Tag Archives: investment

The iShares MSCI Netherlands ETF: A Dutch Treat?

The fund heavily weights Netherlands’ premier global companies. The fund has a consistent positive total returns over its 19 year existence. The main drag on the fund might be due to the strong US Dollar and weak Euro. There’s nothing like getting away to a warm place in the dead of winter. Oh, the idea of heading south to the Caribbean to escape the slush, ice and snarled traffic. Perhaps, Aruba, Curaçao or Sint Maarten? On the other hand, you might get a puzzled look from your co-workers while they’re bundling up for their wintery trek home by announcing that you’re off to the Netherlands for holiday. The fact is you’re actually being quite accurate! Those aforementioned mentioned timeless, carefree, warm, sunny islands are actually autonomously governed members of the Kingdom of Netherlands . The country in northern Europe which might have first come to mind, Netherlands, is actually a forth constituent member of the Kingdom of Netherlands . The Kingdom’s reach doesn’t end there, either! Three other Caribbean islands Bonaire, Sint Eustatius and Saba are special municipalities and its citizens actually have voting rights in Dutch and European election! There’re two details that often confuse people: what’s the difference between Netherlands and Holland ; and who are the people of Netherlands? First, Holland is located in the central region of Netherlands. Second, the people of Netherlands are Dutch ! To put this in perspective, the beautiful cities of Amsterdam, Rotterdam, the Hague, Delft, Leiden and Haarlem are located in Holland, which is in Netherlands. Lastly, Netherlands is governed by a constitutional monarchy, with a bicameral parliament. The monarchy isn’t just a formality, either! King Willem-Alexander actively mediates in Dutch parliamentary politics. At this point there’s a good chance that Netherlands suddenly seems like an interesting place. You might even be asking yourself whether it’s a worthwhile investment. If that is indeed the case, there’s a way you can invest your ‘dollars’ in Netherlands through the BlackRock’s (NYSE: BLK ) iShares MSCI Netherlands ETF (NYSEARCA: EWN ) . According to BlackRock … The iShares (NYSE: MSCI ) Netherlands ETF seeks to track the investment results of a broad-based index composed of Dutch equities. .. The underlying index is Morgan Stanley Capital International’s ( MSCI ) Netherlands Investible Market Index . According to MSCI this index … is designed to measure the performance of the large, mid and small cap segments of the Netherlands market. With 47 constituents, the index covers approximately 99% of the free float-adjusted market capitalization in Netherlands… Although the complete list of holdings and weightings are proprietary information, does indicate the index sector allocation and it is charted below for comparison with the fund’s sector allocation. Data from MSCI The fund’s sector allocations are demonstrated in the pie chart below, and seem to emulate the index quite closely. Data from iShares This fund, like many of the iShares focused funds, has been long established having been incepted in 1996. The fund’s net assets total $169,880,091.00 in US Dollars. It should be noted here that Netherlands is a member of the European Union as well as a Eurozone member; hence the currency of Netherlands is the Euro. This is an important point. Without getting too sidetracked, it suffices to say that it’s likely that the US Dollar will strengthen against the Euro within the next few quarters. This means that the values of individual holdings will decline in dollar terms, even if the individual companies are doing well. This shouldn’t put off the long term investor, but its good practice to be aware of the currency risks, at least in the near term. The fund has 6.8 million shares outstanding, is marginable and has a reasonably good 20 day average volume of over 77,000 shares per trading session. The fund is passively managed and management fees are slight higher than the industry average 0.44%, totaling 0.48%. The present annualized yield is given as 2.47% and the fund is currently trading at a 0.48% premium to NAV. The fund’s P/E ratio is given as 23.64% and a price to book value multiple of 2.14. The total number of holding is 48, which includes a small cash/derivatives holding. A quick overview of the major holdings with some key metrics, in order of sector weightings