Month: January 2016

Submitted by Michael Lebowitz via 720Global.com,

“What The Fed did, and I was part of it, was front-loaded an enormous market rally in order to create a wealth effect… and an uncomfortable digestive period is likely now.” – Former Dallas Federal Reserve Governor Richard Fisher – January 5, 2016.

Throughout 2015 we discussed various measures of evaluating equity prices. All of our analysis points to current equity valuations indicating the market is at an extreme and that poor future returns should be expected. As a result, we have not been shy to recommend investors take a more conservative tack with equities. Indeed, equity market price deterioration in just the first three weeks of 2016 has wiped out nearly two years of gains. While we are uncertain if the recent downturn is the beginning of the anticipated bearish period we expect to materialize, we are certain it is imperative investors better understand the poor risk/reward dynamic of holding equities in the current environment.

On the heels of the frank comments from Mr. Fisher, we thought it would be helpful to share yet another type of equity analysis to help visualize the effect the “enormous rally” has had on equity valuations.

Soaring Price to Earnings Multiples

The scatter plot below shows the strong correlation (r-squared = .75) between long-term earnings growth estimates and the price to forward earnings estimates ratio. This ratio is similar to traditional P/E measures but uses 1-year forward earnings estimates instead of historical earnings data. When long term growth estimates are high, investors tend to be optimistic and likely to pay a higher premium or a greater multiple for earnings. The opposite holds true for lower growth expectations.

Long Term Growth Estimates vs Price to Forward Earnings 1997-Current (monthly)

Deeply concerning to us, and apparently now to Mr. Fisher, is the degree of excessive optimism embedded in current prices. The red line delineates combinations of earnings ratios and long term growth estimates that are 20% greater than the dotted black regression line. The yellow dot, representing the most current data, lies slightly above the red line and at levels rarely seen in the last 20 years. The circled cluster of data points nearest the yellow one are all from the prior 9 months.

**Keep in mind as you view the charts- the data only covers the last 18 years, a time period which we would argue contains three of the largest equity bubbles since the Great Depression. Accordingly, observations that stand out as extreme within this data-set are even more extreme when analyzed over longer time periods.

Where will the dot go over time?

The inevitable question is, “Where and how will the yellow dot shift?” In the following chart we add arrows to the scatter plot to help visualize how the location of the dot might change. In reality there are an infinite number of possibilities but we offer four base cases (A-D) in an effort to asses which shifts might be of higher or lower probability.

Potential Data Shifts

A. This scenario infers prices increase at a faster rate than expected forward earnings, or decline at a slower rate than forward earnings decline. Also conditional is that long term growth estimates remain the same. This scenario leads to further multiple expansion beyond the current levels, which as noted earlier are already historically extreme.

B. This arrow represents a path towards normalization back to the trend line. In this case long term growth estimates rise and investors do not pay a higher forward earnings multiple as they traditionally have. An increase of long term growth rate estimates of 3% currently, absent a change in the price to forward earnings ratio, would bring the market to a fair valuation and a multiple consistent with the last 18 years of data.

C. This arrow presents another path to normalization. Long term growth rates remain stable like arrow A, however unlike arrow A, multiples decline back to trend. In this case a price drop in the S&P 500 of 20% with no change in expectations for one-year forward earnings, would be required to normalize valuations.

D. In this scenario, price to forward earnings multiples remain unchanged despite a shrinking long term earnings growth rate. This would defy historical precedent as reduced long term earnings estimates have usually been met with lower price multiples. The fact that current valuations are already at extremes seems to make this scenario unlikely.

E. This arrow highlights the general direction the data points have traveled over the last 5 years. This is more accurately shown in the scatter plot below which uses yearly color codes to map out the last 5 years of data.

Shifts Since 2011

To help answer the question on which way the yellow dot might shift, we focus on long term earnings growth and the price to forward earnings ratio which are the x and y-axis respectively of the preceding charts.

