Diary of a Financier

Bull v. Bear: Checklist edition

In Capital Markets, Dissertation on Thu 21 Jan 2016 at 11:14

I wanted to crystallize my S&P 500 ($SPX) outlook in another edition of Bull vs. Bear, after I downgraded the market to NEUTRAL amidst the rally in December…


Fundamentals & Valuation

While the bar has been lowered for SPX consensus, the whisper number seems even lower, as sentiment has deteriorated materially ytd.  Currently, consensus expects operating EPS +7.4% yoy @ $125.57 (2015FYe), a product of +3.5% sales growth and unch net income growth.  The remaining work is expected to be done by margin expansion and share buybacks.

Here’s the background…

First, wage growth has started to gain traction, which perhaps predicated the Fed raising rates in December.  Meanwhile, credit spreads have blown-out wider.  So, while these affects are headwinds for margins, interest expense is only 1.65% of net sales and SG&A 13.7% (not all of it wage-sensitive).

Those are de minimis detractors relative to the material offset (and then some) provided by COGS, which currently run @ 69.4% of revenue (2015q2 ttm) and are expected to drop to 61.3% share (2016FYe), an +8pp pickup in margins that drops to the bottom line — due to the commodity input crash.

Another tailwind comes from the aforementioned share buybacks.  Stock repurchases are expected to add +2.0% to EPS (2016FYe), matching the average postcrisis run-rate — which is actually at a pretty normal velocity for any expansion. SPX corporate cash uses 1999-2016e Since companies have been making capital allocation decisions, there’s a mounting concern that wider credit spreads should erode the incentive to borrow cheap debt to buy-back expensive equity (“financial engineering”).  However, SPX’s earnings yield spread has actually increased: +45bps ytd @ +125bps.  In other words, it’s now even more attractive for SPX components to repurchase shares, since their cost of equity is growing more & more expensive than that of debt.

Not only are buybacks immediately accretive to EPS, but they’re also an attractive opportunity cost in a low return environment: a CEO can either invest in a new project (which could potentially yield some low IRR), or he can buy his own company’s equity (which offers a known benefit).

Plus, shares should now be more attractive after the SPX’s recent drawdown — a precedent set in 2011’s correction, when companies boosted EPS by a postcrisis record +2.6% due to buybacks.

My expectation for an acceleration in buybacks is emboldened by the healthy cash flow still being generated by SPX, combine with record levels of corporate cash (+5.8% yoy @ $1.45T in 2015q3, ex-financials).  Furthermore, SPX buybacks contributed a healthy +2.2% to 2015FY EPS without really any contribution from the battered Energy sector.

Finally, the US Dollar can provide a modest tailwind.  The Dollar rallied spectacularly in 2015, and with DXY now having hit a double-top on its chart with consensus unanimously bullish, it should prove overbought.  The affect of USD fluctuations is statistically significant: a 5% change in DXY → 3% change in SPX EPS.

In sum, as we’re undergoing the annual downward revision cycle for FY EPS consensus, which growth estimates exceed the actual reported number by +100% on average.  That precedent makes me expect 2016FYe EPS ~$122.85 (vs $128 current est.), which bear case has SPX trading right at fair value.


While the fundamentals & valuation are bullish (at worst neutral), timing the recovery in risk markets is another conversation.

First, broad indices are completing daily LT H&S tops, with SPX currently propped at 2nd neckline support and IWV having broken-down beneath.

SPX seasonalitySecond, seasonality is strongly negative until the beginning of February.

Perhaps most tangibly, companies are in a blackout period until earnings season ends, meaning they can’t buyback stock until after they report.  To date, only 6% of SPX components have reported, with the lion’s share coming inEarnings calendar (2015q4 reports) the 1st week of February.  I expect a flood of buying at that time, as corporations trafficking in their own shares is historically an important, marginal provider of bids at 2% of stock market volume.

