and ROE consistently higher, one might expect banks to pay taxes at the same rate as they did pre-crisis — but that would occur only in a world that made sense. In our new, banker-centric universe, “profits up, tax rates down” seems to be one part of the new normal even Jamie (“help, we’re under attack”) Dimon would approve of. No sign of regulators ganging up on banks here.


Now, it’s fair to say that global regulators have bombarded banks with complicated capital requirements under Dodd-Frank and Basel I, II, and III. And, based on the graph below, banks seem to be holding 2-3 times the Tier 1 capital required by Basel III. Good job, Mr. D . . . whoops, time out. I almost forgot about recent legislation that allows banks to keep trillions of dollars of derivatives positions off-balance sheet in units that are backstopped by the federal government. Thus, there is no need for the banks to hold capital against such risky positions, because, invoking Jerry Seinfeld: “Ms. Yellen, Mr. Draghi, you’re very good at creating the regulations, but you’re not so good at enforcing the regulations.” Must be tough when Citigroup lobbyists write the laws. The bottom line is, if banks had to hold capital against most of their derivatives positions they would still be vastly undercapitalized. U.S. banks continue using the political process to privatize their profits while socializing potential losses.


Thus far we’ve seen that U.S. banks have higher profits, pay lower tax rates, and appear safer than ever based on their fat and juicy capital ratios — these banks must be returning a ton of cash back to shareholders, right? Well, maybe not. Below I’ve graphed a pseudo-payout ratio (banks’ dividends/revenue ratio, as volatile profits during the crisis years make a conventional payout ratio hard to interpret). U.S. and European banks routinely paid out 10-12% of their revenues in the form of dividends pre-crisis, but post-crisis are paying 6%-8% (with Eurozone banks paying consistently more, despite their lower profitability).


If we include share repurchase activity in shareholder payouts U.S. banks look a bit more respectable — but the total payout to shareholders remains little more than half its pre-crisis level.


The last ratio measures banks’ overall solvency. The ratio of a bank’s market capitalization to all debts plus capital leases is a component of Moody’s Expected Default Frequency (EDF™) calculation. The higher the ratio of value to debt, the lower the probability of default. The deteriorating financial position of European vs. U.S. banks in the pre-crisis period is evident in the graph. European banks’ value/debt ratio displays a long-term decline to less than 15% in 2008, and rises moderately, back to 35%, as of year-end 2013. The value/debt ratio depicts these banks’ precarious slide closer to insolvency, as European banks still owe almost 3 times more to creditors than the market value of their stock. U.S. banks’ mean value/debt ratio tells a completely different story. The ratio achieves a low of only 40% in 2008, and climbs every year thereafter, averaging almost 150% in 2013, which is higher than any pre-crisis value. The ratio suggests a complete return to financial health for U.S. banks, and offers little reason for continued coddling by the U.S. Federal Reserve.


Conclusions: U.S. banks have been given 6 years to restore themselves to profitability — mission accomplished. But they still pay taxes, return cash to shareholders and dodge their capital requirements as if they were on the brink of collapse. European banks, on the other hand, remain trapped in a downward spiral of negative revenue and loan growth, decreasing profitability, increasing impaired and nonperforming loans, and are sporting market value to debt ratios that suggest imminent insolvency. Draghi’s “whatever it takes” promises will probably not be enough this time.

Data obtained from S&P’s Capital IQ.

Categories: Market Commentary

Eurozone Banks Ready to Implode, Part 1: It’s Bad, You Know

This article represents Part 1 on the comparative performance of U.S. and European banks since 2001. (The full paper is available for download from the Social Science Research Network: SSRN. The alternative title refers to the R.L. Burnside song It’s Bad, You Know, featured in an episode of The Sopranos.)

Taking a longer-term view, I find that U.S. banks earned significantly larger stock returns than their European counterparts in the post-crisis years, accompanied by higher rates of revenue and loan growth, lower risk, and superior profitability and loan quality. European banks, on the other hand, remain trapped in a downward spiral of negative revenue and loan growth, decreasing profitability, increasing impaired and nonperforming loans, and are sporting market value to debt ratios that suggest imminent insolvency.

Following are my findings about revenue growth and loan portfolio quality. The next article will cover profitability, capital ratios, interest on deposits and payouts to shareholders. Let’s start with stock returns since April 2009, shown in the graph below.


We know that both corporate profit growth and key macro drivers have been far stronger in the U.S. post-crisis, thus we see the S&P 500 (+150%) outperforming the Euronext 100 (+65%), and the average returns of the U.S. banks (+232%) significantly higher than their European counterparts (+80%). Both sets of banks have had difficulty growing their total revenue post-crisis, as shown in the graph below.


If you follow David Stockman on TalkMarkets, you are familiar with his many excellent articles regarding peak debt around the world. Despite rocky revenue growth, U.S. banks grew their loan portfolios every year post-crisis, for a total gain of +35% from 2010-2013. Over the same period, Eurozone banks’ loan portfolios shrunk by 10%:


Whether growing or shrinking, the quality of banks’ loan portfolios is a critical issue. The following graph shows the percentage of each set of banks’ loans classified as impaired, restructured or nonperforming since 2001:


U.S. banks’ troubled loans have remained stuck at around 7% post-crisis. In Europe, however, the percentage of troubled loans grows every year, approaching 18% by the end of 2013. If you don’t find this sufficiently disturbing, consider that these troubled loans do not take sovereign debt (the debt of other nations) into account, because repayment of these loans is “guaranteed” (Greece has not yet had to sign over the Parthenon as collateral, but the global banking crisis still has room to run, so stay tuned.)

The next graph shows banks’ coverage ratios, which is the amount of “loan loss allowances” relative to impaired loans that banks set aside on their balance sheet in the event of outright loan defaults. After a loan default, allowances are reduced and transferred to the income statement and expensed against bank revenues (as “provisions for loan losses”).


In our new centrally-planned world, banks have adopted a “What, me worry?” attitude about their troubled loans. Despite higher levels of impaired loans, both U.S. and European banks are setting aside much lower relative allowances for loan losses. Here we see the effect of a zero interest rate policy (ZIRP) — why declare a loan as “nonperforming” when it can be rolled over again and again at a short-term interest rate that is essentially zero? What could go wrong?

Next installment will cover banks’ profitability, capital ratios, interest paid on deposits and payouts to shareholders.

Data provided by S&P’s Capital IQ.