Archive for the ‘Stocks’ Category

Reviving a dead horse

Tuesday, August 30th, 2011

This is a horse I shot repeatedly in the Spring of 2011. I thought that it was troubling that the economy was turning out considerably poorer than the economists had expected while stocks were shrugging it all off. That is, the economists were optimistic about the economy and they were being disappointed. The chart I showed then is pictured below, and, in hindsight–naturally–this should have been a screaming sell signal. Stocks were going sideways whilethe economy was weakening.

On a daily, and perhaps weekly, basis, security prices reflect a whole host of influences, not the least of which are fear and greed. Over longer periods of time, however, security prices and trends should reflect fundamentals, and the most basic fundamentals are the economy–or economies. So, generally, stocks should rise as the economy improves and fall as it deteriorates. Non-fundamental factors can trump fundamentals for quite some time, however. One thing should be added at this point. The Surprise Index can rise while the economy is deteriorating if it’s doing better relative to economists’ forecasts.

In the chart below I’ve freshened up the chart–and complicated things by reversing the order of them. The top panel shows the Citigroup U.S. Economic Surprise index, while the bottom panel shows the S & P 500 as a proxy for stocks. I’ve divided the chart into three zones and will proceed to spill more electronic ink than necessary to explain the zones and the possible implications of where we are now, which is zone C.

  • Zone A – in this zone everything is as it should be. The economy is doing better than economists expect. As that plays out economists will be forced to raise their estimates for the economy, which eventually translate into improved overall earnings for companies that comprise the economy.
  • Zone B – all is not right. In this zone economists –for at least three months–overestimate the strength in the economy, yet stocks don’t reflect it, although the flattened trajectory seems to acknowledge that something isn’t right.
  • Zone Cstocks play catch up, as talk of recession heats up. On August, The Economist magazine features the cover below, where recession is lurking just below the surface. Note, though, that in this zone the economic surprise index has turned up.

So, if a falling Economic Surprise Index heralded a decline in stocks, is it possible that a rising index might herald a rise in stocks? Maybe the gradual upward trajectory of the line suggests that a recovery in stocks won’t be vigorous, but if nothing else this should tell us that economic Armageddon or Financial Crisis 2.0 is not yet upon us. That’s sort of how we have portfolios structured at present. Within a modestly overweighted portfolio structure our portfolios are positioned defensively.



Thank you, Sir; may I have another?

Wednesday, December 22nd, 2010

With yesterday’s action, the Dow Jones Industrial Average took out its pre-Lehman Brothers-debacle price level, as can be seen in the chart below.  Not that you care, but I was home on that Monday when the market opened after the news of Lehmans’ declaration of bankruptcy, after months of Alfred-E-Newman-esque claims of adequate liquidity and other stuff.  We were making pear butter after a bountiful harvest that year, but the pit in my stomach sort of spoiled a good time with the kids.

Now that’s a real testimony to buy-and-hold investing.  If you’d only sat tight and done nothing you’d be just fine.  Hopefully, your experience didn’t include any of the casualties of the drop.  That’s one of the problems with buy-and-hold:  the dead bodies don’t talk.  Put more politely, there’s a Survivor Bias.  Only the survivors from the Titanic could tell their stories.  For example, in September 2008–yep, the same September–a couple of companies were removed from the index . . . strike up the Phantom of the Opera music . . . Citigroup and General Motors.

Phwew, glad that’s over.

Trouble is, it’s all happening amidst a huge bout of complacency.

Here are the problem items:

  • Individual investors, as gauged by the American Association of Individual Investors, are as bullish as they’ve been since 2008
  • Investors Intelligence maintains the oldest sentiment survey, its Advisors Sentiment survey, and that one is as bullish as it’s been since 2007′s peak
  • the so-called Fear Index, the CBOE’s index of implied optimism (VIX), is at a multi-year low
  • the ratio of puts:calls transacted at the CBOE is at the lowest levels of 2005
  • the breadth of the advance is narrowing; that is, fewer stocks are participating in the push to new highs; that’s not healthy

Naturally, contrarians cite these as signs of the herd mentality in action, and they embody Warren Buffett’s saw, “be fearful when others are greedy.”  There’s really no problem with any of indicators so long as nothing goes wrong.  However, the market will be ripe for a correction if anything goes wrong.  On the Monty-Python-Meaning-of-Life side of things, I think most of our services view any correction as a buying opportunity for what should be a strong first half of 2010.