is presented below, starting with Consumer Staples. Although there are several ways to measure a company’s financial stability, the ‘Quick Ratio’ is included when available. In brief, Investopedia defines the ” Quick Ratio ” as … an indicator of a company’s short-term liquidity… …a company’s ability to meet its short-term obligations with its most liquid assets … … a quick ratio of 1.5 means that a company has $1.50 of liquid assets available to cover each $1 of current liabilities… Ah! Before continuing, please note that you will often see the Dutch word ” Koninklijke” preceding the company name or brand. It’s equivalent to “Royal Dutch”, like in ‘ Royal Dutch Shell ‘ (NYSE: RDS.A ) Consumer Staples 32.0171% Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business Unilever UL 19.074% 3.05% 41.40% $131.00 0.47 Personal care, foods, refreshments, home care with 400 brand names. Services over 190 countries globally. On par with other global giants, Nestles (OTC: OTCPK:NSRGF ), Proctor and Gamble (NYSE: PG ) and the like. Heineken OTCQX:HEINY 5.439% 1.49% 33.42% $52.321 0.55 Beer brewing with over 50 brand names and global distribution in 75 countries Koninklijke Ahold OTCQX:AHODF 4.7393% 2.50% 50.53% of EPS $14.54 0.65 Food retail brands and Supermarkets in the USA New England area, Netherlands, and Czech Republic; total stores number, approximately, 3200 Heineken Holdings OTCQX:HKHHF 2.0859 1.62% 33.33% $19.11 0.55 Holding 50.005% of Heineken; the holding company segments and manages the Heineken brands by geographical region. There are in addition, three smaller Consumer Staple holdings accounting for 0.6789% of the fund’s total holdings. They are Corbion ( OTCPK:CSNVY ) , 0.3648% of the fund, providing bio-based food additives, emulsifiers, frozen doughs and vitamin premixes; Koninklijke Wessanen ( OTC:KJWNF ) at 0.2069%, which manufactures and markets organic food products, spreads, honeys, cereals, and dietary solutions; Amsterdam Commodities ( OTC:ACNFF ) at 0.1072%, which trades, transports and distributes agricultural products. All three companies contribute to the fund’s overall dividend. There are 9 financial holdings. The smaller holdings: Wereldhave ( OTC:WRDEF ) at 0.6159%; Eurocommercial Properties (Amsterdam: SIPFC) 0.5529% ; Vastned Retail REIT ( OTC:VSNDF ) 0.231%; NSI ( OTCPK:NIUWF ) 0.1405%, all totaling 1.3998% of the fund’s total holdings, are REITS. Delta Lloyd ( OTCPK:DLLLY ) 0.4364% and Binckbank ( OTC:BINCY ) 0.1274% provide traditional banking services, annuities, manage pension funds and online banking. All of the above contribute to the fund’s overall dividends. The lion’s share of financial holdings, at 19.2501%, is summarized below. Financials 21.3515% Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business ING Group ING 14.3798% 2.18% 35.20% $48.335 NA A global player in banking, providing global retail service, investing, insurance as well as commercial service Aegon AEG 2.8773% 4.10% 63.78% $11.42% NA Insurance, pension management, Europe, North, Central and South Americas, U.K.; Expanding into Central and Eastern Europe and Asia NN Group OTC:NNGPF 1.9903% 3.49% NA $9.17 NA Insurance, investment management, annuities, reinsurance. Europe and Asia The fund holds 13 industrials, however, the top four account for over 10% of the fund’s holdings and well over 75% of the total industrial holdings. Industrial 13.6886% Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business Koninklijke Philips PHG 6.5413% 3.28% 154.09% $23.81 0.86 Called ‘Philips’ in the US: Imaging systems, diagnostic imaging, x-ray equipment. Consumer lighting, appliances personal care products. Randstad Holdings OTCPK:RANJY 1.9134% 2.39% 56.95% $8.963 NA Staffing service, temporary and permanent, payroll services, outplacement, and workforce solutions. Koninklijke Baskalis Westminster OTC:KKWFF 1.0719% 3.60% 27.42% $5.09 0.37 Dredging and earthmoving, maritime infrastructure; management of oil and gas terminals TNT Express OTCPK:TNTEF 1.0647% 1.04% NA $3.827 1.20 Express carrier for documents, parcels and freight. Offices in 60 countries with a delivery reach in 200 countries globally Four companies comprise the Information Technology allocation. The topmost are most significant ASML (AMSL) and Gemalto ( GTOFF) accounting for 9.8634% of the fund and over 90% of the IT holdings. The smaller holdings are ASM International, (ASMIY) at 0.5154%, a manufacturer of wafer processing equipment