Light at the End of the Tunnel

by Shawn Narancich, CFAExecutive Vice President of Research

Retailing Blues

Earnings season has all but wrapped up for another quarter, but department store retailers are adding a problematic book-end to a quarter that has generally come in ahead of expectations. Flat third quarter earnings were weighed down by widespread losses in energy and dampened again by the stronger dollar, factors that many investors thought would spare U.S. centric retailers. Following Wal-Mart’s surprisingly weak earnings outlook in October, both Macy’s and Nordstrom came to the earnings confessional this week to report weaker than expected sales and substantially reduced profit forecasts. For Macy’s, its red star seems to be falling, as elevated inventories are forecast to weigh on margins for the company’s most important holiday sales quarter. Despite recent evidence of elevated merchandise levels in traditional retail channels, the subsequent 15-20 percent declines in both retailers’ share prices speak to the traffic challenges afflicting both Nordstrom and Macy’s. Investors long retailing stocks will hope for better news from home improvement, off-price, and specialty retailers next week.

Sales Falling Flat?

Amid increasing concerns about U.S. retailing, news that October retail sales barely budged cast a further shadow on the industry. In our opinion, weakness for select retailers reporting quarterly numbers speaks more to their distribution strategies and product mix than to any deeper concerns about the health of U.S. consumers. Shoppers are buying more of what they want and need online at Amazon.com, disadvantaging traditional bricks-and-mortar retailers that lack the cars, footwear, and food that consumers still want to see and trial firsthand before they buy. Also at work are the weather and the dollar. A mild fall has hurt department store retailers’ apparel sales and the strong dollar has deterred foreign visitors from taking American shopping sprees. Notwithstanding company specific retailing challenges, we continue to believe that a healthy job market, low gas prices, and low interest rates support domestic consumption and will be a tailwind for the U.S. economy.

Oil -- Down but not Out

In addition to the hit that retailers took this week, energy stocks again took it on the chin as oil prices retest August lows. Refineries are going through what’s called the turnaround season, a time of reduced product output that coincides with a change in product emphasis from summer gasoline to winter heating oil. Refinery throughput slows and with it, crude demand. As investors fret about recent US inventory builds, we would observe that seasonal factors are at play that obscure the tightening of oil markets – tightening that coincides with falling U.S. production and flattening OPEC production. We don’t expect OPEC to cut production at its December 4 ministerial meeting, but we do believe it will acknowledge that markets are coming back into balance and accede to the cartel’s current level of output. With fuel demand continuing to grow at healthy levels and global supply flattening, the slack in oil markets is disappearing. We are bullish on oil and look forward to higher prices ahead.

Our Takeaways from the Week

• Retailers are book-ending third quarter earnings season, causing consternation for department store investors

• Oil prices are retesting late summer lows ahead of the upcoming OPEC meeting, amid increasing evidence that supply and demand are rebalancing

Disclosures

Monster Mash

by Ralph Cole, CFAExecutive Vice President of Research

Monster Mash

No holiday better describes earnings season than Halloween.  When companies announce earnings, investors are hoping for treats but often times end up getting tricks. In our view, improving corporate earnings are the catalyst to improving stock market returns in the coming year. As we close out the best month for the stock market since 2011, we should review some of the tricks and treats of earnings season.

Treat

Apple reported earnings earlier this week and beat expectations on almost every level. IPhone sales continue to grow at a robust pace around the world. The company sold 48 million iPhones in the third quarter, up 22 percent from last year. Analysts expect the company to sell 79 million iPhones in the final quarter of the year.  Average selling prices of the phones continue to rise, which enhances profitability and will lead to $60 billion in free cash flow this year alone.

Tricks

As expected, the energy sector has had a rough time of it this earnings season. Earnings for the S&P 500 energy sector were expected to be down 73 percent this quarter and that indeed has been the case. During these distressing times all companies begin to dramatically scale back investment and reduce headcount. We feel that higher quality companies with good assets, low debt levels and quality management teams will benefit from the eventual rise in oil prices.

Trick and Treat

In no place is the bifurcations of earnings season more evident than in footwear. Nike reported earnings that beat analyst estimates by 12 percent and the stock responded with a nine percent pop the next day. Nike also reported a solid outlook for the coming quarters as well. Sketchers, on the other hand, tricked investors and missed earnings by a whopping 21 percent last week and the stock dropped 31.5 percent with the news.

Why have stocks responded so positively to a mixed earnings environment? Expectations for third quarter earnings had been lowered so much that companies have been able to meet and often beat those reduced forecasts. Also, the much advertised slowdown in China has not had as big of an impact on earnings as investors feared. While the investment slowdown in China has hurt some industrial companies, the Chinese consumer has actually helped the likes of both Apple and Nike.

Takeaways for the week

• There have been more treats than tricks this earnings season which has driven the S&P 500 higher by nine percent this month
• Earnings season continues to be very volatile and stock selection has been key

Disclosures

Keep Calm and Carry On

by Shawn Narancich, CFAExecutive Vice President of Research

Feeling Violated

Worries about competitive currency devaluations emanating from China’s small haircut to the yuan last week were supplanted this week by manufacturing related fears that the world’s second largest economy could be experiencing a hard landing. The result was a tough week for equity investors, as European stocks entered correction territory and U.S. stocks fell five percent.

