Linking Macro and Markets (Part 1)

In a conversation with one of my partners - who happens to be my father - over the weekend, a common question emerged, “what percentage of recent market gains are due to broad market euphoria vs. actual company performance?”  While my next task is to compare the individual company gains against the S&P to determine aggregate lead or lag, it brought up another interesting point:  How excited should an investor get about market exuberance?  Judging from financial publication cartoons, the dislocation between economic recovery and stock market recovery is rather evident.  So, how should we look at the differing information.  Further, is the information differing?   We'll have a look at current U.S. economic data, S&P fundamentals as a bellwether for the broader market, and fund fundamentals with the goal to analyze the trends over the next 6 months, 1 year and 2 years.  

Part 1 begins with the economy...  

Last Friday we got a strong jobs report.  Since one report a recovery does not make, the initial positive reaction was likely tempered by the poor unemployment number.  IHS Global Insight states:

Strong jobs growth combined with a declining labor force is not ideal because it brings closer the day on which the unemployment rate hits 6.5% and the Federal Reserve will start to think of raising interest rates.     

Employment

Diving deeper into the numbers we see a 14,000 rise in manufacturing jobs (the same rise from the preceding 2 months), along with a 0.5% rise in overall manufacturing production-worker hours.  Construction employment rose 48,000 for the fifth consecutive double-digit monthly increase, indicating a recovery in the housing market (of course tempered by last week’s Bloomberg article citing underlying dangers if housing resumes its old ways).  Services employment also increased by 179,000, up from 99,000 in January. 

On the negative side, government sector jobs fell by 10,000, all coming from state and local loss as federal jobs remained steady.  However, this number could increase in future months as the sequestration will apply mandatory cuts across all government agencies, which will kick in at the end of March unless Congress acts.  I see the continuation of the sequester at a 60% probability as more and more people in Washington, D.C. seem to agree with the cut to government spending though they fear their own job security.  IHS Global Insight expects sequestration to end in June (optimistic), but if it does last the whole year they predict a 400,000 net job loss.  Looking at the larger picture, discretionary spending will do little to help the U.S. fiscal situation so long as healthcare costs remain elevated. 

Smart pundits point to the labor-force participation rate (LFPR) [more on that below], which had the effect of reducing the unemployment rate to 7.7% from 7.9% in February.  The employment-population ratio held at 56.8% while the LFPR fell to 63.5% matching cyclical lows.  The most comprehensive unemployment measure, U-6, fell to 14.3% from 14.4%.

A worse case scenario would be if current the current trend continues AND there is a 400,000 loss in federal jobs.  In this case, the unemployment rate will not increase due to private sector momentum offsetting the government job losses.  Unemployment will likely stagnate around 7.5% and keep the Fed away from the inflation lever.  The down-side risk comes in the form of stable labor-force participation.  If this number falls, then unemployment could move below 7.0% for the "wrong" reasons prior to 2015 and we could see the Fed consider action.  This would put pressure on consumers and borrowers at the same time providing investors with increased returns.  

Production and Confidence

Durable goods, shipments, unfilled orders and capital goods all fell after multi-month gains.  These production numbers fail to demonstrate a trend and continue to hint at sideways economic activity.  At the same time inventories continued to rise for the sixteenth month to $374.8 billion showing continued upward momentum.  Net-net this leads me to forecast slow recovery.

CPI is still growing at a monthly annualized rate of 0.32%, far below the long term average annualized growth rate of 3.61% indicating that inflation is not currently an issue.  The PPI growth rate for January, 2.45%, is closer to its historical growth rate of 3.10%.  Growth as reflected in the PPI seems to be recovering more quickly than the cost of living is rising in the current environment.  The CPI will be one measure affected by change in Fed interest rate policy.  Consumer sentiment is currently in the middle of its one year range which supports other sideways economic data.

Labor Force Participation Rate

I see the economy in a slow state of recovery with an important caveat.  Investors should pay close attention to the LFPR.  The rate is touching levels not seen since the early 1980s and has failed to recover from its peak after the dot com bubble and the Great Recession.  From the Bureau of Labor Statistics:

When taken to its maximum time period, we can see a substantial run up in LFPR starting in the late 1960s.

What gives?  Willem Van Zandweghe, a senior economist at the Federal Reserve Bank of Kansas City, indicates half of the downward effect since 2007 is due to long-term factors while the other half is cyclical.  Long-term forces including labor population size and gender participation largely explain the period between 1966 and 2000.  Specifically, the increase in LFPR is attributable (1) to the baby boomers entering the labor force and (2) to the increase in women in the labor force (which peaked and leveled off at 60% in 1999).  Both trends leveled off in the early part of the 21st century and correlate with the start of the decline in the participation rate.  Van Zandweghe notes the decline in LFPR correlates to another two demographic events.  First, the boomers began reaching retirement age and began cutting back on work hours or retiring.  Second, there has been a steady decline in participation among youg people, in large part due to school enrollment (he sites Daniel Aaronson and others).

