November 7, 2015


Let’s recap the price action in the market for the year so far.  Stock prices essentially went sideways for 7 months until August arrived.  However, a number of dynamics were developing prior to August that suggested weakness was ahead and the market was coiling up like a spring ready to release.  Then in mid-August, the market broke to the downside and the Dow slid 2,200 points in 5 days.  The market continued its volatility until the end of September.  Since then, we have seen market prices bounce back up to where they were before the market dropped and are essentially flat for the year once again.


Market participants have waffled back and forth regarding thoughts on the global economy, especially China, and what direction the Fed is likely to take with monetary policy.  Early in the year, the market was expecting the Fed to begin raising rates.  Then, due to economic weakness and slowing global growth, expectations flipped to pricing in very little chance they would start to raise anytime this year.  Currently, thoughts have turned full course back to believing they will raise interest rates in December. 


It is increasingly looking like the Fed is basing their monetary decisions on the moves in the stock market and looking for any confirmation in the economy to support getting off the zero bound.  You can overlay comments by members of the Fed on the price of the stock market and see that they communicated that they were likely to raise when stock prices were up and then reversed course when stock prices dropped.  The Fed is turning their focus more and more to very short-term measures, and in the environment we are currently in, it results in causing even more uncertainty since it seems as though they are changing their minds weekly. 


In the midst of all these changing and seemingly conflicting economic and market data, let’s try to step back and see if anything has really changed much over the last few months.  Before we look at a few indicators, we need to address the strong employment report just released for the month of October.  Remember, the report last month was weak and was one of the primary reasons market expectations for a rate hike subsided significantly.  Now, we get a strong report and expectations regarding the Fed flip back the other way.  For now, the Fed is on a clear path to raise in December but this could still change before we get there.  Let’s shift over to look at a few broader economic indications than just the latest employment report.




We can use ECRI’s [Economic Cycle Research Institute] U.S. Coincident Index to get a good sense of broad economic activity since it is a composite measure of aggregate output, employment, income and sales.  This is a broader measure than just GDP.




In the chart above, you can see that broad-based economic activity has been slowing since the first of the year and has not started to turn back up. 


We can also look at a chart by John Hussman which shows a number of economic activity measures.




In the chart above, you can see an overlay of a variety of economic indicators and he has shaded the two previous recessions.  The direction and level of these measures shows how the economy has been slowing.




So, you can see from the previous two charts that broad economic growth has been slowing for much of the year.  Does this one employment report suggest that things are about to change and economic activity is going to improve?  Well, the employment report  is generally not a good leading indicator of what’s to come and can be quite variable as we have seen from just the past two reports.  Therefore, let’s take a look at a leading indicator that has been pretty good in suggesting growth over the next quarter or two.  This is ECRI’s Weekly Leading Index. 




While their Coincident Index captures a very broad measure of economic activity, their Weekly Leading Index tends to give an indication of GDP readings about one to two quarters out.  If you look at the chart above, you can see the weakness at the end of last year which suggested the economic weakness in the 4th quarter 2014 and the 1st quarter of this year.  Then, the rebound at the beginning of the year in their Weekly Leading Index forecasted the rebound in GDP for the 2nd quarter of this year.  The Index then rolled back down beginning in May and forecasted the renewed weakness in 3rd quarter GDP.  It is interesting that the index continues to decline, which suggests that growth is not likely to strengthen in the coming months and may actually weaken further. 




Now, let’s see what effect the economy has had on recent earnings.  Bloomberg just reported that, “So far, about three-quarters of the S&P 500 have reported results, with profits down 3.1 percent on a share-weighted basis.  This would be the biggest quarterly drop in earnings since the third quarter 2009, and the second straight quarter of profit declines. Earnings growth turned negative for the first time in six years in the second quarter this year.”  A notable impact has been from energy and commodity related companies but overall earnings have been muted and top line revenue growth even weaker.  Here is a Bloomberg chart of earnings.






