NEW$ & VIEW$ (3 FEBRUARY 2014)

Slow Income Growth Lurks as Threat to Consumer Spending A slowdown in U.S. income growth could short-circuit the surge in consumer spending that propelled the economic recovery in recent months.

As the holiday shopping season wrapped up, personal consumption rose a seasonally adjusted 0.4% in December from a month earlier, the Commerce Department said Friday. With a 0.6% increase in November, the final two months of 2013 marked the strongest consecutive gains since early 2012.

The upturn came while incomes were flat during the month. Real disposable income, which accounts for taxes and inflation, advanced just 0.7% during 2013. That was the weakest growth since the recession ended in 2009. (…)

Across 2013, the Commerce Department’s broad measure of spending on everything from haircuts to refrigerators was up 3.1% from the prior year. That was the weakest annual increase since 2009 and below the 4.1% growth seen in 2012.

But the pace of spending was substantially stronger in the final six months of last year. Economic growth in the second half of 2013 represented the best finish to a year in a decade. Consumer spending, which makes up more than two-thirds of the nation’s gross domestic product, was the primary driver. (…)

The personal saving rate fell to 3.9% in December from 4.3% in November. (…)

Friday’s report showed subdued inflation across the economy. The price index for personal consumption expenditures—the Fed’s preferred inflation gauge—rose 1.1% in December from a year earlier. While the strongest since August, the figure remains well below the central bank’s 2% inflation target. (…)

A separate Labor Department report Friday said employment costs in the last three months of 2013 were 2% higher than a year ago. Annual cost increases typically exceeded 3% before the 2007-09 downturn wiped out millions of jobs. (…) (Chart and table from Haver Analytics)

Try to see anything positive from the table. I suspect that spending data for the last few months of 2013 will be revised lower in coming months. In any event, the income side is desperately weak.Last 3 months of 2013:

• Personal Income: +0.1%
• Disposable Income: –0.2%
• Real Disposable Income: –0.3%
• Consumption Expenditures: +1.1%
• Real Expenditures: +0.9%

Bloomberg Orange Book comments from retailers about January performances were mostly negative and suggest future weakness. Wal-Mart pared its sales forecast based on curtailment of the food stamp benefit program and other specialty apparel retailers issued statements of concern. (BloombergBriefs)

Makes you wonder about this Bloomberg article: Global Earnings Are Poised to Accelerate in 2014 as U.S. Consumers Spend More

Meanwhile:

China’s Manufacturing Activity Slows

The official manufacturing PMI fell to 50.5 in January, from 51.0 in December, the federation said. The January PMI was in line with the median forecast by economists in a Wall Street Journal poll. (…)

The new orders subindex dropped to 50.9 in January from 52.0 in December, and the subindex measuring new export orders declined to 49.3 from 49.8, the statement said.

The employment subindex dropped to 48.2 from 48.7, while the output subindex fell to 53.0 from 53.9. Mr. Zhang said the fall in the new orders subindex shows weakness in domestic demand.

The subindex measuring the operation of large firms of the official PMI, heavily weighted towards larger state-owned enterprises, dropped to 51.4 from 52.0, while the one measuring smaller firms fell to 47.1 from 47.7. (…)

The HSBC China Manufacturing PMI, which is tilted toward smaller companies, fell to a final reading of 49.5 in January from 50.5 in December, HSBC said Thursday.

In another sign of slower momentum among factory owners, profit at major Chinese industrial enterprises grew at a slower pace, expanding by 6% in December from the same month a year earlier to 942.53 billion yuan ($155.6 billion), a reduction from November’s 9.7% increase, official data released earlier in the week showed

Moscow casts doubt over Russian growth

GDP rose 1.3% in 2013 just missing government forecasts

Gross domestic product increased by 1.3 per cent in 2013, narrowly missing the government’s most recent forecast of 1.4 per cent, the Federal Statistics Service in its preliminary GDP estimate said on Friday. (…)

The economy ministry said while the economy was past its lowest point, it was unclear whether it could grow by 2.5 per cent this year as forecast earlier. Most banks and independent economists are more pessimistic than the government and estimate growth this year to stay well below 2 per cent. (…)

“In the first quarter, we expect growth on a level around 1 per cent. In the second quarter, growth will be higher, probably somewhere around 2 per cent or 1.5 per cent,” Andrei Klepach, Mr Ulyukayev’s deputy, said in remarks carried by Russian news agencies. “We can stick to our forecast of 2.5 per cent, although it is possible, if you take the current trends, that growth might be lower.”

