Weekly Indicators for March 23 - 27 at XE.com

 - by New Deal democrat

My Weekly Indicator post is up at XE.com.

Signals are very mixed.

Three very mixed forward looking signals from this morning's GDP revisions

 - by New Deal democrat

I have a new post up at XE.com.

This morning's final revision to 4th quarter GDP actually contained 3 pieces of forward-looking news, and that news was decidedly mixed.

International Economic Week in Review: Euro Turnaround May Be In Process Edition

This is over at XE.com

Housing is still a positive for 2015

 - by New Deal democrat

At the beginning of the year, I forecast continued growth, in large part due to lower mortgage rates and an improving outlook for housing.

My first update is up at XE.com.  So far, so positive.

Kraft is a Great Company For Heinz to Purchase

     Today’s blockbuster news event was the announcement the Heinz and Kraft would merge.  Bloomberg provides a good,overarching analysis of the deal:

The deal creates a stable of household names -- everything from Heinz ketchup to Jell-O -- with revenue of about $28 billion. It also could presage more consolidation in the U.S. food industry, which is struggling to reignite growth. Buffett and 3G, the private-equity firm founded by Brazilian billionaire Jorge Paulo Lemann, previously teamed up to buy Heinz in 2013 and they cut costs, a strategy they aim to repeat with Kraft.

It’s impossible to argue against the logic of this deal.  Heinz, which, like Kraft, owns numerous iconic American brands, was taken private a few years ago.  Now that private equity has cut costs and increased the company’s efficiency, the next logical business step is to go into acquisition mode to increase the company’s product offerings and market footprint.  Not only do Kraft’s product offerings complement Heinz’s, but the companies can potentially achieve a large amount of synergy and cost savings from their respective positions as market leaders in the consumer staples industry.  The deal illustrates why numerous investors still have tremendous admiration for Buffet’s investing acumen.

 

     Let’s take a look under Kraft’s financial hood starting with their balance sheet.  Asset structure has been remarkably consistent for the last four years, with total assets fluctuating between $21-$23 billion and the composition of those assets remaining near constant levels.  In 2012 the company added $9.9 billion in long-term debt.  But, using their highest interest expense and lowest EBITDA readings for the last five years, interest coverage is still a healthy 4.74.  The current ratio stands at one.  While this would normally create a bit of concern,   receivables and inventory levels are firmly under control, indicating the company is very well managed financially. Finally, with a large consumer staples company like Kraft, a tighter balance sheet should be expected.   

     Kraft’s income statement shows why this merger has tremendous opportunities.  Top line revenue has stalled between $18.2-$18.6 billion for the last four years.  Their biggest problem is the ease with which consumers can purchase substitute goods -- an especially prevalent activity when overall wages have stalled.  There have also been some short-term issues.  Last year the company had a huge, 10% drop in their gross margin, which was entirely attributable to a recalculation of pension liabilities.  Without this loss, EPS would have been 4.82.  But with the loss, EPS was $1.74.  While the company also had an increase in SGA expenses, the overall level rose to one more consistent with recent history.  Because Kraft and Heinz are in the same business, the merger should create tremendous cost savings and synergy, leading to margin expansion over the next 1-3 years.

     Finally, free cash flow to the firm has fluctuated between $1.4 and $2.5 billion for the last five years giving the company ample funds to self-fund all of their activities.  And their cash investing needs, which are solely derived from plant, property and equipment investment, have been very predictable for the last five years; they’ve fluctuated between $440 and $557 million.     

     Kraft was a great company before the merger.  It was the owner of numerous brands that are a staple of the US market.  The company managed its assets incredibly well and literally printed money.  Now with the addition of another major US consumer staple company, the combination can achieve major cost savings by eliminating duplicative operations and achieving even larger economies of scale. 

    

 

 

   

Has the EU Finally Turned the Economic Corner?

This is posted over at XE.com.

Five graphs to watch in 2015: second update

 - by New Deal democrat

At the end of last year, I highlighted 5 graphs to watch in 2015.  Now that we have all of the February reports, let's take another look.

