October 24, 2016
There was the king who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels, are enough, if each kernel is a quarter-inch long (which may not be; I’ve never seen wheat in its pre-English-muffin form), to stretch to the sun and back 391,320 times.
That was nothing more than one kernel compounding at a 100 percent square for 64 squares.
And with that story Bill Priest (Epoch Investment Partners) began his presentation at GIBI (Great Investors’ Best Ideas), which is a fundraiser for the Michael J. Fox Foundation for Parkinson’s Research. I had the pleasure of chatting with Bill the night before at the “speakers’ dinner” held at Shad Rowe’s wonderful home here in Dallas, but I digress. Bill noted that at square 32 on the chessboard you would have 4 billion grains of wheat and at square 64 you have more wheat than has been harvested in recorded history. His point was that technology is just now moving on to square 33 of said chessboard with the back-half of the chessboard bringing with it amazing advances in technology.
The first speaker at GIBI, however, was T. Boone Pickens. Boone began by stating that what has happened with energy prices this year is what he had expected to happen last year. He said inventories are down and demand is up, which is good for crude oil’s price. In November of 2014, he noted, there were 1609 drilling rigs operating in the U.S. That number fell to below 400, but now there are ~550 rigs back at work. T. Boone opined that there will never be 1600 rigs working again in the U.S., but that the rigs currently operating are the best, fastest, most efficient and productive rigs he has ever seen. His “price deck” for year-end 2016 is $60 per barrel with a price deck of $70 for 2017. As written in last Friday’s Morning Tack:
Boone stated that since “they” started drilling in the Permian Basin that field has produced 50 – 60 billion barrels of oil and he expects that same type of production will occur again in the years ahead given the technology advancements. He concluded with four stock recommendations, the only one of which favorably rated by our energy analysts is Pioneer Natural Resources (PXD/$187.00/Strong Buy).
Up next at the symposium was Lisa Hess, from SkyTop Capital Management, who discussed the automobile revolution. She thinks the big winners over the next 10 years will be lithium batteries, natural gas, and electric cars, while the losers will be the “Big Three”; and, that the revolution is happening faster than anyone expects. Think about Siri for the car, collision avoidance systems, cabin overheating technology, and the quest for a lighter car. To this last point, she offered up Constellium (CSTM/$5.60) as an investment idea, which has a favorable rating from our correspondent research organization. According to Lisa, CSTS’s bullet points are: 1) it is one of four companies that can supply high-quality cast aluminum parts to the auto industry; 2) the company is poised for strong growth; 3) it has a new CEO; 4) it just received a new long-term contract; and 5) CSTM has a “cheap valuation.” The shares are down due to a bad acquisition, but the new CEO has written down a lot of that acquisition’s cost, issued some $425 million of bonds for liquidity purposes, and one of its major competitors has been acquired. She concluded that CSTM is a great way to invest in the auto revolution.
Caroline Cooley, from Crestline Investors chimed in by asking, “Did 87% of the stock pickers suddenly become stupid?” Her inference was that active managers have not outperformed the indices for quite some time and therefore passive investing has thrived and has grown 200% over the last ten years. Obviously this is a topic Andrew and I have written about ad nauseum. She, like us, thinks investors are doing the exact wrong thing, at exactly the wrong time, by selling actively managed funds and purchasing passively managed funds. If you want to invest using her reasoning she believes two of the best sectors for alpha (outperformance) are Consumer Discretionary and Technology. Obviously, we agree. Epoch Investment Partners’ Bill Priest also agreed with the active versus passive argument in his presentation and as previously stated he thinks technology is the new macro driver. He also believes the value of a company is driven by cash flows, a point that was drilled into my head by my father. Dad use to say, “Money is the blood of a company and the cash flow statement is the veins!” Bill concluded with, “If you can’t earn enough to reinvest in the business at a rate above your average weighted cost of capital, you should ‘return’ capital to shareholders via share repurchases or dividends.”
