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Earnings anxiety picked up considerably three weeks ago with the Brexit vote. The concern was that large multinational corporations would use the "Brexit ate my homework" excuse to argue that there would be greater uncertainty in the second half of the year, and imply that earnings estimates would need to come down.
It's still early — only 11 percent of the S&P 500 has reported as of this morning — but three weeks after the Brexit vote there has been surprisingly little heard about an increase in global volatility. And that is one reason markets have held up so well.
And while second quarter earnings still appear to be negative, the numbers have been improving fast.
Come on, admit it: you didn't think we'd hit historic highs this week, did you?
I didn't. I expected post-Brexit caution would color the bank commentary (but it didn't happen), in-line economic stats (but Retail Sales and Industrial Production were well above consensus), and a continuing cautious IPO market (but the biggest IPO of the year opened up better than 25 percent, and 5 additional companies announced they would be going public soon).
The biggest surprise was the bank earnings commentary. They all beat, and while there was the usual concern about net interest income being soft to the flatter yield curve and low rates, the other trends were all positive.
Credit is improving. Loan growth is improving. And—most surprising of all—guidance was steady.
And there was surprisingly little commentary on Brexit, even from Citigroup.
What's next? We need to hear from companies outside the banking space.
I want to hear from big Technology companies like Microsoft, which reports on Tuesday and which gets 55 percent of its sales outside the U.S., including nearly 10 percent from mainland China. I want to hear about global electronics and cell phone sales trends from Intel on Wednesday, which gets 80 percent of its revenues outside the U.S., including 20 percent from mainland China.
And I want to hear from a big Industrial like General Electric, which reports on Friday, which gets 55 percent of revenues outside the U.S.
I wouldn't be surprised to see some kind of pull-back next week. We are seeing a modest pullback today in banks, which is very typical immediately after bank earnings season begins.
But if the commentary for stocks like Microsoft, Intel, and General Electric avoid the need for analysts to notably cut earnings expectations for the second half, I would expect any pullback to be rather short and shallow.
AdvancePierre Food Holdings capped a good week for the IPO markets. They priced 18.6 million shares at $21, the middle of the price talk of $20-$23, and opened at $23.50. That's a respectable opening for a food company, particularly following the success of US Foods in late May.
AdvancePierre is following a typical pattern for IPOs this year: investors want companies that are profitable or have a clear path to profitability. The company is indeed profitable, enough to pay a dividend of 2.6 percent at the midpoint of the price range.
It caps a strong week for IPOs, and it's about time. As I've said time and time again, the most important determinant of the health of the IPO market is the state of the overall stock market. With the S&P 500 at historic highs, the IPO business is running out of excuses.
Line's strong debut yesterday, up 27 percent, has a lot of IPO watchers finally declaring the long IPO winter over.
"The success of Line is sending a clear message that the IPO market is open for business," Kathleen Smith of Renaissance Capital told me.
They run the Renaissance IPO ETF (IPO), a basket of the 60 most recent IPOs, which is up 22 percent since the February 11th bottom, outperforming the S&P 500's roughly 17 percent gain.
It's not just Line--while there have been far fewer IPOs than normal this year (44), they have produced an average return of 18 percent, a respectable showing.
And the big-name IPOs have had surprisingly strong returns:
(from initial price)
Twilio: 178 percent
Acacia Communications: 128 percent
BATS Global Markets: 36 percent
MGM Growth: 26 percent
Line: 23 percent
US Foods: 9 percent
SecureWorks: 6 percent
Line, MGM Growth, and US Foods are the three largest IPOs of the year, and the fact they have had such strong showings will encourage others to step forward quickly.
Smith noted that on Monday, five roadshows launched--more than we've seen in a single day all year.
Next week, we get Patheon, the world's largest contract drug manufacturer (it would be the fourth largest IPO this year), and the week after Talend, which helps companies standardize big data bases. Talend would be the second enterprise software company to go public after Twilio.
How about those Silicon Valley unicorns waiting to public? A lot of interest is focused on Spotify. They completed a $1 billion convertible debt offering at the end of March. The interest rate is 5 percent, but the rate increases 1 percent every six months until it reaches 10 percent or until they conduct an IPO.
That sounds like a pretty strong impetus to go public.
But how to describe the surprising rally of the last week, when the U.S. has shrugged off post-Brexit worries and blasted to new highs?