#5.  Mortgage refinancing

After a mini-surge at the end of January (light brown in the graph below), The Mortgage Bankers Association reported that refinancing applications fell back to somnolence during February, due to higher interest rates (blue)  Mortgage News Daily has the graph:
 

Over the last 35 years, refinancing debt at lower rates has been an important middle/working class strategy.  There is little room left for that strategy. David Stockman had an interesting graph last week showing that in this expansion, wage growth and consumer spending have been almost perfectly correlated.  If mortgage refinancing stays turned off too long, and wages don't grow in real terms, then consumer spending falters and so does the economy.  

#4 Gas prices

Here is a graph of gas prices (blue, inverted and averaged quarterly) compared with real GDP (red) over the last10 years:

Once gas prices reach a critical point, roughly $4 a gallon in present real terms, GDP falters.  The cheaper gas prices are from that point, the more GDP can be expected to rise, with a slight lag.  In February, gas prices rebounded as expected over $0.30 from their late January bottom.  This is a typical seasonal increase and so is a neutral. All else being equal, by the 2nd quarter, this should be reflected in more positive real GDP.

#3 Part time employment for economic reasons

This is a graph of part time workers for economic reasons expressed as a percentage of the labor force:

In February this ratio continued to improve, bringing us equivalent to its levels in 1988, but still 2% (about 3 million) above the boom level of 1999 and about 1.5% (2.25 million) above the level of 2007.

#2 Not in Labor force but want a job now:

This moved in the wrong direction in February.  It is now about 900,000 above its post-recession low of November 2013 (just prior to Congress's cutoff of extended unemployment benefits) and some 1.9 million above its 1999 and 2007 lows.

#1 Nominal wage growth

After an anomalous decline in average hourly wages in December, and a big positive reversal in January, wages for nonsupervisory workers were totally flat in February.  Nominal wage growth YoY has now declined back to its post-recession low.

The decline in the last 6 months is  troubling.

Compare our present expansion with the previous three.  In the 1980s and 2000s, by the time we improved to 5.5% unemployment, nominal wage growth was approaching 3% YoY.  In the 1990s expansion, at worst wage growth was on the cusp of acceleration, but was nevertheless 3.5%. Unless wage growth starts to accelerate now, the pattern is not holding.

There have been a few interesting notes about the lack of wage growth.  The staff of the Federal Reserve has done a study indicating that the number of long-term unemployed plays an important role (since presumably these people are more desperate).  It has also been suggested that the disproportionate (compared to normal times) percentage of relatively highly paid employees (Boomers) retiring from the labor force, and being replaced by younger workers, is holding down wages.

Two months of data into the year shows two series positive (gas prices, involuntary part time employment), and no or little improvement in the other three (refinancing, discouraged dropouts from the labor force, and nominal wage growth).  Should wage growth not improve, and mortgage refinancing remain dormant, we are going to run into trouble, and I will be looking for other long leading indicators to start rolling over.

Microsoft is Still a Growth Story

I do already own the company.  But, this is not an invitation to either buy or sell these securities.  Do your own research and figure it out for yourself.

 

     It’s hard to believe that a company such as Microsoft could still be considered a growth story.  After all, a thirty-year old company that is dominant in their industry is usually considered “mature” – a corporation whose revenues grow incrementally at best.  However, this description does not apply to Microsoft which has had year-to-year top line growth between 5%-11% since 2010.  Buy-side analysis, however, does not end here.   Potential investors should avoid purchasing an issue when solid growth is not supported by a strong balance sheet or solid cash flow.  Fortunately for potential investors this tech company has a rock solid balance sheet and continuously strong free cash flow.  One additional factor is the company’s current dividend yield of 2.889% and five-year history of increasing dividend growth.  When these fundamental factors are added together, the decision to buy becomes a matter of when and not if.  And, as an analysis of the chart shows, the time to buy is now, as the security is trading about 5 points above is 1-year low.      

     Let’s begin our analysis by looking at their one-year price chart:

 

  

Microsoft rallied from May 2015 until early November, when prices started to slowly move lower.  They consolidated in a triangle pattern from mid-December to mid-January.  Prices broke through support at the end of January on a disappointing earnings report.  Since then, they have been consolidating between the lower and mid-40s.