12/23/10 Update

I came across the following in a JPMorgan report titled  US Equity Strategy FLASH; Bullish sentiment is not contrarian in a bull market.  I generally agree with the idea.  The herd is usually right until the herd’s sentiment becomes extreme.

Key to sentiment (contrarian or not) was stage of market: Bull or Bear. One thing bothering investors in recent weeks is the seeming rise in bullishness, evidenced by positive 2011 outlooks recently (including J.P. Morgan) and positive sentiment surveys (i.e., AAII survey, or Investors Intelligence). We believe these concerns are misplaced. As shown on Figure 4, sentiment readings take a totally different context depending on the stage of the market—”bull” or “bear.” In bull markets, AAII readings (% bull less % bear) of 0 to +40 have been consistent with forward 6-month gains of 6%-7% while associated with declines of 11%-14% in “bear” markets. This makes sense to us—after all, why is it bad if we acknowledge broadening improvements?

Extreme readings remain high-quality contrarian signals. An AAII reading over 50 (% bulls less % bears) led to declines regardless of bull or bear (see Figure 4). Similarly, AAII readings of -40 or worse saw positive gains of 22% (6-mo forward) regardless of bull or bear. The current reading of 23 (% bulls less % bears) is NOT AN EXTREME READING.


Sentiment update

Wednesday, September 1st, 2010

Sentiment is lousy but I’m too depressed to talk about it . . .


  • Several public surveys show bullishness at very low levels, but . . .
  • Bearish is not at such extremes
  • Insiders are a hopeful sign
  • Much of the September nastiness may already be discounted
  • Bottom line:  sentiment closer to signaling buy than sell



Financial Regulation bill = Sarbanes Oxley?

Wednesday, August 25th, 2010

Way back in 2002, when Sarbanes Oxley was passed, many hoped that it might mark an inflection point in that nasty bear market.  I specifically remember thinking/hearing that the CEO and CFO having to sign off on financial statements might do just that.  According to the internet (it must be true; it was on the internet), here is the timeline of the bill (colors correspond to the vertical lines in the chart below).

  • April 24, 2002 - the House passed Representative Oxley’s bill (H.R. 3763)
  • June 18, 2002 - the Senate Banking Committee passed Senator Sarbanes’ bill
  • July 15, 2002 - the entire Senate grabbed for votes and passed Senate Bill 2673
  • July 24, 2002 - the committee formed to reconcile the House and Senate versions approved the final conference bill.  This marked the first of three final bottoms.

Liberally borrowed from the Wikipedia link above.

Thinking the passage of FinReg might do the same thing, I asked the fine folks at Strategas Research Partners–Dan Clifton, specifically, the firm’s Washington guy–to help us out.

In addition to his comments below on the subject, the firm also provided us with this nice overlay based on when the two bills were approved in Committee.  (The green annotations are mine).  So far, the similarity in the two lines is evident, but as Dan points out below, that was a different time, with the War in Iraq still in the future, etc.

Dan’s comments

Similarities: As you may recall the House and Senate were governed by different parties in 2002. The House, led by Oxley, has a mild plan. The Senate, led by Sarbanes, had a more aggressive plan. President Bush supported the House plan and with the 60 vote threshold required in a 51/49 Senate, investors assumed the more moderate plan would win out. The Senate passed the more aggressive version leading to a stand off between the House and Senate. Worldcom then declared bankruptcy, which occurred in the DC media market, and President Bush asked for a bill and told Oxley to allow the Senate to take the lead. This led to a more aggressive plan (one with higher costs to businesses). The S&P declined into the proceedings. It took more than 3 months later for the S&P to bottom out as investors digested the impact of the bill and investors became more bullish on the potential recovery. It is also important to note this ran into the run up of the War in Iraq which tended to overwhelm the other issues. Financial regulation occurred similar but over a longer period of time. The Worldcom event was the SEC action against Goldman Sachs, which led to more aggressive reforms. We also believe investors are at a similar point in the business cycle, looking for the upturn becoming self sustaining.

