LGR Financial Newsletter
Volume I, Issue 6 (Released On March 09, 2014)
Will Russia continue to play hardball in Crimea? How will the EU and America react? And what will the resulting investor flight from emerging markets, towards “safety,” mean for the Dow?
Let’s get to it: a market update, a portfolio update, and an assessment of the current market environment. The market update relates to the week closing on February 28, so for a fresh analysis, skip to my take on the current market. As always, your comments are appreciated!
(FEBRUARY 24 – FEBRUARY 28)
The Dow (DJIA), the S&P 500, and the NASDAQ all ended the week with nice gains; gaining 1.35%, 1.26%, and 1.05% respectively. The S&P 500 and NASDAQ both closed at new highs, at 1,859.45 and 4,308.12 respectively, while the DJIA still remains approximately 0.9% from its all-time closing high. The new high in the S&P 500 puts any bearish analysis mostly on hold for the time being, as discussed in more detail below, and I expect new highs in the short term – although I expect a small dip first before moving to new highs.
Overall, there was some weakness in short-term economic data this past week, but some good signs from some of the longer-term economic data reports. For example, the Conference Board’s monthly Consumer Confidence Report, released on Tuesday of last week, came in with a reading of 78.1 vs. 80.2 expected. Investors care about the results of the report because “financial confidence is a leading indicator of consumer spending, which accounts for a majority of overall economic activity” (Forexfactory.com). Tyler Durden, a writer at Zerohedge.com, described it as the largest drop in 4 months, and said that the reported number missed “expectations by the most since October” (Tyler Durden - Zerohedge.com). He also outlines the long-term decline seen over the last 18 years. The report is extremely interesting and it can be found by following the link: http://www.zerohedge.com/news/2014-02-25/consumer-confidence-drops-most-4-months.
Likewise, Preliminary GDP growth (q/q), released in annual GDP growth format but demonstrating a quarter-over-quarter growth number, was reported at 2.4% vs. 2.6% expected. The report comes every quarter, approximately 60 days after quarter end, so this report pertains to Real GDP growth in the fourth quarter of 2013. GDP can be calculated either as Real GDP or as Nominal GDP, and neither is better; each uses a different scale of prices on which to calculate results. Real GDP measures output using constant-year prices (for example: prices in 1995 or prices in 2005). Nominal GDP measures output at current-year prices (so it would measure output at prices in 2013). This report works with Real GDP.
The number was very disappointing overall, as it came on the heels of a 4.1% increase in Real GDP in 3Q 2013, and an “Advanced” reading of Real GDP for the fourth quarter of 3.2%. There are 3 versions of Real GDP released a month apart (Advance, Preliminary, and Final – see Forexfactory.com), so this Preliminary GDP is the second reading for the fourth quarter of 2013.
Other economic data released last week was mixed. Weekly unemployment claims at 348K vs. 333K expected, showed some weakness this past week in the jobs market. Core Durable Goods Orders (m/m) at 1.1% vs. -0.1% expected, which shows that the “total value of new purchase orders placed with manufacturers for durable goods, excluding transportation items” (Forexfactory.com), increased over the last month and the fact that “rising purchase orders signal that manufacturers will increase activity as they work to fill the orders” (Forexfactory) will help our economy. In contrast, Durable Goods Orders (m/m) missed expectations with a reading of -1.0%, but “orders for aircraft are volatile and can severely distort the underlying trend” and “the Core data is therefore thought to be a better gauge of purchase order trends” (Forexfactory.com) so it would appear that overall the reports should be viewed as positive from a longer-term perspective. New Home Sales at 468K vs. 406K expected, came in ahead of expectations, showing new single-family homes sold during the previous month had a larger increase than expected.
What, then, about news from the Ukraine? I think investors will follow past behavior. Ukraine impacted the market on Monday, as investors absorbed a reasonable worst-case scenario. “Conservative” speculators (a contradiction in terms?) will increasingly move into Gold and other “safe-haven” investments. This further supports my prior comments on Gold as one of the best areas to invest in moving forward.
Finally, have you “House of Cards” fans noticed recently that streaming on Netflix is slower than usual? The slowdown became particularly pronounced when the new season rolled out. Well, there was a reason for that….Netflix has been refusing to pay! A WSJ article was posted on February 18, 2014 that described how “The online-video service has been at odds with Verizon Communications Inc. and other broadband providers for months over how much Netflix streaming content they will carry without being paid additional fees” (WSJ). The article also described how the “long simmering conflict has heated up and is slowing Netflix, in particular, on Verizon’s fiber-optic FiOS service, where Netflix says its average prime-time speeds dropped by 14% [in January]” (WSJ).
(FEBRUARY 24 – FEBRUARY 28)
My portfolio lost 0.63% this week — very disappointing considering the market’s 0.9% gain and my goal (and the goal of any portfolio manager) is to beat the market. This week taught me one very important lesson; the reason it is so tough to consistently outperform the market is because the market does not have an earnings report. While this may seem obvious, the obvious in this case explains why portfolio management becomes so hard over a substantial amount of time. My portfolio was affected by a few hefty weekly losses by some smaller positions (individually accounting for around 2-3% each of the portfolio), which did not worry me as I am looking to increase the size of my position in several of these companies at a lower price. However, my portfolio saw a huge loss this week from Questcor Pharmaceuticals (NASDAQ: QCOR). Questcor released an earnings report on Tuesday and, unfortunately, it reported results slightly below the average of analyst expectations. However, overall the earnings report was very positive as it showed that the company had huge year-over-year (yoy) increases in both earnings per share (EPS) and net sales. Despite these, Questcor’s share price dropped 5.64% on the day of the release, and then proceeded to fall further after release of negative reports about one of its main drugs. The share price rebounded over 7% in early trading on Monday, March 03, so I am not worried about long-term strength, although I was disappointed in what had been one of my top performers so far this year. I apologize for including data that isn’t from last week, but I think it is important to show that the position isn’t “doomed” by any means.