Timing is Everything

As the sell-off accelerated into today’s close, we couldn’t help but wonder what market soothing policy moves the Chinese might institute next, nor could we ignore the palpable sense that the Fed’s lift-off from zero interest rate policy just got delayed again. Volatility in stocks will register with Yellen & Co. as they attempt to time this cycle’s first interest rate hike. However, more impactful will be the continued deflation in commodities that threatens to leave the price level far from the Fed’s stated goal of two percent inflation. As oil seeks out new cyclical lows and Treasuries benefit from a flight-to-quality bid, the trade-weighted dollar actually declined today. At a time of increased economic and market turmoil overseas, this hints of US monetary policy remaining easier for longer.

Reasons For Optimism

Low fuel prices and an increasingly healthy job market are combining to boost the collective spending power of U.S. consumers, helping drive the economy to what we believe will be a stronger second half of the year. Notwithstanding this week’s pullback in stocks, we look forward to a better second half of the year for corporate America, which should benefit from easier foreign currency comparisons and a turnaround in oil prices, two key factors that have helped keep earnings flat so far this year. As profit visibility improves, we expect stocks to make forward progress.

Ringin’ the Till

With all but a small number of companies having now reported, the sun is setting on a second quarter earnings season characterized again by companies under promising and over delivering. Retailers book-ended Q2 numbers this week by reporting a decidedly mixed bag of results. While America’s largest retailer struggles to grow, Wal-Mart’s rival Target came through with earnings just strong enough to make investors believe that this beleaguered retailer has put the worst of its merchandising and credit breech struggles behind it. Standing out to the upside was Home Depot, which reported another impressive quarter of sales driven by higher house prices and rising home improvement spending. While closing down for the week amidst market turmoil, Home Depot’s stock outperformed the broader market as management once again raised its profit forecast for the year.

Our Takeaways from the Week

• A sell-off in global equities pierced the veil of U.S. market tranquility

• Retailers concluded second quarter earnings season by reporting mixed results

Disclosures

Summertime Blues (and Yoo-hoos)

by Ralph Cole, CFA Executive Vice President of Research

Summertime Blues (and Yoo-hoos)

Earnings season is a whirlwind period of companies reporting their most recent quarterly results. We believe that this tends to be a better indicator of what is going on in the than most aggregate economic statistics. Large U.S. corporations touch virtually every corner of the world, and then report back to Wall Street every three months. This real time data has proven to be more reliable than government economic statistics. What do we mean by that?

Let’s take first quarter GDP, for example. When the Bureau of Economic Analysis first reported U.S. GDP growth for the first quarter it was +.2 percent. While not robust, it was at least positive. The next month they updated their estimate, and decided that the U.S. economy actually contracted .7 percent in the first quarter of the year. Then, last month the BEA updated their numbers again and came back with -.2 percent. U.S. GDP is destined to be revised for years to come. As investors we have to rely on what the companies are telling us in order to anticipate the direction of the global economy.

Thus far, what we have learned from second quarter earnings reporting is that the consumer is in good shape, but they are discerning amongst brands and retailers. The oil and gas slowdown is for real and it is hurting not only energy companies, but industrial companies that sell into that market as well. Banks, technology and healthcare have all seen relatively healthy growth here in the U.S.

Globally companies are citing re-acceleration in Europe despite the headlines in Greece. Weakness is evident in commodity-dependent countries such as Canada, Australia, Brazil and Russia. The materials sector has fallen on weak prices, which is especially troublesome for companies with heavy debt loads.

A number of companies and industries have executed very well in this challenging environment. For example, Amazon is starting to show some profitability along with continued growth. Regional banks are reporting strong loan growth and record low default rates. Biotechnology remains a source of strength for the market with both Gilead and Amgen beating estimates. However, earnings season remains challenging because stocks that miss estimates are punished severely.

Our Takeaways for the Week

• U.S. economic statistics are important, but have to be understood in context of other data because they are often revised multiple times and for several years
• In general, companies are managing well through a mixed macroeconomic environment

Disclosures

Movin' On Up

by Ralph Cole, CFA Executive Vice President of Research

Movin’ On Up

U.S. oil production is finally starting to fall. After unrelenting production increases for the past several years, weekly oil production numbers have begun to decrease. In response to falling oil prices rig counts have dropped dramatically here in the U.S. The number of rigs operating in the U.S. is down 53 percent from the peak reached last year. This change has helped to drive West Texas Intermediate (WTI) oil prices back up to the mid-$50 range from a low of $43 just one month ago.

We would be remiss if we didn’t point out that the global demand for oil continues to rise. This is the other half of the supply-demand relationship that ultimately determines oil prices. The International Energy Agency (IEA) increased their expectations for global oil demand an additional 90,000 barrels per day, bringing their 2015 projected increase of daily oil demand to 1.1 million barrels per day.

No Expectations

Earnings season is a fickle, nuanced and fascinating time of year for portfolio managers. After each quarter of business, companies report their earnings and sales to analysts and the public. Companies guide investors to what they think earnings will be in future quarters. When a management team realizes that they are going to materially beat or miss their earnings guidance they announce it before the scheduled earnings release date which is called a pre-announcement. The pre-announcement ratio is calculated by taking the number of negative pre-announcements and dividing it by the number of positive pre-announcements by company. Strategas Research Partners calculates that the ratio is 6.2 to 1 this quarter, versus a long-term average of 2.73.  This is actually a very positive contrary indicator for the market. Companies have lowered expectations so much, that they usually end up beating the lowered bar. While this is only a short-term indicator, it may help explain positive stock movements on relatively weak earnings.

 Takeaways for the week:

• Oil companies have drastically cut the number of oil rigs operating in the U.S., which will help improve the supply demand balance for crude oil in the coming months
• The stronger dollar and lower energy prices have led companies to pre-announce lower earnings for the first quarter of 2015

Disclosures