It is not surprising that commodity related company earnings have been weak since the underlying commodity prices have been weak.  Here is a chart of a basket of base metals and does not include the weakness in the oil markets.  These are base metals that are used in the global economy. 




You can see the temporary strength during the 2nd quarter of this year which coincided with the better GDP report that quarter.  Then, the weakness that followed in the base metals was also accompanied by weakness in the 3rd quarter GDP.  Currently, base metal prices have not turned higher and further suggest that the strong employment report for October may not be an indication of broader economic strength, especially globally.




Now, where the stronger employment report may have an upcoming impact is on corporate margins with hourly incomes rising.  It appears that this may be a result of increases in the minimum wage and the impact we are seeing with employment costs at companies like Walmart.  So, let’s take a look at corporate profit margins from a historical perspective.  Here is a chart of profit margins going back to 1973.




The chart above shows profit margins with the blue line and the periods that are circled indicate declines in profit margins by at least 60 basis points.  Previous recessions are the shaded areas.  The note on the chart in the blue rectangle indicates that 1985 was the only time where a 60 basis point decline in profit margins or more did not coincide with or predict a recession.  As you can see at the end of the chart, profit margins have rolled over from an all-time historical high and we will see if it turns out to be only the second time we have seen this without a recession in over 40 years.




While we are discussing corporate earnings and profit margins, let’s also touch on corporate debt.  The consensus thinking is that corporations continue to be flush with strong balance sheets and plenty of cash.  However, more and more companies have been issuing debt fueled by the ultra-easy monetary policy and much has been used to buy back stock.  Here are some highlights from a Bloomberg article on October 14th.


“Companies have loaded up on debt.  They owe more in interest than they ever have, while their ability to service what they owe, a metric called interest coverage, is at its lowest since 2009, according to data compiled by Bloomberg.  The deterioration of balance-sheet health is ‘increasingly alarming’ and will only worsen if earnings growth continues to stall amid a global economic slowdown, according to Goldman Sachs Group Inc. credit strategists led by Lotfi Karoui.  Since corporate credit contraction can lead to recession, high debt loads will be a drag on the economy if investors rein in lending, said Deutsche Bank AG analysts led by Oleg Melentyev, the bank’s U.S. credit strategy chief.  ‘The benefit of lower yields for corporate issuers is fading,’ said Eric Beinstein, JPMorgan Chase & Co.’s head of U.S. high-grade strategy.  As of the second quarter, high-grade companies tracked by JPMorgan incurred $119 billion in interest expenses over the last year, the most for data going back to 2000, according to the bank’s analysts.”


“The fallout of more borrowing coupled with lower earnings has raised concern among the analysts who track the debt and the money managers who buy it.  Yet it seems the companies themselves are acting as if it’s not happening. They’re still paying out record amounts in buybacks and dividends.  In the second quarter, the most creditworthy companies posted declining earnings before interest, taxes, depreciation and amortization.  Yet they returned 35 percent of those earnings to shareholders, according to JPMorgan.  That’s kept their cash-payout ratio -- how much money they give to shareholders relative to Ebitda -- steady at a 15-year high.”


“The borrowing has gotten so aggressive that for the first time in about five years, equity fund managers who said they’d prefer companies use cash flow to improve their balance sheets outnumbered those who said they’d rather have it returned to shareholders, according to a survey by Bank of America Merrill Lynch.  Since May, stocks of companies that have spent the most buying back their shares have performed even worse than the S&P 500 index.  That comes after buyback stocks outperformed the S&P 500 each year since 2007, according to data compiled by Bloomberg.”


This article is talking about high grade corporate debt, not junk bonds.  It is important to highlight that all this debt is not being used for capital investment projects for future growth but instead has been used to buy back stock to juice earnings per share in an environment that has offered slow to no top line revenue growth.  Stanley Druckenmiller just this week discussed how everyone has turned very short-term in their focus including the Fed, CEO’s, investors, etc. 


