Monday, March 28, 2016

Deflation worries are not over

A jump in the core U.S. inflation rate has persuaded many people that deflation is no longer a threat. But even those who never subscribed to the idea that consumer prices might decline for a sustained period should be wary of misreading the data and dismissing the risk of deflation.

When prices rise, people think the devil or other forces outside their control are at work. But when they pay less, it’s because they’re smart shoppers.

Consumers (and even economists) also aren’t aware that there's deflation in goods prices. In December 2015, the goods component of the inflation index fell 2.2 percent. Furthermore, U.S. consumers aren’t spending the windfall from lower gasoline prices and thereby spurring the economy and prices.

There’s also a link between the prices of goods and the costs of services, so the annual inflation rate for services has declined to 1.9 percent in December from as high as 2.5 percent in May 2014. (Laid-off oil field workers don’t take as many vacations; they frequent bars and restaurants less often.)

In addition, inflation worriers tend not to look beneath the headlines to acknowledge that the CPI measure considerably overstates inflation. Many quality improvements aren’t reflected in prices, despite what are called hedonic quality adjustments designed to capture improved performance. A new laptop, for example, may cost the same as its predecessor but have 10 times the computing power. Also, the CPI has fixed weights and doesn’t reflect the fact that when oranges are cheaper than apples, people buy more oranges.

So, in my judgment, deflation remains not just possible but probable..... And this matters because the value of the consumer price index reverberates through the economy, ranging from cost-of-living assessments to the returns on U.S. government inflation-linked debt to how the Federal Reserve shapes monetary policy.

Wednesday, March 23, 2016

Dividend payouts and Share Buybacks

Stock Dividends

Although most equity investors today concentrate on capital appreciation, dividends are an important part of stocks’ total return. They were much more so in earlier years, so the long-run average for dividends’ contribution overstates their current importance. Dividend yields today of 2% on the S&P 500 are distinctly below the 3% that was the floor in earlier years. Dividend payout ratios are rising in an era of uncertain stock appreciation when investors want more return here and now, but at 51% are still not high by historical standards.

Furthermore, investor reactions to dividends today are mixed. Relatively high dividend yields is not tempting investors to buy energy and mining companies where earnings are plummeting and whose dividends earlier were considered rock solid. Since the beginning of 2015, the S&P index of metals/mining shares is down 49% while the energy index dropped 27%.

Swiss-based miner and trader Glencore has embarked on a debt-reduction plan of more than $10 billion, including a suspension of its dividend and a $2.5 billion share offering. Anglo American, which lost $5.6 billion in 2015 after a net loss of $2.5 billion in 2014, has cut its dividend while taking massive writedowns on many projects. The company plans to exit the coal-mining business and sharply curtail its iron ore operation while cutting its mining businesses to 16 from 45, a further reduction from the 25 target announced last December. In mid-February, Moody’s slashed Anglo American’s credit rating to junk.

Copper mining giant Freeport-McMoRan dropped its dividend, cut capital spending and is selling 13% of its huge copper mine located on the Arizona-New Mexico border for $1 billion in order to pay down debt. Another major miner, Rio Tinto, cut its dividend in early February as the ongoing commodity price collapse pushed it to an annual loss in 2015. The company said it could no longer maintain, much less steadily increase, its dividend each year and plans to halve its 2016 dividend from 2015’s level. Similarly, last month BHP Billiton, the world’s top miner by market capitalization, abandoned its progressive dividend policy as it slashed its dividend by 75% amidst a $5.67 billion loss in the second half of 2015.

Ceasing to increase dividends every year, much less cutting them, has been devastating for the miners and other commodity producers. At the same time, investors are flocking to predictable dividend payers, especially recently as it became less likely that the Fed will raise rates this year, and, I believe, is more likely to cut them instead. Note that after the Great Recession, the ECB and the central banks of Sweden, Israel, Canada, South Korea, Australia and Chile all raised rates but subsequently cut them. So the Fed would not be alone.

