DAVE JANNY NOV 2015 INVESTMENT LETTER
2015 VOLUME 8
“DIVERGENT, BIFURCATED AND CONFUSED “
October turned out to be one of the best months for global equity markets in many years. I
ended my October Newsletter saying:
“There will probably be the usual year-end Santa Claus rally. Keep in mind that some of the
sharpest rallies occur in a bear market. The rally in the beginning of October could be one of
those rallies. The rally started with a reversal on Friday October 2 nd after what was regarded
as a pretty negative jobs report that day. We’re still in the seasonally tough month of
October, although good trading bottoms can occur after a capitulative downward move.
Economic and earnings news may stay tough as well. Bigger picture, the markets seem to be
in a topping process that I pointed out earlier. There should be some good short term
opportunity, we just don’t know from when and what level.”
There was a lot in that paragraph. We certainly had a sharp rally. A lot of the upward move was
based on the back of generally bad news. Economic and earnings news was very mixed and
generally tough. There seems to at least be talk of “divergent” global central bank policy.
Earnings and stock performance here in the U.S. was very “bifurcated”. There is “confusion”
around the concept of “is good news, good news or bad news?” and “is bad news, bad news or
good news?”. I still think we are in a topping process. Are you confused yet? Let’s explore these
issues.
THE FED SPEAKS AGAIN
The most talked about event of the month was certainly the Fed and ultimately the FOMC
meeting on October 28th. The Fed did not raise interest rates but suggested that they might be
ready to do it at the end of the next FOMC meeting on December 17th. Sound familiar? They’ve
been talking about a rate increase for about a year or so. After the October meeting many of
the Fed governors in their public appearences continued to promote the same message. Then
on November 6th, the October jobs report came in as a positive upward surprise. So after a
quarter of generally bad U.S. economic data, including the bad previous September jobs report
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I referenced in my above quote from my October Newsletter, market participants became
solely fixated on this one data point. Keep in mind that the 3rd Quarter U.S. GDP report had
come in at a very disappointing 1.5%. Janet Yellen continued the “feel good” talk at her
November 4th congressional testimony when she labeled U.S. economic growth as “solid”.
“Solid”? I don’t know about you but another weak quarter of substandard growth in the
slowest recovery in U.S economic history doesn’t exactly strike me as “solid”. Despite my
skepticism, the dollar has had a strong rally, U.S. government bond interest rates have moved
up and commodity prices, including gold and oil, have been very weak again. Also keep in mind
that my above quote from last month’s Newsletter stated that the stock market rally started on
that “bad news” September jobs report.
So, is good news good news? Or is good news bad news? Or is bad news good news? Or is bad
news bad news? It seems like it’s tough to tell. Confused yet? To add to the confusion, take a
read on Art Cashin’s November 9th Daily Comment. Art Cashin is UBS’s head of floor operation
and a very wise old market sage:
“Most estimates for the non-farm payroll number ranged from 150,000 to 200,000. That’s
because lots of folks, including yours truly, had not done the proper due diligence. The
November number (October data) has a traditional upward bias. At this time of the year the
BLS “birth/death model” tends to add a sizeable chunk of “assumed” NFP jobs. In 2013, the
model added 151,000 assumed jobs. In 2014, it was 164,000 and this year it added 165,000 of
the 271,000 headline number. The model tends to add a good bit less to the next payroll
release (the last before the Fed’s December meeting). We hope to do better due diligence
before that release.”
So maybe the number wasn’t as good it looked? The November jobs report to be reported on
Friday December 4th should be very interesting. I think the Fed should start to raise rates, but
I’m not sure they will. The rationale to raise rates is to try to normalize the 7 year “emergency”
level of rates. The problem is the resultant U.S. dollar strength poses a lot of problems. That
dollar strength is negative for U.S. multinational corporate profits. It’s generally negative for the
U.S. economy. It’s deflationary (particularly for commodities) when the Fed is trying to induce
inflation. It’s also particularly negative for emerging market and commodity producer
economies. Additionally, I still think our economy is stalled and everything else being equal, this
wouldn’t be an economically ideal time to raise rates.
One of the things I’ve been speaking about in my Newsletters is the erosion and ultimate loss of
Central Bank credibility. The Fed has now again painted themselves into a corner. It feels like if
they now don’t deliver on the rate hike, they may lose even more credibility. It will be
interesting to see what happens.
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DIVERGENT
More good news (I’m being sarcastic)! ECB President Mario Draghi suggested that he is
prepared to do more QE (quantitative easing) on top of the “bazooka” he’s already used. The
European economy can’t be doing that well. The PBOC (People’s Bank of China) cut interest
rates for the 6th time this year. China continues to struggle. Amid Japanese economic weakness,
there are calls for more QE in Japan. The BOJ (Bank of Japan) hasn’t given in yet, but I believe
they’ll eventually succumb as well. The BOJ must be tired after 20 or so years of
accommodative policy. These policies, for the moment, are very divergent from the Fed’s rate
hike talk. The incredible global stimulus that we’ve seen over the last 7 years has yet to provide
positive economic upside. The U.S. dollar has been incredibly strong versus basically all other
global currencies. This divergence could potentially create a problem at some point. The
continued debt buildup is frightening.
