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All Posts By Cliff Jarvis

2015, Just The Numbers

Earnings for the 500  largest U.S. companies; the S&P 500 are reported in two ways. First is reported or GAAP (Generally Accepted Accounting Principles) earnings. This number is what is reported to the SEC. The second is operating or non-GAAP earnings.  Companies often report both operating or non-GAAP earnings along with required GAAP earnings.  The non-GAAP earnings are what analysts follow because it adjusts for one-time events and is said to more actually reflect their business.

Reported or GAAP earning for 2015 were about $87 (the total of all 500 companies in the index), depending on how and when they were measured. This compares to about $102 for 2014, and about $100 for 2013.

Operating or non-GAAP earning for 2015 were about $100, depending on how and when they were measured. This compares to about $113  for 2014, and about $107 for 2013.

In 2015, the major  U.S. corporations earned substantially less. Much, but not all, of this was due to the decline in the price of oil hurting the energy companies.

The S&P 500 started the year at 2,059 and closed at 2,044 paying out an approximate 2.15% dividend for a total return of about 1.4%.


Sounds boring, but wait, read on. These terms are behind much that matters. First is ZIRP or Zero Interest Rate Policy. The developed world (Europe, Japan, USA) dropped interest rate to zero save the economy from the 2008 crash. Unfortunately, the economy stagnated while bank savings rates to dropped to almost nothing. It did, however, fuel the stock market beyond fair value (see post below). Next is QE or Quantitative Easing. The central banks bought bonds from the public and flooded the system with cash. The plan was to force the banks to lend out that idle cash and start up the economy? That did not work either.

With interest rates now near zero, there is NIRP or Negative Interest Rate Policy. The central banks will force interest rates down through to zero the point where the consumer will be charged to keep their money in the bank, forcing the depositor/consumer to spend it instead and revive the economy. Right? Well, maybe not. The smart choice may be to withdraw the cash and keep it under the mattress. But this would cause bank runs as depositors cash out the accounts. So first, cash must be outlawed. No $100, no $50, no bank runs, nowhere to go. This sounds ridiculous but read the news. Negative interest rates are raging in Europe and Japan, and a “cashless society” is being proposed everywhere.

Perhaps the next step is Direct Monetary Fiscal Policy. The way things currently work is when our government needs money beyond what it collects, they issue debt in the form of Treasury bonds. So far that comes to $19 Trillion in Federal Government debt, $9 trillion of which was just borrowed by the Obama administration. Fortunately, our Federal Reserve Central Bank has soaked up trillions of that through the above-mentioned QE program. So, to oversimplify, our government owes itself trillions. Again, ridiculous. So what may be coming are that laws will be changed so the Federal Reserve can create money to pay for massive government programs directly without the U.S. Treasury issuing any new debt. Traditionally, this would be highly inflationary, but we are not in traditional times.

Being an optimist, I hope it works.

China is a Mirror

This stock market sell off is being blamed on news that China’s economy is weakening, but it is important to note that China’s news is a mirror on what is going on in the rest of the world including the U.S.  China is an industrial powerhouse built on exports and the global economies are just not buying Chinese exports like they used to. Furthermore, raw material economies like Brazil and Australia depend on China to import huge quantities of their raw materials to manufacture finished goods which China then sells to the world. So when China doesn’t sell to the developed world, it doesn’t buy from the raw material economies.

Many attribute this to what changed in 2008. They call it ‘peak debt’. The pillar of aggregate demand (the middle class) maxed out on the money/credit they could or would borrow and spend. So demand for Chinese goods began to falter and the demand for raw materials began to taper off. This effect was delayed as the Chinese government injected stimulus to support their economy;  building even more capacity hoping demand for their exports would return. It didn’t.

Compounding this was the cure the developed world’s central banks undertook only made the problem worse. To reinvigorate economic activity or ‘aggregate demand’ they dropped interest rates to 0% (Quantitative Easing, or Zero Interest Rate Policy). Corporations worldwide used these low interest rates to expand even more capacity to meet the expanding aggregate demand they thought would soon appear.  But it didn’t happen. The American and European middle class was under pressure and not willing or able to continue  their  borrow-and-spend splurge. The expected resurgence in demand for Chinese exports never happened.