Ray Nixon (Barrow, Hanley, Mewhinney & Strauss LLC) likewise began his presentation with the active versus passive argument with the statement, “Passive investing is up from 5% of the equity markets in 1995 to 41% currently, yet he drilled down further into why you should be selling passive and buying active management. As for passive investing, Ray averred it is indeed low cost, has diversification, there is no risk management for portfolios, and no chance for excess market returns (“this is my 500th best idea!”). Active management gives investors the potential for outperformance, it can be structured to meet a client’s needs, you can control the characteristics of the portfolio, and there tends to be a portfolio rebalancing discipline. He also emphasized that most of the time when passive has outperformed active management for a long period of time it has tended to be followed by a difficult equity market. His three tenets of investing are: 1) low price to earnings ratios (P/Es), 2) cheap price to book value, and 3) the stock pays a dividend. One interesting stat he offered was that since 1950 dividend growth in the S&P 500 averaged +5.3% per year, but that in the 2010 – 2015 timeframe it has grown by +13.8% per year; and, that “Baby boomers like mailbox money!” In conclusion Ray talked about two stocks, one of which carries a favorable rating from our fundamental analysts. That company is Phillips 66 (PSX/$80.35/Outperform). He believes PSX to be undervalued at 14x earnings, it pays a decent dividend, it has a Master Limited Partnership (MLP), and crack margins are depressed. Moreover, Warren Buffett has a ~15% ownership in the shares.
Obviously there were a number of other speakers at the 10th annual GIBI Investment Symposium, but I have run out of space in this missive to discuss them. I will say the two highlights of the week were the gracious dinner I had at Shad and Michele Rowe’s home for the speakers at the GIBI symposium last Monday. Then there were the two dinners I enjoyed at John Mauldin’s (Mauldin Economics) condo with his fabulous fiancée Shane.
The call for this week: Well, here we are, at the last week of October, which our models suggested would be the end of the window of vulnerability for the equity markets. Indeed, in late August, with the S&P 500 (SPX/2141.16) trading around 2193, our models telegraphed that mid/late-September represented a potential timeframe for a market decline. At the time, Andrew and I suggested raising some cash to take advantage of new investment opportunities, despite our consul that any pullback would likely be small (3 - 6%). Subsequently, the SPX declined into its 2100 – 2120 support zone, rallied back to 2180, and then retested the 2100 – 2120 level for an intraday top to bottom pullback of 3.6%. Sometimes it takes three downside retests before a correction is complete and this week we should find out if that is true this time. Meanwhile despite some recent softening economic stats, the Philly Fed survey has hooked up (stronger economy – Chart 1), 68% of the companies reporting 3Q16 have beaten the earnings estimates (Chart 2 - foots with our transition to an earnings driven secular bull market), bullish sentiment stinks (read: bullish – Chart 3), our model is turning bullish, and there is plenty of internal energy stored up for a decent market move if it gets going.
It’s someone else’s money
October 17, 2016
The analogy between the stock market and poker has always been irresistible. Interestingly, the stock market increasingly resembles a low-stakes recreational game among friends and less the sort of ‘there goes the ranch’ game favored by cutthroat professionals. Recreational poker is frustrating but ultimately profitable to the serious player. Recreational players come to play. They play every hand. They make long-odds bets. They are hard to read because fear of losing money is not a factor in the game. They can’t be bluffed. The serious player is a different animal, playing the odds, maximizing winnings on pat hands, and figuring that in the long run his superior abilities will prevail.
The stock market is dominated by institutional equity fund managers who are paid to own stocks. The decision to own stocks already has been made by an asset allocation committee or by the individuals who bought the mutual fund. Like the recreational poker player, equity fund managers are there to play. It is not their money and they are far less worried about losing money than underperforming the market. Put it this way: Individuals in the ‘business of investing’ want to out-perform their peers. It’s a different kind of game. If the market is down 20% and the equity professional is down 15%, he or she is ecstatic. If the market is up 20% and the equity professional is up 15%, he or she is despondent. The growing dichotomy of purpose between the owners of the money and the people managing the money is little understood.