Long term earnings trends tend to be highly correlated with economic activity. In the year 2000 investors were incredibly optimistic as expected long term earnings growth rates peaked over 18%. Since then, the expected growth rate of earnings has fallen to 10% and currently resides less than 1% above the pessimistic outlooks observed during the great financial crisis of 2008. The trend this millennium should not come as a surprise as GDP growth, the ultimate driver of long term earnings, has been decelerating for years. The graph to the left uses a 3-year moving average trend line to smooth GDP data. Despite ebbs and flows, the rate of economic growth has been steadily declining for well over 60 years.

Given our stated views on productivity growth declines and the massive level of indebtedness, it is not unreasonable to forecast that actual long term earnings growth will likely follow the GDP trend lower in the future. That does not mean the market cannot temporarily witness periods of optimism where the expected growth rate increases. We are comfortable predicting that long term earnings growth will most likely shift left along the x axis, at least until there is a profound change to the way the government and Federal Reserve promote economic growth.

Earnings are a function of revenue and corporate profit margins. Our earnings growth forecast in the prior paragraph holds true for revenue growth. As long as GDP continues to trend lower, revenues will likely be challenged as well. Margins, on the other hand, are not as reliant on economic growth. Over the last few years, for instance, margins exploded to record levels despite below trend GDP growth. Layoffs, deficient investment, stock buybacks, mergers and a host of other factors, including suspect measurement, facilitated greater profits per dollar of revenue for shareholders.

Margins have a long history of expanding and contracting within a well-defined range. Currently, margins are at the top end of that range, making further margin expansion difficult to expect. In fact many of the aforementioned methods in which companies increased margins have been largely depleted, which adds to our expectation that margins will contract to more normal levels over the coming years. Given the declining long term trend in economic growth and therefore revenues, coupled with expectations for lower margins, we are left to assume forward earnings estimates will also decline.

Declining long term earnings growth forecasts and forward earnings estimates coupled with historically high valuations is a recipe for poor returns. This concoction would most likely result in a shift somewhere between arrows C and D in the chart entitled “Potential Data Shifts” above.

20% Downside and Then Some

A quick glance at the scatter plot would lead one to assume that a 20% decline in the S&P 500 with no change in forward earnings estimates or long term growth forecasts would result in a fair valuation (the yellow dot would follow the path of the C arrow shown above). That is correct, but we would be remiss if we did not mention two other important factors. First, corrections frequently move beyond trend lines and tend to “overcorrect”. Based on the data shown above, it is not farfetched to assume the yellow data point could fall an additional 10-20% below the trend line. Secondly, as stock prices decline, the economy may likely suffer as well. Therefore we should also consider the ramification of a decline in forward earnings estimates and possibly long term growth forecasts. The one takeaway we hope you arrive at is that a decline akin to those seen in 2000 and 2008 is not out of the realm of possibilities.

Many other valuation measures also predict poor future returns. We urge investors to carefully consider the implications of holding a large equity allocation at this time. Our tag line below is worth careful consideration.

At 720 Global, risk is not a number. Risk is simply overpaying for an asset.

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By EconMatters

 

Energy Bankruptcy Boom 2015

 

Dozens of oil and gas companies went into bankruptcy last year. While energy E&P companies were dropping like flies in 2015, credit rating agencies and banks have remained awfully quiet and apparently buried their heads in the sand.   

 

You see, the Fall Borrowing Base Redetermination by banks on the E&P sector was supposed to take place around October 2015. According to a Haynes and Boone, LLP survey conducted prior to the fall borrowing base redetermination season, industry observers and insiders are predicting a decrease in the ability to borrow against reserves by an average of 39%.

 

The result of base redetermination does not require public disclosure.  Nevertheless, it seemed banks were extremely lenient as the average reduction for 17 companies disclosing the borrowing base reduction results was just 4%.  Rating agencies, meanwhile, did not take major E&P downgrade actions till this month in 2016.

 

It’s About Time!

