October 2016 Commentary

As I write this letter we are in the middle of the third earnings season for calendar year 2016, and so far about three quarters of companies have beat analyst consensus, with only about a sixth missing. In a moment, I will discuss the absolute levels of company earnings that we have seen so far this quarter and for the year to date, but I want to highlight a few things we have found (that concern us) as it relates to estimates for earnings. We have found, and several research reports on the topic substantiate our suspicion, that more often than not, analysts covering a particular company start with an excessively high target for future earnings and that number slowly gets revised down to the point where the downward revision is over shot and the end result is the company beating the earnings expectation. According to data compiled by Standard & Poor’s, more than two-thirds of companies have beaten expectations over the last 16 quarters, with no quarter seeing beats fall below 63%. The intriguing part for us? It appears there is an increasing asymmetry to what happens when a company beats or misses its earnings expectation. According to data compiled by J.P. Morgan, there is an increasing disparity between when a company beats earnings expectations (the current impact to the stock is a 0.6% increase on average) and when it misses (a miss will yield a company on average a 2.3% loss). We are constantly looking for asymmetries in the market, and this particular one stuck out tremendously to us.

Digging deeper into the earnings levels themselves, the picture becomes less rosy. Looking back over the same 4-year period (2012 to 2016) that S&P compiled data on, the amount that companies actually earned has done the following: from 2012 to 2014 earnings rose pretty steadily, in 2015 they saw a huge decline (back down to between 2012 and 2013 levels), and now, with almost three quarters of the year in the books, 2016 is shaping up to only be slightly better than 2015. So far we are still reporting below full year 2014 levels, but the margin for error going into the fourth quarter still puts a full year earnings number for 2016 between full year earnings for 2015 and 2014. Fortunately, the current downside case does not make a finish below last year’s numbers very likely, but for reasons expand upon next, we believe it is more likely than most analysts are predicting.

So why was there such a dramatic drop off in earnings between 2014 and 2015? One word – Oil. Back in the fourth quarter of 2014, the spot price of oil dropped precipitously. When the effect of this was priced into earnings during 2015, the effect was catastrophic. Across the energy sector, company earnings fell by over half. The energy sector wiped out the gains from all other sectors in the market and then some. That process has repeated itself again this year. So far, the earnings reported in the energy sector have been down by roughly the same absolute values that they were in the same quarters last year, that means we have seen 100% or more declines in earnings for companies across the sector this year. The effect on earnings for the whole market has been equivalent to last year, with energy fully discounting the earnings gains made by the rest of the market. So, the aforementioned should put the next comment in the proper context – most analyst have their predictions for earnings growth in the market almost entirely dependent on an increase in the price of oil. This is concerning for two reasons. The first is the implication is most analysts expect us to continue to have stagnant growth, and the second is they are predicting a steady rise in oil over the next year so that by this time next year we are averaging over $55 per barrel. While this is certainly possible, we believe it is more likely than not we will stay closer to the levels we have today (in the $40 to $50 range).

There are multiple factors that go into the price of oil, but it boils down to a simple supply and demand problem. On the demand side, you have industrial and consumer use that needs oil for everything from petroleum based plastics to gas in the car. Oil and gas usage has relatively leveled off over the last few years as industry is turning towards different options, such as natural gas and other alternatives. Looking ahead, global demand is expected to remain in line as the adoption of other fossil fuels continues, and the effects of renewable energy adoption begin to take effect. On the supply side, there are three major players: OPEC, Russia, and the United States. OPEC is, again, in the midst of trying to agree upon a production quota. This time it was announced they would reach a deal by this month, but in their most recent meeting just a few days ago, they once again failed to finalize a plan. Russia finds themselves in the precarious predicament where their economy cannot afford for the oil tap to be shut off. In the U.S., we have somewhat of a mix between the problems OPEC and Russia is having. Average profitability for a U.S. producer is around $60 per barrel, with shale profitability around $65 per barrel and non-shale around $45 per barrel. I laid out in the previous section what effect the current price of oil has been on U.S. companies in this sector and picture is pretty grim. Economics would predict, in this case, that since there are sufficiently many firms in the market who are unable to produce a profit at the current prices that they would fail and the lack of supply from their now discontinued product would cause prices to rise, thus restoring an equilibrium in the market. However, this has not happened nearly dramatically, nor quickly enough. Since 2015, only 70 U.S. oil and gas companies have filed for bankruptcy, and their production only represents about 5% of the total output for the U.S. market. A total failure from all of these firms and the subsequent loss of production might be enough to drive oil prices sufficiently high to see both the earnings growth the analysts I mentioned are predicting, and the salivation of the rest of the U.S. oil and gas companies, save one fact – Chapter 11 works too well in this case. The way Chapter 11 proceedings are designed to work is to make sure a company’s creditors are paid, and in the case of these energy producers, with huge sums already invested in the location and procurement, it makes the most sense from a financial standpoint to continue production so the creditors keep receiving a steady stream of payments. So, like I said, the U.S. has a mix of being unable to stem production levels (like OPEC) and not being able to afford producing less oil (like Russia). From here, the road to higher oil prices is clear, but for OPEC, as the saying goes, “there is no honor amongst thieves.” For Russia, as demented as Vladimir Putin may be, he knows his economy could not survive cutting off the oil tap, and for the U.S. it appears things will have to get drastically worse before companies fail at levels that would impact the global market.

