NEW$ & VIEW$ (21 OCTOBER 2013)

Today: update on earnings and market valuation.

Euro Zone May Not Have Emerged from Recession

An influential group of European economists that calls periods of expansion and recession said Friday it is too early to declare that the euro zone has emerged from recession, and the single-currency area’s return to growth in the second quarter may prove temporary.

The Centre for Economic Policy Research, a network of more than 700 economists primarily based in European universities, dates periods of expansion and recession. Its Euro Area Business Cycle Dating Committee provides judgments on the currency area’s entry into and emergence from recession that is independent of policy makers in much the same way as the National Bureau of Economic Research’s Business Cycle Dating Committee in the U.S. (…)

“While it is possible that the recession ended, neither the length nor the strength of the recovery is sufficient, as of 9 October 2013, to declare that the euro area has come out of recession,” the committee said. (…)


Cheap U.S. Gas Attracts Norway Interest

Norwegian fertilizer producer Yara International said it and BASF would decide next summer whether to build a world-scale ammonia plant along the U.S. Gulf Coast, a potential $1 billion investment.

(…) “If you look at the U.S. now, the cheapest area to construct something in is actually the Gulf [Coast]. If you get up in the middle of the Bakken [Shale] area, there is a peak, and farther north, in Canada, [costs are] even higher,” Mr. Haslestad said.

Yara recently postponed expansion plans at its Canadian Belle Plaine plant due to rising construction costs. The Regina, Saskatchewan, plant has a capacity of 700,000 tons of ammonia, as well as 1.2 million tons of urea and urea ammonium nitrate a year.

Construction costs are higher in Canada than along the U.S. Gulf Coast partly due to less competition, cold weather, and a lack of infrastructure, Mr. Haslestad said.

The U.S. has a huge potential to establish more chemical plants amid low energy prices, Mr. Haslestad said, while in Europe high energy prices prevent companies from investing in activity that would create jobs. (…)



Top Bear’s Bullish Tilt Has Followers Growling

One of Wall Street’s leading bears has turned more bullish, riling some longtime clients. (…)

Lately, though, Mr. Rosenberg has changed his tune, a rare turn for a Wall Street strategist with a large following and a high-profile market stance. This past spring, he upgraded his outlook for the U.S. economy, urging investors to buy more stocks and dump Treasury bonds, citing an improving labor market, among other things. (…)

Mr. Rosenberg hardly has been telling investors to bet it all on stocks. He simply has toned down his usual caution, recommending that investors put just over half of their portfolios in stocks, up from about 35% in early 2012, while urging them to flee from bonds, which usually do well in difficult times.

Mr. Rosenberg switched to the more-bullish camp this year after he saw unemployment dropping, detected early signs of wage inflation and observed more workers leaving the workforce for reasons beyond their frustration over job prospects. He also viewed deflation as no longer a concern, as the Federal Reserve aggressively eased policy, and saw other signs of economic improvement for the U.S. (…)

Fiscal Crisis Leaves Stocks in a Sweet Spot

Despite the market disruptions Washington’s mess caused over the past few weeks, analysts who have studied past market behavior say that the current backdrop—moderate economic growth with low inflation and strong central-bank backing—is excellent for stocks.

(…) ‪Analysts who have studied past market behavior say that backdrop—moderate economic growth with low inflation and strong central-bank backing—is excellent for stocks. That may help explain why financial markets remained fairly calm throughout the crisis and how the S&P 500 stock index finished Friday at 1744.50, a record high. The S&P 500 is up 22.3% this year.

“This is the best environment for stocks right now. You don’t have rising interest rates becoming a problem. You don’t have inflationary pressures. You do have earnings growth,” said Tim Hayes, chief global investment strategist at Ned Davis Research in Venice, Fla. ‪The firm has studied stock performance in a wide variety of economic environments going back decades.

Stocks also do better when earnings growth is below 5% on a year-over-year basis than when it is above 5%, according to the Ned Davis studies. That is because moderate earnings growth is less likely to spur inflation or push interest rates higher.

