8/6/21: This Recession Is Different: Corporate Profits Boom

 

Corporate profits guidance is booming. Which, one might think, is a good signal of recovery. But the recession that passed (or still passing, officially) has been abnormal by historical standards, shifting expectations for the recovery to a different level of 'bizarre'.

Consider non-financial corporate profits through prior cycles: 

Chart 1 above shows non-financial corporate profits per 1 USD of official gross value added in the economy. In all past recessions, save for three, going into recession, corporate profit margins fell below pre-recession average. Three exceptions to the rule are: 1949 recession, 1981 recession and, you guessed it, the Covid19 recession. In other words, all three abnormal recessions were associated with significant rises in market power of producers over consumers. And prior abnormal recessions led to subsequent need for monetary tightening to stem inflationary pressures. Not yet the case in the most recent one.

The second chart plots increases in corporate profit margins in the recoveries relative to prior recessions. Data is through 1Q 2021, so we do not yet have an official 'recovery' quarter to plot. If we are to treat 1Q 2021 as 'recovery' first quarter, profits in this recovery are below pre-recovery recession period average by 2 percentage points. Again, the case of two other recessions compares: the post-1949 recession recovery and post-1980s recovery are both associated with negative reaction of profits to economic cycle shift from recession to recovery.

Which means two things:

1. Market power of producers is rising from the end of 2019 through today, if we assume that 1Q 2021 was not, yet, a recovery quarter (officially, this is the case, as NBER still times 1Q 2021 as part of the recession); and
2. Non-financial corporate profits boom we are seeing reported to-date for 2Q 2021 is a sign not of a healthier economy, but of the first point made above.

In effect, some evidence that Covid19 pandemic was a transfer of wealth from people to companies that managed to trade through the crisis. 

3/5/21: Margin Debt: Things are FOMOing up...

 Debt, debt and more FOMO...

Source: topdowncharts.com and my annotations

Ratio of leveraged longs to shorts is at around 3.5, which is 2014-2019 average of around 2.2. Bad news (common signal of upcoming correction or sell-off). Basically, we are witnessing a FOMO-fueled chase of every-rising hype and risk appetite. Meanwhile, margin debt is up 70% y/y in March 2021, although from low base back in March 2020, now back to levels of growth comparable only to pre-dot.com crash in 1999-2000. Adjusting for market cap - some say this is advisable, though I can't see why moderating one boom-craze indicator with another boom-craze indicator is any better - things are more moderate. 

My read-out: we are seeing margin debt acceleration that is now outpacing the S&P500 acceleration, even with all the rosy earnings projections being factored in. This isn't 'fundamentals'. It is behavioral. And as such, it is a dry powder keg sitting right next to a campfire. 

17/9/20: Stonks are Getting Balmier than in the Dot.Com Heat

Via Liz Ann Sonders @LizAnnSonders of Charles Schwab & Co., Inc. a neat chart summarizing the madness of the King Market these days:

Yeah, right: PE ratio is heading for dot.com madness levels, PEG ratio (price earnings to growth ratio or growth-adjusted PE ratio) is now vastly above the dot.com era peak, and EPS is closer to the Global Financial Crisis era lows. 

What can possibly go wrong, Robinhooders, when a mafia don gifts you some chips to wager at his casino?

6/5/20: S&P500 Earnings and Revenues Growth 1Q 2020

With early effects of COVID19 pandemic in:

Both charts via Factset.

24/3/20: Q2 2020 S&P 500 Earnings Outlook: Not As Ugly as It Will Be

Per Factset March 23 report, "the aggregate earnings growth rate for Q2 2020 changed from slight year-over-year earnings growth on March 12 (+0.8%) to a slight year-over-year earnings decline on March 13 (-0.7%)." Note: back at the end of January 2020, the expectation was for y/y growth of 5.9 percent. Worse, "expectations for earnings growth for Q2 2020 have been falling over the past few months. On September 30, the estimated earnings growth rate for Q2 2020 was 8.0%. By December 31, the estimated earnings growth rate had fallen to 5.7%. Today, the estimated earnings decline is -3.9%."

"Four of the 11 sectors are now projected to report a year-over-year decrease in earnings for the second quarter: Energy (-68.4%), Consumer Discretionary (-14.4%), Industrials (-9.9%), and Financials (-7.4%)."

All of that, before the second half of March kicked in...

10/1/19: QE or QT? Look at the markets for signals

With U.S. Fed entering the stage where the markets expectations for a pause in monetary tightening is running against the Fed statements on the matter, and the ambiguity of the Fed's forward guidance runs against the contradictory claims from the individual Fed policymakers, the real signals as to the Fed's actual decisions factors can be found in the historical data.

Here is the history of the monetary easing by the Fed, the ECB, the Bank of England and the BOJ since the start of the Global Financial Crisis in two charts:

Chart 1: looking at the timeline of various QE programs against the Fed's balancesheet and the St. Louis Fed Financial Stress Index:

There is a strong correlation between adverse changes in the financial stress index and the subsequent launches of new QE programs, globally.

Chart 2: looking at the timeline for QE programs and the evolution of S&P 500 index:

Once again, financial markets conditions strongly determine monetary authorities' responses.

Which brings us to the latest episode of increases in the financial stress, since the end of 3Q 2018 and the questions as to whether the Fed is nearing the point of inflection on its Quantitative Tightening  (QT) policy.

26/12/15: A Trendless World of 'Recovery'?

Anyone watching financial markets and economics in 2015 would know that this year was marked by a huge rise in volatility. Not the continuous volatility along the established trend, but a 'surprise' volatility concentrated on the tails of distributions of returns and growth numbers. In other words, the worst kind of volatility - the loss and regret aversion type.

