THE WIZARD OF ODDS (March 3, 2014)

The Q4’13 earnings season is practically over as we now have 486 companies in. The beat rate was 64% and the miss rate 24.5%. Only 4 of the 10 sectors beat the average beat rate: Materials (67.7%), Financials (69.6%), IT (75.4%) and Telecom (66.7%). There were only 3 that beat the average beat rate in each of Q2 and Q3. Only IT, where corporations expertly manage expectations (38% of IT companies had issued negative guidance for Q4), beat in each of the last 3 quarters. Economists would say that the diffusion index of the beat rate is weak.

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

Q4 EPS were $28.02 bringing the trailing 12-month total to $107.07, down from $107.55 two weeks ago. Surprising to mean-reverters, corporate margins just keep rising as the Factset chart illustrates. Importantly, corporate guidance is not getting worse:

At this point in time, 101 companies in the index have issued EPS guidance for the first quarter. Of these 101 companies, 84 have issued negative EPS guidance and 17 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 83%. This percentage is above the 5-year average of 64%, but slightly below the percentage at this same point in time for Q4 2013 (88%). (Factset)

Q1’14 estimates have declined a little more, to $27.93 from $28.17 two weeks ago. Trailing 12-m EPS would then reach $109.23 by mid-May. If inflation stays at 1.6%, the Rule of 20 fair value would be 2010, 2.6% above the current reading of 1960 based on actual trailing earnings. The upside to fair value is therefore 5-8% from the current 1860 S&P 500 Index level.

This is the third time in this bull market that the S&P 500 Index has failed to cross the Rule of 20 fair value. During the last 50 years, each time valuation rose towards the 20 fair value level, enthusiasm carried equities over the line into the higher risk area.

Between 1963 and 1966, equity markets rose in sync with earnings while inflation remained stuck between 1% and 2%. Equities subsequently quickly lost 17% when inflation spiked from 2% to 3.6% in less than 9 months.

Since 2009, traumatized investors have refused to get carried away, nervous and uncertain as they were about the world economy, U.S. politics and Fed behaviour, all these fears being amplified by generally negative media narratives.

Recently, however, little has really changed other than the capitulation of most of the bears as the most recent equity rally silenced most of them and revived greed instincts supposedly extinct forever after the financial crisis.

Yet, equities have so far refused to enter the dark side. As I wrote on December 2, 2013 in ENTERING THE DARK SIDE,

The best that could happen is a repeat of the 1963-66 ride along fair value. Earnings would keep rising but the remaining mean-reverters and Shiller P/E fans (The Shiller P/E: Alas, A Useless Friend) would keep fear high enough to prevent equity markets from getting overvalued. (…)

This bull is now officially 5 years old. Only 3 out of 16 bulls grew older since 1932 and only 4 became more powerful.The only three bulls that lasted longer ended in a speculative frenzy that eventually led to a catastrophe for their riders. On January 13, 2014, in TAPERING…EQUITIES, the wizard of odds in me wrote

The old bull in me is tiring. Time to taper…equities.

Hmmm, I hear you, yes, you may be right, the Fed is taking care of us this time with all this financial heroin. And, yes, Super Mario will do whatever it takes and Abenomics are rewriting economic Japanese history.

Plus, the U.S. economy is clearly reaccelerating, inflation is minimal, we’re about to get Janet’s “new and improved” forward guidance, the GOP finally learned its lesson and President Obama’s golf game is improving by the day.

Blue skies forever! (…)

The only thing blue skies tell me is that it would be nice going out, walking, golfing, fishing, hiking…Investment wise, blue skies are no reason to buy, or sell. If anything, if the skies are so blue, then everybody must feel great. The contrarian in me does not really like that.

Here’s the rub:

• The economic blue skies have darkened since mid-January. The apparent economic acceleration has all but disappeared.
• Tapering is underway. Soft or hard patch? Nobody really knows. Mrs. Yellen wants more data before concluding. We shall see how she reacts now that she controls the trigger. Excellent analysts don’t necessarily make good managers. Some people are simply not comfortable pulling the trigger and tend to analyse to death…
• Inflation is dead for most investors and economists. But it is not. Total CPI was +0.9% YoY last October, +1.2% in November, +1.5% in December and +1.6% in January. Core CPI is +1.6% while the median CPI is +2.0%, unchanged for the past 6 months.  Core PPI jumped 0.4% MoM in January following a 0.3% rise in December. This is a 4.3% annualized rate over the last 2 months. Also, nonpetroleum import prices rose 0.4% in January. House and rent prices have been rising rapidly in the past year. Food-at-home prices jumped 0.7% MoM in January and the BLS is now forecasting they will rise 2.5-3.5% in 2014. We shall see how the California drought impacts fruits and vegetable prices. Gasoline prices rose nearly 8% since early November, 5.5% in the last month. Cold weather is certainly at play here but Brent crude is $109/bbl, up 12% from its April 2013 low while WTI is up 20%.

Energy and food prices may not matter much to those only caring for core CPI. But for most Americans, they eat at the core, especially when wage growth is minimal as it is now.

Should we read something in recent Fed officials debating whether the Fed should allow inflation to run a little without intervening? Prepping investors to prevent a negative wealth effect?