 

On Jan. 22, 2016 Moody’s Investors Service said it put 120 oil and gas companies on review for downgrades. Rival Standard & Poor’s Ratings Services was way ahead of Moody’s. S&P said it already downgraded the debt of 165 U.S. companies back in 4Q 2015, representing $1.5 trillion, led by the oil, gas, and commodity sectors. S&P also said for the full year, downgrades rose by 67%, to 461, the highest level since 2009. From late December to January 2016, Fitch also took individual downgrade action on companies such as NGL Energy (NGL: NYSE), Chesapeake Energy (CHK: NYSE) and Williams (WMB: NYSE).

 

Wall Street’s Lifeline to Frackers

 

We can see how banks do not want to write off and take a loss from their E&P debt on their books and have motivation to keep feeding the high leverage and not call in the energy loans during the base determination last October. 

 

FT reports that as of September 2015, about a dozen E&Ps already had debts as high as more than 20 times their EBITDA. One of the reasons pushing down oil price to the current historical lows, and yet no sign of decline in U.S. production is that quite a few small frackers need to pump oil regardless (even below the economic threshold) just for the cashflow to pay bills and payrolls.

 

So the collective action by banks to sustain the life of many weak oil frackers (so banks won’t  need to book losses) ironically exacerbated the oil over-supply and price crash speeding up the way for these hanging-in-there frackers to meet their maker.

 

 

Why the Downgrade Delay?

 

On the other hand, we fail to see the motivation and logic behind the delay by rating agencies who are supposed to have independent (from banks) evaluation model to provide forward-looking financial risk indications.

 

It is so ironic to see how Moody’s came out and defended the frackers the same time when Einhorn slammed ‘Mother Frackers‘ which prompted a watershed event in oil E&P stocks last May.  At the time, Moody’s said,

…[The oil and gas sector] liquidity-stress index (LSI) more than doubled….[however], the [LSI] index is still well below its 26% peak in March 2009 …..default risk remains benign ….

[Emphasis Ours]

From there, we can only draw two possible conclusions from rating agencies delayed reaction/action:

 

(1) Influences from Banks (or Others) — There is an inherent conflict of interest in the current Wall Street model that rating agencies are basically paid by the ones they are supposed to give ratings on.  Readers who saw the movie “The Big Short” (from the book by Michael Lewis) should remember how rating agencies were prominently profiled as influenced by big banks on their rating calls during the 2008 financial crisis (perhaps that’s why S&P seems to have an earlier jump on the E&P downgrade than the two rivals?)

 

While nobody can say for sure if this conflict-of-interest model has improved since 2008, it is not hard to draw a parallel Déjà vu from the 2008 subprime/housing sector with possible banks influencing rating agencies to the current E&P sector.  An even better question right now would be:  Is this to allow some insiders time to position themselves “on the right side of the trade”?

 

(2) Extremely flawed (perhaps even delusional) oil price assumption by rating agencies.  While EconMatters outlined why WTI is a short as early as July 2013, it is pretty basic (if not alarmed by the booming oil bankruptcies and layoffs) for any competent Wall Street or rating agency analysts to at least reach a similar oil price scenario by 3Q 2015.  But rating agencies did not come out and act accordingly until early 2016.  (In the same vein, it is highly questionable why Moody’s all of a sudden jumped on the bandwaon of oil price forecast.)

 

Fracking Bubble 2015-2016

 

FT reports the 60 leading US independent oil and gas companies have total net debt of $206bn, more than doubled from about $100bn at the end of 2006, and almost a third of the 155 US oil and gas companies covered by Standard & Poor’s are rated B-minus or below (highly speculative, below investment grade).

 

We don’t always agree with Einhorn on his view including Apple long and some of his specific E&P shorts. However, we do see a bubble in the E&P sector similar to the 2000 tech bubble. We noted last May that “the sector is long overdue for a shakeup” with 110+ publicly traded E&P companies in North America (mid to small caps), and many of them came to market just in the past five years for the sole purpose of hitting their IPO pay dirt.    

