Stocks and bonds moved in opposite directions as the S&P 500 finished positive on the week despite falling nearly 2 percent between Thursday and Friday. Bonds, on the other hand, declined due to higher interest rates.
iCan't Afford This
One More Time
Stocks finished the last week of December relatively flat resulting in a 20+ percent total return for the S&P 500 for 2017. Interest rates were steady with the yield on the 10-year U.S. Treasury ending the year at 2.41 percent, down slightly from a year ago.
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
Seasons
by Jason Norris, CFA
Executive Vice President of Research
Seasons
The more things change, the more they stay the same. Five months ago, we rebuked the old Wall Street adage of “sell in May and go away” which, through the end of August, was a good call. From May 1st to Aug 31st, the S&P 500 was up just over 7 percent. However, just like clockwork, the month of September looks to be producing the same results it historically has. Since 1928, September is the only month out of the twelve that has an average negative return. With only a couple of trading days left, it looks like that trend will not be “bucked” this year. Even though there is still time to pull even, the end of the month is usually the weakest (see below).
Source: Renaissance Macro Research
Send for the Man
While this has been a bad week for stocks, it was also not a good week for healthcare mergers and acquisitions. On Monday afternoon, U.S. Treasury Secretary Jack Lew issued some administrative rules making it harder for U.S. companies to start inversion mergers. This type of merger allows a U.S. company to buy a smaller foreign company and relocate offshore to lower tax jurisdictions (see an earlier post for details). Most of these deals are centered in the healthcare space and while these changes will not stop potential inversions, they are designed to make them more difficult. For example, Medtronic is currently in talks to purchase Covidian (based in Ireland) and would use a meaningful amount of offshore cash to finance the deal. With these new rules, Medtronic would not have access to that cash without paying U.S. taxes. Therefore, they will have to look for other financing means, most likely debt, thus slightly increasing the cost. We still believe the deal will be completed, but it does show that the U.S. Treasury is adamant about changing this part of the U.S. tax code. AbbVie and Shire may also be affected; however, the tax benefits are not as meaningful and the gains from the Shire pipeline are significant enough to proceed.
Lesson Learned
Last week was not a good week for Apple. After announcing a record weekend of sales for the iPhone6 and iPhone6+ with over 10 million handsets sold (and this without shipping any to China), any good financial news was eclipsed by issues with the iPhone6+ bending and a botched iOS update. Investors didn’t have patience for the stock during the last few days. We believe that despite these hiccups, this iPhone launch will net over 60 million units this month, and based on pricing and component costs, should be accretive to gross margins.
What we know
- The trend of September probably won’t be broken and stocks will give back some of their summer gains
- Both buy and sell side analysts have been on the phone with their tax attorneys due to Secretary Jack Lew’s administrative order regarding inversions
Independence for Scotland and a UK haggis famine
by Brad Houle, CFA
Executive Vice President
Haggis is a cuisine of Scotland characterized by Wikipedia as a savory pudding containing sheep's pluck (heart, liver and lungs) minced with onion, oatmeal, suet, spices and salt mixed with stock. It is traditionally encased in the animal's stomach and simmered for approximately three hours.
The often lampooned delicacy was featured in the 1993 film, “So I Married an Axe Murder,” staring Mike Meyers. In the comedy, Mike Meyers’ character of Scottish decent when as asked about his fondness for haggis responded, “I think it's repellent in every way. In fact, I think most Scottish cuisine is based on a dare.”
On September 18, a referendum for Scottish independence from the United Kingdom will be put to a vote. Recently, polls suggest that it will be a close outcome. This situation is creating uncertainty and we have seen the pound sterling weaken as a result. At stake is revenue from the oil-rich North Sea which has been greater than 2 percent of the UK's revenues down from over 6 percent of revenue in the 1980s. The North Sea fields are off the coast of Scotland and there is some question about which country would control the revenue after a split. There have been many comparisons of an independent Scotland and Norway based on the countries similar populations and potential energy wealth. While the North Sea fields are in a period of declining production, the revenue would be material to an independent Scotland.
If a vote for independence passes, the UK's fragile recovery from the financial crisis will be called into question. The UK economy has slowly been crawling out of the economic downturn of the Great Recession in a similar fashion to the U.S. A split-off of Scotland would potentially stall the recovery.
The pending referendum has also created uncertainty relative to business investments in that there is a question about the political landscape should a split occur. In a similar situation, Quebec had a referendum for independence in 1995 that failed. However, the uncertainty that it could occur again was at least partly responsible for an economic malaise in the province and reduced business investment.
In Spain, the region of Catalonia has a referendum in November of 2014 for possible secession. The impact of this would be negative for Spain as its economy is in far worse shape than the U.S. and the UK.
While not a catastrophe in the making, an independent Scotland or Catalonia destabilizes what is a tenuous recovery in Europe. Most of Continental Europe is suffering from anemic growth, continued high unemployment, massive indebtedness and the specter of deflation. Above all, the financial markets hate uncertainty and these types of changes are potentially disruptive to the European recovery.
Other Takeaways for the Week
- Apple introduced the iPhone 6, Apple Watch and Apple Pay this week, which were generally well received. The Apple Pay secure transaction using an iPhone rather than a physical credit card has the potential to revolutionize how items are paid for at retailers.
- The late Joan Rivers often used humor regarding her financial life as part of her act. One memorable quote that bears mentioning is, “People say that money is not the key to happiness, but I always figured if you have enough money, you can have a key made.”