‪Another big boost for stocks is the growing hope that low inflation and worries about economic growth will induce the Federal Reserve to keep stimulating the economy by holding down long-term interest rates. (…)

Fed stimulus helps stocks because low interest rates hold down corporate costs, and the stimulus money itself leaks into the stock market, fueling investment there. (…)

A big question for the future, he said, is how and when central banks around the world unwind their financial stimulus. ‪Mr. Hayes thinks how that is handled could determine when stocks next face a bear market, most commonly defined as a 20% decline from a high. ‪While he is optimistic about the immediate future, he said he wouldn’t be surprised to see stocks pull back by next summer.

Such a decline is common after stocks have risen strongly for years, Mr. Hayes said. That is especially true when stock prices are above average when compared to corporate earnings, as they are today. The S&P 500 trades at more than 18 times its component companies’ earnings for the past 12 months, above the historical average of about 16. ‪(…)

Earnings and inflation, that’s the recipe.


A quarter of the way into the Q3 earnings season, many aggregators have released their tally. Remember that there is no “common consensus estimate” and no unique way to assess earnings among aggregators so that beat rates, as well as growth rates, can vary. I try to compare beat rates against each aggregator’s own history. S&P remains the official data provider, giving both operating and “as reported” earnings in a consistent manner..

It is interesting to note that the narratives during this earnings season are clearly tilting on the negative side (my emphasis).

We’re now a week and a half into earnings season, and 190 US companies have reported their third quarter numbers so far.  By the end of earnings season, more than 2,000 companies will have reported, so we’re still in the very early stages of this quarter’s reporting period.

Below is a look at the historical earnings beat rate for US stocks by quarter since 2001.  As shown, 60.5% of the companies that have reported so far this season have beaten consensus analyst EPS estimates.  This is a mediocre reading compared to the average beat rate of 63% that we’ve seen since the bull market began in March 2009.

Top-line numbers have also been mediocre so far this season.  As shown below, 50.9% of the companies that have reported have beaten revenue estimates, which is 9 percentage points below the average of 60% that we’ve seen since the bull market began.

The picture emerging from the 2013 Q3 earnings season is far from inspiring or reassuring. There hasn’t been much growth in recent quarters and not much was expected from Q3 either, particularly after the sharp estimate cuts in the run up to the reporting season. But companies are struggling with meeting and exceeding even those lowered expectations.

Total earnings for the 99 S&P 500 companies that have reported results already, as of Friday October 18th, are up +1.0% from the same period last year, with 62.6% beating earnings expectations with a median surprise of +2.1%. Total revenues for these companies are up +2.1%, with 43.4% beating revenue expectations with a median surprise of +0.0%.

All of the growth is coming from the Finance sector. Excluding Finance, total earnings growth for the companies that have reported falls in the negative category – down -6.2%. This is a weaker performance than what we have seen from the same group of companies in Q2 and the 4-quarter average.

Total Q3 earnings for all S&P 500 companies, combing the 99 that have reported with the 401 still to come, are expected to be up +0.2%, which reflects +0.8% revenue growth and modest gains in margins. Estimates have come down sharply over the last few months, with the current +0.2% growth down from +0.5% last week and +5.1% in early July.

  • S&P’s tally gives a 59% earnings beat rate and a 26% miss rate. Q3 estimates are currently $26.72, down $0.12 from Sept. 30. Q4 estimates dropped from $28.88 to 28.67.

Pointing up At about the same time during the Q2 earnings season, the beat rate on S&P’s tally was 63% and the miss rate 27.5%. All of the deterioration comes from Financials. At that time, the beat rate from Financials was 80% vs 63% this season. Non-Financials’ beat rate is about the same at 57%. Miss rates have been relatively high among Industrials (31%), Consumer Discretionary (36%) and Financials (33%).

