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Lack Of Earnings Quality And Debt Downgrades Limit S&P 500’s Upside
Four in a row. That’s how many consecutive 3-point baskets Andre Iguodala scored against the Houston Rockets in last night’s playoff game. There has also been a “4 for 4″ in the financial markets. One after another, major banks have lowered their year-end targets for the S&P 500. Most recently, the global equity team at HSBC shaved its year-end target to 2,050 from 2,100. On the surface, HSBC’s cut is less severe than other bank revisions to S&P 500 estimates. That said, J.P Morgan pulled its projection all the way down from 2200 to 2000. Credit Suisse? Down to 2,050 from 2,200. And Morgan Stanley slashed its year-end projection from 2175 to 2050. So what’s going on? We had four influential banks expressing confidence in the popular benchmark a few months earlier. Their analysts originally projected total returns with reinvested dividends between 5%-10% in the present 12-month period. Now, however, with the S&P 500 only expected to finish between 2000-2050, these banks see the index offering a paltry 0%-2%. Another way some have phrased it? Excluding dividends, there is “zero upside.” Here is yet another “4 for 4” that makes a number of analysts uncomfortable. Year-over-year quarterly earnings have fallen four consecutive times. That has not happened since the Great Recession. And revenue? Corporations have put forward year-over-year declines in sales growth for five consecutive quarters. That hasn’t happened since the Great Recession either. The bullish investor case is that the trend is going to start reversing itself in the 2nd half of 2016. However, forward estimates of earnings growth and revenue growth are routinely lowered so that two-thirds or more companies can surpass “expectations.” And it is not unusual for estimates to be lowered by 10%. Take Q1. Shortly before the start of the year, Q1 estimates had been forecast to come in at a mild gain. Today? We’re looking at -9% or worse for Q1. Over the previous five years, Forward P/Es averaged 14.5. They now average 16.5 on earning estimates that will never be realized. In essence, S&P 500 stock prices are sitting a softball’s throw away from an all-time record (2130), while the forward P/E valuations sit at bull market extremes that do not justify additional appreciation in price. And what about earnings quality? Wall Street typically presents two kinds: Generally Accepted Accounting Principles (GAAP) earnings and non-GAAP earnings that excludes special items, non-recurring expenses and a wide variety on “one-time charges.” The foolishness of non-GAAP presentations notwithstanding, one might disregard the manipulation when non-GAAP and GAAP are within the usual 10% range. This was more or less the case between 2009 and 2013. By 2014, however, the gap between the two different earnings per share reports began to widen. By 2015, “manipulated” pro forma ex-items earnings exceeded actual earnings per share by roughly $250 billion, or 32%. Can you spell c-h-i-c-a-n-e-r-y? Of particular interest, there was a similar disconnect between GAAP and non-GAAP in 2007. Non-GAAP in the year when the last bear market began (10/07) was 24% higher than GAAP earnings per share. It follows that the discrepancy today in earnings quality is even wider than it was prior to the stock market collapse. “But Gary,” you protest. “As long as the Federal Reserve and central banks are exceptionally accommodating, stocks should excel.” In truth, however, the long-term relationship between the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the Vanguard Total Bond Market ETF (NYSEARCA: BND ) demonstrate that the bond component of one’s portfolio has been more productive over the last 12 months than the stock component. Bulls can point to the market’s eventual ability to shake off the euro-zone crisis of 2011. That was the last time that the SPY:BND price ratio struggled for an extended length of time. Back then, however, the Federal Reserve offered two aggressive easing policies – “Operation Twist” and “QE 3.” Today? Stocks are not only extremely overvalued on most historical measures, but the Fed has only lowered its tightening guidance from four hikes down to two hikes. Is that really enough ammunition to power stocks to remarkable new heights? “Okay,” you acknowledge. “But rates are so low, they are even lower than they were in 2013. And that means, going forward, there is no alternative to stocks.” Not only does history dispel the myth that there are no alternatives to stocks , but many corporations that have been buying back their stocks at attractive borrowing costs are now at risk of debt downgrades, higher interest expenses and even default. For example, the moving 12-month sum of Moody’s debt downgrades hopped from 32 a year ago to 61 in March of 2016. Meanwhile, the longer-term trend for the widening of credit spreads between investment grade treasuries in the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) and high yield bonds in the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) suggest that the corporate debt binge may soon come to an ignominious end. Foreign stocks, emerging market stocks as well as high yield bonds all hit their cyclical tops in mid-2014, when the credit spreads were remarkably narrow. The IEF:HYG price ratio spikes and breakdowns notwithstanding, the general trend for 18-plus months has been less favorable to lower-rated corporate borrowers. The implication? With corporate credit conditions worsening at the fastest pace since the financial crisis , companies may be forced to slow or abandon stock share buybacks. What group of buyers will pick up the slack when valuation extremes meet fewer stock buybacks? Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.