Here are two charts confirming the said pattern.

Starting with asset classes:

Source: BAML

In the 'repaired' world of predictable monetary policy with well-signalled forward guidance, 2015 should have been much calmer, as policy surprises were nowhere to be seen (Bank of Japan continued unabated flooding of money, while ECB embarked on its well-in-advance-flagged QE and the Fed 'cautious rates normalisation' switched was anticipated for months, amidst BOE staying put, as predicted by everyone every time London committee met). Alas, that was not the case and 2015 ended up being a year of more extreme shifts into stress than any other year on record.

Likewise, the U.S. economic growth - the most watched and most forecasted series in the global economy - produced more surprises for forecasters:

Source: Goldman Sachs

Per above, 2015 has been a second consecutive year with U.S. GDP growth surprising forecasters to the downside. Worse, yet, since 2001, U.S. GDP growth produced downside surprises compared to consensus forecasts in 12 out of 15 years.

In the past cycles, the early 1990s recession produced an exit from the downside cycle that resulted in 2 consecutive years of upside surprises in growth; for the exit from the 1980s recession, there were five consecutive periods of upside growth relative to the forecasts. Even in the horrific 1970s, the average forecast over-optimism relative to outrun was closer to zero, against the current post-recessionary period average surprise to the forecast being around -0.5 percentage points.

In other words, if you need a confirmation that four years after the 'recovery' onset, the world of finance and growth remains effectively 'trendless', have another look at the charts above...

Renewing appetite for risk?

“I have some good news, at least for the intermediate term: Investors are slowly regaining their appetite for risk”, wrote Marketwatch’s Mark Hulbert in his today’s column (here)
“This represents a big shift from the situation that prevailed last fall, when investors became so repulsed by any kind of risk that the yields on safe-haven investments like Treasury bills actually went negative.”

But now, says Hulbert, with January effect in full swing, things are looking up – investors are looking for risk once again.

“Of the several straws in the wind that point to at least a partial return of a risk appetite, one of the more compelling is the recent relative strength of risky small-cap stocks over the more conservative large caps. So far this year through Tuesday night, for example, large-cap stocks (as measured by the Standard & Poor's 500 index (SPX: S&P 500 Index) have fallen 3.5%. Small-cap stocks, as measured by the Value Line Arithmetic Index (92040310), have declined by just 1.1%.”

Now, I am not convinced by Hulbert’s main argument.

January effect is a tax-minimization event, driven by heavier sales of shares with lowest capital gains potential to maximize losses in December (blue chips down) and re-balancing portfolio toward higher capital gains potential (small cap) in the new year. In normal years, movements correlate positively with risk, i.e. small cap – higher expected return, higher risk, blue chip - smaller expected returns, lower risk. But is that the case this time around? In other words, the markets might be going into smaller cap because the larger cap is actually relatively riskier (controlling for current valuations), not because they are seeking higher risk-return strategies.

Chart below illustrates Mark Hulbert’s point – at its right-hand margin. Indeed, the short-term performance by the two indices does suggest that the markets are placing more faith in the small-caps. But it shows that this was true for much of the 2008 with exception of the late autumn. In other words, if current divergence vis-à-vis S&P is a sign of new appetite for risk, what did the market have appetite for in July 2008 when small caps went up and S&P stayed relatively flat? Why did the price of risk implicit in the difference in two indices has fallen in April-June and July-early August? Were these the ‘turning’ points in underlying appetite for risk or just traditional bear rallies?
An alternative explanation for the ‘January effect’-like pattern observed is that investors' risk perception might have shifted. Consider the following scenario: You are in a market with four broad asset classes:

• large-cap,
  
• small-cap,
  
• corporate bonds and
  
• Treasuries.

You believe that too much risk-taking has taken place in the second half of December by pursuing a bear rally in S&P500 stocks and the Treasuries. If you move into relative safety, you will move into the two remaining assets. You will have an incentive to prefer the small caps if you believe that they have taken the heaviest beating to date (which they did – see peak to trough moves around September-mid November) and you invoke another powerful anomaly of the ‘Winner’s Curse”. The real question then becomes is what does the analysis of relative position changes in corporate debt and small cap shares tell us. The large cap stocks are irrelevant here.

Hence, what appears to be a renewed appetite for risk can be interpreted as a hedging strategy against rising risk levels and falling expected returns in the so-called traditionally ‘safer’ asset classes.

What Hulbert is right about is that one should not overplay the story too much. Instead, the return of the January effect pattern (or something else resembling it) might mean “that the stock market will gradually resume its normal function of assessing different securities' relative risks and returns, a function it couldn't fulfill when it was indiscriminately punishing virtually everything other than Treasuries.”

Yes, but… even if Hulbert is correct, the return to rationality in the markets will be bound to:
• trigger fresh downgrades in many companies and indices as corporate returns deteriorate throughout H1 2009, as the bath water gets muddier with longer recession; and
• this rationality will remain extremely fragile and prone to collapse every time the elephant in the room – the US Government – moves about.

Hulbert omits the latter issue, but it is non-trivial to his topic. We are in the changing political cycle – and with it – a prospect of a new stimulus that is bound to prop up smaller business. If, as is the case, Uncle Sam’s rescue packages for many blue chips were already priced into these companies valuations in late December, Obama's first 100-day sweetheart package for Congress is yet to be fully priced into stocks valuations. It might be that the ‘January effect’ is simply the reflection of this delay in recognizing that the next Uncle Sam's move will a stimulus for smaller companies?..