China’s economy is cooling because the world’s economies cannot increasingly import their exports. Without the world’s need for China’s exports, they have less need for the raw materials to manufacture those exports. Hence, a concurrent collapse in commodities prices, and not just oil, but iron ore, copper, zinc, etc. This lack of demand for exports from raw material economies then boomerangs back on less demand for Chinese exports, and so on.

It is not just China’s economy that is weakening, it is worldwide.

Back to the Future

I have been around for a while now; decades. I remember when investing was done by stock picking. A stock’s value is mostly the current value of its future cash flow. A good stock picker analyzes the future prospects of the underlying company, buys its stock, and rides the price appreciation as the analysis hopefully unfolds. However, today the Federal Reserve openly states that it targets the level of the stock market as a policy tool to change the “mood” of the economy and thus stimulate economic activity. The plan has been/is to boost asset prices, revive the economy’s animal spirits, which then will start to create jobs. It worked in their mathematical models, but not so much in the real world. The markets are way up, the economy not so much.

Add to this how massive pools of money have developed complicated formulas implemented rocket fast with massive computers jerking markets hundreds of points back and forth with reckless regard. These moves have little to do with underlying value or future cash flows.

How does one cope? One way would to not yield to this at all; to ignore it. Ultimately, all that matters is Fair Value. Fair Value is like gravity. What a company is and will be determines its stock price. This is Fair Value and over the long run, it always wins. So buy quality and only at a good price. Sometimes it involves a great deal of patience. Trade the euphoria of runaway advances for confidence in scary declines as computers run the markets to short run extremes. Go back to traditional stock picking to deal with the future of seemingly crazy markets.

It can be easy to do. Some of the best stock pickers are readily available through tried and true mutual funds.

Stock Buybacks

Not discussed enough is the effect stock buybacks are having on the stock market over the last several years. The concept is simple. Corporations buy shares in the open market the same way ordinary investors do, however, when corporations do it, they ‘retire’ these shares leaving fewer shares outstanding. Each remaining outstanding share then represents a larger piece of the corporation. Therefore, when total earnings are reported a smaller number of shares divide into them. This increases earnings per share more than total profit of the corporation would indicate. Share prices then rise accordingly with the increase in earnings per share. Additionally, buying shares in the open market provides a further boost to share price.

However, this may be sacrificing long-term growth for short-term gains. Corporate cash used for stock buybacks is diverted from investing in additional opportunities,i.e. of buying plants and equipment and employing more people to create more profits over the long run. Corporations are even borrowing to finance stock buybacks; putting more and more debt on their books for future managers to deal with. Activist investors concerned only with immediate gain are forcing the issue. Managers who do not implement buybacks are soon unemployed.

Stock buybacks are a major component of what is driving the stock market to record valuations. It also helps explain why the market is soaring while full-time jobs have not recovered to pre-recession levels.


Gold, Silver, and Japan

Another deflationary impulse hit the global economies. Japan announced shocking news. After several decades of no economic growth, the Japanese government has piled up massive debt. They desperately need to get their economy going and just announced a desperate plan. After the Bank of Japan (their Federal Reserve) copied our grand growth experiment of flooding the economy with vast quantities of newly created money (QE), they are going all in. While our Federal Reserve tapered money creation, Japan is boosting their efforts to the equivalent of three times that of our Federal Reserve. Moreover, the Bank of Japan will be indirectly investing in the stock market (governments creating cash to buy stock … what next?). Of course, the Japanese yen crashed on this news.

So what does this mean for the U.S. economy? In a word: deflation. A cheaper yen means they will try to undercut their Chinese, American, and German competition and export more. They are debasing their currency to steal business from other nations. Competing economies will be forced to retaliate by cheapening their currencies. In a currency war, when everyone tries to fix their slow economy problems at each other’s expense, everybody loses. Currency debasement leads to the inevitability of instability and/or eventual inflation.

