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Category Archives: Context and Perspectives

Is Now the Time to Panic?

Is Now the Time to Panic?

What we are currently seeing in the market is a symptom of a whole lot of leverage in equities that had been in rich territory at a time when, even though it is still moving along, signs abound that the economy is slowing. Is this a ‘buy the dip’ opportunity or is it just the start of a much bigger downturn?

It has been a stormy week from the onslaught of hurricane Michael to the sea of red in global equity markets as the market shift we have been awaiting finally took hold. Wednesday the Dow lost over 800 points and had its worst day since February. The S&P 500 has had its worst losing streak in two years with over half of the S&P 500 at least two standard deviations below their 50-day moving average – the highest such percentage since March. A full two-thirds of the S&P 500 is now down 10% or more from their respective highs – that is a broad-based decline. The Russell 2000 has blown through all support levels down through its 200-day moving average. The once high-flying NYSE FANG+ Index has fallen more than 16% from its recent highs. All 65 members of the S&P 500 Tech sector closed in the red Wednesday, something we haven’t seen since the beginning of April.

Outside the US markets have been struggling even more – the US is just starting to catch up. Germany’s DAX is down to 6-month lows, the MSCI Asia-Pac Index hit a 17-month low, the Emerging Market index hit a 19-month low and 13 of the 47 members of the MSCI all-country index are down 10% or more year-to-date. Korea hasn’t seen a decline like this in 7 years. Taiwan hasn’t seen a decline of this magnitude in over 10 years. China’s Shanghai and Shenzhen Indices are at levels not seen since 2014. For those who regularly read on commentary on TematicaResearch.com, we’ve been pointing out for months that the large outperformance of US equities versus the rest of the world was unsustainable.

 

The big question on everyone’s mind now is, “Is this a ‘buy the dip’ opportunity or is this just the start of a much bigger downturn and what should we expect as we head into earnings season?”

Let’s start with earnings season which is likely to see the reporting quarter’s performance decent relative to expectations, so I’m not worried about meeting target numbers. What I am worried about is investor reactions and guidance. Since mid-September 48 of the S&P 1500 companies have reported and while their results relative to performance have been solid, only 10 companies have traded higher on their earnings day and the average stock has declined 3.8% on the day. This is an acceleration of the reactions we saw from investors last quarter.

Expectations are being adjusted. Over the past month, analysts have raised forecasts for 358 companies in the S&P 1500 and lowered them for 534 which is a net of 12.2% of the index adjusted downward, the most negative EPS revision spread since March 2017. We’d warned earlier in the year that the benefits from tax cuts and the massive injection of federal spending would likely translate into weakness in the later part of the year – well, here you have it. We are no longer seeing dramatic increases in earnings estimates while corporate guidance is slowing shifting to the downside.

Looking at factors affecting forward guidance, we are seeing rising costs across a broad range of inputs – energy, tight labor markets, higher interest rates and let’s not forget everyone’s favorite ongoing trade war. Earnings season also means that one of the major buyers of equities, companies themselves, is forced to sit on the sidelines for some time.

The big picture here is that global liquidity conditions have materially changed as central banks have shifted gears in an environment that is full of extremes.

  • Banks are shedding assets with several having announced layoffs in the credit loan groups as credit growth has been slowing.
  • China and Japan, two of America’s largest creditors to the tune of over $1 trillion, are reducing their exposure to Treasuries at a time when the nation is running fiscal deficits typically only seen during a war or major recession with debt to GDP reaching levels not seen since World War II.
  • This year the net flows into US mutual funds and ETFs is 46% below that experienced in the first three quarters of last year.

 

This contracting liquidity is occurring in the context of a variety of extreme conditions.

  • The recent tax cuts and federal spending boon represents the largest stimulus to the economy outside of a recession since the 1960s, that at a time when the economy is already above full employment.
  • We’ve seen an explosion in debt across the globe with the ratio of global debt to GDP rising from 179% in 2007 to 217% today, according to the Bank for International Settlements.
  • According to S&P Global Ratings, the percent of companies considered highly-leveraged (with debt-to-earnings ratio of 5x or more) has risen from 32% in 2007 to 37% in 2017 – so much for healthy balance sheets in the corporate sector.
  • Around 47% of all investment grade corporate debt is in the lowest category (BBB-rated) both in the US and Europe, versus just 35% and 19% respectively in 2007.
  • Total US non-financial corporate debt as a percent of GDP is near a post-World War II high.
  • The quality of corporate debt is at extreme levels as well with 75% of total leverage loan issuance in 2017 covenant-lite versus 29% in 2007.
  • There was an estimated $8.3 trillion in dollar-denominated emerging-market debt at the end of 2017, according to the Institute of International Finance, accounting for over 75% of all EM debt. According to Bloomberg, some $249 billion needs to be repaid or refinanced through next year with the US dollar having strengthened considerably against their local currencies, making that debt all the more expensive.
  • It isn’t just debt that is at extreme levels as the percent of household net worth in equities has never been higher.