In more positive news, Tesla did extremely well this week with most of the stock’s gains being attributed to a raised price target expectation from analysts at Morgan Stanley, who more than doubled their price estimates from $153 to $320 per share. While this sounds like an incredibly positive development for the stock, the price is now at $246 — the $153 estimate from Morgan Stanley very old, and Tesla’s share price has doubled from $125 to $250 over the past three months. Morgan Stanley was almost forced to increase their price target or else appear to take a bearish outlook for the company — Morgan Stanley held a $153 price target when the stock traded at around $210. With that taken into consideration, the $320 isn’t quite as great as the 100% increase it appears. On the flip side, the Morgan analysts gave very good reasons why they increased the price target, citing “potential for the electric….” And ultimately those reasons justified the 1.68% increase in the share price on Tuesday, the day Morgan Stanley released its analysis.
My View on the Current Market Environment:
Two Newsletters ago I mentioned how a market top could be forming. I used charts showing margin and asset allocation numbers to demonstrate the risk that investors faced if they decided to enter the market (at the time, markets appeared primed for a decline because of illiquidity and high levels of debt/margin, leaving selling shares as the only option to raise cash in a hurry). Not much has changed in terms of the high amounts of leverage investors currently have (in the form of taking on debt to finance more purchases of stocks) margin rates since then. Ultimately these conditions lead to tops in markets, but unfortunately calling tops with precision is extremely difficult (and I do not claim to be an expert by any means!). These conditions are still prevalent behind the scenes right now, although the situation might look a little better as the recent 5-6% decline in the market caused “weak hands” to sell stocks and investors as a whole to lighten their portfolios.
However, the market has quickly regained its footing and is back in major record territory. Just to give you all some perspective on how “stock crazed” everyone was last year, and how it has led to the market (as a whole) seeming overvalued at current price levels: “Last year, U.S. stock funds received $172 billion, the highest annual net inflow on record” (WSJ). To put that in perspective: “Investors put more than $100 billion a year into U.S. stock funds for six consecutive years starting in 1995, according to Lipper Inc. But after the 2008 crisis, they withdrew more than they invested in 2009, 2011 and 2012” (WSJ). The inflow to U.S. stock funds has been more tepid so far this year, but the recent sell-off in emerging markets has prompted a lot of investors to move funds out of emerging market funds and into domestic stock funds.
Is the stock market currently overvalued? Relative to the S&P 500’s historic P/E multiples, the answer to that question is yes. FactSet says that the S&P 500 is currently trading at “16 times its component companies’ earnings for the past year” (WSJ), and currently has a “12-month forward P/E ratio is 15.4. This P/E ratio is based on Thursday’s closing price of 1877.03 and forward 12-month EPS estimate of $121.86” (FactSet). To give some perspective, the S&P 500’s current P/E ratio of 16 “is double its level of five years ago and almost identical to the level at which stocks peaked and began their decline in October 2007” (WSJ).
A broader measure of stock prices developed by Nobel-prize-winning Yale economist Robert Shiller measures the S&P against a 10-year average of earnings. It puts the S&P at 25 times earnings, far above the historical average of 16.5 but not quite back to the 27.5 hit in 2007. These measures show that stocks are riskier than before but don’t tell what stocks will do next. Stocks can remain expensive for years. Mr. Shiller’s measure, for example, was at its current level in 2003 and moved higher and lower for four years before the bull market ended in 2007 (WSJ). To justify further increases in price, the companies that make up the S&P 500 index would have significantly increase their earnings moving forward, which can only happen if the economy continues to have a strong recovery.
As I mentioned in my last Issue, the economy’s recovery might be slowing down. Therefore, pay particular attention to economic data in the next few months, which will show whether the past few months reflect a slowing in recovery, or are merely a result of the weather.
I attached an article with excellent charts (http://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_3.7.14) that discusses how companies will need to significantly improve their earnings moving forward. The chart that I want to direct your attention to is the chart on page one with the heading “S&P 500 Forward 12-Month EPS vs. Price: 10-Year.” It shows how S&P 500 prices have varied along with stocks’ Forward P/E ratio over a long period of time, and it helps you compare the current market situation to historical market environments to help you get a feel for what we can expect in the future.
(I explain P/E ratios in greater detail in the “Appendix” section)
Putting all this news together: I’m confident of a formation of a market top, but not for several weeks at the earliest. The recent new highs suggest upward momentum; rarely in such cases does a new high immediately form a top without some lingering. Thus I think the evidence in the charts I previously shared, and the evidence I supplied above, support a top formation, but I now think any short-term decline will only be a “Dip” that will be used as a buying point to propel the market higher.
If you have any questions about this Issue of my Financial Newsletter please fill out the form below. I also appreciate receiving any comments you might have about what you just read, and I encourage you to send me ideas for topics that you would like to see me write about in the future. Thank you for reading!