Apple, industrial activity, the jobs report

the Employment Situation

The Bureau of Labor Statistics made its monthly Employment Situation report this morning:  +312,000 new jobs, +58,000 upward revision to the prior two months’ data, annual wage gains of an inflation-beating +3.2%.  Yes, it’s just one month and, yes, the margin of error is +/- 100,000 jobs, but it’s still a very strong report, indicating a robust domestic economy.

 

Despite this show of employment strength, the stock market has been on a sharply downward path since late September.  What is the market thinking/anticipating?

–the 10-year Treasury, which was yielding 3.22% in late September now yields 2.56%;  the middle of the yield curve is now mildly inverted.  This suggests bond buyers believe a marked slowdown in economic activity in the US is in the offing–one that will force the Fed to soon begin to lower short-term interest rates again.  Why would that be?

–the Trump tariff war with the rest of the world seems to be affecting publicly traded companies much more negatively than one might have imagined

–only about half the earnings of the S&P 500 come from the US.  Both the EU, dealing with Brexit and Italy, and China are slowing down

–some pundits argue from the bond market situation that the Fed is the problem, having –they think–raised short-term interest rates too far.

 

Two pieces of data from yesterday seem, on the surface at least, to reinforce the sharp slowdown narrative:  Apple (AAPL) and business investment activity.

AAPL

–AAPL announced Wednesday night that its December quarter revenues would be about 8% below the midpoint of the guidance it gave in October.  What makes this significant, besides AAPL’s size, is that the company rarely misses its quarterly estimates.

Two reasons given:  falloff in sales in “greater China” and slower than expected takeup of the newest generation of iPhones by existing customers (the smartphone market is completely saturated–there are no more “new” customers).  Neither reason is clearly a sign of broad-based consumer distress, however.

AAPL recently said it would no longer reveal unit sales of its smartphones, a decision I take to mean it intends to make revenue gains through price increases rather than unit volume gains.  Is the slowdown in replacement demand caused by economic weakness or AAPL pricing new phones so high that other, cheaper phones are suddenly more attractive?

Also, the latest issue of Foreign Affairs reports that popular sentiment in China has turned sharply against the US in the past half year or so as Washington initiated its tariff war.  Maybe, in addition to higher prices, flaunting the newest iPhone is no longer as culturally acceptable in China (think:  the century of humiliation), as having a home-grown product.

ISM

–the Institute for Supply Management issued its monthly report on US manufacturing activity yesterday.  It shows a continuing slowdown in industrial activity.  The reason most often cited in survey respondents’ comments is the administration’s tariff war.  Manufacturers are, predictably, shifting production out of the US to avoid import tariffs on raw materials and export tariffs on finished goods.

It’s important to remember, too, that manufacturing is not the key to US economic strength that it was a generation or two ago.  Spending on software is the largest investment item for most service companies.  Yes, this activity is also being shifted abroad as the administration makes it more difficult for foreign-born computer scientists to work in the US.   But I don’t think the ISP report is “new” news, so I’m not sure why it had such a negative effect on the market yesterday.

my take

In the short term, figuring out the root cause of the worries about the US economy is probably less important than trying to gauge how far along in the selling we are now.  Better to figure out when the storm will be over than debate the direction of the wind.  My guess–and it may be more of a hope–is that we made the lows on Christmas Eve when stocks broke decisively through the February 2018 lows.

Personally, I think the ultimate problem is Washington and the tariffs, not the Fed.  I’m all for protecting US intellectual property, but the levies on, say, steel and aluminum seem so arbitrary and generally harmful.  In a way, it would be a lot better if the Fed is the issue, since then the problem would be a familiar one, the market situation clearer and the fix relatively easy.

 

 

 

 

 

stock market issues for 2019

I see four main issues, which–now that I’m on semester break–I’m planning to write about over the next few days.  They are:

machines vs. humans.  This is the question of increased short-term volatility.  How do we cope with the apparently mad dashes in and out of the market by trading robots using, by historical standards, half-baked trading algorithms?

 

decelerating earnings growth.  EPS growth in 2018 for publicly traded companies was around +20%.  Increases for 2019 will likely come in at +8% – +10%.  This kind of sharp falloff is normally a bad sign for stock prices.  In the current case, however, the 2018 EPS surge is only in after-tax earnings and is due mostly to the one-time decrease in the Federal corporate tax rate from 35% to 21% that went into effect last year.   Pre-tax earnings grew at a much more sedate rate of around 10%, I think.  While the 2019 situation isn’t wildly positive, it would seem to me to imply a flattish market where the investor’s job is to identify areas of potential strength to buy and areas of potential weakness to avoid.

But is this the way algorithms will operate?

