What about the 4th Quarter?
Happy New Year! The start of 2014 will certainly be interesting. The big issue we will be watching is how the new Federal Reserve Chair will either continue the taper or bring her own agenda forward. Of course, as we are told, it is all based on economic data, but I think there is more to it than that. The Fed is still the primary buyer of US Treasuries and MBS securities, so it really comes down to a Supply & Demand question first. We have a new GDP methodology, which as I predict, will show a 4% GDP growth this year. We have the extended unemployment ending along with new machinations to the model with unemployment, which I think we could see a sharp drop as early as the first quarter and then see it drop to 6.5% by year end. All good headlines, but what about the real math?
What about 4th Quarter?
While we are all focused on the New Year ahead, and 2014 in general, we can’t forget that we will be getting some important economic and earnings data that will tell us how the last quarter of 2013 went. I think we will see some very conflictive data.
First, we saw a ramp-up in the GDP growth in the 4th quarter; however, few people are talking about that fact that the government changed the GDP methodology to include trillions in non-tangible assets. Economists pointed out that this would give a significant boost to the GDP, perhaps as much (or more) than 1 full percentage point. I know it seems odd that the GDP grew and is expected to grow strongly in the 4th quarter, with all the silliness that happened including the government shut-down, contraction of 2.6% in Black-Friday sales, sales warnings from Target, Walmart and other big retailers, short holiday season, Obamacare and a taper. Yet, the GDP trend and expectations tell us that we grew far stronger in the 4th quarter than in years. There is SOME real strength, truth be told, but the big strength continues to come from over-seas if we look at top-line revenues . There are some other solid stories in technology and oil production as well. However, these are in specific sectors and not the economy as a whole. What is more fascinating is that the latest revision to 3rd quarter GDP, while the headline number increased, showed it was consumer spending that contracted. The consumer spending, as a percentage of the GDP, is contracting or stagnant. The economic data, coupled with Fed’s QE money has certainly created a utopia, despite itself.
What to watch for:
Courtesy of LendingMemo.com
Earnings should also be interesting and could really set the tone for the first quarter of 2014. While most eyes will be watching Yellen and the Fed, we should not ignore earnings. I think we can’t look at earnings as a whole, but need to focus on sectors. What we should be paying attention to are the following:
Top Line Revenue:
Is it growing on a quarter-over-quarter basis and year-over-year basis? Where is the growth coming from: domestic, West, and Emerging Markets?
This is not the same as revenue. Companies could have MORE sales and lower revenue. That would reflect that the company is seeing margin compression from a variety of factors. These factors include inflation from trade/commodities/currency rates/interest rates, lowering prices to move inventory, competition from a strong dollar vs. imports. It could be a combination of one or all three. We heard margin warnings from domestic retailers that were cutting prices drastically to move inventory.
This is a simple measure of revenue minus costs. Costs come from a variety of things such as taxes, healthcare, rent, insurance, shipping, and currency fluctuation. This year we heard some warnings about compressed margins and it will be interesting to see how they impacted the earnings results.
Debt vs. Cash:
If we divided companies into a couple of buckets based on their debt and cash holdings, we could make some simple observations. There are cash rich companies which have far more cash on the books then debt. Debt (in the form of bonds or loans) are used to avoid taxes on repatriating foreign cash holdings or used because cash holdings (usually in fixed income of some sort) is generating interest that exceeds borrowing cost. Companies that fit into this category are Apple, Microsoft, and Google. Then there are companies that are over leveraged and loaded with debt. These are the companies we need to pay attention to. If the company has solid revenue that can cover far more than their debt financing and obviously pay down the debt, it is usually not a problem. However, it is companies in which they must continue to borrow to service exiting debt, further moving them into the hole that are long-term concerns. Perfect examples of this type of company were GM, Freddie, AIG, and other debt heavy companies. In many cases they used some accounting methods to hide this risk factor by counting forward sales (loans) as assets. The key in knowing a problem had emerged is that they were borrowing to finance existing debt and eventually borrowing to pay for interest on that debt. That is usually the end game.
Earnings Per Share (EPS):
This is less important because if we don’t know HOW the bottom line number is generated, how are we actually able to make a determination if the company is doing better or worse? This is the similar problem with paying attention to any headline data, like GDP or Unemployment. If we focus solely on the headline numbers and not ask WHY, then we make assumptions that may not necessary be true. You don’t have to question the Headline, but you do have to question HOW they derived that number. This is as true with earnings data as it is true with GDP, unemployment, inflation, and pretty much any NET number that we are fed. Never take something at face value.
Let me explain the issue with earnings per share and why we need to look deeper than just the headline. Remember, EPS is based on Revenue – Cost = Profit/Loss. However, the EPS calculation is based on a per share basis and the net bottom line is then divided by the float (outstanding shares).
Share Buy Backs: Share buy-backs are a good thing because they reduce the float (shares outstanding) of the company. That means if profit distribution remains the same then dividends per share will increase. However, we must also come to terms that share buy backs can also hide weaker revenue and sales. Since companies report earnings on a per-share basis, if the company buys back enough shares they could see earnings INCREASE even though revenues DECREASE.
