Earlier we explained why Goldman believes that in 2016 the market, which is now about 1% higher than where it closed in 2014, will also go exactly nowhere. The reason for this pessimism can be summarized in three bullet points:
i) bifurcated thematic returns. Goldman thinks that due to divergent monetary policies (Fed tightening vs. ECB and BoJ easing) the USD will strengthen and benefit some stocks and harm others. Some of those impacted the most will be multi-nationals and luxury retail companies (see Tiffany earnings today). Overall, the biggest headwind cited by companies in Q3 has been the strong dollar - expect this to continue and to further depress revenues, and thus earnings.
ii) higher rates. According to Goldman, "when fund managers eventually realize the tightening process will be more sustained than originally anticipated the P/E multiple will contract and offset the otherwise positive impact of 10% earnings growth."
iii) margin expansion stories. If companies can't rely on top line growth, and multiple expansion is not available, there is just one source of growth: margin expansion.
It is bullet iii) that is the most important, because here the divergence between Wall Street's hopium-driven margin euphoria is most visible.
According to Goldman, "tech accounted for 50% of the overall S&P 500 expansion during the past five years (Apple is responsible for 20% of rise). Tech sector now has margins (18%) that are twice the overall market."
That tremendous tech, but mostly AAPL-driven, margin growth has now ended.
So can this torrid surge in tech margins continue? Goldman's answer is a resounding no.
Many of the drivers of margin expansion during the past few decades appear to be behind us including
Lower interest rates,
S&P 500 net margins have been essentially flat for five years at just below 9%. We forecast margins will remain flat in 2016 and 2017 at 9.1%. Information Technology has been a notable exception with margins rising in recent years to 18%, or 2x the overall market.
However, roughly 40% of the 847 bp leap in Tech margins since 2009 is attributable to Apple (AAPL) alone. Given rising labor and health care costs, firms in most industries will struggle to simply maintain margins. Investors will reward firms able to demonstrate a path to higher sales and margins.
But perhaps the one chart that confirms that one can't have their wage rising cake and eat corporate profits too is the following:
In other words, if the Fed is hiking "because it sees something about the economy" that few others do - i.e., rising wages - then by definition that means that profit margins will contract as growing wages take out ever bigger chunks of the corporate bottom line.
So with sales declines set posied to accelerate due to the soaring dollar, central bank liquidity-driven multiple expansion no longer feasible and corporate margin growth set to resume its contractionary path again, we wonder where will the next leg higher in stocks come from. Unless, of course, the whole "the Fed is hiking because theS&P500 has topped out economy is recovering" was just the latest economist consensus mirage.
MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Nov. 22nd, 2015 - Nov 28th, 2015
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates
Alternative Bank Schweiz (ABS), a small bank in Switzerland broke the negative interest rate on deposits barrier, CHARGING customers to cake their money. (emphasis in caps from the article).
The Alternative Bank Schweiz wrote to customers telling them they would face a -0.125 per cent rate on their money from 2016 – and a -0.75 per cent rate on deposits above 100,000 Swiss francs.
The move echoes the Swiss central bank’s -0.75 per cent negative deposit rate imposed on financial institutions placing money with it.
Sweden’s central bank also introduced negative rates, which currently stand at -0.35 per cent, while the European Central Bank introduced them in part with its -0.2 per cent overnight deposit rate.
The Bank of England’s chief economist Andy Haldane delivered a speech in September discussing how Britain could have to consider negative interest rates as an extreme measure in a future crisis.
The big Swiss banks passed on some of the pain from the Swiss central bank’s -0.75 per cent rate to their institutional clients, but Alternative Bank Schweiz is believed to be the first retail bank to hit savers with a charge.
The bank describes itself as an ethical organisation focused on backing firms investing in social and environmental projects.
With its balance sheet totalling nearly 1.6 billion Swiss francs last year, most of its activities are concentrated in cooperative housing projects, providing affordable housing and sustainable energy solutions, as well as organic farming.
Imagine a bank that pays negative interest. Depositors are actually charged to keep their money in an account. Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero and kept them there for more than a year. For some, it’s a bid to reinvigorate an economy with other options exhausted. Others want to push foreigners to move their money somewhere else. Either way, it’s an unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire. If negative interest rates work, however, they may mark the start of a new era for the world’s central banks.
With the fallout limited so far, policy makers are more willing to accept sub-zero rates. Having once said that the European Central Bank had hit the “lower bound,” President Mario Draghi signaled in October and November that the deposit rate could be cut even further into negative territory. The ECB became the first major central bank to venture below zero in June 2014, and it now charges banks 0.2 percent to hold their cash overnight. Sweden also has negative rates, Denmark used them to protect its currency’s peg to the euro and Switzerland moved its deposit rate below zero for the first time since the 1970s.