and BE Semiconductor ( OTC:BESVF ) at 0.1657%, a manufacturer of semiconductor back-end and packaging equipment. All four holdings pay dividends. Information Technology 10.5445% Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business ASML Holdings ASML 8.5177% 0.79% 21.65% $41.945 1.77 Semiconductor lithography systems for integrated device manufacturing, flash and DRAM memory. Gemalto GTOFF 1.3457% 0.69% 19.53% of EPS $4.897 1.20 Digital security: mobile, machine to machine, transactions There are three significant holdings for the Consumer Discretionary and two smaller holdings. The smaller holdings are TomTom (TOMAF) , the well-known navigation equipment manufacturer, at 0.2914% and Accell Group ( OTCPK:ACGPF ) at 0.1167% of the fund, manufactures exercise equipment, particularly bicycles and bicycle components. Consumer Discretionary Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business Relx RELX 4.5121% 2.62% 65.37% $17.592 NA Information Solutions for science, medical and technical for professionals and students Wolters Kluwer OTCPK:WTKWY 2.7013% 1.68% 48.17% $8.73 0.69 Information software and services legal, business, accounting, medical and healthcare Altice (classes A and B) OTC:ALLVF 2.1537% 0.00% 0.00% $15.92 0.56 Media provider and services, cable TV, broadband internet, telephony Only four companies comprise the Materials Sector holdings, the two most significant are Akzo ( OTCQX:AKZOF ) and Koninklijke DSM ( OTC:KDSKF ) . The two smaller holdings are OCI ( OTCQX:OCINY ) 0.5894% which seems to be as much an industrial by way of its infrastructure construction and project management as well as manufacturing materials, particularly fertilizers. It is a subsidiary of Orascom Construction (Cairo: OCIC) . The second is Koninklijke Ten Cate ( OTC:KNKCF ) 0.1908% manufactures advanced textiles and composite materials. Materials 7.71% Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business Akzo Nobel AKZOF 4.4598% 2.24% 36.27% $14.74 0.90 Paints, coatings, specialty chemicals, marine coatings, metal coatings, vehicle finishes. Also food additives, detergents, cosmetics. Koninklijke DSM KDSKF 2.47% 3.32% 366% of EPS $8.21 0.97 Nutrition, vitamins and nutrients, carotenoids. Also performance materials plastics, resins, polymer materials There’s only one telecom holding, Koninklijke KPN (OTC: OTC:KKPNF ) at 2.9527%. KPN has a $12.61 billion market cap and pays a 3.51% dividend. The company is pretty much a broad based telecom service provider whose primary business is integrated information and communication technology for mobile, residential and business. The least weighted sector is in energy with three holdings each has a weighting of less than one percent. Energy 1.7472% Exchange and Symbol Fund Weighting Dividend Yield Payout Ratio Market Capitalization (in USD Billions) Quick Ratio Primary business Vopak VOPLY 0.7454% 2.29% 43.5% of EPS $4.57 NA Storage of oil products, liquid chemicals, bio-fuels and vegetable oils as well as shipping terminal to terminal. SBMO OTCPK:SBFFF 0.6601% 0.00% 0.00% $2.52 2.02 Offshore energy, floating production and mooring systems, terminals and service Fugro OTCPK:FURGF 0.3417% 0.00% 0.00% $1.37% 1.49 Geotechnical Interpretation services providing information of the Earth’s surface and subsurface. Geosciences and Surveys for the oil and gas industry The fund has a respectable track record, with a consistent distribution as well as positive annual returns since inception, the only exception to that is the -1.59% negative return over the past 52 weeks. Since inception the fund has a total return of 4.98%; over the past ten years, 4.74%; five years, 4.98% and three years, 9.98%. Hence, the fund has a pretty consistent positive return, over different time frames, over the life of the fund, with the exception of the past year. (click to enlarge) The fund has several real global heavy-weight champs with distribution in the world’s best performing economies, like the USA, the U.K. and Germany. Further, the fund is smartly structured to top-weight these premier companies. Hence, it’s not unreasonable to assume that the poor performance over the past year may be currency related , particularly when it comes to US Dollar strength combined with Euro weakness. Should the US Fed raise its benchmark rate, or the ECB weaken the Euro in the coming months this might present an excellent buying opportunity for the investor with a long term outlook.

