MACRO MONITOR February 24 th , 2015 Yellen Testimony & FOMC No matter what Yellen says, we believe that the risk is for a more hawkish rather than more dovish interpretation to the Humphrey Hawkins (biannual) congressional testimony and generally Fed-speak over the coming months. So far the market has keyed in on one thing in Yellen’s testimony today: that the FOMC is not likely to raise rates for the “next few meetings.” That seems to be the status quo of the interpretation of lift off/normalization plans. That means that the potential for a June rate hike is still on the table. The operative word here is “flexibility.” Chair Yellen is seeking maximum flexibility in monetary policy, yet we believe she is setting the table for a nearer term rate hike than the market currently implies or believes. She obviously wants to avoid another “taper tantrum” or volatility in the Treasury market (more on that below). It’s pretty obvious that wage growth is the key to any game-time decision should it come down to the wire, all else being equal. When Yellen testified that to hike/not to hike may be decided on a “meeting-bymeeting basis” it is hard not to believe that there are considerable risks to the downside for bonds – or at least for additional bond volatility. That means that the Fed is, if you didn’t believe it before, completely data dependent! Yes, surprise, surprise, the Fed looks at data and makes decisions based upon the data rather than ideology or some type of secret handshake. It is the Chair’s and the FOMC’s job to keep the market guessing to a certain degree. The worst thing for a central banker is to be backed into a corner, cowered, by the market. At that point, the credibility of a central bank is in play and that is potentially utter doom for fiat currencies. So the financial media will sum up today’s Yellen testimony through a couple of neat, tied-up-in-abow, statements and lines. Markets will somewhat pay attention to those articles and there is likely to be a focal point (e.g., when Yellen states “there is no single trigger for rate hikes” so THUS THE FOMC MUST BE DOVISH…). Really. The cacophony of commentary around this testimony is likely to be deafening, confusing and counterproductive in many respects. By way of illustration, this is what the US 10 Year Treasury Note has done today at 12:00 noon EST: 1 So at 9:57 a.m. EST, the US 10 YR was at a yield of 2.07%. “Holy crap, did she just say something hawkish? Sell, sell, sell! Wait, did she just say something dovish? Is she talking about the international economy again?! No!!! Buy, buy, buy!” That is the nature of trading. People made and lost money in the moment, battling algos, themselves and most importantly the temporal competition to read the tea leaves better than the next guy/gal slinging rates trades. The ultimate analysis is always a balancing act. There is no formula that accords monetary policy the legitimacy of science. This is a judgment call although the market wants to make it a formula1 . Again, we view the key balance as full employment and wage growth against the lag time of monetary policy sprinkled in with some Richard Fisher crankiness over financial stability. Lower Oil Prices In the chart above, when the red line (supply) is above the blue line (demand) the price of oil is likely to be declining2. It is estimated that the world has a total excess supply of 400 billion barrels. From last Wednesday to today, five trading days, WTI has lost roughly 7.5% in price value. The recent run up in prices appears to be a bounce back based upon speculative entry points into the crude curve as well as value seeking throughout the energy complex. We believe that these factors will continue to keep crude at lower prices: muted demand, continuing supply stocking, Iran coming online with additional supplies, US production remaining steady and banks continuing to support existing reserved based lending clients. One item to certainly keep eyes on is the crack spread. The speculative trade into long oil positions may reemerge should crack spreads continue to widen. We think that WTI crude oil prices are likely to go lower in the near term and linger at a lower level. The data related to supply is simply not favorable for oil prices in the near term. 1 OK, you want a formula? Here: maximum employment which is not below NAIRU + continued wage growth + status quo financial stability (mostly in credit markets as the Fed doesn’t care so much about stocks) + a nondecelerating US and global growth picture (it can be soft, but can’t worsen materially) / amount of time which still affords enough lag time for monetary policy changes to transmit and catch up to where US growth is expected to be = June 0.25% rate hike + LOADS of language to signal rates hikes will be glacial and rolled back if need be. Its medicine, but it tastes like sweet grapes. Drink it up! 2 This chart is from Erico M. Tavares of Sinclair Advisors and uses information provided by the US Energy Information Agency. 2 Ultimately, oil prices are going to ping pong around off of supply data for the next while as demand data seems pretty clear – that it will be low if not lower. The fact that rig counts have declined in non-conventional fields (shale oil in the US) doesn’t mean that the supply of oil will go down. This is simply not a one-for-one correlation. Taking down rigs means that oil companies (E&P companies) are managing their costs and no longer spending on lower margin drilling or less productive sites. That means that US shale is “high grading” which means that they are still using their existing, highly productive, drilling operations at full bore. The market’s assumption that rig counts = lower output is false in the very near term3. That bodes poorly for oil prices. US Earnings Season In summary: US stocks continue to chug along with multiples expanding while earnings and sales continue to be a mixed bag. The bears have been extremely wrong for an extremely long time while remaining very vocal. This has actually worked in favor of US stock investors as the general sentiment around stocks has been balanced. Most institutional investors remain nervous about stocks citing stretched valuations, no 10% decline in two years, slowing sales (revenue) numbers, and potentially changing interest rate policy. All of these things overhang the market, have overhung the market, and will continue to overhang the market. Absent one of the risks we briefly discuss below materializing in full, we expect that US stock multiples will continue to slowly expand in 20154. Fourth quarter 2014 earnings season is pretty much over and 75% of companies have reported earnings above expectations and 58% have reported sales above expectations. Earnings growth is much weaker than was anticipated late last year with the energy sector drawing down numbers. Consequently, the forward price to 3 Disclosure: OBHC has a short position in oil via ticker SZO. This is a hedge position. 