Influential newsletter “The Aden Forecast “had a similar take in their October letter:
“As you know, interest rates have been near zero in the U.S. for the past seven years. This is
totally unprecedented, and it’s not just in the U.S.
In Japan, interest rates have been zero for more than a decade. They’re zero in the Eurozone,
and in some cases they’re below zero. That is, you’d have to pay the bank to keep your
money there.
The bottom line is… nearly 90% of the developed world is dealing with interest rates at zero.
And almost half of all the bonds in the world are now paying less than 1%.
The end result is that there’s no incentive to save money. On the contrary, these low interest
rates entice people and corporations to borrow, in many cases much more than they should.
So even though too much bad debt triggered the 2008 financial crisis, this mountain of debt
has not been reduced. There has been no deleveraging.
In fact, the opposite has occurred. Total world debt is now more than $200 trillion.
Amazingly, that’s 40% greater than it was before the financial crisis hit.
In other words, the debt keeps growing and growing, and nothing is being done about it,
which only makes matters worse. This has put the global economy on thin ice, making the
environment more vulnerable to a shock.
All of this debt is also very deflationary. And if you have any doubt about this, look no further
than Japan. As we’ve often pointed out, they have the highest debt to GDP ratio in the
developed world and they’ve been struggling with deflation, recessions, slow growth, and QE
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programs to keep things afloat for nearly 20 years. (During QE a central bank creates cash and
puts it into the financial system.)
The rest of the world is following in Japan’s footsteps. And aside from the possible global
economic repercussions, it’s also resulted in big changes in the investment world.”
Famous “bond king” Bill Gross of Janus is also worried about this debt buildup in what he calls
“finance based economy”. He had this to say in his November Investment Outlook:
“But all central banks should now commonsensically question whether ultra-cheap money
continually creates expansions as opposed to reducing profit margins and hindering recovery.
The Fed, the ECB and the BOJ? Stupid, they are not. But stubborn and reluctant to adopt a
significantly changed finance based economy over the last 40 years? Most certainly. Central
bankers failure to recognize the “Shadow Banking” system pre-Lehman proved that, and their
fixation on zero bound or in some cases negative yields, with their accompanying low and flat
intermediate and long term rates confirms the same today.”
David Kotok of Cumberland Advisors in his November 4th report entitled “Low Short Term
Rates for a Long Time?” talks about how crazy policy has gotten in Europe:
“The European Central Bank is likely to continue negative rates, extend and enlarge QE, and
acquire more balance sheet assets over time. ECB policy influences other nearby non-euro
jurisdictions, as we just saw with Sweden’s additional easing. Essentially, all short-term
interest rates of higher-credit-grade and mid-grade countries in Europe are negative, and the
policy of negative rates is spreading as the rates go even lower (more negative).
The negative rates originate in the euro area but are not restricted to that geography.
Remember the European Union is a trade and commerce union. So non-euro currencies are
heavily influenced by the European Central Bank. The use of negative rates in an open
commercial union means an adjustment process for non-currency zone members who are
part of the union. That requires each of those countries to take their national policy rate
below the ECB. That is why Denmark, Sweden, Switzerland are lower and why other
neighbors are headed lower. In the case of Europe this has now spread beyond just the
short-term rate. About $1.9 trillion value of intermediate-term bonds are now trading at
negative rates. (Source: Bloomberg) We expect that number to increase.”
It’s unbelievable that there is almost $2 trillion of negative rate bonds in Europe alone. All of
this is to try to induce inflation which has yet to surface. John Mauldin in his Nov 1st “Thoughts
From the Frontline” put it this way:
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“That said, to describe inflation we must do more than just blame central bankers for a tooloose money supply. If the Fed, BOE, BOJ, and ECB had pushbutton control over inflation,
don’t you think they would have pushed the button by now? The fact that they have not
indicates that their control is not as complete as we sometimes think. The fact that three of
the four above-mentioned central banks are worried about inflation being too low, even
though their monetary policies are ridiculously easy, indicates that something else is going
on. There are clearly other parts to the inflation equation.”
It’s unbelievable how ineffective many trillions of dollars of global stimulus has been!!! No one
could have predicted this 7 years ago. The “something else” that Maudin speaks of is what
worries me and many other far smarter investors.
WHALE WARNING
Last month I attached a link to Carl Icahn’s warning video. One of his big worries was “credit”
and the high yield market. Despite the stock market rally, “credit” concerns seem to be
mounting, high yield indices are lagging and credit spreads remain wide. Companies with higher
debt ratios have been underperforming. As a matter of fact because rates have been so low,
more and more companies have been adding debt to their balance sheets. ValueWalk had a
great report from Goldman Sachs on their website warning about Corporate America doubling
leverage. Here’s the link:
http://www.valuewalk.com/2015/11/goldman-balance-sheets/
The report calls out “financial engineering” over “organic growth and reinvestment”. This lack
of investment continues to be a drag on our economy. Also levering against “good will” is
another dangerous accounting gimmick.
