Our Perspective on Q3 2015

Stock Valuations Near the End of the Economic Cycle

How do we know when the market is expensive?

We compare a company’s stock price to the profits (EPS – earnings per share) and assets of the company that create value for shareholders. Using these fundamental comparisons - Price to sales, price to book value, price to earnings and debt to sales, we can compare the current valuation of a company to previous points in history.


How expensive are stocks right now?

Based on the current S&P 500 estimates for 2015 of $110.60 the S%P 500 index is valued at 18 times current earnings. This valuations contains an estimate for the last three months of 2015 of $30.21 in earnings per share. If this prove sot be optimistic, then the Index is trading at greater than 18 times earnings.

How did the market get expensive?

When stock prices rise in expectation that earnings will rise, but they don’t…

 

“For Q3 2015, the blended earnings decline is -5.5%. If the index reports a decline in earnings for Q3, it will mark the first back-to-back quarters of earnings declines since 2009.”

John Butters, Senior Earnings Analyst, Factset

 

Earnings are declining and it has become a trend not a bearish forecast. They will continue to decline until demand materializes from somewhere. If earnings decline and demand doesn’t arrive, stock prices will fall under intense scrutiny.


Will earnings get better?

To answer this question, let’s look at what corporate accountants do to increase earnings per share.
  1. Work to increase the company’s revenue and sales which should help EPS.
    1. Bring new products to market that are in demand
    2. Raise prices that customers pay

 

  1. Make an acquisition to increase sales, revenue and profits

 

  1. Reduce expenses
    1. Reducing production costs by modernizing equipment or building more efficient production facilities
    2. Reduce employee headcount (layoffs), wages, and benefits
    3. Refinance company debt to lower borrowing costs.
    4. Cut dividend payments to shareholders

 

  1. Reduce the number of shares outstanding so that earnings are calculated over a smaller share count.

 Revenue growth is stalling out so profit margins are coming into focus. 


"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. - Warren Buffet

 


S&P 500 Profit Margins are nearing 10% (Silverblatt)

It is likely that profit margins will revert back to historical levels. This will reduce earnings and put more pressure on the cost side of business. As a result, companies are reducing wages and benefits.

Once accountants exhaust the profit nudge from reducing employee wages and benefits, they reduce hiring to essential personnel only:

"The U.S. economy created 142,000 jobs in September, a number that missed expectations and could cool expectations that the Federal Reserve will start raising interest rates soon.
Unemployment held at 5.1 percent, according to the Labor Department. A separate member that includes those who are working part-time for economic reasons or have not looked for employment fell to 10.0 percent.
Economists had been expecting the report to show 203,000 new jobs, from the downwardly revised 136,000 in August (from the originally reported 173,000)."


If a slower rate of hiring doesn’t help increase profitability, the accountants issue lay-offs to existing workers.


Companies have exhausted their ability to artificially manufacture EPS gains. They are now left with the reality that they are reliant on consumer spending to grow. Increasing revenue requires that a company can create demand for their products and services. Demand requires 4 conditions to materialize before a sale happens:

  1. Products that are needed by customers
  2. Discretionary income available to purchase
  3. Access to credit to finance purchases that exceed income
  4. The willingness to part with income or to take on debt to fund a purchase


Lately, even high wage earners have seen their incomes stagnate:

 

 
Stagnating wages inevitably lead to reduced spending.
The feedback cycle kicks in:


Source:  Survey of Consumer Expectations,  2013-15 Federal Reserve Bank of New York (FRBNY).

 


What happens when investors realize that the market is expensive and want to get out?

Overbought conditions that change quickly create a lopsided effect as investors head to the exits in unison. The exit can get very crowded in a hurry. This massive Chinese traffic jam is a visual example:

 


Here is a description of the physics behind these situations:

When this happens — when all the cars are traveling at close to the same average speed because of the vehicle density on the roadway — they become highly dependent on one another. A physicist might compare the relationship to the correlated motion of electrons in metals, which gives rise to weird phenomena like superconductivity.

Highly correlated traffic means that a tiny perturbation — a butterfly flapping its wings, or a single driver braking unexpectedly — will send little ripples of corresponding slowdowns through the entire chain of cars behind him/her. That’s one reason why slowdowns and traffic jams occur most commonly at merge points, especially exit and entrance ramps, or when lanes are closed due to road construction. 

Sound familiar? The exit can get crowded with investors selling to cash but also speculators who used borrowed money to leverage their gains as the market increased. These margin investors have increasingly added to the borrowing balances since 2009:

While the total amount of margin borrowing is eye-catching, sudden reversals of margin usage are more important. These reversals signal a shift in momentum that can lead to the crowded-exit phenomenon that leads to panic selling and excessive price declines.  

 


Summary

None of the circumstances we described here are new or secret. In fact we have been warning clients about these conditions for more than a year. Why should investors take heed now? With the summer decline in foreign stock and bond markets, investors have other options to consider besides selling domestic stocks and sitting in cash. Chris Brightman (aptly named, by the way) published an excellent article that outlines the valuation discrepancies between emerging markets and domestic markets.

You should read it and digest his analysis.

Investors have no excuse to ignore domestic economic weakness and domestic stock valuations. They have cheaper investment options to rotate into and reduce risk.

 

 

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Job’s Friday Update – September Jobs report is 30% weaker than the average for 2015

For wonky asset managers (yours truly) the first Friday of the month is "Jobs Friday". The anticipation for this morning’s report was huge since this is the most meaningful statistic (after Personal Consumption Expenditures - PCE) that Janet Yellen and the Fed will get before they reconsider their interest rate stance. If Yellen follows the bond markets lead, she stay on hold for the foreseeable future. 

