The Signs of Trouble in Financial Markets

Good news from the Financial Times:

Earnings of companies listed on the S&P 500 index are expected to rise by 0.63 per cent from the same period in 2015 — not exactly a dazzling rise, but still an improvement from the 1 per cent decline that was projected before the earnings jamboree kicked off.

We say good news, although it flies in the face of your editor’s claims of an impending recession.

It also flies in the face of the chart we’ve shown you time and again in Port Phillip Insider over the past year. You know the one. If you don’t, because you’ve either forgotten or it’s the first time you’ve seen it, here it is again:

US S&P 500 Index


Source: Bloomberg
[Click to enlarge]

The chart shows historical and forecast earnings for companies in the US S&P 500 index.

The white line to the left of the green line shows historic earnings. The white line to the right of the green line shows forecast earnings.

The important thing to note is that earnings have declined since the end of 2014. Yet the forecasts continue to represent growing earnings.

Not just a small earnings increase, either. For S&P 500 companies to meet analysts’ forecasts, earnings will have to grow 19.7% over the coming year.

Is that possible? Sure, anything is possible. Is it probable? Not in our view. Not when, as the FT notes, earnings are on track to rise 0.63% compared to the same period last year.

In other words, if earnings per share are to increase by 19.7% over the next year, growth will have to be 30-times greater than the growth for the current quarter.

You get our point. We don’t see it happening.

Furthermore, we’ll enter into evidence the earnings results of a giant of the US economy, General Electric Co [NYSE:GE].

For most of its history, General Electric was an industrial giant. Big in trains, turbines, engines, and business and household electrical appliances.

But then the business changed. It changed from an industrial company into a financial services company.

To the extent that, by 2007, GE’s financial services division, GE Capital, accounted for US$56.5 billion (45.2%) of the company’s gross revenue.

It’s no wonder that the GE share price fell 84% from the peak in 2007 to the trough in 2009. Investors priced GE as a financial stock, not an industrial stock.

Don’t get us wrong, industrial stocks fared poorly, too, but not to the same extent as financial stocks.

As the market turned, the GE stock price turned higher, too. It was, after all, a financial stock. Even after a recent dip, the stock price is still up 290% from the 2009 low.

That’s almost on a par with JPMorgan Chase & Co [NYSE:JPM], which is up 330%.

But last year, GE changed. It sold its GE Capital business to Wells Fargo & Co [NYSE:WFC], a US bank. GE has moved away from finance and into the industrial sector again.

Good move? Maybe in the long term. But perhaps not in the short term. There isn’t much doubt that the biggest beneficiaries of low interest rates have been finance companies which get to borrow for next to nothing and then charge individuals and businesses handsome interest rates.

As for the industrial business, as Bloomberg reports, things aren’t looking so good, especially for GE:

General Electric Co. may not grow this year as low oil prices, a strong dollar and a sluggish economy crimp demand for oilfield equipment and locomotive parts, a setback for Chief Executive Officer Jeffrey Immelt as he pursues a sharpened focus on manufacturing.

The stock fell after GE cut its outlook for organic sales growth, projecting the figure would be flat to up 2 percent this year. GE previously forecast an increase of as much has 4 percent.

GE is struggling to demonstrate the benefits of a corporate transformation in which Immelt has refocused on making power turbines, jet engines and oilfield equipment while selling off financial and consumer operations. GE rallied last year, but the stock has been weak in 2016 as investors question whether the company can sustain the momentum amid global headwinds.

To be fair, we should commend GE. It’s doing what people of our ilk would like more businesses to do — focus on making and doing things that actually help the private sector, rather than being a parasite on the economy.

It’s the honourable thing to do. Unfortunately, in this government and central bank manipulated economy, honour doesn’t appear to count for much.

GE’s third quarter revenue of US$29 billion is the lowest since at least 2005. In the third quarter of 2008, GE Capital accounted for US$17.3 billion in revenue; for the third quarter this year, the rump of the GE Capital business accounted for just US$2.6 billion.

That’s a big chunk of revenue to slice out of a business.

Arguably, the ‘new’ GE should be a representative example of the type of company an economy needs.

(By the way, GE is the only stock that has been in the Dow Jones Industrial Average since the beginning (in the late 19th century), so it has a good pedigree.)

That’s why we bring it to your attention. And it’s why we remain bearish on the US and global markets.

We’re not saying that GE is the perfect company, or that it’s without fault. At the end of the last financial year, it had nearly US$200 billion in debt. That’s a big chunk for a US$260 billion market capitalised company.

But we do believe it is representative of the problems facing many US industrial and manufacturing companies.

Companies are finding it hard to grow revenues and profits, because despite (or rather, because of) the trillions of dollars of printed money, capital is being allocated to the wrong places.

Companies that can, and do, produce ‘things’ are competing with other companies that likely wouldn’t exist in a higher interest rate environment.

Anyway, it’s always possible that we’re reading too much into this. But we don’t think so. To us, it’s mounting evidence of a major financial storm that could soon strike the markets.

We continue to be on high alert for a stock market crash.

Eyebrows raised

More signs of trouble? Iron ore stockpiles in China are now at the highest level since late 2014. Chart below:

Iron Ore stockpiles in China


Source: Bloomberg
[Click to enlarge]

Stockpiles, production, and prices vary all the time. So, just as one swallow doesn’t make a spring, a new two-year high for iron ore inventories doesn’t make a market crash.

Maybe not. But it does raise an eyebrow.

Pleading to spend more

Speaking of eyebrows, the Wall Street Journal informs us:

A growing number of investors and policy makers, seeing central banks as powerless to revive an anemic global economy, are championing a resurgence of fiscal spending.

A move away from central-bank-led policy, and toward the use of the government’s taxing-and-spending power to revive growth, would end a years-long economic era and cause upheaval in financial markets.

Investors, among them bond kind Bill Gross, once feared that government profligacy was a death knell for sovereign bonds. Back in 2011, Mr. Gross dumped U.S. Treasurys and declared that U.K. government bonds were resting “on a bed of nitroglycerine.”

Today, he is calling for more government spending.

Sigh.

Your editor isn’t as smart, or as well educated, as Mr Gross, or the thousands of economists who traipse the halls of central banks, merchant banks, and retail banks worldwide.

But we do know something of which these super-educated economists appear not to be aware: If an economy needs the government to spend more (lots more), can it really be in good shape?

Cheers,

Kris Sayce,
Publisher, Markets and Money

Editor’s Note: This article was originally published in Port Phillip Insider.


Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Markets and Money e-newsletter in 2005. He is the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service, Markets & Money.


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