An informal survey of traders this morning produced a series of suggestions, including several expressing disbelief, from MMTB (More Money Than Brains) to "The Everything Rally," kind of like an everything bagel, but for stocks.
There's something to the idea of an "everything" rally, but most traders identified three specific reasons driving the rally, and suggested acronyms to describe it:
1) FEBB: FOMC, ECB, BOJ, BOE. Central bank liquidity. The majority voted for central bank liquidity as the primary driver of the rally, and who can blame them? There's talk of "helicopter money" in Japan. Of bailouts of Italian banks. Of more bond buying by the ECB. Of rate cuts in the UK.
2) TINA: "there is no alternative" to stocks. Stocks are the better buy. This acronym, already old, has been much derided recently. There is always alternatives to stocks, like bonds, cash, and gold. This is true but not interesting. The marginal buyer looks at the low rates on Treasuries, and the comparatively high dividend yields on stocks, and rationally concludes that stocks are a better buy. Throw in the mostly improving U.S. economic data—which, however sluggish you may describe it, is better than the rest of the world--and you have the additional stimulus of foreign money pouring into our U.S. stock and bond markets.
3) FOMO: fear of missing out. Lagging performance: marginal buyers (hedge funds, active traders) are again surprised by the rally and need to catch up.
But my favorite—suggested by several baffled traders—was this one:
4) The Pokemon rally: all fluff, no fundamentals. This rally in stocks is not really being fueled by fundamentals, so nobody knows how long it will last.
Let me quickly address two other reasons that have been put forth for the market's advance:
1) Stock buybacks have greatly reduced the amount of stock available to trade. This is widely believed, but not true. In 2005, the "float" (the amount of stock freely available to trade) of the S&P 500 was 299.8 billion shares, according to S&P Capital IQ. Today, it's 298.2 billion shares, essentially unchanged. And that includes stock splits!
Huh? What happened to all those buybacks? It's important to distinguish between buybacks and share count reductions. Most buybacks do not result in share count reductions because the buying is offset by corporations issuing new stock, mostly in the form of options, to employees. Several companies—such as IBM and ExxonMobil—did buy back more stock than they issued and have notably reduced their share counts, but they are in the minority.
2) There's a lot fewer companies that are public than 20 years ago. There's some truth to this. According to S&P Capital IQ, In 1997, there were 5,316 companies in 1997 with a market capitalization above $50 million. Today' there's 4,370, a drop of almost 20 percent. But as I noted above the amount of stock available to trade for the largest companies haven't changed much.
What has changed dramatically is the price of stocks. The average S&P 500 stock was $51 in 1997, only $52 ten years later at the end of 2007, and $86 today. So every time we trade, we're moving around more money than a decade ago.
The S&P 500 is at a new high, but it has been there all year, once you factor in dividend gains of roughly 2.2 percent.
The S&P hit record highs 10 times in 2016, once dividends are factored in, according to Dan Wiener, the President of Advisor Investment Management and editor of the Independent Advisor for Vanguard Investors.
How important are dividends? They account for half of the S&P's total returns over long periods of time, according to Wiener. Since 1988 the S&P 500 index is up about 720 percent while the S&P Total Return index has gained about 1,450 percent.
Think about that. Your actual returns on owning the S&P 500 are twice what the price index indicates since 1988, if you reinvested the dividend.
And ETFs that are dividend-weighted have been hitting new highs as well, as Luciano Siracusano, Executive Vice President and Chief Investment Strategist at Wisdom Tree, has pointed out to me.
All five of the Wisdom Tree U.S. dividend-weighted ETFs listed below made all-time highs yesterday:
WisdomTree Total Dividend: Exposure to the entire dividend-paying part of the US market
WisdomTree LargeCap Dividend: Large-cap
WisdomTree MidCap Dividend: Mid-cap
WisdomTree SmallCap Divdend: Small-cap
WisdomTree High Dividend: High dividend yielding
The DTD, for example, is tied to a dividend-weighted index that reflects the proportionate share of the aggregate dividends each component company is projected to pay in the coming year. The biggest holdings are ExxonMobil, AT&T, Verizon, Microsoft, and Johnson & Johnson. Current dividend is 3.06 percent.
