Posts published in February 2015
It was a giddy era, a time of seemingly endless possibilities. At the beginning of 2000, New Media upstart AOL announced a planned takeover of one of the storied blue-bloods of the print world, Time Warner. Silicon Valley was awash in engineers and secretaries alike cashing in their millions in stock options and buying vineyards in Napa Valley. Affixing a “dot.com” to the name could turn just about any run-of-the-mill business proposition into a high-flying multimillion dollar enterprise.
And then it all ended, horribly. The NASDAQ Composite index, home to virtually all the newly-minted Internet hotshots, crashed through record high after record high on its way to 5048, the March 10, 2000 close. And that was the last time NASDAQ ever saw daylight, to paraphrase the movie Titanic’s Rose Dawson. In fact the trajectory of NASDAQ’s rise and fall bears appropriate resemblance to an iceberg, as shown in the chart below.
The Long Road Back
Well, it may have taken 15 years to get here, but the NASDAQ Composite is now poised to put the final coda on the Great Macro Reversal of the 2000s. The S&P 500 and the Dow Jones Industrial Average both surpassed their previous records in 2013. NASDAQ is the third of the so-called headline U.S. stock indexes, the ones that news announcers unfailingly recite in their daily financial news segments. Of course, there is nothing intrinsically special about 5000 or 5048 – a price by any other name is still just a price. But perception often becomes reality, as long-term students of the ways of markets understand. Round numbers and prior highs matter because they are triggers embedded in the bowels of thousands of algorithms. When the trigger activates, the money flows. Momentum doesn’t last forever, but it can lend a tailwind to near-intermediate term price trends.
Not the NASDAQ of Yore
Beyond the “NASDAQ 5000” headlines there are fundamental differences between the index circa March 2000 and that of today. Nowhere is that more clear than in a valuation comparison. At its 2000 peak, NASDAQ sported an eye-popping LTM (last twelve months) P/E ratio of 100. Of course, many of the most popular trades of the day didn’t even have a meaningful “E” to put in the denominator of the equation – they had no earnings to speak of for as far ahead as the eye could see. Investors bought these first-gen Internet companies on a wing and a prayer.
Today’s NASDAQ includes a handful of survivors from the Fall, as well as others that have made an indelible mark on the world since. The top 15 companies by market cap on the index (which collectively account for just under 40% of the total market cap of all 2500+ companies listed on the Composite) are a veritable Who’s Who of the industry sectors at the forefront of U.S. economic growth. Leading the way is Apple, of course, with a $750 billion market cap and a stranglehold on the smartphone industry. Apple’s share of all global operating profits from smartphone sales was an astounding 89% in the 4th quarter of 2014.
The other names in NASDAQ’s elite bracket are likewise familiar, including Internet giants Google, Amazon and Facebook, biotech leaders Gilead and Amgen, mobile chip maker Qualcomm and still-feisty Microsoft. Now, it’s still not a particularly cheap proposition; the average LTM P/E for this top 15 is 29.1 versus 20.5 for the entire index (which in turn is about a 1.15x premium to the S&P 500’s LTM P/E of 17.8). At the same time, though, it is a very far cry from the silly nosebleed valuations prevailing at the turn of the century.
L’économie, c’est l’Internet
In 2000 the Internet still accounted for only a small sliver of real economic activity. Social media had yet to be born, online retailing was still embryonic, and few companies outside the tech sector had any real clue about how the New Economy affected them, beyond the basic effort of putting up a static corporate website. In the span of fifteen years, the Internet has come in from the periphery to envelop practically every conceivable sphere of economic activity. By all appearances, its influence will only grow more pervasive. Now, this of course does not mean that NASDAQ has nowhere to go but up. At some point a significant correction will likely be in the cards. But it seems hard to imagine how a properly diversified portfolio in the second decade of the 21st century could avoid meaningful strategic exposure to the NASDAQ Composite’s leading lights.
The narrative has been the same for the past five years: Europe as the global economy’s new sick person. The ill-fated single currency union, goes the narrative, has joined Japan as the ageing, no-growth patient being kept alive on life support and the jawboning feats of Dr. “Whatever It Takes” Draghi. Divergence is the new normal, with the U.S. economy regaining its growth mojo while the Old Continent slowly sinks into senescence and irrelevance. But narratives don’t last forever, and a few recent data points suggest that this one may be due for a change.
