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.

Economic Outlook 2015, Part 3: The Leading Indicators Suggest Growth Will Continue into 2015

This is Part 3 of my 3-part review of The Conference Board’s economic indicators. Monday I reviewed the lagging indicators, confirming that 2014 has been the best year for economic growth since the financial crisis, although sluggish wage growth and rising consumer debt (aided by artificially low interest rates) presented some concerns. Yesterday I reviewed the coincident indicators and found that the U.S. economy is growing and adding jobs, although the mix of jobs is still too tilted toward part-time positions, and consumer spending is benefiting from an unsustainable rise in transfer payments. This article will cover The Conference Board’s leading economic indicators. Overall, the analysis indicates that momentum in the U.S. economy should extend into early 2015, but conditions will likely slow by mid-year as the Fed gradually removes the Quantitative Easing training wheels.

The leading indicators are depicted in the table below, along with my -1, 0 or +1 rankings and the weights assigned by The Conference Board. The equally- and Conference Board-weighted diffusion index scores of +40% and +44%, respectively (based on a possible range of -100% to +100%), show that the U.S. economy will most likely sustain its recent momentum into the first half of 2015. A detailed review of each leading indicator follows below.


The most heavily-weighted component is the Average Length of the Manufacturing Workweek (weight = 27.8%), shown below with the Average Length of the Construction Workweek. The manufacturing workweek has exceeded 42 hours for the first time in many years. The gradual rise in the series is mirrored in the length of the construction workweek. On the surface, these would appear to be purely positive developments . . .


. . . except, as shown below, the U.S. economy has shed an astounding 5 million manufacturing jobs and almost 2 million construction jobs in the last 10-15 years. Ouch! Given that context, I can only rank this indicator zero.


The second leading indicator is the ISM’s New Manufacturing Orders Index, weight = 16.5%. (Does it strike anyone else as strange that The Conference Board weights their leading indicators with a 44% focus on manufacturing, which is anything but a leading industry in the U.S. any more?) The index has recently reversed its post-recession downtrend, bouncing strongly off its recent low of 50 in 2012 (suggesting economic contraction — notice how previous recessions have been preceded by similar downtrends). But the 2-year uptrend causes me to rate this indicator +1.


The University of Michigan’s Consumer Sentiment Index (weight = 15.5%) has also been in a slow, steady uptrend, which merits a score of +1. Notice how the indicator collapsed in late summer of 2011 before Bernanke went to Jackson Hole and vowed to leave the QE spigot on full blast for “as long as it takes.”


Interest Rate Spread Between the 10-year T-Note and the Fed Funds Rate (weight = 10.7%). This indicator is really a proxy for the slope of the yield curve. A steeply sloped yield curve indicates economic expansion, while a flat or inverted yield curve indicates slowdown or contraction. The curve has recently flattened as longer-term rates have slumped, despite the Fed’s threats to raise rates (some day, perhaps even in our lifetimes). The 2% spread is typical for the middle of an economic expansion, but with the Fed’s central planners maniacally pinning the short end of the yield curve at zero, I have to score this indicator zero.


Manufacturers’ New Orders for Consumer Goods (weight = 8.1%). Nominal and real Durable Goods Orders (deflated by the Personal Consumption Expenditure Index, or  PCE) are shown below. The indicator rebounds sharply following the last recession, with Durable Goods Orders displaying slow, steady growth back to their levels preceding each of the last 2 recessions. Although the indicator is positive on its own, the underlying support that consumer spending is receiving from zero interest rates and transfer payments leads me to assign it a score of zero.


The Conference Board’s proprietary Leading Credit Index is replaced by The Chicago Fed’s National Financial Conditions Index (weight = 7.9%). Lower levels indicate “looser” borrowing conditions. Access to credit remains easy, especially for this stage of an economic expansion, so I’ll rate this indicator +1.


Level of the S&P 500 (weight = 3.8%). The S&P 500 has, with the voodoo elixir of Quantitative Easing, broken out of its secular bear phase. As stock prices are supposed to lead economic conditions by 3-9 months, I will rate this indicator a cautious +1.


Manufacturers’ New Orders for Capital Goods (weight = 3.6%). Unlike the pattern observed in Durable Goods, the inflation-adjusted Capital Goods Orders index has yet to match its level from prior expansions. The trend is up, however, so I’ll rate this indicator zero.