All of this in mind, it still begs the question of why we, according to analysts, cannot expect the rest of the economy to make meaningful gains in earnings. For this, we have to go back to the issue I highlighted in my July letter (the last time we discussed earnings) – Debt. Currently, both domestically and abroad, we are running the economy on astronomically high levels of debt. While in good times a reasonable amount of debt can be used strategically to yield great results, countries and consumers around the world have been piling on more and more debt for the past few years, leading to some interesting effects. Generally speaking, there are several areas that can stimulate growth in an economy, and they are: consumer spending, investment (savings), net trade, and government expenditure. It is this last one, government expenditure, that has drawn my attention most recently. Over the last month or so I have looked at several studies that look at government expenditure, and what is referred to as the government expenditure multiplier which measures the magnitude of the growth in the overall economy for every dollar the government spends on the public good. Usually this is a positive number between 0 and about 1.5 in developed economies like ours, but what these studies were finding was in extremely high debt environments (debt-to-GDP exceeding 100%) the government expenditure multiplier appeared to be negative. The most recent study I have researched took this a step further and analyzed this negative multiplier’s effect on corporate profitability, and (surprise, surprise) as government outlays increased, corporate profitability decreased. Several developed economies have already gone (or are currently going) through the throws of this predicament. Sweden was probably the first in modern times during the early 90s, followed by Japan (which I have discussed at length). It appears France and Italy are currently on the chopping block, and while the U.S. might not be next in line, we certainly are not bringing up the rear. So there lies a possible answer to our question. As with most cases in an economy, the answer is not just that simple, but to me, this serves as a good starting point in assessing how the engine is currently running.

Besides the debt problem, we see a few more pressure points on the economy, one or more of which should lead to an interesting end to the year. With the Federal Reserve leaving rates unchanged in their November meeting at the beginning of this month that leaves them with one meeting left this year in December. Prior to the November meeting, the likelihood of a December rate increase was about 75%, and since then it has increased to over 80%. This is important for a few reasons as I was reminded by an article I read shortly after the Feds November indecision was released. The last time they raised rates, it was December of 2015 and, from then, it had been nearly a decade since the last time we had a rate hike. The market nearly collapsed in the two months following that rise, and the Fed indicated they had 4 more raises planned for 2016. Yet here we sit, with one meeting to go, and they have yet to raise rates since almost a year ago. Also, they have yet to revise their rate targets for 2017 and 2018 which indicate a few more hikes in each of those years to achieve targets that we are currently well below.

There is a real possibility the Fed misreads the current economic data and raises rates too much, too quickly. Over the summer, hedge fund icon Ray Dalio (founder of the $150+ billion fund Bridgewater Associates) made the comment that he believed the market has only priced about a 50 basis point (0.5%) rise over the next 3 years. He went on to say that the risks are very asymmetric at the present time. In a worst case scenario, the Fed could raise rates only one hundred basis points (1%), cause a recession, and still not have given themselves enough room to cut rates to get back out. In fact, central banks all over the world are starting to understand just how bad they have painted themselves into a corner. On the first day of the month, the Bank of Japan announced they would leave rates unchanged while also signaling they would table any further effort to stimulate the economy. In other terms, they finally tapped out after a long fight to try to get the economy back on track with an extremely self-limited monetary policy arsenal. The Bank of England followed suit with the Fed and Bank of Japan late last week by leaving their policy unchanged as well. The last point of pressure we see is the strength of the U.S. dollar. The greenback has strengthened significantly over the last couple of months and that is a tremendous concern for U.S. companies that have high levels of exposure to foreign markets. It is unclear at the moment how the outcome of the election is going to effect the dollar, but currently, with so much uncertainty in other developed economies, there is a very high demand for our currency. One scenario we have discussed is a feedback loop that could be created if we were to enter a recession here that then sparked a global recession. This would mean that investors from around the world would still flock to USD denominated assets keeping the demand high for the greenback, further strengthening its value relative to other currencies, and further hurting U.S. multinational corporations. A rate rise from the Fed would have a similar effect, in that demand for USD denominated investments would increase and therefore demand for the currency would increase.


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