 

More Pains To Come

 

Many highly leveraged and poorly managed drillers have been able to hide under the cloak of high oil prices (and Wall Street) in the past few years.  Now Barclays estimates that without a rebound in commodity prices, the potential oil bonds downgrade volume for 2016 and 2017 could exceed $170 Bn while another $155 billion worth of high-yield debt supply will enter the market.

Chart Source: Bloomberg

The long overdue credit agency downgrade is only the beginning of a tsunami hitting the entire oil E&Ps (bonds and stocks). More E&Ps will go out of business while some solid companies may get smacked down (but hopefully eventually survive) simply by the sector association.  

 

Wall Street had a hand in this Frack Bubble of 2015-2016, not much different from the 2008 housing bubble.  We know Shell just fired another 10,000 workers while global oil job losses top 250,000, but it is too early to tell how the market and economy will turn out in this bubble aftermath. 

 

Not to be despair though, the better news for now is that with weak shale E&P companies going out of business, oil production should progress to reflect the logical supply volume in the current oil price environment.  That should eventually lead to the rebalance of the oil market, price and the proper valuation of the remaining energy stocks.

 

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By Francesco Filia, CIO of Fasanara Capital

US Inflation Expectations Closing Gap To Europe’s

In January, surprisingly, US Inflation expectations, as measured by 5y5y forward inflation swaps, plunged closer to European forward inflation rates (within 10bps from 5yr lows).

In stark contrast, the 5y interest rates spread between US Treasuries and Bunds stands near its 5-yr highs, as the FED expects (and is expected) to raise rates, while the ECB contemplates deeply negative interest rates.

As the FED may find it impossible to finalise their plan for 4 rate hikes this year (25bps each in March, June, Sept and Dec, of which ~40% is priced in by markets currently), due to inflation expectations plummeting in addition to recession in US manufacturing, Oil, Commodities, China, EMs etc.. the 5y interest rate differential may have to capitulate and compress over the course of 2016.

Chart: US 5y5y Inflation Forwards vs Eur 5y5y Inflation Forwards (spread in lower panel)

 

Chart: 5y US Treasury yield vs 5y Bund yield (spread in lower panel)

Our views on Structural Deflation can be found here:

• 01/18/2016: Latest Investment Outlook
• 01/25/2016: Today’s interview with CNBC: CNBC: Could technology lead to stagnation?

 

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Seemed appropriate…

But we just had to show this…Who says bears don't know how to have fun?

 

It appears the BoC-inspired bounce has run its correlated margin-call course…

 

And as goes crude so goes stocks…

 

As every asset class is the same trade…

 

And stocks are rolling over fast…as it seems Sraghi did not offer enough dovihsness today…

 

Small Caps were the worst performer today (along with Trannies) after being the most-squeezed in the last few days…

 

This is the 3rd dip that was ripped, only to turn into another dip…

 

As FANGs were hit hard (along with TSLA)…

 

Treasury yields rallied 2-4bps (with the curve bull flattening)…

 

Stocks caught down to bonds' early warning…

 

The USD Index drifted lower on the day led by EUR strength as Draghi's jawboning today did nothing to help…(notable weakness in commodity currencies)

 

Commodities were a mixed bag today with crude and copper giving back their gains as gold and silver rallied notably…

 

WTI crashed back below $30 as Gold broke back above $1100…thanks to Saudi Aramco's comments…

 

As Crude started to run for $30, stock losses accelerated…

 

Charts: Bloomberg

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Submitted by Lance Roberts via RealInvestmentAdvice.com,

I recently received an email from an individual that contained the following bit of portfolio advice from a major financial institution:

“Despite the tumble to begin this year, investors should not panic. Over the long-term course of the markets, investors who have remained patient have been rewarded. Since 1900, the average return to investors has been almost 10% annually…our advice is to remain invested, avoid making drastic movements in your portfolio, and ignore the volatility.”

First of all, as shown in the chart below, the advice given is not entirely wrong – since 1900, the markets have indeed averaged roughly 10% annually (including dividends). However, that figure falls to 8.08% when adjusting for inflation.