Buffett’s 5 Business Lessons
Originally published on Mar 30, 2016 What by Buffett’s standards is a good business? A good business according to Warren Buffett is a business that earns a high rate of return on tangible assets. The very best businesses are ones that earn high rates of return on tangible assets and grows. You can turn a good business into a bad investment by buying at too high of a price. Buffett’s statements above alludes to businesses that do not require a lot of capital investment such as the Van Tuyl Automotive car dealership business he purchased in 2014. Whereby in the dealership business, you can lease the real estate, arrange the floor plan, and sell a lot of volume with narrow margins and still manage a high return on capital. Years ago, car dealerships were many and across the U.S., there were about 30,000. Now that amount is a little more than half and on average each dealer does greater volume than ever before. However, I will say that his investment in BNSF Railway is quite the opposite and is a highly capital intensive business. Click to enlarge Are the big banks good business and are they still as good of a business prior to the 2008 crisis? Banks earn on assets not on their net worth. Since 2008, the government now requires banks to have more net worth for each dollar of asset. Meaning that their earnings on net worth will go down. Banks are required to have more net worth than before to make the “same” amount of money. In general, they are great business because they can borrow money cheaply. Think of your deposits sitting in a Wells Fargo (NYSE: WFC ) or Bank of America (NYSE: BAC ) checking or savings account. What interest rates are those paying out? More than likely it is something to the tune of less than 0.10% annual percentage yield. Banks turn around and lend that money out at interest rates at least 20 to 30 times that. “Keep the business if you expect the company to do well in the future versus the price now compared to other opportunities you might think you know equally well.” In 2014, Buffett still believed that most stocks were being priced at a range of reasonableness. There has only been five times in Buffett’s lifetime that he recalls whereby businesses were either priced too expensive or very cheap. There is no way to pinpoint exactly where those peaks and troughs are, but he believe he can make a call on either end of the spectrum every 5-10 years. Overall, buy good businesses at reasonable prices and you’ll make money. Another piece of advice? Buy stock in a business so good that an idiot can run it because one day an idiot will. Forget about what is happening in the United States about the Fed and economy. In the long run, the American system works and unleashes human potential, which will bring value to the economy. Buy a business because of what is happening in the business not because of what you think political effects have on the business or doesn’t have on the business. When do you throw in the towel on an investment or business? If you have a bad manager with bad results, you can sometimes change the manager and get good results. But if you have a bad business and a good manager, most of the time, you can’t get better with a better manager. Some businesses are just plain tough and the bad economics almost always trumps good management. Buffett loves it when the things they buy go down in value. When you go to the grocery store and find something cheaper today than yesterday you are elated. But for some reason with a stock, people tend to hold on to it and sell when it gets to what they paid for it. People have a tendency to justify holding on to positions. The stocks don’t care what you bought them for. You are nothing to the stock, but the stock is everything to you. How do you know when to sell a stock or rearrange your portfolio? When you can get can more for your money somewhere else. Prices change constantly and valuations shift daily. Today, you can rearrange your business empire at virtually no cost. But people can use that to a disadvantage as well by trading too much. Keep the business if you expect the company to do well in the future versus the price now compared to other opportunities you might think you know equally well.