This year, the stocks in the S&P High-Yield Dividend Aristocrats Index—companies that have increased their dividends every year for at least 20 years—are up 3% including dividends while the S&P 500 index suffered a total return drop of 2.8%. The total return on the S&P Utility index is up 6.7% year-to-date and I’ve favored utilities for years because of their attractive dividends as well as predictable earnings based on services consumers buy in good times and bad.

Banks are not immune from dividend cuts, and big British bank Barclays just slashed its dividend by more than 50% as it reported a loss of $552.6 million in 2015 vs. $244 million the year before.

Share Buybacks

Many companies prefer share buybacks to dividend payouts because they don’t imply long-term commitments. Still, many announced buybacks are never completed, and the tendency is to buy high, sell low. Buybacks are often made at stock price peaks when CEO's are feeling confident and corporate cash is ample. In contrast, few are announced at equity price bottoms when fears of liquidity shortages if not bankruptcy are widespread. 

In any event—as with dividends—investors of late have not been impressed by buyback announcements even though they increase earnings per share by reducing shares outstanding. Furthermore, buybacks often simply offset stock awards to company employees. Since the financial crisis, firms have repurchased $1.3 trillion in shares. Over the last three years, reductions in equities outstanding have increased S&P earnings per share by 2%, as of the last quarter.

via Forbes

Monday, March 21, 2016

Next major profit margin move may be downwards

Investing Myth:  Stocks Are Superior Investments In The Long Run

They are indeed because of long-term economic growth and the parallel growth in gross corporate product, which is essentially corporate sales. Although other sectors of the economy, such as unincorporated business, government spending and financial transactions, are significant, corporate revenues are involved in most aspects of the economy and therefore closely linked to GDP. In the post-World War II era, nominal GDP grew at a compound rate of 6.49% while GCP rose about the same rate, 6.66%.

In the long run, corporate profits rose at about the same rate as nominal GDP and GCP as revenues, after deducting costs, dropped to the bottom line. In the 1947-2015 years, corporate profits as defined by the Commerce Department, rose at a 6.74% annual rate and 6.11% for S&P 500 earnings.

That S&P reported earnings gain was below both the growth in GDP and GCP, which is puzzling because of the upward survival-bias in the S&P 500 index that we’ll discuss later. Also, you’d expect earnings by any measure to grow faster than the economy due to operating leverage as sales rise and spread fixed costs over more units of output, to say nothing of financial leverage. And financial leverage as reported on corporate balance sheets will be increased by new regulations requiring companies to add to their liabilities their huge leases on real estate, airplanes, office equipment, etc., which are effectively debt. Furthermore, the corporate sector’s share of GDP has grown on balance in the post-World War II years.

As a residual, profits—the difference between corporate revenues and costs—are obviously volatile. So, on a short-term basis, the growth in Commerce Department corporate profits and S&P reported earnings per share varies widely from the rise in nominal GDP. Profits are also influenced by the trade-off between the share of national income received by business and that which goes to employee compensation. In a democracy, neither labor nor capital gets the upper hand indefinitely, so the two shares swing from one extreme to the other as mirror images.

Real economic growth has been very slow and inflation absent, with deflation reigning in the goods sector. So the normal source of profits gains, revenue growth, has been missing with little unit volume growth and no pricing power.

In response, American business slashed costs, which spurred profits’ share of national income, a measure of the nationwide profit margin. Since most business costs—directly or indirectly—are for labor, employee compensation’s share saw a mirror image fall. But while profit margins remain on a record-high plateau, advances stopped several years ago. It remains to be seen whether business has scraped the bottom of the cost-cutting barrel or has picked all the fruit and has to wait for more to ripen. History however, suggests that the next major move in profit margins will be down.