EOD: This Global Equity Fund Could Bounce Back

Summary 15% Discount to NAV is near 5 Year Highs. High 11% Distribution Rate Combined with Discount Produces Alpha. The fund uses dividend capture and an options overlay to increase distributable income. The Wells Fargo Advantage Global Dividend Opportunity Fund (NYSE: EOD ) is a covered call global equity closed-end fund, created in March 2007, with about $365 Million in assets under management. The primary objective of the fund is to provide a high level of current income, with a secondary objective of long term capital growth. (Data below is sourced from the Wells Fargo Advantage website unless otherwise stated.) The fund is currently selling at a 15% discount to NAV which is near its five year high. Here is a five year history of the premium/discount from cefconnect: (click to enlarge) The Fund invests in global equities with an emphasis on companies with attractive dividend policies and/or those with the potential to grow their dividends over time. The Fund focuses on companies in the utilities, telecom and energy sectors. They also employ dividend capture and an options overlay to increase distributable income. Within the equity covered call CEF sector, I generally prefer funds that use index options over those that use options on individual stocks. Aside from the tax advantage, the options on stock indexes generally trade with a lower bid-asked spread and are more liquid. This means reduced “slippage” costs resulting in less drag on performance. EOD uses both kinds of options. But the options holdings are modest (around 7%) of equity value, so the slippage factor is not a big deal here. As with many covered call funds, the fund uses a high managed distribution plan where they currently are paying out $0.18 per quarter. Five years ago the fund was paying out $0.28 per quarter, but the NAV has fallen because the total return has not kept up with the large distributions. EOD usually “earns its distribution” because of the options overlay and dividend capture strategies, but occasionally will use return of capital if there is a small shortfall. The quarterly distribution was reduced to $0.21 in November, 2012 and was lowered again to $0.18 in November, 2013. The distribution cuts have been successful in preventing major drops in NAV the last three years. This was the top eight country allocation as of July 31, 2015: U.S. 51.3% U.K. 11.4% Italy 8.2% Bermuda 7.4% France 6.8% Canada 5.4% Spain 5.2% Germany 4.2% The top equity sector allocations as of Sep. 30, 2015 are listed below. Note that there was zero exposure to the Basic Materials, Technology, Consumer Defensive or Healthcare sectors. Equity Sector Allocation Utilities 31.8% Real Estate 20.3% Communications 16.1% Financials 11.3% Consumer Cyclical 9.4% Industrials 5.6% Energy 5.5% Source: Morningstar Here is the total return NAV performance record since 2008 along with its percentile rank compared to Morningstar’s World Allocation category.   EOD NAV Performance World Allocation NAV Percentile Rank in Category 2008 -33.55% -39.30% 31% 2009 +13.33% +46.71% 100% 2010 + 3.13% +23.98% 100% 2011 – 4.44% – 3.21% 65% 2012 +9.23% +19.81% 85% 2013 +12.65% +11.07% 85% 2014 + 8.29% + 6.14% 30% YTD – 4.42% + 0.06% 91% Source: Morningstar Here are the top ten holdings for EOD as of Sep. 30, 2015: (click to enlarge) Fund Management Timothy P. O’Brien, CFA: Managing partner at Crow Point Partners LLC. Previously worked with the Value Equity team of Evergreen Investments. Has been in the investment management industry since 1983. Kandarp Acharya, CFA, FRM: Senior portfolio manager at WellsCap. Has a background in quantitative research, development of capital markets expectations, multi-asset class market risk modeling, risk management and hedging and optimization strategies. Christian L. Chan, CFA: Senior portfolio manager at WellsCap. Prior positions include roles as head of investments on several asset allocation funds at Wells Fargo, and quantitative research manager at an institutional investment consultancy. The discount to NAV as of November 6 is -14.83%. The one year discount Z-score is -1.24 and the one year average discount is -10.69%, which means that the current discount to NAV is more than one standard deviation below the average discount over the last year. Source: cefanalyzer Alpha is Generated by High Discount + High Distributions The high distribution rate of 11.46% along with the 15% discount allows investors to capture alpha by recovering a portion of the discount whenever a distribution is paid out. Whenever you recover NAV from a fund selling at a 15% discount, the percentage return is 1.00/ 0.85 or about 17.6%. So the alpha generated by the 11.46% distribution is computed as: (0.1146)*(0.176)=0.0201 or about 2% a year in discount capture alpha. Note that this is way more than the 1.07% baseline expense ratio, so you are effectively getting the fund management for free with a negative effective expense ratio of -0.93%! Ticker: EOD Wells Fargo Advantage Global Dividend Opportunity Fund pays quarterly Total Assets= $361 Million Annual Distribution (Market) Rate= 11.46% Fund Expense ratio= 1.07% Discount to NAV= -14.83% Portfolio Turnover rate= 76% Average Daily Volume= 192,000 Average Dollar Volume= $1.2 million Call Options as a % of total assets= 6.62% No leverage used This looks like a good time to start buying EOD. It is liquid and easy to purchase. Tax loss selling may still be depressing the price, so there may be more purchase opportunities as we approach year end. For those in a high tax bracket, it is probably best to purchase EOD in a tax deferred IRA account since most of the distributions are taxable income. Full Disclosure: Long EOD.