A company that has excessive cash levels over and above what dividends they need to support at comfortable payout levels as well as needs for capital investment to fund future growth can be used productively to buy back their own stock.  However, companies are usually not good at this as they often buy back the most shares near stock market peaks and high valuations and buy back few shares after big price declines and at low valuations.    In the world of low to no top line revenue growth, levering up to fund stock buybacks at the current high valuations to support short-term earnings-per-share growth is likely to come back an haunt those CEO’s and their respective Boards.  This will turn out to be another unintended consequence of profligate monetary policy.




Before I close for this month, let’s take a brief look at a few global dynamics.  First, the amount of negative yielding assets in Europe continues to increase as the following chart illustrates.




Deflationary pressures continue to increase and the European Central Bank indicated last week that they will likely add to their already $1 trillion a year run rate in money printing.  China is likely to continue to cut rates and even here in the U.S., 3-month Treasury Bills auction at 0% a few weeks ago.  It is also important to note that in the past two weeks, the two most prominent Fed members [Yellen and Dudley] both said that negative rates here in the U.S. are on the table if they perceive it is warranted.  Going negative here in the U.S. like many parts of Europe was previously thought of as extreme and would never happen.  It is no small change in thinking at the Fed for these two members to clearly state that negative rates are a viable policy tool.




Due to the slowdown in China and the related impacts to growth around Asia, capital is flowing out of emerging market economies.  It is impacting capital reserves and as a result U.S. Treasury bonds are being sold.  Here is a chart that reflects this recent dynamic and it is likely to continue and may accelerate.




Let’s go ahead and wrap up for this month.


The latest employment report has turned market expectations to thinking that growth may be picking up and that the Fed is going to raise rates in December, after having the opposite view of both as recently as a few weeks ago.  This flip-flopping is likely to continue.  Also, it is worthwhile to note that the “strong” employment report for October continues to show that it is the low paying, low quality jobs that showed strength and that is where minimum wage pressures are found most.


Growth has been weakening around the globe and here in the U.S. for most of the year, and in view of ECRI’s leading indicator it does not appear that the economy is likely to improve in the coming months.  In fact, it may continue to weaken.  This has impacted corporate earnings, and profit margins continue to roll over from all-time highs.  Corporations have issued large amounts of debt to fund stock buybacks for short-term earnings performance and as a result we are starting to see signs of balance sheet deterioration.  


Deflationary pressures continue around the globe, and as more interest rates are going lower and into negative territory, our central bank just put going below the zero bound on the table.  Currently, market participants believe the Fed will raise rates in December.  However, I continue to think that the data will either continue to weaken enough before their meeting in December and they will not raise, or they will raise and the data will weaken afterward and they will reverse course as claims of a “policy mistake” surface.  I would have preferred that the Fed never went to the zero bound or printed money but this is more about what is likely to happen than what should happen.




As for market implications, let’s look at what Stanley Druckenmiller said in an interview this week at a New York Times investment conference.  I have highlighted Druckenmiller many times as he is probably the best investor in the last 50 years.  “You’re pulling demand forward today, this is not some permanent boost.  You’re borrowing from the future,” Mr. Druckenmiller said. “The chickens will come home to roost,” warned Mr. Druckenmiller, who has been a frequent and vocal critic of the Fed and its policy of near-zero interest rates.  “I can see myself getting very bearish, I can’t see myself getting bullish,” he said.  Mr. Druckenmiller also told the audience that some of his best returns had been in “great periods of chaos.”


One of his important perspectives that he shared is that he is currently operating under the assumption that a primary bear market started in July.  If he is correct, the declines in August and September were the first wave down and this subsequent bounce in stock prices will roll back over and we will see prices break below the lows in August. 


Although investors have become bullish once again as a result of the latest bounce this past month, risk remains high.  If Druckenmiller is right, we will see what Yellen and Dudley put on the table of acceptable monetary policies this past week become reality in 2016.  The investing environment will become even more interesting if the majority of the world’s interest rates go negative for the first time in history. 



Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.