Overall, 97 companies have reported earnings to date for the third quarter. Of these 97 companies, 69% have reported actual EPS above the mean EPS estimate and 31% have reported actual EPS below the mean EPS estimate. Over the past four quarters on average, 70% of companies have reported actual EPS above the mean EPS estimate. Over the past four years on average, 73% of companies have reported actual EPS above the mean EPS estimate.

In aggregate, companies are reporting earnings that are 2.3% below expectations. Over the last four quarters on average, actual earnings have surpassed estimates by 3.7%. Over the past four years on average, actual earnings have surpassed estimates by 6.5%.

In terms of revenues, 53% of companies have reported actual sales above estimated sales and 47% have reported actual sales below estimated sales. The percentage of companies beating sales estimates is above the percentage recorded over the last four quarters (48%), but below the average over the previous four years (59%).

In aggregate, companies are reporting sales that are 0.6% below expectations. Over the previous four quarters on average, actual sales have exceeded estimates by 0.4%. Over the previous four years on average, actual sales have exceeded estimates by 0.7%.

At this early stage of Q3 2013 earnings season, 18 companies in the index have issued EPS guidance for the fourth quarter. Of these 18 companies, 14 have issued negative EPS guidance and 4 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the fourth quarter is 78% (14 out of 18). This percentage is well above the 5-year average of 63%.

Using S&P’s numbers, trailing operating earnings are now expected at $102 after Q3, down 1% from what was expected on Sept. 30 and 1.6% from June 28. Nonetheless, trailing earnings would be 2.7% higher than their level after Q2 and cross the $98-99 wall that they have been hitting since March 2012.

imageThe next 2 weeks will be crucial for market sentiment, not only for Q3 results but importantly for company guidance into Q4 since estimates for the last quarter of 2013 have held up reasonably well so far. The current $28.67 estimate remains nearly 24% above Q4’12 ($23.15) which was impacted by big pension fund provisionings which S&P rightly treated as operating expenses but which is a highly discretionary management decision often made after yearend (see below).

If analysts are right, trailing 12-month EPS would jump to $107.52 after Q4, 8.3% above their level after Q2.

The chart below uses $102 as trailing EPS and 1.5% as trailing inflation. On these basis, the Rule of 20 P/E fair P/E of 18.5 means 1887 for the S&P 500 Index, 8% above its current level. We will get the September CPI on October 30.



Assuming Q4 estimates hold, the ensuing jump in trailing earnings would bring the Rule of 20 fair value to 1980 (+13.5%) if inflation stays at 1.5% (1926 at 2.0%). As I said, the next 2 weeks are crucial.

Pointing up BTW, from this weekend’s FT:

US corporate defined benefit pensions gain some lift

(…) Funding ratios for the 100 largest DB pension plans at US companies, which boast close to $1.4tn in combined assets, rose to an eye-catching 91.4 per cent last month, having climbed from just 74 per cent in September 2012, according to Milliman, the actuarial firm. The improvement was largely due to shifting projections for interest rates, changes in strategy and stronger investment returns.

It marks the highest funding ratio for US DB schemes since the collapse of Lehman Brothers in October 2008.

The improvement has mainly been driven by a rise in market interest rates. This has reduced the estimated value of pension scheme liabilities, as these liabilities can be discounted at a faster rate in the future.

This process may have further to run. Actuaries at Milliman forecast that pension managers at the aforementioned 100 US companies will see their funding ratios rise to an impressive 98.1 per cent by the close of next year. Their deficits should drop from $132bn at the end of September to as little as $29bn over the same period, Milliman predicts.

John Ehrhardt, a principal and consulting actuary at Milliman, explains: “As interest rates come up, it will reduce the cost of maintaining these plans.”

He adds: “If the Federal Reserve takes its foot off the floor on interest rates, rates could go up significantly.