However, the decline of the rouble, which has fallen to its lowest against the dollar in five years amid the recent emerging markets currency jitters, could alter that calculation, as a weaker currency makes its exports more competitive.

“In our view, a lower rouble rate is better for economic growth,” said Mr Klepach. “But it would be worse for both growth and inflation if there were bigger volatility.”

In a survey published last week, MNI, an affiliate of Deutsche, said the weakening rouble was helping Russian businesses and respondents were the most positive on exchange rate conditions in January since the survey began last March.

Materially Slower Spending Growth by Emerging Market Countries Will Be Felt

Emerging market economies are of increasing importance to mature economies, such as the US. For example, the share of US merchandise exports shipped to emerging markets has risen from 2003’s 44% to 2013’s prospective 55% of US merchandise exports. During the first 11 months of 2013, US exports to emerging markets grew by 4.6% annually, which compared most favorably to the -0.5% dip by exports to advanced economies.

The faster growth of US exports to emerging markets is consistent with 2013’s much faster 4.7% growth of the emerging market economies compared to the accompanying 1.3% growth of advanced economies. Moreover, this phenomenon is hardly new according to how the emerging markets outran mature economies for a 14th straight year in 2013. Since year-end 1999, the average annualized rates of real economic growth were 6.1% for the emerging markets and a sluggish 1.8% for the advanced economies. By contrast, during the 14-years-ended 1999, the 3.7% average annual growth rate of the emerging markets was much closer to the comparably measured 3.1% growth of the advanced economies. (Figure 1.)

Emerging markets are acutely sensitive to industrial commodity prices
Emerging market economies can suffer to the degree major central banks succeed at curbing product price inflation. Though it’s difficult to separate the chain of causation, the 0.74 correlation between the growth of Moody’s industrial metals price index and emerging market country economic growth is much stronger than the price index’s 0.28 correlation with the growth of advanced economies. In fact, the 0.74 correlation of emerging market country growth and the base metals price index is far stronger than the 0.19 correlation between the growth rates of emerging market and advanced economies.
According to the above approach, the percent change of Moody’s industrial metals price index is relative to the price index’s average of the previous three years. The recent industrial metals price index trailed its average of the previous three years by -8%. (Figure 2.)

The latest decline by industrial metals prices suggests that the emerging market economies will grow by less than the 5.1%, which the IMF recently projected for 2014. When the aforementioned version of the percent change for the industrial metals price index is above its 8.3% median of the last 34 years, the median yearly increase by emerging market economic growth is 5.9%. By contrast, when the base metals price index grows by less than 8.3% annually, the median annual increase for emerging market growth drops to 3.7%. (Moody’s)

As U.S. debates oil exports, long-term prices slump below $80 Long-term U.S. oil prices have slumped to record discounts versus Europe’s benchmark Brent, with some contracts dropping below $80 in a dramatic downturn that may intensify producers’ calls to ease a crude export ban.

Oil for delivery in December 2016 has tumbled $3.50 a barrel in the first two weeks of the year, trading at just $79.45 on Friday afternoon, its lowest price since 2009. That is an unusually abrupt move for longer-dated contracts that are typically much less volatile than prompt crude. For most of last year, the contract traded in a narrow range on either side of $84 a barrel.

The shift in prices on either side of the Atlantic is even more dramatic further down the curve, with December 2019 U.S. crude now trading at a record discount versus the equivalent European Brent contract. The spread has doubled this month to nearly $15 a barrel, data show.

