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Wise Guys Tend to Be Pessimists These Days

Wise Guys Tend to Be Pessimists These Days

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Tuesday, 12 January 2016 04:30 PM Current | Bio | Archive


It was certainly a terrible way to start the New Year, with the worst first-week decline for the S&P 500 on record. That doesn’t augur well for the so-called January Barometer, which posits that a decline during the first month of the year often leads to a down year.
 
The only real positive technical development is that sentiment is extremely bearish, which has often been a good contrarian buy signal. The Bull/Bear Ratio compiled weekly by Investors Intelligence dropped to 1.10 during the week of January 5. It must have dropped below 1.00 this week. Such bearish readings have often set the stage for relief rallies, though they can sometimes take a few weeks to do so.
 
Another bullish spin on the bearish technical picture is that it turned so grizzly so fast last week that there may not be a lot more downside for stocks, with only 22.8% of them trading above their 200-day moving averages. Furthermore, as we noted yesterday, the rapid downward rerating of forward P/Es has certainly made many stocks cheaper and possibly more attractive.
 
We aren’t convinced that the fundamental outlook for earnings has deteriorated as much as suggested by last week’s panic attack in the stock market. So we also think that the downward rerating of P/Es has been overdone.
 
On the other hand, some very smart people are warning that there may be more downside for both earnings and valuation multiples. Some of them are warning about a bear market this year. Others are anticipating another volatile year like last year, when the S&P 500 was essentially unchanged.

Let’s review the views of some of the more notable doomsayers:
 
(1) Central banks out of ammo. In a 1/8 CNBC interview, Mohamed El-Erian, the Allianz chief economic adviser, said that the big issue for financial markets is that central banks are running out of ammo: “Markets are realizing that central banks can no longer repress financial volatility. And they are repricing to new volatility paradigm.” So any shocks to the markets will take longer to reverse themselves, he said. “What we’re going to see is every time something happens in the world it’s going to take longer to restore stability. That’s what we’re seeing with China today.” El-Erian added that it’s a good thing the Federal Reserve is starting to normalize monetary policy: “They realize that they can’t artificially repress financial volatility.”
 
That’s a very good point. Investors have decided to pay less for earnings because the major central banks may have lost their ability to reduce volatility in the financial markets. Indeed, Fed Vice Chair Stanley Fischer went so far as to say that the Fed is no longer interested in coddling the markets.
 
In a 1/6 CNBC interview with Steve Liesman, Fischer agreed with the latest “Dot Plot” indicating three to four interest-rate hikes in 2016. He said, “Those numbers are in the ballpark.” Fischer then was asked about the divergence between the more dovish view of the market and that of the FOMC. Fischer responded, “Well, we watch what the market thinks, but we can’t be led by what the market thinks. We’ve got to make our own analysis. We make our own analysis and our analysis says the market is underestimating where we are going to be. You know, you can’t rule out that there is some probability they are right because there is uncertainty. But we think that they are too low.”
 
Volatility certainly increased last week, though it wasn’t off the charts. The S&P 500 VIX rose to 27.0 on January 8. That’s still below the previous spike of 40.7 on August 24 of last year. This measure of volatility is highly correlated with the yield spread between high-yield bonds and 10-year Treasurys, which remains at the widest since December 2011 but didn’t change much last week. Not surprisingly, VIX is also highly correlated with the percentage of bearish advisors compiled by Investors Intelligence. Bearishness was elevated at 31.6% last week, and probably rose this week within the bounds of some of the other panic attacks that have hit the current bull market.
 
The bottom line is that last week’s volatility in stock markets around the world was mostly triggered by the gang that couldn’t shoot straight in China. Chinese officials have plenty of ammo, but shot themselves in the foot.
 
(2) Buyback burnout. The 12/18 Bloomberg included an article titled, “Once-Mighty Buybacks Land With Thud as Profit Margins Shrink.” It noted: “The share-enriching influence of buybacks, a pillar of the 6 1/2-year equity bull market, is diminishing. But that doesn’t mean companies have stopped trying. A Standard & Poor’s index of companies repurchasing the most shares is trading at the lowest level in 16 months relative to an equal-weight gauge of S&P 500 members, Bloomberg data show. Meanwhile, U.S. companies bought back about $150 billion in the third quarter, up 14 percent from the previous three-month period, according to data compiled by S&P Dow Jones Indices.”
 
In addition, “That influence is waning as the strengthening dollar and slowing global growth have crimped profit margins and companies now faced higher borrowing costs following the Federal Reserve’s first interest-rate increase in almost a decade….”
Bloomberg ran another article debunking the notion that buybacks, which have clearly fueled the bull market, might start to decline. Data are only available through Q3-2015, when buybacks totaled $602 billion at an annual rate, its fourth-highest quarterly reading since 1998, and added up to $407 billion on a four-quarter basis. I believe that as long as the forward earnings yield of the S&P 500 exceeds the after-tax cost of money in the corporate bond market, corporations will have an incentive to buy back their shares with borrowed money. The Fed’s rate hike at the end of last year hasn’t pushed bond yields up much, which remain well below the forward earnings yield.
 