That means investors holding to maturity won’t get all their money back. Banks have been reluctant to pass on negative rates for fear of losing customers, though Julius Baer began to charge large depositors.
Negative interest rates are a sign of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans to businesses or to weaker lenders. Rates below zero have never been used before in an economy as large as the euro area. While it’s still too early to tell if they will work, Draghi pledged during the height of Europe’s debt crisis in 2012 to do “whatever it takes” to save the area’s common currency, signaling the ECB’s willingness to be innovative. It chose to experiment with negative rates before turning to a bond-buying program like those used in the U.S. and Japan.
In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead. Janet Yellen, the U.S. Federal Reserve chair, said at her confirmation hearing in November 2013 that even a deposit rate that’s positive but close to zero could disrupt the money markets that help fund financial institutions. Two years later, she said that a change in economic circumstances could put negative rates “on the table” in the U.S., and Bank of England Governor Mark Carney said he could now cut the benchmark rate below the current 0.5 percent if necessary.
That's actually a balanced synopsis by Bloomberg as far as it went.
But unlike Europe, the US has large money market funds that would be destroyed by negative rates. Banks may be able to hold out for a while by raising other fees, but money market funds would immediately be in trouble.
Customers would withdraw money, put it into banks charging the lowest fees, stuff cash under the mattress, or open safe deposit boxes.
If rates get negative enough, there would be a run on the banks, but arun on money market funds would likely happen first.
Someone Has to Hold the Cash
The central bank thesis is to get people to spend the money. But note the absurdity. Someone must hold every dollar printed at all times.
If you buy a candy bar and eat it, or a coat and wear it, the store that sold those items to you has has the money. Mathematically, someone at all times must hold all the money.
What About Velocity?
Reader "Vince" has been bugging me to write about the velocity of money. Velocity purportedly measures the speed at which money circulates in the economy.
I have commented before on the absurdity of the velocity thesis, but this seems like a good time for a rehash.
Velocity = Value of transactions / supply of money
The value of transactions = price * transactions = GDP.
Thus, velocity is nothing more than GDP divided by money supply. Here is the equations, two ways.
V = PT / M
V = GDP / M
Right now, velocity is falling simply because money supply is increasing faster than GDP.
But what constitutes money supply?
M1, M2, MZM, base money, and true money supply all yield different measures of velocity.
So is velocity 1.7, 5.9, 1.5, 1.3 or something else?
If we rearrange the equation, GDP / Velocity = M.
Supposedly we know GDP but what do we plug into the equation for velocity to derive M? Can one independently measure velocity?
The answer to that question is a resounding no.
Since GDP = PT, GDP can rise if prices rise and GDP can go up if transactions go up. GDP can rise if transactions decline, provided prices rise enough. And GDP can rise if prices decline, provided transactions rise enough.
Velocity can rise with rising prices
Velocity can fall with rising prices
Velocity can rise with increasing transactions
Velocity can fall with increasing transactions
Velocity has no life of its own.
Velocity does not cause anything to happen.
Velocity cannot be measured by any independent means.
Curiously, economists are concerned about "falling velocity" as if it means something other than the central banks are printing money that sits as excess reserves.
Inquiring minds may also be interested in the Frank Shostak's 2002 article Is Velocity Like Magic? Much of my understanding of velocity comes from that article.
Mario Draghi has dropped his clearest hint yet that the European Central Bank is about to inject more monetary stimulus into the eurozone economy, brushing aside staunch opposition from Germany’s powerful Bundesbank.
The ECB president said yesterday that ECB policymakers would “do what we must to raise inflation as quickly as possible”. The remark echoed a promise Mr Draghi made during the region’s debt crisis in 2012 to do “whatever it takes” to save the single currency.
The ECB is widely expected to unleash a souped-up version of its €1.1tn quantitative easing package and consider cutting one of its benchmark rates deeper into negative territory.
“If we conclude that the balance of risks to our medium-term price stability objective is skewed to the downside, we will act by using all the instruments available within our mandate,” Mr Draghi said. “In particular, we consider the APP [asset-purchase programme] to be a powerful and flexible instrument, as it can be adjusted in terms of size, composition or duration to achieve a more expansionary policy stance.”
He added: “The level of the deposit facility rate can also empower the transmission of [QE], not least by increasing the velocity of circulation of bank reserves.”
Question for Draghi
I laughed out loud at that last line. If QE increases velocity, then why is velocity declining in the US, in Europe, and in Japan?
By the way, bank reserves do not circulate. Reserves are deposits that are not lent out. One can even argue that money does not really circulate per se, as it has to be held at all times by someone.
Negative Interest Rates Crazy?
Let's return to this statement by Bloomberg: "Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero and kept them there for more than a year".
Desperation and Hubris
Negative interest rates are a sign of central bank desperation.
