publication date: Feb 9, 2018
author/source: Kris Rosemann and Brian Nelson, CFA
Image Source: Maximo Santana
We believe the next crisis will not be a banking crisis, but one of a breakdown in market structure.
By Kris Rosemann and Brian Nelson, CFA
The volatility of US equity markets has simply been incredible of late. What a change of tune from the past 12-18 months. Many investors are growing more concerned about the health of US sovereign credit and implications on borrowing costs, the benchmark Treasury yield, and further, such implications on long-run equity values (rising interest rates in stock valuation models reduces intrinsic value, all else equal). Moody’s has been warning about the deteriorating health of the US as a result of tax reform, pointing to “at least a $1.5 trillion deficit impact over 10 years,” that “federal debt reduction will be even more challenging because tax cuts will not be self-financing or offset by equivalent spending cuts in the near term,” and “absent increased revenues/reduced expenditures, debt-to-GDP ratio will rise and debt affordability will weaken significantly (Source: Moody’s, US Tax Law Teleconference, January 2018, Zerohedge).”
We believe market participants may be coming around to the tremendous risks that tax reform may create in the intermediate-term as it relates to government tax receipts, and the idea that the US will have to issue a tremendous amount of debt, incremental to spending plans for infrastructure and defense. Longer-term, the implications on the benchmark 10-year Treasury, as a core component of intrinsic equity value estimation, may be large, and we point to the strong performance of stock markets during the past near-40 years, where the risk-free Treasury rate went to practically 0% from nearly 20% over this time. We maintain our view, however, that despite the rather large declines, the recent stock-market pullback has merely been a blip compared to the aggregate advance of this nine-year bull market, originating from the March 2009 panic bottom. Fed officials seem determined to increase rates, too, regardless of what stock prices do. New York Fed President William Dudley went so far as to say that the recent drop in the stock market has been “small potatoes.”
We’re seeing investors take action, too. For starters, US stock funds set a record (data dating back to 1992) for withdrawals in a given week, as $23.9 billion was pulled out of ETFs and mutual funds during the week ended February 7. ETFs accounted for the bulk of the withdraws at $21 billion, and we think this is having a systemic, broad-based impact across equity markets. ETFs make it all-to-easy for the market to experience wild swings, as large baskets of stocks can be bought and sold, pressuring prices indiscriminately. Meanwhile, in the bond world, money is also leaving high yield--the SPDR High Yield Bond ETF (JNK) has lost nearly 30% of assets since the start of 2018--into loan funds with similar credit ratings such as the PowerShares Senior Loan Portfolio (BKLN). We think many advisors are worried that rising benchmark interest rates will be a long-term headwind to the bond market.
Amazon (AMZN) is at it again. FedEx (FDX) and UPS (UPS) have both been sent searching for answers after reports that Amazon is expected to launch a delivery service in the next couple weeks with third-party sellers on its site. To be called “Shipping with Amazon,” the service will pick up packages from businesses and ship them to customers. UPS seems to be taking the news especially hard, perhaps a result of its current position as industry leader in adjusted operating margin in small packages, and the potential pricing pressure that has become known as the “Amazon Effect” could be a meaningful development as both UPS and FedEx have raised shipping rates recently to combat the lower margins that often come with increased residential deliveries as e-commerce proliferates. Amazon remains an incredibly healthy entity, too, even as it pursues initiatives in grocery retail and pharma, among others.
Though its shares have experienced some volatility more recently, Nvidia’s (NVDA) strong fourth quarter results, released before the open February 9, added to its impressive run since the start of 2016 (shares are trading at more than 7 times the level at which they began 2016). Gaming revenue continues to advance at a strong double-digit rate (29% year-over-year growth in the fourth quarter of 2017), and its Datacenter revenue growth has been nothing short of explosive as it more-than-doubled in the fourth quarter of 2017 from the year-ago period. Demand for its core technologies, GPUs and Tegra Processors remains strong. GPU revenue (~85% of total revenue) for gaming, datacenter and professional visualization revenue climbed 33% in the fourth quarter, and Tegra processors revenue (~15% of total), which includes system-on-a-chip (SOC) modules and development services, leapt 75%. Our fair value estimate for Nvidia, however, remains far below its current stock price at the time of this writing.
After Best Ideas Newsletter portfolio idea and Dividend Growth Newsletter portfolio idea General Motors (GM) reported a year of record sales in China in 2017, rival Ford’s (F) repositioning in the country resulted in its sales in China falling 18% on a year-over-year basis in the month of January. Ford brand vehicles led the decline with a 29% drop in China in the month, while GM’s China sales in the month advanced 14.5%. We like GM’s position relative to Ford in the world’s largest and growing auto market, as well as its higher levels of profitability in the ever-important North American market and relative position in emerging vehicle technology. GM’s valuation is much more palatable, and its dividend yield is a head-turner, too, especially for a corporate. Car-making operations will always be cyclical, however, so don’t ever lose sight of that.
Restaurants (PBJ) in the US continue to face an uphill battle as traffic weakness persists across the industry. According to TDn2K, traffic fell 3% in the month of January from the year-ago period, though average guest check growth, led by the casual dining segment, nearly offset the traffic loss. Promotional activity in the increasingly competitive fast-casual space kept pricing growth below the industry average, and restaurants have reported increasing levels of employee turnover in the tight labor market. We think the recent special one-time bonuses from companies as a result of tax reform might be a precursor to higher wages, and therefore lower profit margins, particularly in service-oriented businesses. Franchise-heavy enterprises such as McDonald’s (MCD) may avoid this pain at the corporate level, but this could pose trouble for company-owned enterprises such as Chipotle (CMG), which takes on all the operating risk of running its restaurants.
As we part with this note on February 9, we wanted to remind you of our tremendous efforts to warn you about the changing structure of the stock market and its unique risks with the 18 videos that we posted on our website during the months of December and January, before the recent collapse in the stock market from all-time highs. We talked about the systemic risks of indexing and quantitative investing, which to a large degree, lack the rigors of security analysis in their processes, and we noted that ETFs can cause considerable damage to the market environment given that most amount to theme-based speculation on price movements, not driven by expectations of price-to-fair value convergence. We believe the next crisis will not be a banking crisis, but one of a breakdown in market structure.
Finally, just a reminder, we are not a financial adviser and we cannot give individual buy, hold, and sell recommendations. Please contact your personal financial adviser that knows your goals and risk tolerances to see if any idea or strategy may be right for you. Thank you for your attention during these very volatile times.
Related: SPY, QQQ, DIA
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Kris Rosemann and Brian Nelson do not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.