 

the business cycle and interest rates.  Typically, the Fed raises short-term rates when it perceives the economy is overheating.  Higher rates make bonds less attractive.  They make other financial instruments, like stocks, less attractive, too.  But the negative effect of higher rates is offset by surging earnings growth.  Is +10% enough to do the job in 2019?

 

–tariffs.  (A side note first:  it seems to me the Trump administration argument that it can usurp Congress’s power to set trade policy because everything economic is a matter of national security is ludicrous.  Not a peep from Congress, though.  To me, this implies that Mr. Trump is simply the spokesmodel for policies the forces in Congress want enacted but don’t want to be held responsible for.)

Tariffs have, at best, a checkered history.  They invite retaliation.  They have unforeseen/ unintended negative effects: Apple’s preannouncement of weaker than expected results in its current quarter may only be the first.   In addition, the rapid and seemingly arbitrary way tariffs have been enacted in the US has already given both domestic and foreign corporates pause about expanding operations here.  One thing is certain, though –tariffs slow economic growth.  The question is by how much and for how long.

 

the independence of the Federal Reserve.  By conventional measures, there’s still too much money sloshing around in the US.  So there’s every reason for the Fed to continue to shrink its bloated balance sheet and to slowly raise short-term interest rates (the specter of Japan’s three decades of stagnation–resulting in large measure from saveral bouts of premature policy tightening–continues to be a cautionary tale against moving too quickly).  Because of this, Mr. Trump’s musing about firing Jerome Powell has a distinctly Nixonian ring to it, conjuring up echoes of the runaway inflation and currency collapse in the US of the 1970s.  From a stock market point of view, threatening the Fed may be the single most damaging thing Mr. Trump has done so far.

 

More details over the next few days.

looking at today’s market

In an ideal world, portfolio investing is all about comparing the returns available among the three liquid asset classes–stocks, bonds and cash–and choosing the mix that best suits one’s needs and risk preferences.

In the real world, the markets are sometimes gripped instead by almost overwhelming waves of greed or fear that blot out rational thought about potential future returns.  Once in a while, these strong emotions presage (where did that word come from?) a significant change in market direction.  Most often, however, they’re more like white noise.

In the white noise case, which I think this is an instance of, my experience is that people can sustain a feeling of utter panic for only a short time.  Three weeks?  …a month?  The best way I’ve found to gauge how far along we are in the process of exhausting this emotion is to look at charts (that is, sinking pretty low).  What I want to see is previous levels where previously selloffs have ended, where significant new buying has emerged.

I typically use the S&P 500.  Because this selloff has, to my mind, been mostly about the NASDAQ, I’ve looked at that, too.  Two observations:  as I’m writing this late Tuesday morning both indices are right at the level where selling stopped in June;  both are about 5% above the February lows.

My conclusion:  if this is a “normal” correction, it may have a little further to go, but it’s mostly over.  Personally, I own a lot of what has suffered the most damage, so I’m not doing anything.  Otherwise, I’d be selling stocks that have held up relatively well and buying interesting names that have been sold off a lot.

 

What’s the argument for this being a downturn of the second sort–a marker of a substantial change in market direction?  As far as the stock market goes, there are two, as I see it:

–Wall Street loves to see accelerating earnings.  A yearly pattern of +10%, +12%, +15% is better than +15%, +30%, +15%.  That’s despite the fact that the earnings level in the second case will be much higher in year three than in the first.

Why is this?  I really don’t know.  Maybe it’s that in the first case I can dream that future years will be even better.  In the second case, it looks like the stock in question has run into a brick wall that will stop/limit earnings advance.

What’s in question here is how Wall Street will react to the fact that 2018 earnings are receiving a large one-time boost from the reduction in the Federal corporate tax rate.  So next year almost every stock’s pattern in will look like case #2.

A human being will presumably look at pre-tax earnings to remove the one-time distortion.  But will an algorithm?

 

–Washington is going deeply into debt to reduce taxes for wealthy individuals and corporations, thereby revving the economy up.  It also sounds like it wants the Fed to maintain an emergency room-low level of interest rates, which will intensify the effect.  At the same time, it is acting to raise the price of petroleum and industrial metals, as well as everything imported from China–which will slow the economy down (at least for ordinary people).  It’s possible that Washington figures that the two impulses will cancel each other out.  On the other hand, it’s at least as likely, in my view, that both impulses create inflation fears that trigger a substantial decline in the dollar.  The resulting inflation could get 1970s-style ugly.

 

My sense is that the algorithm worry is too simple to be what’s behind the market decline, the economic worry too complicated.  If this is the seasonal selling I believe it to be, time is a factor as well as stock market levels.  To get the books to close in an orderly way, accountants would like portfolio managers not to trade next week.

Trump on trade

so far:

intellectual property…

One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.