When individuals played a bigger role in the stock market, those great allies of the serious independent – fear and greed – came more frequently into play. Every couple of years there would be compelling bargains or shorting opportunities. The market favored by institutions – the S&P 500 – is expensive by historical standards. But the institutions aren’t selling – as individuals might have done – because they have to be invested, and where else can they put all that money?
. . . Frederick “Shad” Rowe, Greenbrier Partners
The aforementioned prose was scribed by my friend Frederick “Shad” Rowe, of Greenbrier Partners fame, decades ago and it is just as relevant today as it was back then. I dredged it up this morning because I am in Dallas this week to attend Shad’s “Great Investors’ Best Ideas Symposium” (GIBI) tomorrow. Tonight I will be attending the speakers’ dinner convened at Shad’s home where Michael Price, David Einhorn, T. Boone Pickens, and Mario Gabelli (to name but a few) and I will dine to discuss the “state of the state.”
Obviously, one of the main topics of discussion will be about the recent stock and bond market consternations since mid-September. Of course my models suggested such consternations would be the case since late August, however I did not think the environment would be this frustrating. So, we got the first “consternation” on September 13 when the D-J Industrials (INDU/18138.38) fell 258 points, while the S&P 500 (SPX/2132.98) surrendered 32 points and, in the process, tested its 2100 – 2120 support level. That downside test proved successful, leading to a rally that carried the SPX back to its 2180 – 2200 overhead resistance zone. While many pundits believed that rally meant the correction was over, Andrew and I were less sanguine since our models failed to confirm that THE low was “in.” Sure enough, the SPX came back down and broke below the September lows in mid-October and again select pundits said the correction was over. Hereto, our models were not so sure. So far, all we have seen is the July upside breakout from the nearly two-year range-bound stock market and a subsequent downside retest of the support level of 2100 – 2120 (see chart 1). Last week we experienced more frustration with the Industrials up about 88 points on Monday, off 200 points Tuesday, better by 15 points on Wednesday, down 45 points comes Thursday, and up some 40 points on Friday, although we would note the Industrials were up over 100 points early in Friday’s session. That caused one savvy seer to lament, “Up mornings and down afternoons is not particularly good market action!”
For the week, the Industrials fell 0.56%, the SPX declined 0.96%, and the NASDAQ Comp surrendered 1.48%. On a sector basis, the worst sector was Healthcare (-3.27%) with Utilities (+1.33%) and Consumer Staples (+0.66%) the only sectors posting gains. The weekly wilt left the SPX and NASDAQ Comp at critical support levels. As often stated, 2100 – 2120 is the key support zone for the SPX with downside “pivot points” at 2108 and 2092. If these levels are violated on a closing basis, we will have to rethink our near-term strategy. But until then, as repeatedly stated last week, “What has happened this week is NOT a definitive break to the downside.”
Two of the major events that occurred last week happened in the bond market, where the 10-year T’note yield broke out to the upside (read: higher rates – chart 2) and the collapse of the British pound (chart 3). The weaker British pound is actually quite bullish for British multinational companies and I am tilting portfolios accordingly. I am using select actively managed mutual funds to accomplish this. As often stated, I think individual investors are doing the exact wrong thing by selling actively managed funds, while buying passive funds. When stocks are undervalued, and the indices are going straight up, investors need to own “cheap beta” (passive funds). However, when stocks are neutrally valued, or by some measurements over-valued, you want actively managed funds. The reason is that an active manager can say, “I don’t want to play in that particular game because valuations do not make sense.” Case in point, for months Andrew and I have made the argument that the defensive stocks, or low volatility names (chicken longs) are extraordinarily expensive. And guess what, that space has “rolled over” in the charts and has broken down. We suggest pruning those names from portfolios.