By the way, the search for yield continues in the bond market as well. The largest corporate bond ETF —the iShares Investment Grade Corporate Bond ETF, took in $1.1 billion of new funds on Thursday. That's its biggest daily inflow ever and the largest ever recorded for a corporate bond ETF.
Will the first quarter be the trough in earnings? Second quarter earnings season will again see negative growth for the S&P 500, the fifth consecutive negative quarter (the worst showing 2008-2009).
Earnings "bulls" are arguing that the direction of earnings is getting "less bad" and indeed will soon turn positive. The amount that earnings have gotten cut in the second quarter is not as bad as the first quarter, and the amount earnings have been cut in the third quarter appear to be less bad than the second quarter.
There's some truth to this: second quarter earnings are an improvement over the previous quarter (now expected to be down 5.4 percent, versus 7.3 percent for the first quarter, according to Factset), and third quarter may go positive, with fourth quarter projected to be up mid-single digits.
Bulls keep harping on this slow improvement and insist that the earnings "trough" was in the first quarter.
Truth is, earnings are still pretty lousy. Only four sectors are expected to report positive growth in the second quarter, according to S&P Capital IQ, led by Consumer Discretionary which is expected to be up over 9 percent.
That's not a big surprise. We know the consumer has been doing well.
Some industrials are expected to do well, with companies like General Electric and Boeing expected to post strong earnings. There's also some modest 3 percent growth likely from health care and utilities.
But that's the extent of the good news. Financials are going to be down almost 9 percent, and energy earnings are still awful, down 80 percent, though that is an improvement over the first quarter's down 106 percent.
This is all supposed to start turning around in the third quarter. As I mentioned, in the second quarter, only four sectors are expected to report positive earnings. In the third quarter, eight sectors are expected to be positive, with only energy (down 53 percent) and telecom (down 1.8 percent) expected to be in negative territory.
And the numbers get even stronger in the fourth quarter.
In other words, a lot has to go right for the earnings recession to end.
Bears insist that issues like higher labor costs and Brexit fallout (stronger dollar, lower rates) will derail hopes of the long-sought earnings expansion.
First, we have to have a perfect scenario where rates stop dropping and gently rise. It has to rise enough to help banks but not enough to bother other sectors.
Sound like a tall order to you? It does to me.
And what about the dollar? It rallied immediately on the Brexit news, and it's likely we will hear about that in the earnings commentary. When this happened at the end of last year, multinational U.S. companies took note because they were less competitive in the global marketplace.
So the parameters of the debate are pretty simple: where do you stand on the dollar and on interest rates? Much of this depends on where you stand on inflation. If you believe we are miles from the Fed's target of 2 percent inflation and will be for a long time, you're probably bearish on the dollar and expect bond yields to remain low.
Finally, there's oil. There is a very high correlation (0.93, according to S&P Capital IQ) between oil (West Texas Intermediate) and energy stocks. For the second half of the year, energy analysts are modelling in higher earnings based largely on: 1) production stability, and 2) steady and in some cases slightly higher oil prices. You can see this in the earnings estimates:
S&P 500 Energy Sector
Q1: $0.35 loss
Source: S&P Capital IQ
Lower oil is not modeled into this scenario.
Get my point? A lot has to go right to end this earnings recession.
One final point — it's true that the stock market does not always correlate to earnings growth. It isn't now, largely because of outsized stimulus measures. But don't kid yourself — in the long run the trajectory of earnings has always mattered in the valuation of stocks.
Oil markets have closed out a wild day.
The EIA put out its (delayed) weekly inventory levels, and to make a long story short, there was a draw-down in oil inventories, but it was much less than most expected. Gasoline inventories barely budged.
The oil market reaction? West Texas Intermediate (WTI) oil went from roughly $48 to $45, a drop of 6 percent, in two hours. It's now at its lowest level in nearly two months.
Now I understand there may have been some disappointment with the inventory levels, but there is nothing fundamental that would drive oil from $48 to $45 in 2 hours. This is clearly the work of speculators who were long oil who are now unwinding positions.
It's the latest Wall Street parlor game: parsing the effect of Brexit on the U.S. economy.
While the effect on U.S. stocks has been fairly muted so far, with the S&P 500 down only roughly 1 percent since the vote, we can already see broader effects on the global economy. Notably, we have seen tighter financial conditions, some bank contagion, and some dramatic currency moves, with the British pound down 13 percent against the dollar, and the yen up 5 percent.
