Tag Archives: U.S.

Today’s Melt Up Triggers Tomorrow’s Melt Down

Since November of 2016, the NDX has soared by 72% and is poised to break the recent all-time high of 8027. Today, it seems that sentiment is shifting back to selling bonds and buying riskier equities with hyped estimates. FAANG stocks have fueled an ongoing rally, via stock buybacks, non – GAAP financial gimmicky, and promises of eventual profitability for many unicorn startups.

Source: Stockcharts.com – 9/12/19

Sentiment has moved prices up as the market has suspended its disbelief of key fundamentals like future earnings, declining sales, job layoffs, contracting world trade, and negative cash flow.

First, let’s look at downward revised earnings forecasts for the rest of the year indicating a decline almost to a contraction level in the U.S.:

Sources: Bloomberg, IIF – 9/10/19

Analysts expect lower earnings and profitability due to declining sales. The pivotal function of any business is sales. The inventory to sales ratio is now at 2008 levels indicating that sales are declining while production is continuing, which is typical of the later stages in the business cycle:

Sources: The Wall Street Journal, The Daily Shot – 9/12/19

Continuing present production levels with flat to declining sales is unsustainable.  Executives are faced with declining sales overseas in part due to tariffs. As such, the number of production shifts must be reduced, as the highest cost for most businesses is payroll.  A key indicator of executives beginning to reduce staff is indicated by an increase in jobless claims in five key manufacturing states starting about when tariffs were first enacted in November of 2018:

Sources: B of A Merrill, Haver, The Wall Street Journal, The Daily Shot – 8/30/19

Markets are underestimating the devasting impact that broad tariffs are having on U.S. corporate sales.  S & P 100 corporations generally recognize from 50 – 60 % of total sales from overseas, and profits of 15 – 25 % or more from emerging markets like China and India.  When tariffs hit U.S. products, there is a cascading effect on small businesses, and throughout the worldwide supply chain. Even if a product is produced domestically, many of the sourced parts come from several emerging markets which now face tariffs. China’s tariffs on U.S. farm products like soybeans have reduced sales by 90 %.  Soybean farmers are looking for new markets, but are having a difficult time replacing the massive purchases that China makes each year.  Tariffs are culminating sales headwinds and investment uncertainty at the fastest rate since 2008.

Sources: CPB World Monitor, The Wall Street Journal, The Daily Shot – 9/11/19

In the midst of all these economic and business headwinds, executives should be running tight finances, right?  Well, not exactly. Due to a surge in debt issuance, corporations now have the highest debt to GDP ratio in history.  However, they may not have learned about how to keep out of financial trouble.  S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

Source: RIA PRO (www.riapro.net) Chart of the Day -9/10/2019

Unicorn IPO valuations are off the chart, many with unproven business models and large losses. 2019 has seen the highest value of IPOs since 2000, an indicator of high interest in risky investments and soaring investor sentiment. Not surprising, 2019 has the highest number of negative earnings per share IPO companies since 2000 as well.

Sources: Dealogic, The Wall Street Journal, The Daily Shot – 6/18/19

Sources: Jay Ritter, University of Florida, The Wall Street Journal – 3/16/18

The lack of profitability and the number of IPOs ‘to cash out before it’s too late’ evokes memories of the 2000 Dotcom Crash.  Then, investors were looking for ‘high tech growth’ stocks, and as it was assumed that companies would figure out their business model later. 

When?  As an example, Uber just recorded a $5.24 billion loss for the 2nd quarter of 2019.  Lyft lost $644 million in the same quarter.  Despite the popularity of their services, the business models for both ride-sharing companies has yet to be proven. Making profitability even harder for these companies, the State of California legislature just passed a bill recognizing ride-sharing drivers as employees and not contractors. Gov. Gavin Newsom is expected to sign the legislation.  If Uber and Lyft have to pay salaries, benefits and other costs for full-time employees they will incur staggering costs, and may likely never be profitable.  Uber says it is building a ‘transportation platform’ where drivers are delivering food and packages not transporting passengers so they can avoid being labeled a passenger transportation company.  Both firms are planning to put an initiative on the ballot to declare their drivers as contractors to save their business models.  It is still unclear, even with drivers being recognized as contractors, that they have viable business models. Yet investors just didn’t care at IPO time, though both stocks have since dropped in price dramatically since their IPO dates. Ride sharing is just one small industry and one example. There are many other unicorns with questionable businesses that are flourishing in the markets.