…and metals

Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it.  His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table.  In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.

This action has prompted the imposition of retaliatory tariffs on imports from the US.

the effect of tariffs

–the industry being “protected’ by tariffs usually raises prices

–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think:  US pickup trucks, some of which still use engine technology from the 1940s)

–some producers will leave the market, meaning fewer choices for consumers;  certainly there will be fewer affordable choices

–overall economic growth slows.  The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot

is there a plan?

If so, Mr. Trump has been unable/unwilling to explain it in a coherent way.  In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.

automobiles next?

Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US.  This is a much bigger deal than what he has done to date.   How so?

–Yearly new car sales in the US exceed $500 billion in value, for one thing.  So tariffs that raise car prices stand to have important and widespread (negative) economic effects.

–For another, automobile manufacturing supply chains are complex:  many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.

–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China.  Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold.  It will send cars from Japan instead.  [Q: Who is the largest exporter of US-made cars to China?  A:  BMW  –illustrating the potential for unintended effects with automotive tariffs.]

 

More significant for the long term, the world is in a gradual transition toward electric vehicles.  They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.

This is an area where the US is now a world leader.  Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.

This has already happened once to the US auto industry during the heavily protected 1980s.  The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency.  The relative market position of the Big Three deteriorated a lot.  During that decade alone, GM lost a quarter of its market share, mostly to foreign brands.  Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles.  GM has been the poster child for this.  It controlled almost half the US car market in 1980; its current market share is about a third of that.

In sum, I think Mr. Trump is playing with fire with his tariff policy.  I’m not sure whether he understands just how much long-term damage he may inadvertently do.

stock market implications

One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.

Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit.  So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways.  They are:

–currency weakness and

–an emphasis on IT sector in the S&P 500.  Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products.  My guess is that if auto tariffs are put in place, this trend will intensify.  Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.

 

Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut.   This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.

 

 

~$70 a barrel crude (ii)

Two factors are moving the Energy sector higher.  The obvious one is the higher oil price during a normally seasonally weak time.  In addition, though, the market is actively looking for alternatives to IT.  It isn’t that the bright long-term future for this sector has dimmed.  It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher.  With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.”  It can go on for months.

 

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff.  In particular, all but the least adept shale oil drillers must now be making money.  This is where investment activity will be centered, I think.

 

–refiners and marketers, who have benefitted from lower costs are now facing higher prices.  So they’re net losers.  Long/short investors will be reversing their positions to now be short refiners and long e&p.

 

–the biggest multinational integrateds are a puzzle.  On the one hand, they traditionally make most of their money from finding and producing crude.  On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil.  This has been a horrible mistake.  Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects.  But, in theory at least, writeoffs aren’t supposed to create future profits.  They can only eliminate capital costs that there’s no chance of recovering.  As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow.  As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation.  Small companies in this situation would likely be acquired by larger rivals.  But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that.  Will they turn themselves into quasi-bonds by paying out most of this cash in dividends?  I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over.  So watch them.

a rainy Friday in August in New York

August is the month when many senior portfolio managers are away from the office on vacation.  So big decisions on portfolio structure tend not to be made.

Friday is the day of the week when short-term traders’ thoughts turn to flattening their books so they won’t carry risk over the weekend.

It’s raining, which sparks thoughts in traders of sleeping in or leaving work early.

Add all that up, and the heavy betting should be that US stocks will likely move sideways in the morning and fade off toward the close.

That means this is a good day to stand on the sidelines and size up the tone of the market.

 

In pre-market trading, tech is up and bricks-and-mortar retailing (on the earnings miss by Foot Locker) is down.  …nothing new about this.  At some point there will doubtless be a fierce counter-trend rally.  But the negative earnings surprises are still provoking severe selloffs.  So I don’t think today is the day.

Pundits are speculating about the damaging effects on his political agenda of Mr. Trump’s apparent defense of neo-Nazis in Charlottesville.  …but the Trump trade has been MIA since January, with the US a laggard among world stock markets during Mr. Trump’s time in office so far.  Yes, there may be residual hope for corporate tax reform from the administration, which this latest demonstration of the president’s ineptness as a executive could arguably undermine.  My guess is, however, that he is already well understood.

Two questions for today:

–will the market perform more strongly than the season and the weather are suggesting? This would be evidence that there’s still an untapped reservoir of bullishness waiting for somewhat better prices to express itself.

–should we be buying in the afternoon if it’s weaker than I expect?  My answer is No.  I think there is a lot of untapped bullishness, but we’re in a slowly rising channel whose present ceiling is less than 2500 on the S&P 500.   That’s not enough upside for me.  I’m also content to wait for any incipient bearishness to play itself out further.

It will be interesting to see how today plays out.