The drop in so-called “long-dated” U.S. oil futures extends a broad decline that has pushed prices as much as $15 lower in two years. It also coincided with an abrupt drop in near-term futures, which fell by nearly $9 a barrel in the opening weeks of 2014 amid signs of improving supply from Libya.

But while immediate prices have rebounded swiftly thanks to strong demand amid frigid winter weather and new pipelines that may drain Midwest stockpiles, longer-term contracts have not.

The unusual speed, severity and persistence of the decline has mystified many in the oil industry. Brokers, analysts and bankers have offered a range of possible explanations: a big one-off options trade in the Brent market; new-year hedging by U.S. oil producers; liquidation by bespoke fund investors; or even long-term speculation on a deepening domestic glut.

Regardless of the trigger, however, it may be cause for growing alarm for crude oil producers, who are increasingly concerned that falling prices will crimp profit margins if U.S. export constraints are not eased. Producers say this would hand over some of their rightful profits to refiners who can freely export gasoline and diesel at world prices. (…)

EARNINGS WATCH

Amid all the EM turmoil and the barometers of all kinds, let’s pause for a moment to take a look at the main ingredient, half way into the earnings season.

• Factset provides its usual good rundown:

With 50% of the companies in the S&P 500 reporting actual results, the percentages of companies reporting earnings and sales above estimates are above the four-year averages.

Overall, 251 companies have reported earnings to date for the fourth quarter. Of these 251 companies, 74% have reported actual EPS above the mean EPS estimate and 26% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is
above the 1-year (71%) average and the 4-year (73%) average.

In aggregate, companies are reporting earnings that are 3.6% above expectations. This surprise percentage is above the 1-year (3.3%) average but below the 4-year (5.8%) average.

The blended earnings growth rate for the fourth quarter is 7.9% this week, above last week’s blended earnings growth rate of 6.3%. Upside earnings surprises reported by companies in multiple sectors were responsible for the increase in the overall earnings growth rate this week. Eight of the ten sectors recorded an increase in earnings growth rates during the week, led by the Materials sector.

The Financials sector has the highest earnings growth rate (23.7%) of all ten sectors. It is also the largest contributor to earnings growth for the entire index. If the Financials sector is excluded, the earnings growth rate for the S&P 500 falls to 4.9%.

In terms of revenues, 67% of companies have reported actual sales above estimated sales and 33% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is above the average percentage recorded over the last four quarters (54%) and above the average percentage recorded over the previous four years (59%).

In aggregate, companies are reporting sales that are 0.1% below expectations. This percentage is below the 1-year (0.4%) average and below the 4-year (0.6%) average.

The blended revenue growth rate for Q4 2013 is 0.8%, above the growth rate of 0.3% at the end of the quarter (December 31). Eight of the ten sectors are reporting revenue growth for the quarter, led by the Health Care and Information Technology sectors. The Financials sector is reporting the lowest revenue growth for the quarter.

At this point in time, 54 companies in the index have issued EPS guidance for the first quarter. Of these 54 companies, 44 have issued negative EPS guidance and 10 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 81% (44 out of 54). This percentage is above the 5-year average of 64%, but slightly below the percentage at this same point in time for Q4 2013 (84%).

For Q1 2014, analysts are expecting earnings growth of 2.2%. However, earnings growth is projected to improve in each subsequent quarter for the remainder of the year. For Q2 2014, Q3 2014, and Q4 2014, analysts are predicting earnings growth rates of 8.5%, 12.4%, and 11.9%. For all of 2014, the projected earnings growth rate is 9.6%.

Note that the 2.2% growth rate expected for Q1’14 is down from 4.3% on Dec. 31. The 9.6% growth rate for all of 2014 is down from 10.6% on Dec. 31.

Data can vary depending on which aggregator one uses. Factset’s reports are the most complete but the official data still come from S&P.

• Half way into the season, S&P’s tally shows a 69% beat rate and a 20% miss rate.

