The Most Important Thing

“The most important thing is to keep the most important thing the most important thing.” – D. Coduto

The most important things to me as an equity investor are future earnings, valuations and what might change them.

S&P500 earnings are split 50/50 between domestic and international:

• The Emerging Markets have not been having a good couple of years, growth is in decline, as is direct foreign investment (at least until recently) and currency reserves. One of the reasons the market may have celebrated Halloween early this year in August and September are that ~33% of S&P500 profits come from Emerging Markets, specifically the BRIC. (More on the EM in an upcoming post.)
• USD strength continues its climb relative to other currencies. A stronger USD hurts US export profits.
• Wage inflation is still low, but the more the job market continues to tighten, the greater the probability wage increases are on their way. The more labor costs increase, the lower profits go.

Over the last two months, analysts have been dropping their future earnings projections like they were Canadian pharmaceutical distributors. Currently, S&P 500 total estimates for 2015 are roughly $118-120 and 2016 are projected at $118-$130. Within that range, the S&P500 forward multiple is 16.8-17.8. That’s not the most historically expensive stocks have ever been, but its close. The more expensive it is now, the theory goes, the smaller the return will be going forward. In terms of what might negatively impact valuations, here’s a small list:

• Interest rates have been going in one direction for over a decade, but now the biggest and most important economy, the US, wants to go a different direction and raise rates. With the USD as reserve currency, and EM having borrowed (a lot) in USD since the financial crisis of 2008, this is a big deal.
• The Central Banks of the world have been engaged in what’s known as Quantitative Easing (QE) monetary policy. Europe and Japan have been trying to pick up the slack since the US exited its QE program one year ago. Since exiting, the S&P 500 is flat.
• Commodity prices have fallen radically, including grains, iron, copper, precious metals and of course, oil, coal and natural gas. Consumers pay at the pump, and a big chunk of the money gets collected –and put to work in the form of loans and investments– by the petro-state Sovereign Wealth Funds. Going down the list of the world’s largest SWF is a who’s-who of the world’s oil, gas and coal exporters, and with commodity pricing in the tank, (well beneath where they need it to be for their own domestic spending programs) they’re selling and making withdrawals at a rapid rate. SWF redemptions were a big deal for hedge funds and the big asset managers (ie Blackrock) in 3Q.

The list goes on…Debt levels, leverage, contagion, war, social upheaval, the fossil-based economy the world has followed for 150 years getting turned on its head by new climate regulations. Some of these are tougher to track, but make no mistake there’s a lot on the radar of your average money manager.

I mentioned yesterday Tepper has pulled in his bullish horns. He’s done this before, but he’s now being joined by a rather large number of super-investors like Ray Dalio, Stan Druckenmiller, etc… Its not hard to see why. We’re trading on the richer side of valuations, profit estimates are falling and the number of concerns that valuations might come down (rapidly) are growing.

Tepper likes to say, “There are times to make money and times not to lose money.” I agree. I also think the markets have a tendency to frustrate the maximum number of participants. Hedge funds and speculators were net short through the entire ramp in October. They are only now showing signs of capitulating shorts and going long. With the market up again today, indicators are starting to flash that we’re short-term overbought, but it wouldn’t surprise me if the squeeze continued for a bit further.

Be cautious.

I’m going to be experimenting with the blog a bit. You already have the genius of Fly’s realtime commentary, so even were it possible, (its not) I don’t see much value in trying to duplicate him. These longish posts take a bit of time to craft, so hopefully you’ll be ok with a slower production rate.

-g

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