 

The Bottomline on the Recent Market Turmoil

We’ve got a whole lot of leverage in the system with equities that had been in rich territory at a time when while the economy is still moving along, signs of slowing abound. Is this time to panic? Definitely not. The US stock market is getting in sync with what has been happening with yields, what is going on outside the US and with more realistic growth prospects. Both myself and Chris Versace, Tematica’s Chief Investment Officer, will be examining and re-examining thematic signals identify well-positioned companies in light of our 10 investing themes. This means being on the lookout for confirming data points that give comfort and conviction for positions existing Thematic Leader positions and opportunities to scale into them at better prices. It also means building a shopping list of thematically well-positioned companies to buy at more favorable prices.

This means asking questions like “Where will the company’s business be in 12-18 months as these tailwinds and its own maneuverings play out?”

A great example is Amazon (AMZN), which our regular readers know continues to benefit from our Digital Lifestyle investment theme and the shift to digital shopping, as well as cloud adoption, which is part of our Digital Infrastructure theme and with its significant pricing power, our Middle-Class Squeeze theme which focuses on the cash-strapped portion of the population. And before too long, Amazon will own online pharmacy PillPack and become a key player in our Aging of the Population theme. Amid the market selloff, however, the company continues to improve its thematic position. First, a home insurance partnership with insurance company Travelers (TRV) should help spur sales of Amazon Echo speakers and security devices. This follows a similar partnering with ADT (ADT), and both arrangements mean Amazon is indeed focused on improving its position in our Safety & Security investing theme. Second, Bloomberg is reporting that Amazon Web Services has inked a total of $1 billion in new cloud deals with SAP (SAP) and Symantec (SYMC). That’s a hefty shot in the arm for the Amazon business that is a central part of our Digital Infrastructure theme and is one that delivered revenue of $6.1 billion and roughly half of the Amazon’s overall profits in the June 2018 quarter.

At almost the same time, Alphabet/Google (GOOGL) announced it has dropped out of the bidding for the $10 billion cloud computing contract with the Department of Defense. Google cited concerns over the use of Artificial Intelligence as well as certain aspects of the contract being out of the scope of its current government certifications. This move likely cements the view that Amazon Web Services is the front-runner for the Joint Enterprise Defense Infrastructure cloud (JEDI), but we can’t rule our Microsoft or others as yet. I’ll continue to monitor these developments in the coming days and weeks, but winning that contract would mean Wall Street will have to adjust its expectations for one of Amazon’s most profitable businesses higher.

Those are a number of positives for Amazon that will play out not in the next few days but in the coming 12-18+ months. It’s those kinds of signals that team Tematica will be focused on even more so in the coming days and weeks.

 

Changes Afoot at S&P, But They Still Lag Our Thematic Investing Approach

Changes Afoot at S&P, But They Still Lag Our Thematic Investing Approach

Revisions to S&P’s Global Industry Classification Standard (GICS) means big changes to mutual fund and ETF holdings that tracks one of several indices, but were these reclassifications outdated before they even launched?

 

While many investor eyes were focused on the latest round of escalation in the current trade war between the US and China, there was a major change about to take place that would affect people’s investments going forward. In the last week of September, S&P rolled out the largest revision to its Global Industry Classification Standard (GICS) since 1999. Before we dismiss it as yet another piece of Wall Street lingo, it’s important to know that GICS is widely used by portfolio managers and investors to classify companies across 11 sectors. With the inclusion of a new category – Communication Services – it means big changes that can alter an investor’s holdings in a mutual fund or ETF that tracks one of several indices. That shifting of trillions of dollars makes it a pretty big deal on a number of fronts, but it also confirms the shortcomings associated with sector-based investing that we here at Tematica have been calling out for quite some time.

The new GICS category, Communications Services, will replace the Telecom Sector category and include companies that are seen as providing platforms for communication. It will also include companies in the Consumer Discretionary Sector that have been classified in the Media and Internet & Direct Marketing Retail subindustries and some companies from the Information Technology sector. According to S&P, 16 Consumer Discretionary stocks (22% of the sector) will be reclassified as Communications Services as will 7 Information Technology stocks (20% of that sector) as will AT&T (T), Verizon (VZ) and CenturyLink (CTL). Other companies that are folded in include Apple (AAPL), Google (GOOGL), The Walt Disney Co. (DIS), Twitter (TWTR), Snap (SNAP), Netflix (NFLX), Comcast (CMCSA), and DISH Network (DISH) among others.

 

 

After these maneuverings are complete, it’s estimated Communication services will be the largest category in the S&P 500 at around 10% of the index leaving weightings for the other 11 sectors in a very different place compared to their history. In other words, some 50 companies are moving into this category and out of others. That will have meaningful implications for mutual funds and ETFs that track these various index components and could lead to some extra volatility as investors and management companies make their adjustments. For example, the Technology Select Sector SPDR ETF (XLK), which tracks the S&P Technology Select Sector Index, contained 10 companies among its 74 holdings that are being rechristened as part of Communications Services. It so happens that XLK is one of the two largest sector funds by assets under management – the other one is the Consumer Discretionary Select Sector SPDR Fund (XLY), which had exposure to 16 companies that are moving into Communications Services.