S&P 500: The Perfect Short

Summary Valuations at their highest levels in over a decade on a price/book, price/sales, and price/cash flow basis. Buy backs / M&A now representing 70% of all buying volume. Declining market breadth. The world is back to normal. The S&P (NYSEARCA: SPY ) is ~1% from its high, China is stabilizing, the U.S. is adding jobs, average hourly earnings are rising, and Dennis Gartman is ever so slightly long crude. This change in sentiment from the August lows led to the largest point rally in history, significantly weakening bear sentiment among individual investors, asset managers and the boys/girls with leverage, shown below. (click to enlarge) (click to enlarge) While the vicious upward move shook a lot of bears, including myself on the second leg, the concerns voiced during the sell-off are still present today, if not worse; however, the market seems to be operating under the assumption that everything is normal again given its recent price action, bringing me to one of my favorite graphics (note “return to normal.”) Yours truly, the S&P. (click to enlarge) So here we are, hovering around all-time highs with: Valuations at their highest levels in over a decade on a price/book, price/sales, and price/cash flow basis The largest amount of non-gaap adjustments as a % of total earnings since 2009 Buy backs / M&A now representing 70% of all buying volume The highest amount of corporate leverage in history Companies issuing debt to buyback record amounts of stock (’00, ’07) Two quarters of negative earnings growth 80% of IPOs with no earnings (last seen in 1999) A dollar that is breaking out 9.6 trillion of foreign debt denominated in dollars The highest sales/inventory levels since 2008 Declining market breadth Eerily similar price action to 2001 and 1937 And A Fed that “is definitely raising rates” in December With this as the backdrop, my view is that the path of least resistance is to the downside. I see an 8% chance that we break the previous highs. If that is that does manifest, a blow-off top may be in the cards. Valuations: I detailed in my previous post on gold (NYSEARCA: GLD ) that the current market multiples across a series of valuation metrics are the highest we have seen in 10+ years. This is by no means an indication that the market will go down, as something overvalued can become additionally overvalued, but should be used as an indication of how far the market could move under a perception change, which I believe we are currently undergoing given two quarters of negative earnings growth. As you can see below, the S&P currently trades at a price-to- EBITDA multiple of 10.4x, roughly in-line with the tech bubble. That turned out well. (click to enlarge) H/t @Jpcompson Buying Volume: In a recent interview , Ray Dalio sat down with Tom Keene and Michael McKee to talk all things markets. While the headline news was Ray calling for additional easing (QE4), his comments on buying volume were just as interesting. DALIO: American businesses right now are the number one thing is they’re flush with cash. And as a result, the biggest force in the stock market right now is the buy backs and mergers and acquisitions. So something like 70 percent of the buy, the buying in the stock market, is along those lines. So the largest buyers of stocks are corporations themselves. Think about this for a minute. 70% of the buying volume is coming from corporations not market participants. Companies typically buy back their stock for a few reasons: The stock is cheap, i.e. (NASDAQ: AAPL ) There is a lack of investment opportunity/uncertainty Artificially inflate EPS With that being the premise, let’s look at the current environment. Stocks are clearly not cheap, although value can still be found ($AAPL). The domestic economy according to many economists and pundits is doing “fine,” so there should be plenty of investment opportunities. So by process of elimination, companies are levering up to reduce shares out, in turn artificially inflating numbers and making their stocks look cheaper than reality. If companies are deploying capital to buy their stock at 16-17x non-gaap earnings (30+x gaap), the return over the following year would need to be 17% (30%+) to justify the investment. What we are witnessing is one of the most value destructive deployments of capital in history that will reemerge in future earnings, or the lack of. Corporate Leverage / Buy Backs / Cash Usage: The process of levering up to buy back stock is a direct effect of ZIRP and lack of corporate discipline, as companies allocate cash to please shareholders rather than invest in the future of their businesses. Goldman Sachs details this in the chart below. As you can see, buy backs as a percentage of total cash use has doubled since 2009 when stocks were