This month I want you to watch a warning from one of the most famous investors ever, Stanley
Druckenmiller. Like, Icahn, Druckeniller is a true investing “whale”. Druckenmiller is a
billionaire who was George Soros’s right hand man until he broke out on his own to form
Duquesne Capital. I strongly urge you to watch this CNBC interview and see how one of the
great investors thinks:
http://www.cnbc.com/2015/11/03/stanley-druckenmiller-heres-how-fed-bubble-will-end.html
BIFURCATION
The definition of bifurcation is “the division of something into two parts”. This is how I would
define the stock market reaction to the multitude of earnings reports in the last couple of
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weeks. The main market averages advanced despite many stock actually getting ravaged on a
daily basis in that stretch. Yes, some stocks had big gains as well, but that list is certainly
narrowing. Earnings season was mixed at best. As a matter of fact there were some metrics that
were downright worrisome. Fred Hickey of the High Tech Strategist newsletter summarized it
well in his November letter:
“According to FactSet, as of this past Monday (November2), with nearly 70% of S&P 500
companies reporting, the average blended estimate of earnings per share (including alreadyreported and estimates of yet-to-be reported results) is a year over year decline of 2%. These
aren’t GAAP (based on Generally Accepted accounting Principles) earnings – those are far, far
worse. FactSet is using non-GAAP numbers, which exclude lots of bad stuff (including the
“one-time” massive write-offs, stock based compensation and more). The 2% decline is
worse than the 0.44% drop in Q2 EPS and also represents the first back-to-back declines since
the 2009 Great Recession.
The harder to fudge blended year-over-year revenue drop for Q3 is 3%. It will be the third
straight quarter of revenue declines. The 2009 recession saw four straight quarterly revenue
declines. A repeat performance in Q4 is expected with another 3% revenue drop and a
2plus% falloff in earnings. Note that revenue and earnings declines such as this only occur
during recessions…. and bear markets. The median stock price/earnings (P/E) ratio is already
a record high. As the “E” keeps shrinking, the record median P/E ratio keeps setting new
records. Record P/E levels and declining economic activity are not tenable for very long.”
As I’ve pointed out in the past, the fact that everyone is looking at non-GAAP earnings is already
dubious. Also keep in mind that the EPS numbers Hickey talks about are goosed up because of
the very aggressive share count reduction affected through stock buybacks, the EPS numbers
would even be a couple of percent lower than the already lower number. Also keep in mind
that the already generally conservative guidance that is being provided is getting tougher and
tougher to beat. Revenue has been a problem for a while and very few industries have any real
pricing power in a deflationary environment. A relatively small number of large cap stocks are
holding up the indices. It is very reminiscent of what I spoke about in my June and July
Investment Letters. The bifurcation and the divergences could again be a harbinger of pending
problems. With earnings and revenues going down, it’s no wonder the stock market is having a
tougher year. With global growth concerns mounting, that likely declining “E”(earnings) could
be very bad for “P” (prices).
RANDOM (MAYBE NOT SO RANDOM) OBSERVATIONS
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Every month, as I write my Newsletter, I end up with a list of topics that I can’t get to because
of space and time. So what I figured I’d do this month is include a list of random thoughts that
can be food for thought.
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I’ve been reading a lot about how Obamacare premiums will be rising significantly next
year. It could be an added headwind for consumers and the economy.
The wealth gap is widening everyday thanks to the Federals Reserve policies. Savers are
being punished and the middle class is suffering the most.
Yes the unemployment numbers are falling, but why is the labor participation rate
(according to U.S. News and World Report) the lowest it’s been in almost 40 years? It’s
more than demographics.
Cybercrime continues to grow rapidly. Cyber warfare is the battle of the future and the
future seems to be now. What I don’t see a lot of people talking about is the cost for a
company to protect itself is all extra overhead cost with no productivity enhancement.
The migrant/refugee crisis in Europe should provide a lot of extra cost and headwind to
the overall economy. Hopefully it doesn’t present additional terror concerns. I’m afraid
that might be wishful thinking.
Relatively quietly, Portugal just ousted their pro austerity government in favor of a
socialist government. Portugal is still very debt burdened and this is another headache
to come for Europe.
Some of the best hedge fund investors around, guys like Bill Ackman and David Einhorn
amongst others have been victims of the bifurcation I spoke about. There are a lot of
high profile funds having performance issues.
The strong dollar “trade” is probably one of the most crowded trades in the market. An
important turning point for the dollar is somewhere in the offing and could surprise
many people and many markets.
FINAL THOUGHTS
I wonder if the strong rally was a do-over chance to lighten up for those that are holding too
much in the market.? I still think the big picture is that we are in a topping process similar to
2000 and 2007. There will continue to be rallies, but overall there are still many distressing
market signals flashing.
HAPPY THANKSGIVING to you and your family!!!
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David Janny
Senior Vice President
Financial Advisor
Morgan Stanley Wealth Management
200 Nyala Farms Rd.
Westport, CT 06880
203 221-6093
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