The suspended disbelief we see today is similar to the sentiment that sent the NDX up nearly 400% just before the Y2K crash.   We can learn from what happened beginning 20 months before the Y2K crash.  The NDX started in October of 1998 at 1063 and peaked at 4816 in May of 2000:

That astounding move up was followed by a roller coaster ride down to 2897 for a 38 % decline by May of 2000, followed further by a two year decline to 795, or 84 % decline from the 2000 peak.  The NDX would not reach the 4816 level again for another 16 years!  Investors had to wait a long time just to break even.

One similarity to the Y2K related drop in sales we see today is from tariffs. Companies have pulled purchases forward to avoid tariffs. Similar activity occurred in 1999 as IT departments bought new software and hardware to solve a possible year 2000 (Y2K) software bug. Software and hardware purchases were pulled forward into 1999, then as one IT manufacturer CEO put it ‘the lights went out on sales.’  The hard dates for tariff increases a year ago forced corporations to pull up purchases that would otherwise be made later in the year, resulting in an unnatural boost followed by a contraction of business activity.

Consumer products will be hit with 15 % tariffs in October and 25 % in December, so consumer, like businesses, are likely moving up their purchases. We expect consumer spending to show increases in August, and September, and decline after that.  A contraction in consumer business operations is likely to follow pulled up consumer purchases.

Plus, investors need to be cognizant of the huge transformation of the world trade infrastructure into two competing trade blocks triggered by the trade war by the U.S. and China as discussed in my post: Navigating A Two Block Trading World. The forming of two trade blocks will change the character of world trade, and therefore create uncertainty in international sales for all businesses dependent on overseas customers to maintain growth and profitability.

Today, sentiment is set in suspended disbelief that ‘the Fed will cut rates’ and make the economy grow.  Corporations are swimming in low-cost debt, with negative cash flows and flat to falling sales.  If the Fed governors pick up an attaché case with a sales pitch and get sales going again then the Fed might have an impact on corporate profitability. Yes, cheap money may help stave off layoffs or cost reductions, but in the end businesses will have to cut costs to match new lower sales levels.

The market ‘hopes’ that a trade deal will revive the economy as well.  An ‘interim’ trade deal where China gives up very little except a commitment to purchase agriculture and livestock products in return for a suspension of increased tariffs won’t change the broad-based tariff damage to the economy.  Unless broad-based tariffs are ended, as 1,100 economists recommended in a letter to the Trump administration 18 months ago, the hemorrhaging of sales will continue.

So what can we learn from today’s investor sentiment compared to sentiment observed during the Dotcom crash?  When the market finally ends its disbelief and is hit with the reality of business fundamentals, the decline will be fast and deep. The melt up, or whatever is left of it, will trigger a melt down.  The 4:1 return difference in the 2000 melt up versus today’s melt up today is likely due to the 4.7 % GDP rate in 1999 versus the forecasted 1.7 % GDP forecasted for 2nd quarter this year.  In 2000, the economy was simply growing a lot faster than today, and productivity was rapidly growly. This helped sentiment and provided some basis for the melt up.  Further the melt up in 1999 was fueled by the Fed providing excessive liquidity to help ensure that Y2K did not shut down the economy.

The current melt up is occurring at a much lower level of economic activity. Yet, both instances are based on a disconnect between what is happening in the economy and the valuations of stocks. The longer the disconnect with fundamentals, the longer it will take for the reversion to the mean to rebalance the economy. Plus, the further the disconnect the larger reversion to the mean or even an overshoot and it will take longer to get back to ‘even’ – maybe 16 years from the peak as we saw in Dotcom Crash in 2000.

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Navigating A Two Block Trade World

“Investors Need to Be Ready for a Two Block Trade World – U.S. and China”

On Bloomberg TV, VMware CEO, Pat Gelsinger, observed that with escalation of the trade war he sees, “two separate trading blocks forming the United States and China, we want to be a player in both and will have to adjustour strategy, investments, supply chains and operations as a result.”  He sees both countries digging in for the foreseeable future.

The evolution of a two trading block global economy has a major impact on how businesses operate in the next five to ten years.  Those with major operations in China that ship products to the U.S. will continue to be adversely affected by U.S. tariffs on Chinese goods. Growing trade headwinds also face, U.S. companies shipping goods to China. Besides tariffs, trade research shows Chinese importers will need to deal with U.S. non-tariff barriers that are not only costly but time consuming.