It’s pretty obvious, by looking at the chart above, that you should just invest heavily in the market and “fughetta’ bout’ it.”

If it was only that simple.

There are TWO MAJOR problems with the advice given above.

First, while over the long-term the average rate of return may have been 10%, the markets did not deliver 10% every single year. As I discussed just recently, a loss in any given year destroys the “compounding effect:”

“Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

 

 

The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

Here is another way to view the difference between what was “promised,” versus what “actually” happened. The chart below takes the average rate of return, and price volatility, of the markets from the 1960’s to present and extrapolates those returns into the future.

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over the long-term.

The second point, and probably most important, is that YOU DIED long before you realized the long-term average rate of return.

The Problem With Long-Term

Let’s consider the following facts in regards to the average American. The national average wage index for 2014 is 46,481.52 which is lower than the $50,000 needed to maintain a family of four today.

• 63% of can’t deal with a $500 emergency
• 76% have less than $100,000; and
• 90% have less than $250,000 saved.

If we assume that the average retired couple will need $40,000 a year in income to live through their “golden years” they will need roughly $1 million dollars generating 4% a year in income.  Therefore, 90% of American workers today have a problem.

However, what about those already retired? Given the boom years of the 80’s and 90’s that group of “baby boomers” should be better off, right?  Not really.

• 54% have less than $25,000 in retirement savings
• 71% have less than $100,000; and
• 83% have less than $250,000.

(Now you understand why “baby boomers” are so reluctant to take cuts to their welfare programs.)

The average American faces a real dilemma heading into retirement. Unfortunately, individuals only have a finite investing time horizon until they retire.  Therefore, as opposed to studies discussing “long term investing” without defining what the “long term” actually is – it is “TIME” that we should be focusing on.

When I give lectures and seminars I always take the same poll:

“How long do you have until retirement?”

The results are always the same in that the majority of attendee’s have about 15 years until retirement. Wait…what happened to the 30 or 40 years always discussed by advisors?

Think about it for a moment. Most investors don’t start seriously saving for retirement until they are in their mid-40’s. This is because by the time they graduate college, land a job, get married, have kids and send them off to college, a real push toward saving for retirement is tough to do as incomes, while growing, haven’t reached their peak. This leaves most individuals with just 20 to 25 productive work years before retirement age to achieve investment goals. 

Here is the problem. There are periods in history, where returns over a 20-year period have been close to zero or even negative.

This has everything to with valuations and whether multiples are expanding or contracting. As shown in the chart above, real rates of return rise when valuations are expanding from low levels to high levels. But, real rates of return fall sharply when valuations have historically been greater than 23x trailing earnings and have begun to fall.

But the financial institution, unwilling to admit defeat at this point, and trying to prove their point about the success of long-term investing, drags out the following long-term, logarithmic, chart of the S&P 500. At first glance, the average investor would agree.

However, the chart is VERY misleading as it only looks at data from 1963 onward and there are several problems:

1) If you started investing in 1963, at the end of 1983 you had less money than you started with. (20 Years) 

 

2) From 1983 to 2000 the markets rose during one of the greatest bull markets in history due to a unique collision of variables, falling interest rates and inflation and consumers leveraging debt, which supported a period of unprecedented multiple (valuation) expansion. (18 years) 

 

3) From 2000 to Present – the unwinding of the stock market bubble, excess credit and speculation have led to very low annual returns, both a nominal and real, for many investors. (15 years and counting).

So, as you can see, it really depends on WHEN you start investing. This is clearly shown in the chart below of long-term secular full-market cycles.

Here is the critical point. The MAJORITY of the returns from investing came in just 4 of the 8 major market cycles since 1871. Every other period yielded a return that actually lost out to inflation during that time frame.