September Jobs report

No need to meet this month Janet. Instead of 200,000 jobs the report came in at 142,000 new jobs. Worker participation declined to match the 1977 low. The work week shrank and wages were flat. We are tempted to cheer that part-time positions jumped 53,000. This gain unfortunately came at the expense of full-time positions which declined 185,000 in the month.

The household version of the survey which includes self-employed workers and business owner actually showed a 236,000 job DECLINE in September. Harvard economics professor Greg Mankiw has an excellent description of the survey differences here.

The pundits who called for further positive revisions to previous reports are having humble pie for breakfast too. Last months jobs stinker was met by a chorus of cheerleaders who promised that, “August is usually revised higher!” Instead of an upward revision, August job gains were indeed revised-lower. The BLS cut 37,000 more jobs from the initial report of 173,000.

We expect the jobs report in November to get worse after the long list of announced layoffs are fully reflected. Stock futures are responding with red arrows in equities and green arrows on bonds. Please revisit your stock allocation in your 401K accounts. Stay tuned.

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Trump, Taxes & You…

We are at an interesting point in our political history. “Change” seems to be the buzz word that all political candidates are embracing in many aspects of their campaign. The current tax system is not immune to this change. If one of these major tax system proposals became law, it would be the first major overhaul of the tax system since the 1980’s under Ronald Reagan.

Donald Trump released his proposed tax plan on Monday. According to his release, the plan is designed to achieve 4 simple goals:

  1. Tax Relief for middle class
  2. Simplified tax code
  3. Grow the economy
  4. Don’t add to debt or deficit

What does it mean for you?

This is all just a big proposal that’s a long way from reality, but how would it impact an average client of mine. Let’s say this client is married and has $100,000 of taxable ordinary income. Under the existing tax system, this taxpayer would have a tax liability of $16,588. The Trump plan would have a 0% rate for the first $50,000 and a 10% rate for the second $50,000, so the tax liability under this proposal would only be $5,000. That’s less than a third of the current tax burden!

We have a long and winding road between now and the elections next year. Along this journey, we are going to hear many things about our country and especially taxes. I’d love to be your guide as we all try to process what this “change” means to you.

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How Can This Possibly be a Good Sign?

Isn’t It foretelling when Collector Car “pawn services” ramp up their marketing? Have to meet a fat margin call in your brokerage account? No worries, just pawn your vintage Ferrari or that case of Jefferson’s 1787 Château Lafite Bordeaux! (Just make sure there is no traces of Cesium-137 in it.) to Borro.com "the luxury asset lender":



They have to be the only lender on the planet that hopes their clients default so they can keep the collateral! It would be fun to shop in their retail location. 

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ROTH versus 529 college planning- a CPA's perspective

It’s surprised me how many times this topic has come up in my accounting work recently.  It could be that college just started back and people are keenly aware of the ever increasing cost of Junior’s education.  Thus, parents are often conflicted with the enormous burden of higher education expenses and the realization that they are responsible for funding their own retirement.  To add to the stress, they are inundated with information on College 529 plans and ROTH IRA’s.

So here’s the question I always get “Where should we put the money and which comes first?”  The answer to this question is very dependent of personal situations, but my initial advice is to always take care of retirement first.  When you get to retirement age, the sources of money are limited, so you better have planned well.  If not, you may be fighting for one of those scarce Wal-Mart greeter jobs.  While maybe not ideal, your children have other options to pay for school from savings, scholarships, part-time jobs, and as a last resort borrowing.

If the situation is right, a ROTH IRA does provide some powerful flexibility in saving for the future. While your investable dollars added to a ROTH can be used for both Retirement and college expenses, you have to remember that those dollars can’t be used for both goals.  You need to use this wonderful tax advantage account prudently as part of your overall financial plan.

Do you have a plan to navigate the path of funding college education without sacrificing your own retirement happiness?  We can provide clarity and experience that can help you utilize these options to meet your goals.

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The most annoying question in the world is one word

In our wealth management practice we are asked a variety of questions by clients and prospective clients. The one that I loathe the most is, “What 5 stocks I should be buying right now?” It smacks of greed and a contempt for risk. I usually respond to this question with one word. “Why?”

Responding to the “What” questions is easy. How questions might take time to answer but they are pretty straightforward as well. When, where? Those typically require a simple procedural response. “Why” questions create problems. They cut to the heart of our reasoning, rationale and authority. The most effective responses to “why” questions require that a relationship exists between questioner and respondent. Maybe that’s why our kids employ them at such an early age. When my son asks me why he should eat his vegetables, I could appeal to authority and respond with “Because I am your dad and I said so.” That sort of response will likely be met with resistance pretty quickly.

The better response would require a deeper level of connection. “Son, look at this picture of you when you were only 2 months old. You weren’t even able to eat solid food then but you have grown in two years to the point where your body needs more fuel. If you want to keep growing taller and stronger, you should give your body the energy that it needs and vegetables are part of that energy. That’s why your mother and I eat our vegetables too.” This response demonstrates more attention and care than the appeal to authority and will foster a conversation based on mutual trust. 

Here are some “why” questions for you to try on:

Why are you invested in the stock market?

Why do you benchmark your results to the S&P 500 (or whatever benchmark you prefer)?

Why aren’t you maximizing your 401K contribution?

Why is your 401K (or other investment accounts) allocated the way that it is?

Why don’t you have a budget for your household?

Try to avoid rote answers that might pop up from a google search. Dig deeper to understand your motivation and discover any roadblocks to clear out of your financial path. If you struggle with this exercise, consider one last question, “Why don’t you call us for help?

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