Therefore, for now, there is worldwide deflation. The price of gold and silver, which traditionally hedges against inflation and instability, has stagnated. However, in a world of currency debasement or, in other words stuffing the world with more and more currency from nowhere, precious metals are the last stable currency. Governments cannot create gold. Citizens of developing economies know this. That is why they are buying gold and silver at record rates. Even some of the foreign central banks are buying gold and building their gold reserves.

In the past, gold has held its value. Currencies run by desperate governments have not.

The Iron Law of Valuation

The discipline which holds that stocks and the market in aggregate have a fair value based on past, current, and estimates of future earnings. This method is calculated through exhaustive mathematical analysis and statistical back-testing.  Through this methodology, a current fair value can be derived.  The Iron Law of Valuation is that, while actual prices will fluxuate, the inevitable pull of fair value will win over the long run. This analysis compares the current price to what is historically normal and can further demonstrate the degree of the difference; whether this market is under or overvalued.

Furthermore, by assuming, what has been true will continue to be true and comparing the current price to an expected future fair value, the probability of an expected future average annual return can be derived. Therefore, history gives a fair value: an average, a mean, a best fit. In addition, because stocks are no more than the present value of future earnings, these earnings can be anticipated, then assigned a current value discounted at some function of the Federal Reserve’s ‘neutral policy’ interest rate. It becomes a simple matter to determine whether the current price of the stock market is above or below fair value; whether it is under or overpriced.

Right now, the current price of the stock market is higher than this discipline would expect. But reality often turns theories about the appropriate value of the stock market into junk. Recent history is full of instances where the stock market continued to make substantial gains long after these theories stated otherwise. No one better documents this divergence than Laszlo Birinyi, and he is still bullish.

However, I believe knowing fair value is very important. The Iron Law of Valuation is like gravity.  Over the long term, it wins.


It has recently been argued by a leading economist that the Federal Reserve’s great financial experiment of buying massive amounts of bonds (QE), dramatically dropping interest rates (ZIRP), and flooding the system with newly created money was not about bailing out the big banks, it was about Main Street jobs. That, in order to restart the economy the Fed’s began a policy of targeting not just bonds prices, but stock prices as well.

Too many people taking on too much debt caused the 2008 financial crash. Debt they could not pay back. After 20 years, the economy topped out and went bang. In the aftermath, Americans were choking on debt and unable/unwilling to continue spending at binge rates. Economists call this a Liquidity Trap. Dropping interest rates did not encourage us to borrow more and spend. Someone who already ate too much is not interested in free hamburgers.

The argument continues that it is not the level of debt, but rather the amount of debt relative to equity that matters. A $300,000 mortgage on a house worth $250,000 is not good. However, the same mortgage on a $500,000 is another story. Price influences behavior. A homeowner with $200,000 equity in their house behaves differently than a homeowner that is underwater….they spend. Furthermore, corporations are run by people, so by lifting their equity (their stock price), they would also behave differently. Expansion plans would be undertaken, plants built, orders made, and finally, people hired. Therefore, by boosting the stock market, middle class jobs are created.

In this way, the level of the stock market became a policy tool of our Federal Reserve. Their plan to escape this Liquidity Trap was to lower interest rates, flood the system with money, and thus run the stock market to change the “mood” of the economy. The plan is to boost asset prices, revive the economy’s animal spirits, which then will start creating jobs.

So, here we are. The Fed has fully implemented its Grand Experiment of Zero Interest Rate Policy and Quantitative Easing (QE). They are now one of the largest holders on U.S. Treasury bonds. Their policy of driving stock prices higher worked. The market is up. However, the economy has yet shown little response. Consumer expenditure has remained weak.

The “fair value” of proper asset prices so important to capitalist systems was no match for the determined will of the central planners of our government. The price of the stock market is now a policy tool of the Federal Reserve and freed from the Iron Law of Valuation, freed from fundamentals of the underlying economy.

So, there it is. Government policy intentionally rallied the stock market to kick-start our anemic economy. Now it is time to see if it worked.