Importantly, Q4’13 estimates rose from $28.77 On Jan. 23 to $29.23 on Jan. 30. S&P also detailed the impact of two large pension adjustments at AT&T and Verizon: their gains added $0.94 to the Q4’13 operating EPS while they cost the Index $1.26 in Q4’12. Taking these out, just for growth calculation, Q4’14 EPS would be up 16% YoY if the remaining 250 companies meet estimates, up from +12.2% in Q3 and +3.7% in Q2. The economic acceleration is thus translating into faster profit growth and still rising margins.

• But let’s not get carried away as Zacks Research suggests:

We should keep in mind, however, that easy comparisons account for a big part of the strong earnings growth. Comparisons are particularly easy for three companies – Bank of America, Verizon, and Travelers. Exclude these three companies and total earnings growth for the S&P 500 companies that have reported drops to +6% from +12.0%.

Nonetheless, Zack acknowledges that if remaining companies meet estimates

Total earnings in Q4 would be up +9.6% on +0.7% higher revenues and 79 basis points higher margins. This is a much better earnings growth picture at this stage of the reporting cycle than we have seen in recent quarters. In fact, +9.6% growth is the highest quarterly earnings growth rate of 2013.

Zacks provides another useful peek at earnings trends with actual dollar earnings instead of per share earnings.

Trailing 12m EPS are now seen reaching $108.28 after Q4’13 (+5.9% QoQ) and $110.64 after Q1’14, assuming Q1 estimates of $28.13 (+9.2%) are met. They have been shaved 0.6% in the last week.

• The Rule of 20 P/E barometer, a far more useful barometer than the January barometer, has retreated back into the “lower risk” area at 18.2x, down from 19.7x in December 2013. This is the third time in this bull market that the Rule of 20 P/E (actual P/E on trailing EPS + inflation) has refused to cross the “20 fair value” line after a rising run, a rare phenomenon that last occurred in the early 1960s.

In all the media frenzy about the recent equity markets setbacks, the U.S. earnings trend should take center stage. Rising earnings remain the main fuel for bull markets, over and above QEs of all kinds. Notice the sharp uptrend yellow line in the chart above. This line plots where the fair value of the S&P 500 Index based on the Rule of 20. In effect, it is derived from multiplying trailing 12m EPS by (20 minus inflation) or 18.3 at present using core CPI. It is the difference between the yellow line and the actual S&P 500 Index (blue line) that is measured by the thick black line (actual P/E + inflation).

Deep undervaluation is reached when the thick black line, the Rule of 20 barometer, is below 17.5 (historical lows around 15). Extrapolating 3 months down with trailing EPS at $110.64, the Rule of 20 P/E would be 17.8x if the Index remains at 1782 and inflation is stable at 1.7%. This would dictate a fair value of 2025 on the Index, +13.6% from current levels. On the other side, a decline in the Rule of 20 P/E to the 15-16x range would take the Index down 11-17% to 1470-1580. Taking the mid-point downside risk of 14%, the upside/downside is nearly identical, not a compelling risk/reward ratio to increase equity exposure just yet.

The S&P 500 Index is now sitting on its 100 day m.a.. It has held there four times since June 2013. The 200 day m.a. is at 1705 and is still rising. At 1700, the Rule of 20 P/E would be 17.1x. At that point, upside to fair value would be 19% and downside to the 15.5x level would be 10%. Unless the economic picture, or inflation, change markedly between now and the end of April, I consider the 200 day m.a. to be the worst case scenario in the market turmoil.

Eurozone Bank Earnings Weigh On Stocks

Banks saw the heaviest losses, with poorly-received updates from Lloyds Banking Group andJulius Baer dragging on the sector.

Data showing a faster-than-expected expansion in euro-zone manufacturing in January did little to lighten the mood, as investors focused on the latest disappointments in a downbeat earnings season.