Let me give you a simple example:
Company reports $1 million in net earnings on 1 million shares. That equals $1 per share in earnings. Next quarter the company buys back 250,000 shares, reducing the float from 1 million shares to 750,000 shares. The next quarter the company has $800,000 in net revenue. Because there are fewer shares, the company reports an INCREASE in their earnings per share from $1 to $1.06. That sounds great if we measure the company based on earnings per share, as the company grew 6% in earnings. The truth, however, is that the company saw a rather huge DECREASE in net earnings of 20%, down from $1 million to only $800,000. However, with only 750,000 shares, $800,000 net earnings is $1.06 per share. As you can see, share buy backs can mask actual revenue, sales, and margin concerns, if one ONLY pays attention to the per-share basis.
I am constantly asked why a company’s stock fell when earnings came in HIGHER than last quarter, or why a company‘s stock rose when earnings came in LOWER than last quarter. We need to ignore the earnings per-share basis IF there are any changes to the float or reporting data. That is why I always say pay attention to top line revenue, sales, and margins.
Earnings season is just around the corner, along with government economic data. We need to pay attention to the 4th quarter number and not solely rely on the headline numbers to make forecasts about the first quarter of 2014.
Mixed Results Expected
I think we will see a mix of data in the earnings, with good and bad, mainly reflecting a stagnant Western consumer that is still struggling and strong growth in the emerging markets. The government economic data, as I predict, will continue to show resounding improvement if we pay attention to the headlines alone. However, we will see a lower participation rate and extended unemployment drop-offs being the lead factor in driving down the U3 unemployment rate and GDP continue to climb higher, not because of consumer strength, but because we just added trillions of equity to this nation out of thin air based on the new model changes. As several economists have pointed out, because of the huge changes in the unemployment rate, GDP, and CPI – we need to change the baselines significantly. If we do not we are only fooling ourselves, much like the person that only pays attention to EPS and ignores how it was derived.
Support & Resistance
While the market did move higher at the end of 2013 in parabolic fashion, I thought we might get a follow through because I didn’t see the “shoe shine boys” come out in numbers. However, it looks like the futures are under pressure. I would look at 16,200 as a short-term support if we have a pull back and still believe that we could get a move up to 17,000 before we see a market correction. I could very well be wrong and we could see a correction come earlier, but it just seems that we haven’t seen the last of the bulls yet.
This is the short-term support in the NDX. There are some great stories in tech and I think we should see technology over this year continue to be a market driver. Unfortunately, this index relies too much on the over-weights such as Apple. I am currently neutral to bearish on Apple, unless they can see a significant growth in both bottom line revenue with the China Mobile deal.
The SPX is looking weak in the pre-market. The VIX looks like it might move above 14. The VIX is still pricing in some small possibility of correction. The VIX is a good matrix for the “shoe shine boy”, when it gets into the 10′s or single digits, it’s letting us know the “show shine boy” is here. That is one reason that I thought we could see some follow-through at the beginning of the year, I hadn’t seen the “shoe shine boy” yet.
The RUT continues to be the best measure of order flow in and out of equities. It has not seen the move that the other indices had, but it had moved higher. I would look at 1130 as short-term support. If this index doesn’t hold at 1120 at least, it could show a sign that we are going to see the correction earlier than later.
A Government Conundrum
There is a good economic data conundrum taking place. On one hand, the government wants the economic data to improve, as it helps the Democrats into the mid-term 2014 elections. If we see unemployment down at 6.5% and GDP at 3.5 – 4%, that bodes well for them heading into the election cycle. On the other hand, good economic data means the Fed has to taper,and even possibly raise rates, if we are to believe that they are “Data Dependent”.
What happens when the data does improve, as I suspect, but the Fed doesn’t taper or in fact increases their QE money printing program? How can the Fed justify more QE and continuing to support both the bond and mortgage market if the economy is seeing huge improvements? What is the Fed actually telling us if they don’t taper or taper very small or even raise, in spite of this data?
Well, my observations, as I have put it directly to the Fed President and Fed Governor in Q&A sessions in years past, are that QE is not a function of economic data, but rather it is a function of financing government deficit spending and buying up unwanted MBS. The Fed CAN taper, if and when the government reduces their deficit spending – either from more taxes, sequesters, less spending, or a combination thereof. In both cases, they never denied my allegation. In one case, via innuendo, they agreed with my assertion when they responded to my question by stating that QE in NOT a mathematical inevitability as I suggest, because Congress will reduce the deficit and interest rates will eventually rise. I don’t disagree at all. In fact, that was my very point. It IS a mathematical inevitability until that does happen and since it has not, then we should continue to see more QE. It is interesting to note in my Q&A exchange that not once did unemployment or inflation play into the conversation; it came strictly down to government deficit spending.
Yet, while improvement in government economic data with a continuing dovish Federal Reserve that continues with QE and zero interest rates might bring into question the government economic data’s accuracy, it could also bring forth a huge move upward in equities. Imagine the headlines, better government economic data and NO taper or even an increase in QE. That could bring confidence to the market while at the same time fund more leverage spending and continue to force people into equities as bonds remain unattractive.