 Differences: Financial regulation is more than 2,300 pages and we are still finding provisions we did not know existed. Sarbox was 60 pages and the main provision impacting cost was a couple of sentences. The financial regulation bill also outsources the details to regulators and spreads out the timeline in some cases as long as a decade. There will be continuing uncertainty but over time the banks can adjust to the costs.


A potentially huge accounting change

Wednesday, August 25th, 2010

The Economist featured a story in this week’s magazine–or as the Brits call it, newspaper–on a proposed accounting change. It was proposed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) on August 17, and it focuses on how leases are characterized.

Here’s the short-term version of lease characterization–and I’m playing loosey-goosey with this, too (if you’re an accounting type, feel free to clarify or correct by adding a comment below.) Basically, by having or not having certain characteristics–a bargain purchase option comes to mind–a lease can be characterized as operating or capitalized.  That’s a critical difference, as an operating lease doesn’t show up on the balance sheet, per se, nor does the asset that’s being leased.  A capitalized lease, in contrast, is considered long term debt, with an associated asset on the balance sheet, and that can have huge implications in corporate finance and investing.

The Economist cites a Pricewaterhouse Coopers study that, “found that it would add about 58% to the average company’s interest bearing debt.”  Rent is paid on an operating lease while principal and interest are paid on capitalized leases.  Those two items are found in different places on the financial statements:  rent is part of operating income; principal and interest payments are not.  “On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards.”  Also, that, “since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge.”

Thanks to Dave Whisler, CPA, for pointing out that, “one more consideration is that in many situations companies that in the past had been in compliance with their debt covenants will now be violating them. This means that banks and their borrowers will be in a different world than they are this year. You still have the same benchmark (debt covenant) but you are calculating ratios such as debt to equity using different components than what was used when the loan was originated.”

Here’s an example of one company that would be very affected.  Walgreens (WAG), along with most other retailers, owns none (again, loosey-goosey) of its store buildings, but occupies them with operating leases; thus, there is no debt related to buildings on the company’s balance sheet.

A close look at its SEC 10-Q filing shows that its long-term debt is $2.35 billion (see below; click to enlarge).  That gives it a very modest 13.5% long-term debt to capital ratio.  Its operating leases, however, total $36.4 billion.  A portion of that ($2.2  billion) is due in the next year and is considered a current liability, so long-term debt should be $34.2 billion (36.4 – 2.2) higher.

Complete table below.

Suddenly, a company conservatively positioned–i.e. with low leverage–is outrageously leveraged at 2.08x–or on an equivalent basis, 208%!

Unfortunately, the operating lease information is buried in the notes to the financial statements, which means that one can’t screen for high or low operating leases.  It requires going through each company’s 10Q and searching for the data.

As our newest-minted earner* of the Chartered Financial Analyst† designation, Zach Higgins, pointed out, this shouldn’t be news to the analysts.  They should have looked through to the notes and seen the financial impact.  Zach’s right if the analysts do their jobs, but the same should be able to have been said about options expensing, and yet that produced plenty of softness in the big option issuers.

*  Technically, Zach needs another year of experience before he can be a holder of the coveted designation.

†  Just in case any one from the CFA Institute is trolling the internet looking for degredations of the integrity of the charter, Zach will not be a CFA.  Instead, he will be a holder of the CFA® designation.

One would think that at least the cashflow impact would be nill since the cash effect of the reclassification is zero:  the companies are still going to make the same payment.  In fact, the statement of cash flows will be different.  The statement is divided into three parts:

  • Cash from operating activities
  • Cash from investing activities
  • Cash from financing activities

The cashflow associated with the operating lease is shown as an outflow in the operating section.  A capitalized lease’s cashflow is shown as a cash outflow in the financing section.  The operating section is considered the core of the business, since it represents what the company is set up to do (i.e. operate, sell books or machines or whatever).  The financing and investing sections represent the way the company funds its operations.

So here’s the bottom line.  Reclassifying from operating to capitalized will do the following:

  1. Make operating earnings look better
  2. Make operating cashflow look better; total cashflow will be unchanged
  3. Make a company appear more levered