Still, in the long run, the growth rates for nominal GDP and profits are similar. This means that over time, stock prices ride up with nominal GDP—except for the price-earnings ratio that converts earnings into equity prices. In effect, long-only stockholders are relying on a rising economy, which makes it a plus-sum game, on average. But beyond the average result, it is a zero-sum game. Anytime that investors who outperform the market gain, underperformers lose. After all, the average performance is the average. I doubt that many individual investors and probably lots of institutional investors understand the simple reality that the stock market isn’t like Garrison Keillor’s Lake Wobegon where all the children are above average.

via forbes

Wednesday, March 9, 2016

Top market myths and why they are wrong | VIDEO

We are seeing the stampede for the US Dollar and Treasuries as safe haven and we are seeing the threat of deflation.

Monday, March 7, 2016

Central banks still trying to beat deflation | US Dollar could rise more

Central banks are deadly fearful of deflation. That’s why the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of Japan and Sweden's Riksbank, among others, have 2 percent inflation targets. They don’t love rising prices, but they worry about the consequences of a general decline in consumer prices, so they want a firebreak. Unfortunately, they seem powerless to meet their targets in the current economic environment.

The guardians of monetary policy are riveted by Japan, where consumer prices have declined in 48 of the last 83 quarters. This pattern of deflation long ago convinced Japanese buyers to hold off purchases in anticipation of lower prices. But the result is excess inventories and too much productive capacity, which force prices even lower. That confirms expectations, resulting in yet more buyer restraint. The result of this deflationary spiral has been a miserable economy with an average growth in real gross domestic product of just 0.8 percent at annual rates since the beginning of 1994.

Central banks also fret that in a deflationary environment, debt burdens remain fixed in nominal terms, but the ability to service them drops along with falling nominal incomes and waning corporate cash flows. So bankruptcies leap, while borrowing, consumer spending and capital investment all weaken.

As I argued on Monday, deflation remains a clear and present danger. Worryingly, the remedies central bankers are using aren’t working. First, in reaction to the financial crisis, they knocked their short-term reference rates down to essentially zero, and bailed out their stricken banks and other financial institutions. That may have forestalled financial collapse but it did little to stimulate borrowing, spending, capital investment and economic activity. Creditworthy borrowers already had ample liquidity and few attractive spending and investment outlets; slashing borrowing costs to record lows stimulated asset prices such as equities, with little economic benefit.

Furthermore, banks were too scared to lend. And as they resisted attempts to break them up and eliminate the too-big-to-fail problem, regulators bereaved them of profitable activities such as proprietary trading and building and selling complex derivatives. That forced them back toward less lucrative traditional spread lending -- borrowing short-term money cheaply and lending it for longer at a profit -- just as the shrinking gap between short- and long-term funds made that business even less attractive. With the amount of capital banks are obliged to set aside against their trading activities also leaping, they're now regulated to such an extent that many of them probably wish they had been broken up.

For their next move, central banks introduced quantitative easing, purchasing massive amounts of government debt and other securities. As the Fed bought trillions of dollars’ worth, the sellers plowed much of the proceeds into equities. That hyped stocks but didn’t induce economic growth (equities are primarily owned by rich folk who don’t spend much more on goods and services as their portfolio values rise).

The Fed called a halt to QE in October 2014; but the ECB and the Bank of Japan are still extending their programs, and have turned to negative interest rates out of desperation. They know full well that borrowing costs at or below the so-called zero bound cause multiple financial distortions as investors’ zeal for yield drives them into hedge funds, private equity, junk bonds, emerging-market equities and debt and other risky asses. But they're praying that negative rates will spur investment and spending as borrowers, in real terms, are paid to take the filthy lucre away. Against a deflationary backdrop, nominal rates must be even more negative than the rate of consumer price declines to create negative real rates.

Central banks have tried almost everything, but in the current deflationary climate monetary policy is impotent and policy makers are proving the ineffectiveness of pushing on a string. That's good news for Treasuries and the dollar, but bad news for equities and commodities.