And now there is Ukraine. But don’t worry Barron’s tells us, it is  “Hopeless, but Not Serious”:

While much more is at stake politically for Vladimir Putin, the situation is “hopeless, but not serious,” at least in economic terms, quips David P. Goldman, head of Americas strategy at Hong Kong–based Reorient. To put Ukraine’s economy in perspective, he noted in a CNBC interview that its entire stock-market capitalization is roughly that of Walt Disney, its gross domestic product is one-fifth of Turkey’s, and its per capita income is a bit higher than Egypt’s. Per capita income of Ukrainians is estimated at well less than half of Russians’ and even less than that of Poles.

But, as Bloomberg reminds us, Ukraine is also a breadbasket, a natural gas chokepoint, and a nation of 45 million people in a pivotal spot north of the Black Sea. Ukraine matters—to Russia, Europe, the U.S., and even China. Ukraine may not matter directly to Americans, but it matters much to Europeans and Chinese, both of which matter to the U.S. and both of which are weighing on world economic growth these days. The WSJ’s Matthew Kaminski interviewed Mikheil Saakashvili, former president of the ex-Soviet nation of Georgia who knows a thing or two about Putin’s intentions and ways and means:

“What does he want here? Chaos,” Mr. Saakashvili says. “He has good chances here this time to really chop up Ukraine. It’s going toward big-scale conflict. Big, big internal conflict. He’ll stir up trouble in some of the Ukrainian regions. It’s a very crucial moment. Russia will try to Balkanize Ukraine.”

Why?

“If [a European] Ukraine’s a success, a smooth transition, a nice government, doing nice reforms—for Putin, it’s the end of him,” says Mr. Saakashvili. Russians will see the contrast with their slowing economy dragged down by an oligarch-Putin complex that makes Mr. Yanukovych’s corruption look thrifty. “Putin is old fashioned,” says the Georgian, who is now 46. “He is really obsolete.”

How?

Based on Georgia’s experience, Mr. Saakashvili believes that Russia will try to incite a clash in Crimea and then offer its services to restore order. He doesn’t believe Russia will provoke a direct military clash with Ukraine’s still-formidable military, which wouldn’t be popular in Russia itself. “It’s not Georgia,” he says. “Putin wants to be at the same time a peacemaker and a troublemaker,” he says. “He did it quite well in Syria.” The Russians shielded and armed Bashar Assad’s regime. When President Obama late last summer sought a way out of his empty promise to intervene militarily, Russia popped up to mediate with Syria.

However,

The Crimean crisis has brought back from diplomatic obscurity the “Budapest Memorandum” of 1994, in which the U.S., U.K. and Russia pledged to guarantee Ukraine’s territorial integrity. Mr. Saakashvili says the outcome on the Maidan showed that the Russians overestimate, and the U.S. and Europeans underestimate, their leverage in the region.

The West dragged its feet on financial sanctions against the Yanukovych circle, but on Thursday last week a move by the EU—after 77 protesters were shot dead in broad daylight—helped bring down the Ukrainian leader. Fearing for their assets and visas, his cronies quickly dropped him.

If Russia keeps up the heat on Crimea, Mr. Saakashvili says, then the West should hit the Putin circle with sanctions. “It would be the same” reaction as in Ukraine. “The last time I was in Miami, it was full of rich Russians. If you tell them you can no longer come here and you have to freeze in Moscow, then they will turn on Putin.” Western governments have “much more leverage than they realize. They just need to apply it.” (…)

“I’m worried about Crimea, but I’m more worried about Kiev. If Kiev goes into protracted political crisis, then everything else will explode.”

How does that impact the U.S. stock market? I don’t really know. What I know is that the equity investment odds are not compelling in this highly uncertain world. Allow me to re-quote Ben Hunt from my Nov. 4, 2013 post BLIND THRUST:

We are enduring a world of massive uncertainty, which is not at all the same thing as a world of massive risk. We tend to use the terms “risk” and “uncertainty” interchangeably, and that may be okay for colloquial conversation. But it’s not okay for smart decision-making, whether the field is foreign policy or investment, because the process of rational decision-making under conditions of risk is very different from the process of rational decision-making under conditions of uncertainty. The concept of optimization is meaningful and precise in a world of risk; much less so in a world of uncertainty.

That’s because optimization is, by definition, an effort to maximize utility given a set of potential outcomes with known (or at least estimable) probability distributions. Optimization works whether you have a narrow range of probabilities or a wide range. But if you have no idea of the shape of underlying probabilities, it doesn’t work at all.

As a result, applying portfolio management, risk management, or asset allocation techniques developed as exercises in optimization – and that includes virtually every piece of analytical software on the market today – may be sub-optimal or downright dangerous in an uncertain market. That danger also includes virtually every quantitatively trained human analyst!

(…) We should be far less confident in our subjective assignment of probabilities to future states of the world, with far broader margins of error in those subjective evaluations than we would use in more “normal” times.  (…)

Ben is totally right. We are all, in fact, blind investors hoping that our blind leaders, clueless as to where we are in the “cycle”, will shortly safely guide us to some unknown promised land that remains to be landscaped by the never tried before QE experiments.

Add China to the portrait, and the 5-8% upside with similar downside to the (still rising) 200 day m.a. with all the uncertainty (known unknowns) and blindness (unknown unknowns) warrants continued caution. On the other hand, there are no signs of a recession in the U.S. As to the bear market risk, while earnings growth could disappoint, an outright decline is not apparent at this time. The main risk is valuation given that multiples of all kinds are in extended territory, although not in bubble area as many contend. Central bankers remain determined to keep the U.S. and the Eurozone economies growing, even if it is at very slow speed. The financial heroin will continue to flow. I remain moderately invested, carefully watching inflation trends.