These demographic trends seem intuitive, but what of the cycle?  According to Van Zandweghe, the LFPR cycle has an increasingly negative correlation with the unemployment rate since the beginning of the last three recessions, reaching negative correlation levels not seen since 1982.  This indicates a very tentative hiring situation.  To what extent this is due to productivity or efficiency is a topic for another time.  What is clear is that corporate earnings have turned positive well ahead of LFPR recovery, which is logical.  What is unknown is the effect of policies, such as the extension of unemployment benefits, the general willingness of Americans to accept jobs they see as below their skill level, or the size of the shift from a manufacturing economy to knowledge economy (assuming the latter is less labor intensive).  Whatever the case, it is clear that the "jobless recovery" is an indicator that the U.S. economy is in uncharted waters.  

Economic Conclusion and Forecast

The above LFPR review indicates why the economy will take longer to recover from the 2008 recession than at any time in modern history.  There are changes in labor demographics, employment cycles and business trends never dealt with in modern American economy.  For these reasons, expect policy makers to stumble through the complexities (getting wrong more then they get it right) and expect businesses to continue to seek efficiencies which will stall large scale hiring for the next two years.  The LFPR will adjust to new norms around 63-64%.  Assuming the current situation (and no drastic policy changes), I anticipate unemployment to re-calibrate around a norm of 5-5.5% and GDP to grow at 2.5-2.9% by mid 2015, at which point the Fed will begin to raise rates priming the investment motor.

Part 2 on S&P Fundamentals to Come...

   

The Gold Standard Graphic

I read the post from Zero Hedge on Bernake's testimony yesterday.  We hear commentators, financial professionals and economists express opinions on the collapse of the gold standard, but this graphic is pretty stark.  Certainly doesn't look like Ben is a dove.

Zero Hedge - "Next Comes the Downgrade"

A fiscal cliff deal is reached and the market is gaping up this morning, which my portfolio likes (up >2% in the first 45 minutes), but nothing is solved.  Congress and the President have averted a self imposed "crisis".  This appears to be stage one of this year's battle.  While the news media reports that Republicans lost ground, I say that they decided to move the spending debate to March when the debt ceiling debate comes up again.  So let's recap:

1) Congress passes legislation that raises taxes on those making over $450K/annum but does not cut spending and markets around the globe rally...

2) The CBO raises the long term ramifications for the federal debt...

3) Thus, not much changes in the long term and the US is still in fiscal peril.

Not to sound too pessimistic, but we see a prime example of politics outweighing common/economic sense.   Once again the burden of this negotiation fell mostly on the middle class.  Those collecting paychecks would see the most immediate impact, had a deal not been reached.  However, as my father stated, investors would not have to deal with implications until April 15, 2014, at which point additional deals would surely be made with the possibility of retroactive application.  While the politicians may say they work for their constituents, the investors, of the institutional stripe, wield the influence.  An adverse reaction to this deal in the coming weeks will likely result in a reexamining of the policy in the coming year.

-JGM 

November Jobs Report - More Sideways Movement

We just got the nan-adjusted jobs report for November and the headline states 146,000 jobs were added and the unemployment rate fell to 7.7% from 7.9%.  Retail, business and IT services, and hospitality all gained jobs (+131,000), while the manufacturing and construction sectors lost jobs (-29,000).  On the flip side the participation rate declined to 63.3%.  Setting aside the need to apply adjustments down the road, this report seems to indicates the economy continues to muddle along.

Some things to consider:

• Seasonal workers for retail and holidays
• Weather prevents some from working
• Market sees this as a beat and futures are up

And for some additional perspective on just how difficult this recovery has been, have a look at the below chart from Calculated Risk (I saw a similar chart at the end of last year from an economist at Bloomberg):

The Fed and the ECB, or Lessons on Using a Pocket Bazooka

It is now clear to me that Euroland (love that moniker Mr. Gross, but I don't agree that the cult of equity is dying) and the Fed have one thing in common.  Over the past year they have decided to influence markets with language rather than action.  Let us not forget that while the current tactics of inaction and blabber may be similar now,  over the past five years the central banks' tactics have been very different.  In the face of great crisis, the Fed and Treasury -with a gun pointed at their heads in the form of market collapse- took decisive action by rapidly expanding the Fed's balance sheet by more that $1.5 trillion dollars over a couple months whilst simultaneously lowering rates to 0-.25%.  As a result the Fed eliminated the economic safety net in order to soften the crisis fallout and jump start the recovery.  While they succeeded at the former, the latter was less than successful.  However, it cannot be said that they fiddled while Rome burned.  I don't think the same can be said of the ECB.