arguably the cheapest. The percentage of cash used for CAPEX is 30%, or 2% off the lowest level seen in the past 16 years. Cash used to invest in growth is also near the lowest levels seen since 1999, while cash returned to investors nears an all-time high. (click to enlarge) Due to the abundance of short-termism, corporate leverage, buy backs and debt issuance are at or near the highest levels we have seen in 25, shown below. This is in the face of back to back quarters of declining sales and earnings growth, according to FactSet. Excessive leverage is akin to running a marathon with a 100 pound weight on your back. That said, earnings growth in the face of a stronger dollar, global slowdown, wage inflation, corporate leverage, higher rates, and diminishing CAPEX leads me to believe the past two quarters of declines are just the beginning. (click to enlarge) Forward Estimates: Wall Street analysts currently see earnings growing substantially over the next year as FactSet highlights below. While this is completely possible, I’m not sold given the trends that we are seeing today. Friday’s jobs report showed the strongest average hourly earnings y/y growth since 2009, reinforcing corporate comments on wage inflation. Barbarian Capital had a great post recently highlighting restaurant wage pressure, which he views as a good proxy for the following reasons: “The US food service labor market is probably the deepest and most liquid labor market in the US. At the entry level, there are no entry barriers either in terms of credentials or task skills (people already make sandwiches and wash dishes at home).” “The labor force in the industry is big: 14 million people, or about 10% of the labor force” “Employee turnover is very high : it was 66% in 2014 and 81% in 2007 (chart at the bottom of the linked article). So at the entry level, 100%+ turnover is likely the norm. This means that employers, as a whole, pay the market rates: there is no lag or scheduled increases (ex of local min wages), unlike professional or unionized industries” “Publicly traded restaurant companies generally report direct labor costs in their filings, unlike retail establishments (another large liquid labor market). My impression is that this fosters labor discussions more often than in retail.” Here are a few of the many examples of wage inflation outlined on recent conference calls: Historically, SG&A has been ~17% of sales, COGS ~66% of sales, interest and taxes ~5% of sales, depreciation and other ~5%, leading to a 9% EBIT margin (note this is as of 2013.) Over this period, yields, the employment cost index, and effective corporate tax rates have all fallen, providing a tailwind to operating earnings. While the quality of gains in the jobs report are debatable, it is clear that the risk is to the upside on wage inflation, which will clearly have an adverse effect on operating income. And given the fact that Bernie Sanders is somehow in the presidential race, who knows where corporate tax rates will be. I am assuming that taxes remain around current levels and spreads widen (outlined below), which will further reduce the operating earnings. Below are the Wall Street margin assumptions that get you to $128 in earnings power for FY16. While the trend looks like it is about to roll over, people much smarter than I are forecasting continued expansion. I’ll take the other side. H/t @Callum_Thomas As I previously stated there is clearly some wage pressure being felt by corporations. At ~17% of sales (likely lower given additional items in SG&A), that alone puts material pressure on margin expansion, but price and COGS are the real levers here. Price – COGS (66%) = Gross Margin. I’m no economist, but when there is demand for goods, a seller is likely able to raise prices at a faster clip than the costs of those goods, in turn increasing margins. That being said, below is a chart of the personal consumption expenditures deflator showing that inflation is near post crisis lows and almost negative. H/t @Mktoutperform Core PCE is much stronger, but again minimal signs of inflation given its current downtrend. (click to enlarge) So as prices of goods and services continuously trend lower, how is it that margins will expand from here if Price – COGS = GM, especially given the recent dollar strength and a 70% chance of a hike in December. In addition, it will be very difficult to raise prices given current inventory levels. The inventory to sales ratio shown below was last seen during the financial crisis. Forced liquidations and falling orders is likely not good for margins. (click to enlarge) Corporate Leverage: To recap, we have the highest valuations in the past 10+ yrs, multiple factors are putting downward pressure on margins, and record amounts of corporate leverage is