Initial Unemployment Claims (weight = 3.3%). Unemployment claims continue trending lower. This indicator therefore rates a score of +1.


Building Permits for New Private Housing Units (weight = 2.7%). This indicator continues advancing, but only to levels associated with the depths of the 1982 and 1991 recessions. I will therefore rate the indicator zero.


The individual scores for each leading indicator and their weighted and unweighted averages were shown at the beginning of this article, resulting in equally- and Conference Board-weighted scores of +40% and +44%, respectively (possible range = -100% to +100%). Although still positive, these scores are far below the +70% I assigned to the leading indicators in January 2014. Overall I expect economic momentum to continue through early 2015, but conditions are likely to cool off a bit as the economy gradually loses the support of its Quantitative Easing training wheels.

Categories: Market Commentary

Economic Outlook 2015, Part 2: U.S. Economy is Strong and Gaining Momentum

This post contains Part 2 of my 3-part Economic Outlook for 2015 (read part 1 here). In this article we’ll examine The Conference Board’s 4 Coincident Economic Indicators, which measure the strength of current economic activity. My rankings for each indicator are shown below (-1, 0 or +1), along with the equally-weighted and Conference Board-weighted scores of +50% and +67%, respectively (based on a scale ranging from -100% to +100%). The coincident indicators show that the U.S. economy is currently strong and gaining momentum heading into the turn of the year.


The first coincident indicator is Retail and Food Service Sales, heavily weighted at 53.2% (this is a substitution for The Conference Board’s Manufacturing and Trade Sales indicator).  Total sales have risen steadily since the last recession, earning this indicator a score of +1. S&P’s Capital IQ reported that in the period ending with Q3-2014, sales grew at an annual rate of 2.9% and EPS increased a red-hot 9.2%.


The second coincident indicator is Total Nonfarm Payrolls (weight = 25.9%). The U.S. economy is producing new jobs, with total employment finally exceeding its level from the mid-2000s. The series is clearly in a long-term uptrend.


There are several reasons to be a bit cautious about the Nonfarm Payrolls data, however. First reason: the 7 million workers who are working part-time but would prefer to be working full-time:


The second reason is that while payrolls are growing briskly, the pace of new hiring is more sluggish:

CO-2-A-Payrolls-HiresAn unusually low level of voluntary terminations accounts for the slower pace of new hiring.  I will therefore rate the Total Nonfarm Payrolls indicator zero — the uptrend is positive, but the mix of full- and part-time jobs being created and the sluggish rate of new hiring tempers my enthusiasm.

The third coincident indicator is Personal Income Less Transfer Payments (weight = 13.6%). Personal income in the U.S. is at an all-time high, which is definitely a positive. Examining the next graph below, however . . .


. . . I compare Personal Income to Transfer Payments and Personal Consumption Expenditures. Notice how the upward trend in income and spending is strongly supported by an above-trend surge in Transfer Payments. (Large and growing transfer payments are one of the primary reasons the U.S. owes the rest of the world $18 trillion.) Although I have strong concerns that future reductions in Transfer Payments will be fiscally necessary, and the accompanying effect on spending will be unpleasant, I’ll rate this indicator a cautious +1 for now.


The fourth coincident indicator is The Index of Industrial Production (weight = 7.3%). Industrial Production was the most heavily-weighted coincident indicator until a few years ago. The nominal series is trending upward, but the real series has grown more slowly than the rate of inflation. Although the trend in the nominal series is upward, the lackluster behavior of the real series leads to a ranking of zero. It is not consistent with robust, sustainable growth.


Merging the above -1, 0, or +1 ratings into a diffusion index provides a score of +50% if all indicators are equally-weighted, and +67% if we use The Conference Board weights. The indicators show that growth and economic activity are strong and accelerating.  Except for two concerns:

  • Retail Sales and Consumer Spending are enjoying a boost from the multi-year rise in Transfer Payments, which is clearly unsustainable over the long term, and
  • the mix of new jobs being created remains tilted toward part-time positions;

The U.S. economy is on solid footing, and poised to extend its recent 3.0% real growth into early 2015.

Part 3 of my 2015 Outlook will cover The Conference Board’s Leading Economic Indicators.


Categories: Market Commentary