Confused smile  What will happen to pension asset values when rates rise? Bond losses could far exceed past equity losses given current excessively low interest rates. And I am not so sure the pension funding problem is near the end:

(…) However, there are a number of corporate stalwarts in the US whose DB plans are still open to further accrual by existing members, such as Boeing (which has a pension funding ratio of roughly 74 per cent), General Electric (70.6 per cent), AT&T (76.5 per cent), Lockheed Martin (67.2 per cent), ExxonMobil (63.4 per cent), UPS (78.1 per cent), Pfizer (71.8 per cent), Johnson & Johnson (80.3 per cent) and Federal Express (78.1 per cent). (…)

And this from Pensions & Investments:

This slide lays out year by year the allocations to fixed income. Starting in 2008, you can see a dramatic change to fixed income by corporations. Numerous corporate plan sponsors now have allocations to fixed income of more than 75%. Intel’s DB plan, for example, has an 85% allocation to fixed income.

FIxed income allocations of corporate and public pension funds

Ford's asset allocation


S&P 500 funded status in $ bil.


Back to Financials:


Banks Facing Profit Squeeze

The nation’s biggest banks are getting squeezed from almost every direction, quarterly reports show, from slumping mortgage demand to a sluggish economy and tumultuous bond markets.

The 10 largest traditional commercial banks and securities firms in the U.S. that have reported earnings thus far posted a 6.9% decline in combined adjusted net income, to $17 billion. Adjusted revenue totaled $116 billion for the quarter, a 4.8% decrease from the same period in 2012. (…)


There are pockets of strength in the banking sector. Commercial real-estate loans are picking up, and consumer banking has been healthy. But plunging mortgage lending is weighing heavily on banks’ results. (…)

Among the six biggest banks and securities firms in the U.S., Morgan Stanley was the lone bright spot, in part because of its smaller fixed-income operation. It swung to a third-quarter profit, outpacing Goldman in total revenue for the first time in two years. (…)


Thomson Reuters writes:

Tracking the Top 50 Global Financials for our third consecutive quarter of TRust Index metrics, Q3 saw a continuation of several trends that we’ve been observing throughout 2013. According to our media sentiment analysis, trust in global financial institutions remains negative overall, but regional differences have shifted. For the first time since January, European financials have moved higher than US financials, while US financials have remained flat but have the lowest levels of confidence overall. Q3 data also shows the continued proliferation of regulatory activity, essentially double since the introduction of the Dodd-Frank Act.

Interesting, but my money would rather buy the view of Chuck Clough, CEO of Clough Capital Partners on European banks:

We think Europe’s banks are not as healthy as they claim to be. Many pledged much of their risk weighted assets as long-term refinancing operation collateral and the improvement in capital ratios is ephemeral in our opinion. Eventually these assets must be repurchased and that is the difference between what the European Central Bank (ECB) and the US Federal Reserve have done in efforts to resuscitate their respective banking systems.

Via the quantitative easing programs and troubled asset relief program the Fed outright purchased troubled assets. That passed the cost onto shareholders and taxpayers but cleared balance sheets so banks could renew lending. Nothing of the sort is happening in Europe. Europe’s banks still own the toxic assets they hypothecated with the ECB and time
worsens the state of those assets.

In an op-ed article in the Financial Times, Wolfgang Munchau cited a report which estimated that the size of any bad bank which might be set up to absorb losses would have to be capitalized at more than 1 trillion Euros (out of a total Euro bank balance sheet of 27 trillion Euros) and reportedly that does not include hidden losses from loans about to default but which were rewritten to make them good, the “pretend and extend” strategy. Even German banks are not free of issues since Germany’s
current account surplus has forced its banks to take on a lot of peripheral debt. Recapitalization will likely occur at much lower equity . If they are low enough we could be buyers.

Thomson Reuters continues:

image(…) the aggregate changes to recommendations over the quarter by sector analysts on the Top 50 Global Financial institutions show that downgrades outnumbered upgrades across all regions. While the Asian institutions scored the highest number of upgrades in Q2, these were outpaced by the number of downgrades in Q3 – again, increasing concerns about Chinese banks appears to be having a particularly strong influence.