4 Like everyone else, we think higher volatility is likely. 5 These statistics are courtesy of Factset. 6 With all due respect, and we mean that in the most sincere way, it is very easy for people who already have a significant wealth to stand aside in cash earnings ratio of the S&P 500 is 17 right now while the “Shiller PE” (Cyclically Adjusted Earnings Ratio) stands at 27.755. There has been a lot of commentary about Nobel Laureates and other market luminaries getting out of stocks because they are “overpriced” and there is no upside6. We recognize that the idea of an average PE ratio in determining the fair value of a market is habitually used by market pros and commentators alike. Context is everything in investments and saying that a market has a high PE and thus it is overvalued and thus it is a bad riskto-reward proposition or that therefore the market will go down is really amateur hour thinking. Yes, there is a strong tendency to revert to the mean – over time that is. The fact of the matter is that even if the FOMC does raise interest rates, discounting future cash flows in equity analysis will still be an exercise in using very low discount rates. Thus, one can make the very cogent and plausible argument that at such a low discount rate, stocks actually deserve a higher valuation because their cash flows are worth more. This is really stock analysis in its junior form and should be very self-evident to any professional investor. Instead, we are inundated by the claims that stocks are overvalued because they have high historical PE ratios. We are not unabashedly bullish. Not at all, but we recognize that this market has climbed many walls of worry and keeps on keeping on. Is it stock buybacks? Yes. Low interest rates. Yes, also. Great balance sheet management? Agreed. Financial engineering and too many analysts drinking the Kool Aid? A bit. A much more attractive asset class on a relative basis? Definitely. If we want to get negative on US stocks, our starting point is price to sales. Earnings can be manipulated, sales are not as malleable. Q4 sales grew far above expectations at 1.9% (estimate was 1.1%). However, earnings are only growing at an average pace at 3.54% per annum (average is 3.52%) while the multiple on the price and yield-focused investments and tell others about their plans as though they should also follow. It is one thing to go to cash or rotate out of stocks in a declining, overly volatile or technically terrible market. It is quite another thing to suggest getting out of equities because there is limited upside when they continue to go up. 3 to sales ratio is quite high now at 1.83. OK, we jest, the price to sales ratio is actually the highest it’s been since 2000. It is high. Risks to Global Markets Bond market volatility. We think one of the underappreciated risks to all markets is the potential for US bond market volatility. Most likely such volatility would be caused by unexpected moves in US interest rate policy. The secondary cause could be related to a bond market which is universally recognized as being less liquid with fewer dealers than ever before7. At a bare minimum we urge consideration of this issue in its base format: that bond market volatility forces a risk off environment which eventually metastasizes into other asset classes. In particular, when the US 10 Year Treasury Note is volatile, it can force traders out of portfolio positions due to the leverage employed and the fact that the 10 YR is a frequent hedging instrument. We wrote about it here in more detail. China. A material slowdown in China is a still a very real risk to global economies and risk assets. This risk is almost always counterbalanced with the prospect of the People’s Bank of China stimulating the economy. That whole notion scares us as it is deflationary at best. US Dollar Strength. One of the soft spots for US stocks is USD strength. So far, only the obvious multi-national companies have warned about USD strength as a considerable risk for earnings and sales. Our feeling is that the market got ahead of itself in analyzing the velocity of this risk – how quickly that USD strength would hit US stocks. Now that the issue hasn’t bled through to Q3 and Q4 2014 earnings in a massive way, many market participants have dismissed the issue as less important. We think that this issue will be with us for the remainder of the year. Kool Aid. Definitely a risk: Geopolitics. We still think that geopolitical risks are rampant. Ukraine is clearly devolving and the likelihood that Russia and Putin will attempt to, if not actually, test NATO’s resolve is very high. Also, we believe that Eastern Ukraine is not going to be given back to Ukraine. The world has to understand this idea. The fact that the world does not understand this idea creates the potential for very bad, unintended consequences. The other geopolitical issue that we believe will shortly be back on the hot burner is an Israeli attempt to neutralize Iranian nuclear assets. We believe that Israel views the ongoing US-Iranian nuclear negotiations as a charade and that the upcoming Israeli general elections could give cover to any government acting to neutralize the perceived existential threat (to Israel) of a nuclear capable Iran. This is a complicated issue and we are loathe to cover it in three sentences. Acknowledge however, that it exists. 7 More debt outstanding + retail chase for yield + fancy ETF products + less dealer inventory = risk of bond liquidity crunch. 4 OLD BLACKHEATH COMPANIES DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. 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