The call for this week: I should be gleaning some good investment ideas from tomorrow’s GIBI event. Additionally, I will be speaking at Thursday’s “Money Show” here in Dallas where the preponderance of speakers will be bearish, except on gold. To those “bear boos” we offer this from the astute Lowry’s Research organization:
Since the sideways trading range in the S&P 500 began in mid-July, our Buying Power Index has weakened by 41 points. During the same period, our Selling Pressure Index has increased by a relatively minor 17 points – far short of the intense selling needed to turn the Advance-Decline Lines sharply lower, in order to warn of an impending major market decline (chart 4). Therefore, a short term correction may be needed to revitalize investor Demand. However, over the past 90 years, with few exceptions, major bear markets have been preceded by a contraction in the Advance-Decline Line lasting for a period of at least four to six months before the S&P 500 Index reaches its final bull market high. Thus, while portfolio holdings should be given extra scrutiny, it still appears to be too early to abandon all equities.
Plainly we agree, yet our models suggest the period of consternation should continue into the last week of October. Until then, we are not doing very much. This morning at 4:00 a.m., the preopening S&P futures are off 6 points as the U.S. threatens Russia with cyber-attacks. I would note that if said attacks on Russia were real it would not have been announced and it would be the NSA, not the CIA, carrying them out. Still, this is really serious stuff.
October 10, 2016
I knew that I had to adopt a cold, unemotional attitude towards stocks; that I must not fall in love with them when they rose and I must not get angry when they fell; that there are no such animals as good or bad stocks. There are only rising and falling stocks – and I should hold the rising ones and sell those that fall. I knew that to do this I had to achieve something much more difficult than anything before. I had to bring my emotions – fear, hope and greed – under complete control. I had no doubt that this would require a great amount of self-discipline, but I felt like a man who knew a room could be lit up and was fumbling for the switches. . . . I started to see that stocks have characters just like people. This is not so illogical, because they faithfully reflect the character of the people who buy and sell them.
Like human beings, stocks behave differently. Some of them are calm, slow, and conservative. Others are jumpy, nervous, and tense. Some of them I found easy to predict. They were consistent in their moves, logical in their behavior. They were like dependable friends. And some of them I could not handle. Each time I brought them they did me injury. There was something almost human in their behavior. They did not seem to want me. They reminded me of a man to whom you try to be friendly but who thinks you have insulted him and so he slaps you. I began to take the view that if these stocks slapped me twice I would refuse to touch them anymore. I would just shake off the blow and go away to buy something I could handle better. . . . I tried to detect those stocks that resisted the decline. I reasoned that if they could swim against the stream, they were the ones that would advance most rapidly when the current changed.
After a while, when the first initial break in the market wore off, my opportunity came. Certain stocks began to resist the downward trend. They still fell, but while the majority dropped easily, following the mood of general market, these stocks gave ground grudgingly. I could almost feel their reluctance. On closer examination, I found the majority of these were companies whose earnings trends pointed sharply upward. The conclusion was obvious: capital was flowing into these stocks, even in a bad market. This capital was following earning improvements as a dog follows a scent. This discovery opened my eyes to a completely new perspective.
I saw that it is true that stocks are the slaves of earnings power. Consequently, I decided that while there may be many reasons behind any stock movement, I would look for one [thing]: improving earnings power, or anticipation of it. To do that, I would marry my technical approach to the fundamental one. I would select stocks on their technical action in the market, but I would only buy them when I could give improving earnings power as my fundamental reason for doing so.
. . . Nicolas Dravas, How I Made $2,000,000 in the Stock Market
Read that last paragraph, and then read it again, because the wisdom of those words is profound! It is particularly significant since we believe the equity markets are transitioning from an interest rate-driven bull market to an earnings-driven bull market. Indeed, we think the “profits recession” troughed in 2Q16 and that easy earnings comparisons will be seen in 3Q and 4Q of this year. Now many strategists and analysts downplay such an earnings improvement as being driven by “easy earnings comparisons,” but as our friend Rich Bernstein writes: “However, every profits cycle, by definition, begins with a series of easy comparisons. It is impossible to begin a cycle with difficult comparisons.”