Here is a list of industry sectors most impacted by the trade war with businesses exports and imports to China:

Sources: U.S. Census Bureau, Marketwatch  – 6/27/19

Major software and electronics companies like Apple, with $56b in sales making up 20% of total global revenue from China, will continue to see declining sales. Apple, and other companies in the same shoes, will have to radically shift supply chains and sourcing for manufacturing.

CISCO, a global network systems manufacturer, recently reported to shareholders a 25% drop in sales of network products to both state-owned and private corporations in China. Many American manufacturers’ source components and sub-assemblies from China which are then shipped to the U.S. mainland for final manufacturing. These supply chains will have to change if they are to sustain profits.

Caterpillar, in the transportation sector, recognizes 10% of global revenue from China and has experienced a significant drop in sales.  Tariffs have significantly reduced soybean exports to China by U.S. farmers to nearly zero. The Federal Reserve in Minneapolis reports farm bankruptcies have reached 2008 levels.

These are just a few examples. Each day the list of impacted industries and companies grows longer.

What does the two block trading world mean to investors?  

The trade war seems to be here to stay. As such, agile CEOs are already planning for the U.S and China to be heavily competing for global trade.  Investors will need to assess the implications for both short and long term investments.

Short term tactical investments:

  1. Research business sectors with major exposure to imports and exports to China
  2. Identify companies with exposure to China trade and related operational vulnerabilities
  3. Identify countries that may act as bridge zones between the two blocks, ie: Australia, Singapore, and Vietnam

Long term strategic investments:

  1. Identify companies that are well-positioned to leverage quickly the now forming two block trading world
  2. Research bridge countries that are making investments in shipping infrastructure and establishing long term trade treaties with both the U.S. and China
  3. Watch the business horizon for new businesses or services that will evolve as a result of the new U.S. – China trade competition

A new global trading structure is forming fast presenting both opportunities and pitfalls for investors.  Agile investors might want to position themselves for optimal growth and income in bridge countries or firms like VMware, where the CEO is moving quickly to establish good relationships with both countries.  

Investors should also consider longer-term investments in Australian based companies or U.S. firms with major operations in Australia as a bridge country.  Many U.S. firms have regional operations headquarters in Sydney.  Sydney, positioned in the Asian region, offers a well-skilled labor force, is an open country to many immigrants from all over Asia that speak and write many languages. Further English is the main language for easy use of technical documentation and recruitment of support staff. The Australian government has been an ally of the U.S. for decades and yet has a bilateral free trade agreement with the Chinese government signed in 2015. As a bonus, the Australian economy has been in expansion for 27 straight years.  The incredibly long string of growth is likely due to a diverse economy, welcoming immigrants who start new businesses, an abundance of natural resources, located at the nexus of Asian growth and a business positive government and culture. It is these same traits that should help them thrive in a two trading block economy.

Investors should be wary of Hong Kong or China-based businesses with American ties that are not politically correct.  The Chinese economy is a state controlled managed economy of state run businesses and private businesses that run under strict guidelines.  Problems in Hong Kong go beyond the present protests. The island city has seen the CEOs of a few local businesses ‘disappear’ when making trips to mainland China. In some instances these disappearances have happened for months throwing the businesses into turmoil and dropping stock prices by 70 – 80%. 

Hong Kong’s future is highly uncertain as the Chinese government is growing increasingly concerned that democracy might ‘leak’ to the mainland and thereby threaten authoritarian rule.  The Chinese government has announced the development of an ‘entites’ list of U.S. companies that Chinese firms are not to do business. American firms affiliated with these targeted firms will see significantly reduced sales. On the U.S. side, the Trump administration has gone back and forth on suppliers to Huawei and is now writing a ‘blacklist’ of Chinese firms that American companies are to end business with. Smart investors will need to keep track of U.S. and Chinese government pronouncements and policies in regard to which companies are ‘in’ and which are ‘out’. These may change by the day or week.

Monitoring markets or executive behaviors that are likely to catch government scrutiny will offer investors an early warning of which firms may soon appear on the lists. One possible new sector of scrutiny are cybersecurity companies, which provide both countries an edge in the digital economy. Both countries will want to maintain control, access and future development of digital security power.

The two trading block global economy will require careful research, constant monitoring, and quick moves as politically ‘in’ companies can become ‘out’ at the whim of government leaders in both countries.  Investments in stable countries, with firms that have a long history of bridging their business between both China and the U.S. are likely to be the best investment opportunities over the long term. Note that in any global recession, these bridge countries and companies are likely to be the first to recover from a recession.

Patrick Hill is the Editor of The Progressive Ensign writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.