At this point, the EU has not experience the action forcing event that we saw in the U.S. in 2007-2008, but their actions to date dealing with the drop-in-the-bucket size economies of Greece and Spain (with all due respect, of course) do not give me confidence that they are willing or able to step in if need be.  Thus far "actions" have been political.  Markets have traded on whispers and weak follow through.  Whilst this does not effect my long-term holdings, I am squeamishness that if a large event -credit or liquidity- hits Euroland they will not be capable of taking action.  THIS TYPE OF CRISIS WOULD NOT BE A BLACK SWAN.

So, I now look for ways to protect portfolio value against a market correction or collapse stemming from Euroland folly.  The worry is that inaction by the ECB in a crisis and a lack of Fed tools to absorb the event in U.S. markets leads to large drops in markets across the board.  So, my current homework is to identify market and technical indicators that I can use to signal those times when it is time to put on protection (since having protection consistently will consistently reduce profits). 

NKE is a BUY!!

I was not planning on making any moves as the weekend approached. Rather I was content to sit on my four open long positions (BRK.B, KMR, KO, CVS) and enjoy the weekend. But then I received an alert that NKE had broken $94.  It fell 10% overnight, between Thursday and Wednesday, on an earnings miss of 14.6% for Q4 and FY earnings results.  So here is a readout of my analysis and action.  Bottom line...I am glad this was on the watch list and that I know the company, because this is a great opportunity.


EPS Summary

• $25 million charge related to the restructuring of its business in Europe

• Increased spending on marketing by 23% QOQ (Olympics/NFL jersey contract/World Cup)

Revenue was up 12% to $6.5bn (missing projection - so what) and up 16% for the full year to $24.1bn, with increases across all product sectors with the U.S. market leading the way (not the greatest news). While there was revenue growth in China ($667mm) NKE sees growth moderating and will need to clear some inventory additional inventory from the region.

The real issue is that the gross margin declined by 1.5% in Q4 and 2.2% in the full year due to high product costs and investment in digital business. Net income declined by 8% largely due to the above one-time events.

Thesis

It is the first time since the last two years that NKE missed estimates. The company saw slowing growth in China in the last quarter, with orders coming in at 2%, which were expected to be somewhere in the range of 10%-15%. Overall, the announced results were disappointing weighing down on the company's stock. However, I maintain a positive outlook for the NKE as it has consistently shown growth in its earnings for a number of years, with strong revenue growth. It has also consistently beaten analysts' estimates in the past, which is why the current miss has come as a shock to many.  Moreover, one-off charges related to its European division and marketing costs related to the summer Olympics led to the recent decline in quarterly earnings. It has a strong business model with strong financials and a worldwide presence, and I expect it to do well going forward.  Despite the stock losing value in the past three months, it has outperformed over a one-year period. It currently trades close to its 52-week low of $77, which is a good entry point as the negative earnings results have been priced in.

Action and Forecast

I picked shares at $88.56 per share.  While this is not a trade, I do expect to see rebound by Monday (there was but not as big as I thought) with the stock likely trading up 3-5 points.  For the long-term, NKE is still the company that is was at the time of my last complete analysis (April).  It has ZERO debt, is the industry leader with a proven track record, and has some very positive events on the horizon (Olympics, World Cup, NFL Season as title jersey sponsor).  While I think that it will take 18-24 months for NKE to test its recent levels of $115, especially with global headwinds, I see this earnings release as a good opportunity to lock in a large margin of safety on the purchase of this company.

All Fed Up?

Looks like TWIST and not QE.  


So, the Fed is doing something to address what they see as an economy growing "less quickly that it normally would" without exhausting all their tools.  The Fed’s now forecasts an unemployment rate between 8% and 8.2% this year — basically, no improvement from June’s level of 8.2%.  

The Fed indicated that the housing market remains depressed and noted that global financial strains are also weighing on economic growth...not the most novel of observations.

• Here are the Fed's projections.
• Here is Goldman's take brought to you by ZeroHedge.

What does this mean for the Fed's balance sheet (something the media generally ignores and focuses on the rhetoric)?  After three months of contraction (from expiration), we should once again see sudden growth from the new TWIST.  This action will keep the balance sheet at the $2.9-$3 trillion level for the next year.  That is a large sheet my any measure.

While the economic news is not good, this provides value investors additional time to hunt for deals (that is me!).  Expect stock market volumes to remain low.  The largest worry for me is still corporate revenues.  How will continued global economic slowing effect my models?  More later.