But there's one other effect of Brexit that has been little discussed: The effect on direct foreign investment in the U.S.
I'm not talking about buying or selling U.S. stocks or bonds. Those are indirect investments. Direct investments are when a foreign company sets up a subsidiary in the U.S., or merges with a U.S. company, or engages in a joint venture.
In 2015, the U.K. was the largest single source of foreign direct investment in the U.S. It accounted for $483 billion of the $3.1 trillion in foreign direct investment in the U.S. that year. That's about 16 percent of all foreign investment.
Brexit may have slowed global markets, but the initial public offering (IPO) business is continuing to recover. May had a measly 8 filings, but a flurry of filings at the end of last week brought the June total to 17. We already have two for July.
On Monday, Japanese messaging app Line increased the price range of its IPO, the first IPO of the year to do so. It will be the biggest IPO of the year when it begins trading in the U.S. next Thursday.
The price talk is now 35 million shares at 2,900 to 3,300 yen, or about $30.50 at the midpoint, up from 2,700 to 3,200 yen.
That is a billion-dollar IPO, folks.
The road show is reportedly going very well, and there is talk the book could close as early as today. One unusual aspect of the Line IPO: the procedure follows Japanese rules. So it will be pricing Monday night, but not trading in the U.S. until Thursday, and not trading in Tokyo until Friday (this is a dual listing). That means it will not trade until three days after it prices, which introduces significant price risk for the IPO — but those are the rules.
Line is getting all the attention, but there are plenty of other IPO players entering the game. Yesterday AdvancePierre Foods Holdings, a major food manufacturer, announced terms and will likely begin trading next Friday at the New York Stock Exchange under the symbol "APFH."
It's a substantial offering: 18.6 million shares at $20 to $23, which is a $400 million IPO at the midpoint (the average IPO is roughly $100 million). This is an Oaktree Capital-backed leveraged buyout, created when Oaktree merged Pierre Foods and Advance Brands in 2010.
Several well-known consumer names have filed recently. Last Friday, Yeti Holdings filed to raise up to $100 million. Yeti makes coolers and outdoor gear. Don't laugh: It had sales of $608 million for the year ending March 31. That's a lot of coolers.
Acushnet, which makes Titleist golf balls and other golf equipment, filed for a $100 million IPO that will likely be increased. It booked $1.5 billion in sales for the 12 months ended March 31.
After Twilio's blowout debut, French-based data integration platform Talend filed last week. It simplifies the process of aggregating multiple data sets for analysis. Competitors include Informatica and Tibco, as well as more traditional enterprise software vendors like IBM, Microsoft, Oracle and SAP. Customers include AOL, Citi, GE Healthcare, Groupon, Lenovo, Orange, Sky and Sony. Silver Lake is a backer.
There's a surprising lack of small biotech IPOs among the recent filings, but there was a filing from Medpace Holdings, a contract research organization that provides research services to the pharmaceutical and biotech industries.
Finally, here's a surprise: Centennial Resource, an oil and gas exploration and production (E&P) company based in the Permian Basin, has filed for a $100 million IPO. You can see the effect the oil collapse has had on these small E&Ps: revenue went from from $24.1 million in the first quarter of 2015 to $15 million in the first quarter 2016. Sales are small, but just the fact that we have an E&P IPO is a sure sign some of the deer-in-the-headlight fear that gripped the oil markets in the early part of the year has let up a bit.
This is the first energy IPO since Sunrun in August, 2015, but that was a solar company. Green Plain Partners, another MLP, this one for ethanol, was in June of last year. There were a few midstream (pipes) IPOs around this time, as well.
You have to go back to August 2014 when Independence Contract Drilling, which provides rigs for E&Ps in the Permian Basin, went public. That's the last driller or E&P company that went public.
Bottom line: There hasn't been an E&P-related IPO in almost two years!
What will be the main theme in the second half of 2016? It's all about "TINA" vs. earnings/ valuations.
Besides determining if Brexit is a long-term problem for U.S. stocks or a short-term blip, the main issue is the tension between investors who believe that with rates lower for longer, "there is no alternative" to owning stocks (TINA) and those who believe valuations and earnings estimates remain way too high and that the market will correct lower as soon as the majority realizes this. So, who's right here?