They are a sign central banks are clueless about how the economy really works.
And they are a sign of extreme hubris coupled with extreme stubbornness as Japan has proven over the course of three decades that unconventional measures do not work as economists expect.
It's crazy to keep trying things that cannot possibly work, over and over again.
STOCK MARKET VALUATIONS
10 - US Stock Market Valuations
S&P 500 Earnings Slumped By Most in Six Years,
Worse to Come
Third-quarter U.S. earnings look set to be the worst since 2009 and the trend remains negative through year-end. Profit fell 3.3 percent on a share-weighted basis in the latest quarter, based on data from about 96 percent of S&P 500 companies already reporting.
This marks a second consecutive quarter of negative earnings growth. The energy sector saw the biggest damage, hurt by plummeting oil prices, with earnings dropping 57 percent in the third quarter, year on year.
Dollar strength is also hurting U.S. profits and revenues, according to Societe Generale.
“The question for us is not are we in a U.S. profit recession, but how bad is it likely to get and what are the implications for the wider U.S. economy, and with that massive consensus long on the U.S. dollar,” SocGen quantitative analysts led by Andrew Lapthorne wrote in a Nov. 19 note.
"We continue to be very concerned about U.S. profits. For over a year now excuse after excuse has been rolled out as to why U.S. profits are not actually as weak as the headline numbers imply, but the reality is the U.S. profits and revenues are declining and the strong U.S. dollar is a large part of the problem," they wrote.
Decline and Fall: U.S. Earnings Seen Negative Through Q4
The negative trend is set to continue into the fourth quarter, with analysts expecting a 5 percent year-on-year decline in S&P 500 profits, according to data compiled by Bloomberg.
In dollar terms, profits from S&P 500 companies have fallen by about $25 billion in the first three quarters of the year compared with the same period in 2014, while revenues have dropped by $287 billion.
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
TECHNICALS & MARKET ANALYTICS
COMMODITY CORNER - AGRI-COMPLEX
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur
Investing based on The Austrian school of Economics
The infographic above shows some differences in Keynesian and Austrian views. Courtesy of The Austrian Insider.
FRA Interview of Robert Wenzel by FRA Co-founder Gordon T Long.
Across well-known literature, the Austrian school of economics has earned and put its indelible mark on the complicated world of economic analysis and theory. The school of thought varies significantly from the mainstream schools of economics like the classical, neoclassical and Keynesian schools of thought. In essence the Austrian school of thought believes in using logical thoughts to explain and solve economic problems rather than getting technical and going into mathematics to explain the same problems.
“The key to understanding is that what you have with mainstream economists is that they look at things from a very mathematical, very empirical approach… unlike in physical sciences you cannot do that for the science of economics because you’re dealing so many variables like changes and desires”
Unlike the mainstream none-Austrian economists, Wenzel believes that there’s a lot to be understood from the economy based on logical build up from solid premises. He goes on to mention that another key aspect to be understood is that Austrian economists believe that when the Fed injects money into certain sectors of the economy, it’s those sectors that turn to boom. According to Wenzel, when the Feds eventually start tightening this money supply it leads to a crash.
On the current economy:
“We’re in a period of accelerated money supply”
Wenzel thinks there could be an increase in price inflation and the possibility of another dip in the price of oil.
Explaining how we have inflation in some areas and deflation in others when we’ve been pumping money into the system, he explains it by outlining how it depends on how quickly people want to spend the money.
“if there’s a great desire to hold money, you’re not going to see the inflation right away”
When people don’t spend money what happens is you have money building up in cash balances which Wenzel terms “the desire to hold cash balances”. With this you see people reluctant to spend money and hence a low velocity of money.
On the confusing environment of economics and how understanding the Austrian school can help to clear things up .... Understanding the business cycle and inflation comes about in terms of the Austrian school of thought. It definitely helps to clear a lot of things up but even more can be taken from this approach. The methodology additionally helps out in terms of having people analyzing the world through logic rather than attacking it solely with empirical data.
On considering Quantitative easing and going into negative nominal rates .... QE is a method where the fed prints a lot of money and buys long durtion debt. The negative nominal rates idea is based on the Keynesian idea that it’s spending that helps the economy to grow, so the idea is to use negative rates to pressure people to spend their money. Wenzel calls this “a tax on holding money”.
Asked if he sees Hyperinflation in the future:
It could happen at some point. The Fed’s target of 2% could easily go up to three 3% with accelerated printing of money. At this point they might raise rates but if the inflation is at 5% and they raise rates from 12bp to 2% that still won’t be able to fight the inflation. However it may be too soon to say hyperinflation.
The business cycle should be understood as a boom and bust cycle.
“Whatever is going up now does not necessarily mean it will go up long term. The bust will occur but they will pump it up with new fed printing, which is eventually where the inflation comes in”
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
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