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Category: Market Commentary

Earnings season is underway, and the path to quick profits (or losses) is right in front of us.

Expectations are high because of tax reform and solid trends in earnings growth. Sales are trending up, and operating profits are on the rebound. Meanwhile, profit margins are high, with Wall Street analysts projecting more of the same.

All this should propel the market higher.

However, there’s a disconnect between the market and the typical company.

Government statistics compiled from all corporations show that not only did profit margins peak years ago, but that the trend has deteriorated further over the last 12 months.

The differences likely come down to one thing that public companies can do that private companies can’t that can make a big impact on its profits.

That one thing? Buying back stock.

When companies buy back stock or pay a dividend, it’s called “shareholder yield.” Returning capital to shareholders is great, right? Possibly, but…

Not all shareholder yield is created equal.

At Hidden Profits, I focus on a version of my forensic accounting stock tracker called “Show Me the Money.”

I overweight the shareholder-yield component while also keeping the earnings-quality factors in the model so that, when I make a stock recommendation to my readers, we can have more confidence that management isn’t pulling the wool over our eyes by returning capital to shareholders.

IBM (NYSE: IBM) is a great example of a company that loaded up with tens of billions in debt to buy back stock and dish out dividends. Meanwhile, revenues were slowing (down quarter after quarter for about five years), and cash flow performance was dismal.

Propping up earnings by buying back stock is not good shareholder yield. While we can simply avoid investing in specific companies that do this, what’s scary is the market as a whole is flashing a huge red flag… marked “shareholder yield.”

Companies are using their tax windfalls to goose the numbers. Financial engineering is reaching new heights. In the past five years, companies have spent $4.9 trillion in mergers and share repurchases. In the first quarter of 2018, that trend actually accelerated, with $305 billion spent on takeovers and buybacks.

This has been going on for a while. When it ends, it will expose the market for what it is: financially engineered without sustainable profits to support stock prices.

Look out below.

 

This post was originally published on Economy & Markets and can be seen here.

There’s an old market axiom that goes something like this: You can’t go broke taking a profit.

Of course, for every piece of a conventional wisdom, there’s usually a piece of counter-wisdom, such as “let your winners run and cut your losses short.”

Both can be useful, depending on the circumstances.

In this space in recent months I’ve highlighted rich market valuations and overly optimistic investor sentiment. As both of these conditions persist, I’m very concerned that any gains in the market would only be erased entirely and then some at a later date.

After the shellacking many retail investors suffered in early February,, their views of the market changed. Realizing that stocks can actually go down will do that! We’ve since seen investor sentiment normalizing a bit, as record amounts have been pulled from exchange traded funds. But sentiment has not swung to the other side of too much pessimism.

Which is to say, the risks are still present and dangerous.

As a result, in Hidden Profits this month, I followed the first maxim and booked some large profits in three of my recommendations, all around 50%.

Not bad!

Earnings season is upon us, and, with the recent uptick in market volatility, anything can happen going forward. While tax reform generated some market tailwinds, my view is that any company that whiffs even a little bit on their earnings release or guidance will face the wrath on unrelenting selling by investors.

We’re now longer at the stage of the market cycle where free hall passes are being given out.

It’s like the old mafia members in the movie Casino trying to figure out who to whack to save their own hides. Alas, they  wipe everyone out: “Why take a chance?”

Interestingly, while I’ve been cautious on the market, two of my biggest winners were conservative investments. One is in the unloved refining business. Far from sexy, Valero (NYSE: VLO) has solid operating performance and earnings quality. In fact, it’s at the top the rankings in my forensic accounting software.

Our biggest winner, Wyndam Worldwide (NYSE: WYN), is a hotel and vacation operator that had taking a beating just prior to my recommendation to buy the stock. What we viewed as the “Apple of hospitality” has had an unrelenting move to higher prices. I have no doubt the business is well managed and operating performance has been strong, but the stock is ahead of itself, in my opinion.

Finally, we booked a profit in QVC (NYSE: QRTEA), which is led by industry veteran John Malone, who sports a track record that rivals the legendary Warren Buffett. It’s a solid business that we also recommended after a short-term decline. Great managers and loads of cash flow are a wonderful combination, as the pick has proven.