The critical factor was being lucky enough to be invested during the correct cycle.  With this in mind, this is where the financial institutions commentary goes awry with selective data mining:

“Among the key findings: On average, participants who kept contributing to their retirement plans throughout the 18-month period (October 2008–March 2010) had higher account balances than those who stopped contributing; Participants who maintained a portion of their retirement plan asset in equities throughout the entire period ended up with higher account balances than those who reduced their equity exposure amid the peak period of market distress.

Thus, retirement investors who kept contributing to their plan and who maintained some exposure to equities throughout the period were better off throughout the market’s 18-month bust-boom period than those who moved in and out of the market in an attempt to avoid losses. Retirement investors who kept exposure to equities amid the peak of the global financial crisis ended up with higher account balances on average than those who reduced their equity exposure to 0%.”

The main problem is the selection of the start and ending period of October, 2008 through March, 2010. As you can see, the PEAK of the financial market occurred a full year earlier in October, 2007. Picking a data point nearly 3/4ths of the way through the financial crisis is a bit egregious.

In reality, it took investors almost SEVEN years, on an inflation-adjusted basis, to get “back to even.”

Every successful investor in history from Benjamin Graham to Warren Buffett have very specific investing rules that they follow and do not break. Yet Wall Street tells investors they can NOT successfully manage their own money and “buy and hold” investing for long term is the only solution.

Why is that?

There is a huge market for “get rich quick” investment schemes and programs as individuals keep hoping to find the secret trick to amassing riches from the market. There isn’t one.  Investors continue to plow hard earned savings into a market hoping to get a repeat shot at the late 90’s investment boom driven by a set of variables that will most likely not exist again in our lifetimes.

Most have been led believe that investing in the financial markets is their only option for retiring. Unfortunately, they have fallen into the same trap as most pension funds which is that market performance will make up for a “savings” shortfall.

However, the real world damage that market declines inflict on investors, and pension funds, hoping to garner annualized 8% returns to make up for the lack of savings is all too real and virtually impossible to recover from. When investors lose money in the market it is possible to regain the lost principal given enough time, however, what can never be recovered is the lost “time” between today and retirement.  “Time” is extremely finite and the most precious commodity that investors have.

With the economy on a brink of third recession this century, without further injections from the Fed to boost asset prices, stocks are poised to go lower. During an average recessionary period, stocks lose on average 33% of their value. Such a decline would set investors back more than 5-years from their investment goals.

This leads to the real question.

“Is your personal investment time horizon long enough to offset such a decline and still achieve your goals?”

In the end – yes, emotional decision making is very bad for your portfolio in the long run. However, before sticking your head in the sand, and ignoring market risk based on an article touting “long-term investing always wins,” ask yourself who really benefits?

As an investor, you must have a well-thought-out investment plan to deal with periods of heightened financial market turmoil. Decisions to move in and out of an asset class must be made logically and unemotionally. Having a disciplined portfolio review process that considers how various assets should be allocated to suit one’s investment objectives, risk tolerance, and time horizon is the key to long-term success.

Emotions and investment decisions are very poor bedfellows. Unfortunately, the majority of investors make emotional decisions because, in reality, very FEW actually have a well-thought-out investment plan including the advisors they work with. Retail investors generally buy an off-the-shelf portfolio allocation model that is heavily weighted in equities under the illusion that over a long enough period of time they will somehow make money. Unfortunately, history has been a brutal teacher about the value of risk management.

via Zero Hedge http://ift.tt/1nL1qPd Tyler Durden

Zero… nada… zip! That's how many IPOs have started trading on US exchanges in 2016 so far…

As Bloomberg reports, at this rate, January is on track for the slowest month for IPOs since December 2008, when no companies filed after the bankruptcy of Lehman Brothers Inc.

 

In fact, January 2016 was globally the worst month for capital formation (IPOs) since August 2008…

 

And not even the insiders are particularly hopeful…

An IPO market recovery may take a while, said Tom Farley, president of NYSE Group Inc. “They will, by and large, IPO eventually. The question is when,” Farley said in a Bloomberg TV interview at the World Economic Forum in Davos, Switzerland. “It is likely a matter of months, not days or weeks.”

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