So what are these moves really trying to accomplish?

The simple answer is they taking an out-of-date classification system of 11 sectors – and are attempting to make them more relevant to changes and developments that have occurred over the last 20 years. For example:

  • Was Apple a smartphone company 20 years ago? No.
  • Did Netflix exist 20 years ago? No.
  • Did Amazon (AMZN) have Amazon Prime Video let alone Amazon Prime 20 year ago? No.
  • Was Facebook (FB) around back then? Nope. Should it have been in Consumer Discretionary, to begin with alongside McDonald’s (MCD) and Ralph Lauren (RL)? Certainly not.
  • Did Verizon even consider owning Yahoo or AOL in 1999? Probably not.

 

What we’ve seen with these companies and others has been a morphing of their business models as the various economic, technological, psychographic, demographic and other landscapes around them have changed. It’s what they should be doing, and is the basis for our thematic investment approach — the strong companies will adapt to these evolving tailwinds, while others will sadly fall by the wayside.

These changes, however, expose the shortcomings of sector-based investing. Simply viewing the market through a sector lens fails to capture the real world tailwinds and catalysts that are driving structural changes inside industries, forcing companies to adapt. That’s far better captured in thematic investing, which focuses on those changing landscapes and the tailwinds as well as headwinds that arise and are driving not just sales but operating profit inside of companies.

For example, under the new schema, Microsoft (MSFT) will be in the Communications Services category, but the vast majority of its sales and profits are derived from its Office software. While Disney owns ESPN and is embarking on its own streaming services, both are far from generating the lion’s share of sales and profits. This likely means their movement into Communications Services is cosmetic in nature and could be premature. This echoes recent concern over the recent changes in the S&P 500 and S&P 100 indices, which have been criticized as S&P trying to make them more relevant than actually reflecting their stated investment strategy. For the S&P 500 that is being a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.

As much as we could find fault with the changes, we can’t help it if those institutions, at their core, stick to their outdated thinking. As I have said before about other companies, change is difficult and takes time. And to be fair, for what they do, S&P is good at it, which is why we use them to calculate the NJCU New Jersey 50 Index as part of my work New Jersey City University.

Is this reclassification to update GICS and corresponding indices a step in the right direction?

It is, but it is more like a half step or even a quarter step. There is far more work to be done to make GICS as relevant as it needs to be, not just in today’s world, but the one we are moving into.

That’s especially true compared to the thematic approach that we employ. As we see it, there is a major distinction between grouping companies based on a sector classification – one of 12 choices – vs. doing so based on the tailwinds that are driving their businesses, especially as companies acquire and divest businesses that will have a pronounced impact on their business model.

For example, while Walt Disney competes with the content business at Comcast Corp. (CMCSA), it doesn’t have a cable network or other communications business like Comcast, Charter Communications (CHTR) or Verizon. AT&T (T) is in the midst of acquiring Time Warner that would dramatically alter its business mix and product strategy, but how does the Communications Sector view account for that? Gaming companies such as Activision Blizzard (ATVI) and Take-Two (TTWO) are consuming network data with linked, multi-player games, but are they each more a gaming and content company than a Communications Services company?

And so on…

These shortcomings reveal the flaws with grouping companies and their business models by sectors, which Webster’s Dictionary defines as “a distinct part of society or an economy.” Inherent in this sector based classification schema is the idea that companies don’t change their business model. As we’ve witnessed over the years, Amazon has continued to add to its business model and today is delivering all sorts of products and services that are a long way off of its original book based business. Complicating the sector based classification further is Amazon Web Services, its pending acquisition of online pharmacy PillPack and the rollout of its Amazon Go stores that employ technology that could change the retail shopping experience entirely. Then there is Amazon’s Prime Video offering that stream TV shows, movies, original content and NFL games, it’s Prime music service as well as its Whole Foods business. Oh yeah, and then there is its Alexa/Echo digital assistant business that is moving beyond smart speakers to being incorporated into appliances, cars and home security services.

Is Amazon a Consumer Discretionary company? Is it a Communications Services company like Walt Disney and CBS or a Consumer Staples company like Kroger (KR)? Or does Amazon’s burgeoning home security capabilities mean one day it will be an Industrial company alongside ADT?

We could go on, but odds are you get the point – trying to sandwich companies into 12 sectors is not always easy, and in some cases, it could be quickly dated.

That’s why we prefer our thematic approach that evaluates each company against the changing landscapes of economics, demographics, technology development, psychographics, regulatory mandates and others. These intersections get to the heart of the how and why a business’s customers are altering their behaviors, changing the required value equation for companies along the way. Viewed through that lens it comes as little surprise that brick & mortar retail companies are struggling, shelf-stable and frozen food companies are suffering, why beverage companies are on a renewed acquisition frenzy, and fast food companies are reinventing their menu and overhauling the food and drinks they serve.