Greece Is Not the Word
The headlines coming out of Europe this week have largely been about the high-stakes negotiations between Greece and its EU policy partners over the terms of extending the financial assistance to the troubled nation which runs out at the end of this month. The story has had plenty of drama, not to mention a bevy of telegenic Hellenic ministers. But the Greek refinancing outcome is likelier than not to be a non-event. Negotiators will probably find a way to do what they do best – defer the final reckoning to another day. Even a so-called “Grexit”, where Greece leaves the single-currency union, would potentially have relatively mild repercussions outside the country’s own borders. Germany’s tough stance in the current negotiations belies a mood of serenity should that be the result.
The Purchasing Managers Speak
No, the interesting news in Europe this week comes in the rather bland form of a monthly reading of the Eurozone Purchasing Managers Index. The PMI serves as a proxy for the pace of business activity in both the manufacturing and the services sectors. A reading over 50 indicates expansion, while a number below that threshold suggests that business activity is contracting. The reading this month came in at 53.5, a solid uptick from the previous month and the third month in a row of gains. According to Markit, the publisher of the Eurozone PMI, the pace of activity indicates that Eurozone real GDP is likely to grow at approximately 0.3% for the quarter, or an annualized rate of 1.2%. That may not sound like much, but for an economy that has mostly seemed to be on the brink of falling back into recession, it is manna from heaven.
Riding the Currency Tailwinds
These recent economic readings align with a potential narrative we at MV Financial floated in our annual market outlook last month; the recent dramatic fall in the euro could be a catalyst for regional growth, at least in the short term, by making Eurozone exports more competitive. Indeed, the two big winners in the PMI report are Germany and France, who also happen to be the continent’s largest value-added exporters. This suggests that the euro’s 19.4% peak to trough decline (52 weeks), illustrated in the chart below, may be starting to show up on corporate balance sheets.
Make no mistake, it’s not all roses and honey for the Eurozone. The region still suffers under double digit unemployment and listless wage and price trends. Policymaking organs suffer from structural inefficiencies seemingly designed to ensure gridlock. Another recession is not inconceivable. But the recent numbers are at least a move in the right direction. The ECB’s forthcoming quantitative easing program may provide a further tailwind. Greece or no Greece, this year could mark a positive turn in Europe’s economic fortunes. That in turn would be good news for markets elsewhere.
The collapse in oil prices was arguably the headline economic story of 2014. The malaise carried into January of this year, with prices of key benchmark crudes hitting six year lows last month. A sharp rebound in the first two weeks of this month has observers wondering if the slide is over, and, if so, what that may portend for the months ahead. One interesting development, which will be the focus of this post, is a significant widening of the spread between two of the most widely-referenced benchmarks: Brent crude and West Texas Intermediate crude. Why is this seemingly arcane byway of commodities markets of interest? In our opinion it sheds light on some key supply and demand factors at play that may influence economic and asset market trends as the year winds on.
We normally think of commodities as fungible – one person’s barrel of oil or bushel of wheat is the same as the next person’s. While that is true in the abstract, the reality is that the prices of many commodities are strongly influenced by differentiating factors. Crude oil is a case in point. There are many “flavors” of crude oil, measured chiefly by a range of densities (light to heavy) and sulfur content (sweet to sour). These determine how a given barrel of crude is used – for gasoline, jet fuel, home heating oil etc. The location of crude oil sources also matters. Brent crude, a light-sweet variety, comes from the North Sea between Great Britain and western Scandinavia. West Texas Intermediate is also a light-sweet variety, but as the name would suggest it is produced and traded in the U.S. mid-southwest. The chart below shows the price trends for both benchmarks over the past six months.
Brent and WTI crude are quite similar in terms of density and sulfur content, and so all else being equal one would expect them to trade at or close to the same price. All else is not equal, of course. As the above chart shows, Brent crude has traded at a premium to WTI for almost all of the past six months, and in fact the Brent premium has been a staple feature of the market for a much longer period. However, Brent prices plunged at a faster rate in the final throes of the price meltdown, reaching parity with WTI in the middle of last month. It was a brief parity. In the second half of January Brent oil stabilized while WTI continued to fall to new lows. The percentage spread between the two benchmarks is now more than twice its last six months’ average. A barrel of Brent crude is more than 6% dearer today than on January 1, while WTI crude is about flat year to date. What’s behind this divergence?