We have compiled data showing that the S&P 500 companies generated enough aggregate operating earnings to cover 100% of their buybacks and dividend payouts during Q3. In other words, they don’t need to borrow money to buy back their shares and to pay dividends.
 
(3) Less urge to merge. According to data from Thomson Reuters, 2015 is set to be the biggest year ever (once the planned deals close) in worldwide deal-making, with $4.7 trillion in announced mergers and acquisitions -- up 42% from 2014, and beating the previous record of $4.4 trillion in 2007. Thomson Reuters counted 137 mega-deals (exceeding $5 billion) last year, which accounted for 52% of the year’s overall M&A value.
 
A 1/9 article on the subject in The Atlantic observed, “The justification for M&A is usually the combination of reduced costs of doing business and increased revenue from greater market share.” In addition, the same corporate finance math that drives buybacks also drives M&A. If combining two companies results in a forward earnings yield that exceeds the cost of borrowing to make a deal happen, then it makes sense to do so.
 
The naysayers say that M&A booms usually are a sign of a market top. Companies are most likely to combine to cut costs and to reduce competition when their sales outlooks are deteriorating. We are expecting another solid year of M&A activity, much of it driven by technological innovations that are disrupting business models in almost every industry. Our global economy is going through another great transformation driven by another round of great technologically driven creative destruction.
 
(4) China Syndrome. Last Thursday, George Soros contributed to the global financial panic by predicting that another global financial panic is imminent. He told an economic forum that today’s problems remind him of the “crisis we had in 2008.” He added: “China has a major adjustment problem, I would say it amounts to a crisis.” Last year, the renowned investor warned that China was a much bigger threat to the global economy than Greece: “The major uncertainty is not the euro but China. The growth model responsible for its rise has run out of steam.”
 
The 1/10 FT included an article titled “Emerging economies are coming under ‘even more pressure.’” The concern is that the Chinese will continue to devalue their currency, which would depress the competitiveness of exporters in other emerging economies. If those economies devalue their currencies, that would increase their difficulties paying their sizable foreign currency debts in a devalued local currency. The Emerging Markets MSCI stock price index (in local currency) has weakened as the yuan has weakened.
 
In his recent interview with Barron’s, economist David Levy warned: “But the emerging markets are not just going into a recession, they are going through a secular adjustment. Their strategy for the past 20 years -- most evidently in China, but in other countries, as well -- has been just massive investing and exporting.” He figures that game is over, and that the resulting recession overseas could drag down the US economy. Levy did acknowledge, “There is no postwar recession prior to which the U.S. economy was doing fine, only to get knocked down by the rest of the world.” But he warned, “That’s one reason people don’t see the risk.”
 
(5) Commodity bust. My friend Marc Faber added to the gloom last week. The Swiss investor who publishes the Gloom, Boom & Doom Report told MarketWatch that the stock-market downturn could result in the S&P 500 hitting lows not seen in five years. Interestingly, Marc isn’t pointing to problems in China as the direct cause for his bearish outlook. “The main factor is diminishing global liquidity because of the decline in oil prices,” he told MarketWatch.
 
Faber views the plunge in oil prices as a sure sign of a global slowdown or worse. While lower oil prices certainly benefit consumers, he believes that oil’s slump will hit export economies that sell to oil-exporting countries now facing ever-shrinking revenues. It’s a good point. Commodity producers around the world are cutting back their imports of all goods and services, not just capital goods.
 
The 1/9 NYT included an article titled “China’s Hunger for Commodities Wanes, and Pain Spreads Among Producers.” It noted: “Multibillion-dollar investment decisions made years ago on big projects, like the oil sands fields in Canada and iron ore mines in West Africa, are just getting up and running. Facing huge costs, companies cannot simply shut off projects. So the excess could take years to work through.”
 
Again, while this should be good for commodity users, it is very bad for producers: “But economists worry that the commodity mess reflects a weakening global economy, lowering the value of trade worldwide and perhaps even pushing some countries into the same kind of deflationary spiral that has hampered the Japanese economy for decades. Global turmoil last summer, stemming from China, prompted the United States to delay raising interest rates until the end of last year.”
 
The bursting of the commodity super-cycle bubble is certainly depressing global economic activity currently, more than cheap and abundant commodities are boosting it. However, global oil demand is growing more rapidly, suggesting that lower oil prices are giving a boost to the global economy.



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EdwardYardeni
The bursting of the commodity super-cycle bubble is certainly depressing global economic activity currently, more than cheap and abundant commodities are boosting it. However, global oil demand is growing more rapidly, suggesting that lower oil prices are giving a boost to the global economy.
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2016-30-12
Tuesday, 12 January 2016 04:30 PM
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