SENTIMENT WATCH

• Investors pull $12bn from EM stocks Effects of turmoil spread to developed world’s markets

Not since the early summer of that year has the S&P 500 experienced a standard correction of at least 10 per cent. This type of pullback, like a gardener pruning roses in late winter in order to encourage healthy growth in the spring, is what many professional investors would like to see this year. (…)

Alhambra Investment Partners this week said not only has margin debt hit a record, there has been a massive rise in overall leverage. (…) The firm estimates that total margin debt usage last year jumped by an almost incomprehensible $123bn, while cash balances declined by $19bn. “This $142bn leveraged bet on stocks surpasses any 12-month period in history.” (…)

A torrent of margin calls and larger ETF outflows can easily feed on itself and may well prompt a far stronger corrective slide in stocks than investors expect.

• Cautious mood spills over into February Global stocks near three-month lows as weak China data bite

• Stocks Slide as Jitters Persist U.S. stocks capped their biggest monthly selloff in more than a year as investors cast a nervous eye to selloffs in emerging markets.

• Another Week, Another Walloping for Stocks With a tapering Fed and turmoil in emerging markets, the slide may only be starting.

• Dow Dumps To 2nd Worst January In 24 Years

  Trader’s Almanac –  every down January on the S&P 500 since 1938, without exception, has preceded a new or extended bear market, a 10% correction, or a flat year.

• Most Expect Stock Turmoil to Pass A spate of bumpy, uncertain trading has knocked the Dow Jones Industrial Average down 5.3% from its Dec. 31 record. It is threatening to hang around for a while, many money managers say. The big question is how much worse it could get. The widespread belief is, not much.

Get used to it.

A spate of bumpy, uncertain trading has knocked the Dow Jones Industrial Average down 5.3% from its Dec. 31 record. It is threatening to hang around for a while, many money managers say. The big question is how much worse it could get.

There is just about everything in this last WSJ piece…and just about nothing with any substance.

ANOTHER BAROMETER…

If you are of the statistical type, you should buy the Stock Trader’s Almanac and drown yourself in numbers and, often, stupidity. Here’s the Decennial Cycle from Lance Roberts, to help you keep the faith ;

There is another piece of historical statistical data that supports the idea of a market “melt up” before the next big correction in 2016 which is the decennial cycle. 

The decennial cycle, or decennial pattern as it is sometimes referred to, is an important one. It takes into account the stock market performance in years ending in 1,2,3 etc. In other words, since we just finished up 2013 that was the third year of this decade. This is shown in the table below.

This year, 2014, represents the fourth year of the current decade and has a decent track record. The markets have been positive 12 out of 18 times in the 4^th year of the decade with an average return for the Dow Jones Industrial Average since 1835 of 5.08%. Therefore, there is a 66% probability that the end will end positively; however, that does not exclude the possibility of a sharp dip somewhere along the way.

However, looking ahead to 2015 is where things get interesting.  The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015.  As shown in the chart above, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%. 

The return of the positive years is also quite amazing with 10 out of the 15 positive 5th years (66%) rising 20% or more.  However, 2015 will also likely mark the peak of the cyclical bull market as economic tailwinds fade and the reality of an excessively stretched valuation and price metrics become a major issue.

As you will notice, returns in the 6th and 7th years (2016-17) become substantially worse with a potential of negative return years rising.  The chart below shows the win/loss ratio of each year of the decennial cycle.

AND MORE ON THE JANUARY BAROMETER

OK, this will be the end of it. Promise. But I thought it was relevant and, I must admit, a little interesting. Cyniconomics introduces the “JAJO EFFECT”:

Our argument begins with four observations (we’ll get to theories in a moment):

1. Market sentiment often changes during the earnings reporting season – in which most of the action occurs in the first month of the quarter – and these sentiment shifts tend to persist.
2. Individual investors tend to pay extra attention to their positions early in a quarter, reacting to the past quarter’s results and then looking ahead to the next performance period.
3. Professional money managers often refine their strategies prior to client reviews or board meetings, which typically occur after results for the prior quarter become available.
4. Investors (individuals and professionals) are even more likely to rethink strategy in January, partly because it marks a new annual reporting period but also because it tends to be a time for planning and reflection. (How are you doing on those resolutions, by the way?)