During the exercise of reviewing all of the positions very closely, I made another observation…

A couple of the very best opportunities in the portfolio are trading a touch below my ideal buy-up-to price, but nothing has changed to alter my opinion of these stocks. In fact, the fundamentals have improved. That just hasn’t been recognized by the market.

That’s the hidden profit: well-run companies with good operating performance but a misunderstood opportunity.

If the investment thesis plays out as expected, that only means even bigger returns. They’re out there, even in this up-and-down market.

You just have to know where to look.

Good luck,

John

 

This post was originally published on Economy & Markets and can be seen here.

Consumers are confident.

That has me nervous.

In fact, they’re the most confident they’ve been in more than a decade. The Reuters/University of Michigan Consumer Sentiment Index just registered its highest reading since 2004.

That should be good for the economy, right?

Well, consumers are people, and people as a whole are terrible at predicting much of anything. They’re even worse when it comes to financial matters.

For example, consider some consensus views of the stock market.

Individual investors held the highest allocation to stocks ever in 2000, at 77%. That was also the lowest cash position ever, at 7%, leaving no cushion to soften a major blow. For you history buffs, that wasn’t too long before the market cracked and many technology stocks fell over 90% as the Internet Bubble popped and deflated.

Then, in 2009, individual investors held just 41% in stocks at the market lows in March 2009. That represented the lowest equity allocation ever – right in front of one of the most monstrous bull markets in history.

It’s a bull market we’re still living through, in fact.

It might be a bit old and tired, but this baby has legs!

I subscribe to my own theory of wealth management,  the “George Costanza Theory of Money.” You may remember George from the iconic 1990s sitcom Seinfeld. He gets into all sorts of trouble from episode to episode, brightening my day with plenty of laughter an untold number of times.

Here’s just one “George” story.

One day, fed up with all his continued misfortune, George decides to do the exact opposite of everything he thinks he should do. Throughout his life, his gut instinct has caused him nothing but problems.

But when he starts doing the exact opposite of what he thinks he should do, life starts going his way.

First, he lands a beautiful girlfriend. Then, he gets a job offer with the New York Yankees. Finally, he snags an apartment that allows him to finally move out of his parents’ house.

Life is grand for George!

The average investor or consumer is the typical George – before he decides to do the exact opposite of what he thinks he should do.

Collectively, we make bad decisions because we’re driven by emotion. And, at best, all we can get is “average.” Otherwise, we’d all be sitting rich on a beautiful sandy beach, drinking Bahama Mamas, and watching our online trading account balances soar.

That’s why when folks are incredibly optimistic, I get nervous. When they’re spending money hand over fist, I’m squirreling it away for a rainy day. When they’re pessimistic about the economy and their own prospects, I’m looking to spend money to obtain the best deals in years.

In the short term, these might be good indicators of economic growth – for a quarter or two. But there’s no greater contrary indicator than when masses of people are at multi-year highs in optimism. Any short-term benefit will be wiped out when the pendulum swings the other way.

So, while the popular media might cheer the 14-year high in confidence, please remember George.

And proceed with caution.

Good luck out there,

John

This post was originally published on Economy & Markets and can be seen here.

Bitcoin has bounced back off its lows after getting absolutely smashed earlier this year. After nearly topping  $20,000 in 2017, the price of bitcoin fell back to $7,000 before rebounding to about $11,000.

And, wouldn’t you know it, high-flying prices and insane volatility have caught the interest of regulators.

That’s a good thing.

Wait, wait. Hear me out.

I’m pretty libertarian about things, which means I’m not usually a big fan of regulation. But a space like bitcoin is ripe for ordinary folks getting taken advantage of. You can see it coming a mile away. Recently, the Securities and Exchange Commission (SEC) issued dozens of subpoenas to crypto-issuers and are warning that these offering should be treated like securities.

I have no doubt there are illegal securities offerings. The market is growing exponentially, with 50% growth over all of 2017 in just the first two months of the year. With bitcoin looking like the Wild West, I keep picturing a guy with a desk, a fax machine, and a pager lighting up the phones to sell some sort of crypto-related investment. Formerly, these people were junior gold miner prospectors.

It always ends badly.

With the request for information, the regulators are clearly trying to get ahead of the curve and nip the illegal activity in the bud. This might also make life difficult for legitimate operators, but, hopefully, that’ll only be short-lived. Once the smoke clears, legitimate companies have a better chance to prosper without being dragged through the mud with the frauds.