being used to purchase stocks at nose bleed valuations. This brings me to the leverage part of the equation. As shown below, the median debt-to-EBITDA ratio for both investment grade and high yield bonds is at the highest level since 2005, which is being accompanied by rising default rates. I am not an economist nor a credit analyst, but given the trends I’ve highlighted above I can make a pretty strong case for why this will likely deteriorate further. (click to enlarge) Rising spreads will have an adverse effect on earnings and make it increasingly difficult to refinance given that ~30% of the aggregate S&P debt matures in the next three years. (click to enlarge) As you can see below, junk bonds are rolling over again even as the market nears all-time highs. The same is true for investment grade corporates. I will put my money on bond market here. H/t @Callum_Thomas Breadth: Under the surface the S&P is losing steam, as the leadership of the market has narrowed substantially over the past few months. This has been evidenced by the difference between the S&P and the equally-weighted ETF, the RSP . As you can see the RSP:SPY ratio is breaking down to 2 year lows. Here is a chart from @NorthmanTrader that further illustrates the discrepancy. (click to enlarge) In addition, the number of stocks above their 200 day moving average and the current downtrend is indicating waning breadth. This further illustrates to me that the path of least resistance is to the downside. (click to enlarge) The Fed And The Dollar: The Fed’s recent commentary strengthened my view that their credibility, like the market’s breadth, is waning. From the press release: “household spending and business fixed investment have been increasing at solid rates in the recent months.” What are they looking at? Source: Zerohedge The committee then states the “pace of job gains has slowed,” and longer term inflation expectations remaining stable. This is clearly not the case as illustrated by the PCE deflator above. But fear not, the committee, “expects inflation to rise gradually toward 2% over the medium term as the labor market improves further” from its recent slowing. The illustration below from @NotJimCramer gives you an idea of the Fed’s talk and lack of action. (click to enlarge) The first thing that came to my mind was: www.youtube.com/watch?v=eKgPY1adc0A The Fed got their wish last Friday with a blowout jobs number, sending the Fed Fund futures probability of a December hike to 70% and moving the dollar up with it. In my opinion, the last thing the world needs right now is a stronger dollar. There is roughly 9.6 trillion of foreign debt denominated in dollars, 3 trillion of which has been added by emerging markets since Lehman. With global demand slowing, sovereigns are forced to devalue their currencies, in turn strengthening the dollar without the Fed’s move. It is my view, that there are currently multiple reflexive relationships that will force the Fed to hold off on hiking rates. Should the Fed hike, which the market and participants seem to believe is a foregone conclusion based on a jobs number that under the surface was not great, the dollar will: Hinder the repayment of emerging market debt Further reduce commodity prices, which will in turn hurt earnings and likely result in an abundance of defaults given the amount of debt tied to commodities Make U.S. goods less attractive, in turn further reducing sales and earnings That said, I am sticking with my view that the Fed is trapped in a corner and the next move will be to ease or cut rates, which has recently shown up in their verbiage. Price Similarities: In turning to history as a guide of the future I looked at 2001. The blue line is the S&P from 10/16/1998 to 12/20/2000 and the red line is the S&P from 10/10/2014 to present. As you can see the price action is almost identical. The next leg is clearly lower and should manifest over the next two weeks. Nautilus provides an additional analog comparing 1937 to today. Note the 93% correlation. Conclusion: Based on the evidence provided above, it seems the path of least resistance is to the downside. My thesis will be wrong should the following manifest: The dollar weakens significantly, aiding commodity prices, U.S. sales, and earnings Short-term: the market moves to all-time highs on increasing breadth Inflation increases significantly Wage pressures dissipate Spreads tighten Corporations halt buybacks and invest in the future at similar historical levels. (Although this would cut the current bid) The market fails to follow either analog sequence I am agnostic to the Fed in relation to my short thesis on the S&P. I believe a hike from them would be extremely detrimental to the macro economy, but the failure to hike can be as destructive. Feedback welcomed.