These observations are admittedly vague, but we suspect they’re relevant to stock performance. They suggest that the first month of a quarter may set the market’s tone in subsequent months. In the context of today’s markets, they tie into a few questions you may be asking about early 2014 volatility:  Is January’s market drop merely noise on the way to another string of all-time highs, or is there more to it than that? For instance, doesn’t it seem a little ominous that we stumbled out of the gates this year despite sentiment being rampantly bullish? Does this tell us to be cautious going forward?

If you happen to read the Stock Trader’s Almanac, you’ll connect our questions to the “January barometer” (…). The Almanac’s founder, Yale Hirsch, coined the term in 1972 when he presented research showing that January’s return is a decent predictor of full-year returns. He concluded: “As January goes, so goes the year.”

We’ll take a closer look at the January barometer below, while testing two variations drawn from the observations above.

“Downsizing” the January barometer

First, we doubt that any carryover of January’s performance is likely to persist for an entire calendar year. Based on the idea that quarterly reporting cycles may have something to do with these types of anomalies, it doesn’t seem right to think that January’s events should still be relevant near the year’s end.  The first month of a quarter may offer clues about the next quarter or two, but probably not three or four quarters later after investors have shifted focus to subsequent corporate earnings and investment performance reports.

In fact, even without quarterly reporting cycles, you may still question why January would continue to be a “barometer” by the third or fourth quarter.  You may expect to find lower correlations of January returns with the year’s second half than with the first half, and this is exactly what we see:

Note that the 33% correlation for the “downsized” January barometer is very high for these types of relationships. It’s comfortably significant based on traditional tests (the F-stat is 8.2).  By comparison, the correlation of January’s return with the 11 months from February to December is still high at 28% but less significant (the F-stat falls to 5.1).

Here’s a scatter plot and trendline for the year-by-year results:

The chart shows that 54% of the years with negative January returns included negative returns from February to June (13 of 24), while only 9% of the years with positive January returns were followed by negative February to June returns (8 of 60). In other words, the probability of a down market between February and June was six times higher after a down market in January.

Do years or quarters hold the key to the calendar?

Second, we considered whether April, July and October also qualify as barometers, based on our speculation that the January barometer is partly explained by quarterly phenomena.

In particular, we calculated correlations with subsequent returns for all 12 months to see if the beginning-of-quarter months stand out:

Needless to say, the correlations fit the hypothesis, with the four highest belonging to January, April, July and October. The odds of this happening in a purely random market are nearly 500 to 1. Call it the “JAJO effect.”

(…) If stocks don’t recover strongly by month’s end – say, back to the S&P 500′s 2013 close of 1848.36 – the odds favor continued weakness. As January goes, so goes the first half of the year.

 M&A — Best Start to Year Since 2011

Companies and funds inked $228.2 billion worth of acquisitions this month, the highest volume of activity since 2011, according to Thomson Reuters. (…)

Deal making volume is up 85% from January 2013 when all three indexes wrapped up January with gains between 4% and 6%. Yet all that could change quickly, and a big start to the year doesn’t necessarily translate into a big year for M&A.

By mid-February 2013, it looked like M&A was back in a big way — $40 billion worth of deals were announced on one day that month. Despite a 30% plus pop in stock indexes in 2013, M&A activity ended the year far below the pre-crisis peak years.

Still a big difference so far in 2014 is that overall deal making has been wide and deep — crossing industries and regions. Many of the big deals have been corporations buying up other corporations, and the stock market has mostly applauded buyers for making deals. (…)

The winning banks so far? Morgan Stanley takes the top spot for announced global M&A. Credit Suisse is right behind Morgan Stanley. The bank served as an adviser to Lenovo on both of its $2 billion plus bids for U.S. companies in the past two weeks – Motorola Mobility and IBM‘s low-end server business.  Behind them: Goldman Sachs, Bank of America, Deutsche Bank and then Citi. J.P. Morgan, typically a powerhouse deal maker, is in the 10th spot.