The other area where the SEC has flexed its muscle is in the exchange-traded fund (ETF) space. The SEC had blocked bitcoin ETFs in the past, but once futures started trading on bitcoin, several ETF sponsors filed to list their funds on exchanges. They could price the ETF based on the futures contracts traded on bitcoin. Previously, it would’ve been impossible for an ETF based on bitcoin to function properly.

I have no doubt that these bitcoin ETFs would’ve garnered billions of dollars in assets quickly after their respective launches. These would be the most successful ETF launches in recent history, if not all-time. What’s more is that if normal bitcoin volatility, which is like a death-defying roller-coaster ride, didn’t whet your appetite, you’d also have been able to purchase ETFs with added leverage designed to juice the returns.

Fortunately, regulators stepped in and expressed deep concern with how these ETFs would function. In short order, the ETF sponsors withdrew their filings. Tons of money in future management fees also went up in smoke.

Our last Hidden Profits stock pick is engaged in blockchain technology. But, instead of changing its name to Sock Puppet Blockchain to capitalize on a trend, it’s actually operating real blockchain businesses. I remain quite skeptical on the currencies themselves, but blockchain technology is real and here to stay.

Even if I’m wrong and bitcoin goes to $100,000, bigger gains will be made in the winners of the blockchain battle.

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.

Last week I talked about how the implosion of the short volatility trade was likely not the start of a bear market.

However, it is a nasty reminder that stock prices do, in fact, actually go down from time to time. I think that the record lull in market volatility is over for the foreseeable future. Expect big moves in both directions as speculators react to day-to-day events.

A bear market likely needs a nudge from a major default, a bankruptcy, or a painful increase in interest rates. As far as rates go, market pundits watch every move of the Federal Reserve to try and glean what the members might be thinking about inflation and the impact it will have on the markets.

I think those pundits are looking in the wrong direction.

They should be watching the London Interbank Offered Rate, or LIBOR for short. It’s an important rate because a lot of financial instruments – as is the case with the federal funds rate – are priced off of it.

LIBOR has been rising, so much so that the chart looks a bit like bitcoin. This could be a bad omen. Worse yet, the Fed is well behind the curve.

So what’s the problem?

Well, people with heavily invested portfolios at big banks have used ultra-low interest rates to borrow against their investment holdings to fund other needs. These lines of credit can be used for virtually anything. They may have used the money to pay for day-to-day expenses. Maybe they bought a boat or built a wine cellar. It’s easy money, and it’s cheap – rather, it has been cheap, until recently.

Sound too good to be true? I’ve used one myself.

It was surprisingly easy to access capital.

I have an elderly parent with health issues that I needed to relocate for both better medical care and closer proximity to immediate family. I borrowed against my portfolio and had access to the capital almost immediately. As long as I didn’t use the money to buy stocks, I was free to tap into the line of credit as I needed. Road trip to Austin, Texas, this weekend? Hey, no problem! Want to fire up a private jet to Cabo San Lucas from Dallas? We got you covered.

I used the line of credit for what I would consider a reasonable and fair situation. Rather than get a mortgage on a second home to take care of my parent, I just use the line of credit. It was cheaper and easier, and you’re essentially offering cash for a property which gives the buyer a lot of leverage in the negotiation.

What’s more is that I paid it back in 10 months, and therein lies the rub.

People may be using these lines of credit for all sorts of reasons, with little ability to pay them back if something causes stock prices to fall. Higher interest rates create a cash flow pinch, and falling stock prices create margin calls.

What are you supposed to do in that situation? As a sailing friend of mine once told me, “You can always buy a boat, you just can’t always sell one.” The heavy use of cheap money against stock portfolios will eventually blow up in people’s faces. Markets change, the key drivers of the markets change, but human nature never changes.

In 2015, when I first started researching credit lines, the three-month LIBOR was about 25 basis points. See, the rate fluctuates, and you have to tack on the extra percentage the bank takes as well. A loan that was about 0.85% a couple of years ago is nearly 3% today.

There’s a tipping point which could lead to a massive margin call on stocks when a snafu in the market occurs and these lines are shut down. What that point is, I do not know.

All I know is that we’re getting closer by the day.

Good investing,

This post was originally published on Economy & Markets and can be seen here.

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