In addition, SPX had to recouple with peers — whether via risk catching-up or quality catching-down.  The latter is now underway.  Compare…

SPY -14% drawdown (intraday)
IWR -21%
IWM -26%
EFA -24%
ACWI -22%
HYG -20%


Short & medium term outlook

This all amounts to a bearish black hole in the short term, between now and month-end, throughout which period there are no catalysts to support this market.

While bearish for the short term, we are bullish for February, since the passage of time will heal much of what ails the markets, as discussed above: time will allow repurchase SPX futures net speculative positions (non-commercial longs less shorts 2016.01.12)programs to resume; time will provide earnings reports, guidance & economic data to assuage investors’ greatest fears; time will also let extremely negative sentiment manifest itself in a bottom-marking capitulation (e.g. retail investors, institutional investors & speculators).

Long term outlook

There are other, more secular trends to heed: chiefly, demographics.  International developed markets will remain mired in a demographic trough until ~2030.  Demographics_China vs Japan (prime working age population)In particular, China’s demographic tailwind just crested, providing global growth’s most formidable Future labor market demand- Working age population change (Global, 2010-50)handicap.

While China’s population in isolation would otherwise drag on global growth, it’s substantially offset by resurgent populations in the US & India.  US population demographics don’t swing to a net tailwind until 2017-20 (leaving a bit of a doughnut-hole in the interim years), but India is already surging.

Even without that net positive demographic catalyst, a lot can happen in that long term — like Fed intervention, government stimulus, or an energy recovery.  The major upside risk is the American consumer, who can offset most secular headwinds thanks to the opportunity engineered by policymaker: Households are as deleveraged as they’ve been since the 1980s; the commodity/energy collapse has savings rates higher; wage growth has finally gained traction; and the Dollar is strong.

That’s a perfect alignment-of-the-stars for consumers, who could boom at any time.  Accordingly, we overweighted the Discretionary sector ($XLY) in 2015, and while the sector outperformed last year, it underwhelmed our expectations that the consumer would lead the economy full-speed ahead.  (Consumption is the largest component of US GDP @ 68.4%.)  Rooted in objective data, this observation makes us wonder whether the millennials are another generation of “Depression Babies”…?

Those are only a few of the inputs in my multifactor model.  In aggregate, the combine inputs give me the objective evidence to maintain my longer-term market outlook at “NEUTRAL

1. Economy (NEUTRAL)
– GDP: Bullish
– Inflation: Bullish
– PMI: Bullish
– Wages: Neutral
– Consumer confidence: Neutral
– Retail sales: Neutral
– Housing: Neutral
– Durable goods: Bearish

2. Credit (NEUTRAL)
– Corporate credit: Bearish¹
– Household credit: Bullish
– Commercial lending: Bullish

3. Fundamentals (NEUTRAL)

4. Valuation (BULLISH
– PE NTMe (14.9): Neutral
– PE 2016e (15.0): Neutral
– PEG 2016e (1.49): Neutral
– PS NTMe (1.59): Neutral
– PB/ROE NTMe (11.52): Bullish
– Earnings yield spread (+125bps): Bullish³

5. Sentiment (NEUTRAL)
– Retail sentiment: Bullish
– Retail allocations: Neutral
– Institutional allocations: Neutral
– Strategist allocations: Bullish

6. Technicals (BEARISH)
– Charts: Bearish
– Net speculative positioning: Bullish
– Large Cap divergence: Bearish
– Margin debt: Bearish
– Seasonality: Bearish
– Demographics: Bullish


¹Spreads & supply

²Using SPX Operating EPS

³Using SPX E/P NTMe (6.71%) less Baa Corporate Bond yield (5.46%)

  1. Absolutely nailed both the time & catalyst for the recovery rally…

    There’s Only One Buyer Keeping S&P 500’s Bull Market Alive
    “Index constituents are poised to repurchase as much as $165 billion of stock this quarter, approaching a record reached in 2007. The buying contrasts with rampant selling by clients of mutual and exchange-traded funds, who after pulling $40 billion since January are on pace for one of the biggest quarterly withdrawals ever.”


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