Texas Hold ‘Em
Both supply and demand are at play here, but the trend of U.S. oil prices is at heart a supply story. We are producing more oil, at a faster rate, than at any time since the early 1980s. Financial media chatter to the contrary, the pace does not appear to be slacking off despite the global plunge in prices. Last week both crude oil production and inventories reached record levels. And domestic oil production is a captive of home-grown demand; the export of U.S. crude to other markets is prohibited by current government policy. Whatever is left over in the storage tanks after U.S. orders have been filled stays in the tanks. Energy-hungry manufacturing economies in Asia and elsewhere get their stuff from other sources, including the North Sea.
A number of the major exploration & production (E&P) companies have announced plans to delay forthcoming U.S. drilling projects, and that may help provide more price support down the road. And there is a reasonable possibility that the export ban may weaken or be eliminated in the not too distant future, which would open new sources of demand. But the supply-demand imbalance shows few signs of going away any time soon. If indeed prices have found a structural floor, they may still face significant headwinds in getting anywhere close to the $100-plus levels where it has traded for most of the past five years. Which may not be a bad thing at all; “stable and low” may turn out to be a pretty nice recipe for consumers, businesses and stocks alike.
The job numbers released by the Bureau of Labor Statistics this morning were broadly upbeat for the American labor force. Even wage growth and labor force participation, which have been the “yes, but” metrics in recent months, showed movement in the right direction. There is an important caveat to the good news, of course. If we really are at the juncture where jobs growth puts upward pressure on wages, we are probably closer to that day when the Fed begins raising rates. The question is whether higher growth will trump rising rates as a market driver. The answer to this question will likely give us near-term directional clues to both stocks and bonds.
Year of the Century
2014 turned out to be the best year for jobs growth in the U.S. since 1999 – better than any year during the 2003-07 recovery and capping a steady recovery since unemployment peaked at 9.9% in late 2009. The chart below shows the five year trend in the headline unemployment rate and payroll growth.
Wage growth, as we have noted in recent commentaries, has been patchy for much of this time. But average hourly wages for January grew by 12 cents, bringing year-on-year wage growth to 2.2%. That is not particularly impressive by historical standards, but it does mean that wages are managing to stay ever so slightly ahead of inflation. Add to that a bit of relief at the gas pump, and the case for a pickup in household spending comes into focus. Of course, one month of improved wages does not a trend make. And labor force participation, though up slightly from last month, is still close to multi-decade lows, meaning that there is still plenty of spare capacity. But the overall picture is one where the U.S. shows little sign of getting dragged into a global deflation pandemic.
Your Move, Chairwoman Yellen
Are the January jobs numbers enough to put a rate hike by mid-year back on the table? The yield on the 10-year Treasury is heading back towards 2% after spending most of the year to date well below that threshold. The 2-year note yield, which as a short-term rate will be more closely influenced by Fed policy, is less than 10 basis points away from its 52 week high. The bond market may be reassessing its no-growth-anywhere outlook and coming to terms with a higher likelihood for rate policy action in 2015. It’s too early to write it in the books, though. The Fed meets next in March, and there are plenty of macro data points on tap between now and then (including, yes, another jobs number). Inflation remains below 2%. But unless the growth numbers are all completely illusory, prices will at some point trend upwards, and probably sooner rather than later.
Low Rates Good, Strong Growth Better
While there is no telling how stock markets will react in the day-to-day environment approaching any rate hike, we believe there is a better case to make that growth will, indeed, trump rates as the key market driver. Much of the higher volatility we have seen in the year to date has had to do with uncertainty about growth and the specter of global deflation. That specter will most likely not disappear completely as long as other economies and the U.S. remain on divergent paths. But home-grown organic growth should provide a tailwind in navigating the course through rising rates.
That being said, though, there are upside risks as well. The strong dollar is having a pronounced effect on U.S. corporate earnings. “FX headwinds” is perhaps the most overused phrase on quarterly earnings calls in recent memory. An environment of growth and higher rates could drive the greenback higher still against the euro, yen and other key currencies. That could have a disproportionate effect on large multinational stocks and work in the favor of those enterprises with a smaller global footprint. So while the overall market trend may continue up, this could be a year when judicious stock selection matters more than it has recently.