Meanwhile, select pundits continue to predict a calamitous end to this secular bull market. Hereto, Rich Bernstein of Richard Bernstein Advisors (RBA) writes:
Some market observers have cautioned that overvaluation always leads to poor returns because multiples contract. There is indeed history to support such concerns. However, the key word is “always.” As we have shown, there have been many periods in stock market history during which earnings growth improves, interest rates increase, PE multiples contract, and a bull market continues. They are called earnings-driven bull markets. It is always headline-grabbing to predict a calamitous end to a bull market, and a broad range of sentiment data strongly suggests investors are quite scared. At RBA, however, we continue to swim against that fearful tide, and our portfolios are positioned for a cyclical rebound in earnings and an earnings-driven bull market.
Sticking with the “earnings” theme, 3Q16 earnings season begins this week when Alcoa reports. Of interest, at least to Andrew and I, is that more fundamental analysts are raising their earnings estimates on the Technology sector than lowering them (see chart 1 on page 3). Obviously, that is music to our ears, because we have recommended a large portfolio overweighting in Technology. Meanwhile, net earnings revisions for the S&P 500 continue to be negative but to a lesser degree (chart 2). Interestingly, earnings revisions by sector are favoring Technology, Utilities, and Financials (chart 3 on page 4), while the percentage of raised guidance by sector is also worth consideration (chart 4). Nevertheless, recall that, going into 2Q16 earnings season, we opined earnings were going to “come in” better than the lowered-bar expectations. Bingo! . . . Last quarter, 64% of reporting companies beat their earnings estimates and 57% beat their revenue estimates. We expect the same kind of results (or better) for 3Q16.
Within the bookends of last week there were some significant events: 1) the yield on the 10-year T’note surged from 1.59% to 1.72%; 2) higher rates caused the U.S. Dollar Index to rise as the British Pound collapsed versus the greenback last Friday; 3) rising rates left the defensive stocks (we have termed them “chicken longs”) under pressure, because most of them pay high dividends and most of them are very expensive, as we have suggested for months; 4) another “defensive play” fell last week as gold traded lower and tagged its 200-day moving average; 5) crude oil had a very good week for a multiplicity of reasons; 6) the ISMs had their biggest monthly rise ever (read: no recession); 7) the employment report was not as bad as the media said; 8) the Labor Force Participation Rate looks to have bottomed (chart 5 on page 5); 9) Bullish stock sentiment has been below 40 for 49 weeks (historic); 10) seasonal factors favor the “bulls” as we move into mid-October, which is the second best month of the year for the past 20 years (chart 6); and the list goes on.
Speaking to the recently stronger dollar, while longer term we think the U.S. Dollar Index has traced out a giant top in the charts, near term the dollar could trade higher given the higher environment of short-term higher interest rates. Historically, periods of dollar strength tend to see stocks with the majority of their revenues coming from the U.S. to outperform. Therefore, for your potential “buy lists,” we have screened stocks from the Russell 1000 that have large domestic revenues, are favorably rated by our fundamental analysts, have attractive long-term chart patterns, and have positive metrics on our proprietary algorithms: Sun Trust (STI/$45.69/Outperform), Incyte (INCY/$97.83/Outperform), Laboratory Corp of America (LH/$138.87/Outperform), Union Pacific (UNP/$98.07/Strong Buy), Booz Allen (BAH/$30.19/Outperform), and Vantiv (VNTV/$56.48/Outperform).
The call for this week: Despite the bravado, the reality is seen in the chart of the S&P 500 (SPX/2153.74), which in early July, broke out to the upside of nearly a two-year trading range with bullish implications (chart 7 on page 6). More recently, we have targeted the triangle chart formation the SPX has worked itself into since early September (chart 8 on page 6). The SPX is now at the apex of that triangle and should be resolved with either a break to the upside or the downside. A break up would obviously have positive ramifications, while a break down would suggest further consolidation. As stated, there is a decent chance our models’ prediction of downside vulnerability in the mid/late September timeframe may be over, but it will take a close above 2187 by the SPX to turn our models positive. If that happens, it would suggest the equity markets will grind higher into 1Q17, which would surprise the greatest number of participants. However, until our models “flip” positive, we continue to exercise patience.
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