This brings me to last quarter’s positive GNP report:

Gross domestic product, the broadest measure of goods and services produced in the U.S., grew at an annual rate of 4.6% in the second quarter.


Bonds and then Bonds.

The Federal Reserve responded to the financial crisis by dropping interest rates to zero (ZIRP) and by buying massive quantities of bonds and thus flooding the banks with newly created cash. We were told it would short lived. However, five plus years later it is still mostly with us because we are told that the economy is fine but only by a little. Therefore, faced with a banking system flush with cash and the average investor desperate for yield, there has been a multiyear rally in bonds. This rally was interrupted last spring but has since remained calm at marginally higher rates. While this calm lasts, it is important to review what are bonds, and what are bonds.

Bonds have a credit rating. The credit rating is based on the ability of the lending organization to repay the money lent to them. Standard and Poor is a leading bond rating service. Their ratings run from AAA to CCC or lower. AAA are the highest quality bonds. BBB and up are referred to as ‘investment grade’. Investment grade bonds have adequate to extremely strong capacity, depending on their rating, to both meet their dividend payments and return your capital. CCC’s are considered “vulnerable”.

Link to Standard and Poors

This is important because the recent years of yield chasing have dropped the yield on BB and lower bonds to record lows. In addition, these ‘junk’ bonds command a higher premium over their investment grade brothers. Investors rightly required a much higher dividend yield to compensate them for their higher risk. However, this premium is now near historic lows. This makes them vulnerable on two fronts. First, all bonds suffer a decline in current market price if interest rates rise. Second, their current market price will decline if the outlook for their financial stability worsens. So, you have to ask yourself; “Is the extra dividend yield worth the risk?”.

Link to the SF Fed

So there are bonds and there are bonds. It is important that you know which ones you own.

Time Will Tell

While the stock market continues to remain orderly, there have been some recent changes. The prices of many of the momentum stocks, which are long on promise and short on earnings, are down 50% or more so far this year. The iron law of valuation always wins. Fortunately, the stock prices of large traditional companies are holding (keeping many stock index returns slightly positive for the year). This could be a return of rationality, which bodes well going forward. While the valuation of the broad market is still rich, it is still well below previous extremes. It looks like it is headed higher.

Recent numbers on the state of the economy are mixed at best. The early report on first quarter GDP came in flat. The unemployment rate has improved substantially, but this is due to a decline in the U.S. labor-force participation rate. The stock market advance continues without much support from the economic fundamentals. Perhaps stock investors are looking ahead, optimistic about what they anticipate. For example, new technologies in natural gas production are boosting the oil & gas industry. These technologies are increasing domestic supplies, dramatically lowering energy costs and therefore potentially igniting a domestic manufacturing renaissance. Other technologies, too numerous to itemize, are also changing the world for the better. Innovations have become commonplace and, in past, solutions from seemingly nowhere have solved the challenges we faced. Why not this time, again.

Then there are bonds. Last year the interest rate on the 10-year Treasury spiked to 3% at year-end from an epic low of 1.75%. This left the Bloomberg U.S. Treasury Bond Index with a loss of 3.4% and the Barclays U.S. Treasury Inflation Protected Securities Index with a loss of 8.6%. So far this year, the interest rate of the 10-year Treasury has dropped back down to about 2.6%, resulting in higher year-to-date bond prices. The Bloomberg U.S. Treasury Bond Index is up about 2.6% and Barclays U.S. Treasury Inflation Protected Securities Index is up almost 3.8% this year. This is not something that normally happens in an improving economy. Rates should be going up and bond prices down; especially with the Fed’s Quantitative Easing bond buying program pulling back. However, rates are so far stable to down and bond prices are up. Perhaps higher bond prices are the result of the shortage caused by the years of the Fed’s bond buying. Or perhaps it is because our bonds look attractive relative to those globally. U.S. Treasuries are still seen by the world as a safe haven. Therefore, bonds look attractive for now despite interest rates remaining near historic lows.

The markets remain orderly. However, as always, participate with caution.