This next comment was before the Q3 earnings season:

In Q3, earnings growth estimates for the U.S. Financials sector regained their top spot (having slipped to second in Q2) based on high expectations by analysts for financials. At 9%, earnings growth estimates for the sector are lower this quarter, but still well ahead of the other S&P 500 sectors.

And here’s Factset after 30% of S&P Financials have reported Q3 (including the largest ones):

The Financials sector has the second lowest earnings growth rate (-2.1%) of any sector. Four of the eight industries in the sector are reporting or are expected to report a decline in earnings for the quarter, led by the Diversified Financial Services (-32%) industry.

Factset drills down:

At the company level, Bank of America and Morgan Stanley are the not only the largest contributors to growth for the sector, but for the entire S&P 500 as well. Bank of America reported actual EPS of $0.20, relative to year-ago actual EPS of $0.00. Morgan Stanley reported actual EPS of $0.50, compared to year-ago actual EPS of -$0.55. If both of these companies are excluded from the index, the growth rate for the Financials sector would fall to -11.9%, while the growth rate for the S&P 500 would be -0.5%.

On the other hand, JPMorgan Chase is not only the largest detractor to growth for the sector, but for the entire S&P 500 as well. The company reported actual EPS of -$0.17, compared to year-ago actual EPS of $1.40. If this company is excluded from the index, the growth rate for the Financials sector would improve to 14.0%, while the growth rate for the S&P 500 would rise to 3.8%.

S&P differentiates between “operating” and “as reported” earnings. In JP Morgan’s case, S&P treated most of Q3’s “extraordinary costs” (mainly litigation expenses) as non-operating (or at least “non-recurring”, hopefully!). JPM’s Q3 “operating” EPS are thus $1.43 vs $1.41. Using only operating EPS, the 22 Financials that have reported Q3 so far are showing average EPS growth of 18.1%. But that is heavily influenced by BAC’s and SLM’s respective +211% and +87% jumps. The median growth rate is a more modest +4.1%, so far.

Finally, Thomson Reuters keeps track of regulatory activity worldwide:

The proliferation of regulatory activity over the past two years (and its clear implications for the financial sector in terms of managing compliance) can no longer be considered a post-crisis tsunami (which would imply a surge and then receding level) but must be seen as the growing and permanent conditions under which the global financial industry will rebuild.



expandBARRON’S COVER Return of the Bulls 

America’s money managers expect stocks to rise 7% from now through the middle of next year.

The managers’ subdued forecasts reflect the fact that 71% of poll participants now regard stocks as fairly valued, compared with 58% in the spring. Only 15% consider the U.S. market undervalued, down from 26% last April.

Just over half of the Big Money managers expect the price/earnings multiple to expand in the next 12 months, while 11% see a contraction, and the rest see no change.


71% say equities are fairly valued and 68% are bullish. Personally, I tend to be less bullish when stocks are fairly value.


52% expect higher P/Es.



Condos Go Back Up for Sale

Many condominium developers who rode out the real-estate downturn by renting out their units are reverting to for-sale housing, in another sign of the market’s continued recovery.

(…) Now, in big markets from San Francisco to South Florida, “Condos for sale” signs are popping up at a steady pace as the improving housing market creates an opening for landlords to sell off rental housing. That hot market also is spurring new construction of condo buildings. (…)

Reversions are being driven by a supply shortage in the single-family-home market, which has sent prices upward. There were 2.07 million existing homes for sale at the end of August, up 5.1% from January but still down about 6% from a year ago, according data from the National Association of Realtors and Trulia, a real-estate listings site. The data include both condos and single-family homes. (…)

Few places have seen as big of a turnaround as South Florida. As of the second week of October, there were about 21,000 condos and townhomes for sale across Miami-Dade, Broward and Palm Beach counties. That was down 66% from the fourth quarter of 2008, according to multiple-listing-service data compiled by Condo Vultures Realty, but up about 14% from a June low of about 18,000 listings. (…)

We put our South Florida condo for sale in mid- August. We received 5 offers in 8 weeks. We signed yesterday for closing in 3 weeks! A hair below the ask price. All but one all-cash offers.


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