     At these price levels, MSFT is slightly under-valued, as shown on this table from Morningstar:

MSFT is slightly under-valued on a PE, price/sales and price to book level.  This gives us room to move a few points higher which is increased slightly when you consider the company slightly outperforms their industry peers on ROA, ROE and net margin. 

     Let’s turn to their financials, starting with their balance sheet.  Like most tech companies whose primary asset is intellectual property, this is a beautiful financial document.  The current ratio is 2.45 while the quick ratio is only slightly lower at 2.24.  The company has been keeping a close eye on receivables, with their percentage of assets dropping from 15.1% in 2010 to 11.34% in fiscal 2014.  They also keep a ton of cash handy; they’re got $85 billion on their 2014 balance sheet, with most of their holdings in short-term securities.  Fundamental investors should like that their overall book value has increased from $46.175 billion in 2010 to $89.784 in 2014, which is almost a doubling in five years.  The only “drawback” is their increased use of long-term debt, which now totals $20.6 billion.  But with an interest coverage ratio of 50.8, it’s difficult to be concerned.  The balance sheet indicates they have ample liquidity and have kept receivables well-managed.  Their near-doubling in book value over a five year period also indicates they have shareholder interests at heart.  Finally, they most likely tapped the debt markets to prevent a high tax bill from repatriation of foreign holdings. 

     Their cash flow statement is no less impressive.  They’ve had free cash flow to the firm of between $22 billion and $29 billion over the last five years giving the company ample financial maneuvering room.  This allows them to self-fund most small acquisitions (those involving both companies and property) if they desire. 

     And finally, we have their income statement.  As mentioned in the opening paragraph, the company is growing between 5%-11%/year.  They did have a large 5% jump in COGS in their latest annual statement.  They offered the following explanation in their 10-K: “Cost of revenue increased mainly due to higher volumes of Xbox consoles and Surface devices sold, and $575 million higher datacenter expenses, primarily in support of Commercial Cloud revenue growth. Cost of revenue also increased due to the acquisition of NDS.”  This trend continued in their latest quarterly statement, increasing COGS by 8.1%.  While this is not an optimal development, it is partially caused by their move into cloud based computing, which most analysis (myself included) believe will provide solid growth avenues for the foreseeable future.  In addition, there are continued costs related to the Nokia acquisition, as they noted in their latest 10-Q: “Cost of revenue increased, mainly due to the acquisition of NDS.”  These increases should subside in the next 4-6 quarters.

     I have to admit that I have made my fair share of Microsoft jokes, even referring to them as the evil empire on more than one occasion.  But all kidding aside, it’s hard not to like the company.  They have solid revenue growth, a very strong balance sheet and the company literally prints money.  They’ve been increasing their dividend for the last five years, and have ample cash and potential revenue growth to continue this practice for the foreseeable future.  All these factors add up to a solid company.

           

International Economic Preview For the Week of March 23-27

This is over at XE.com

US Equity Market Review For the Week of March 16-20: Small and Mid-Caps Outperform, Edition

This is over at XE.com

Weekly Indicators for March 16 - 20 at XE.com

 - by New Deal democrat

My Weekly Indicators post is up at XE.com.

Continuing weakness in steel production and domestic rail carloads are warning flags for a continuing slowdown in industrial production.

International Economic Week in Review: Minute by Minute, Edition

This is over at XE.com

No, the yield curve is NOT forecasting mediocre growth. Right now it actually isn't forecasting anything

 - by New Deal democrat

A 3 dimensional view of the yield curve in the treasury bond market at the New York Times has gotten a lot of play in the econoblogosphere yesterday.  

Why pay attention to the yield curve, i.e., the difference in interest rates paid by short term vs. long term treasury bonds?  Here's why:  an inverted yield curve, I.e., short term interest rates higher than long term interest rates, is a nearly perfect warning of a recession 12 to 18 months in the future. In the last 100 years, it has had only one false positive (1966). 

If we are sure we will have inflation rather than deflation in the next several years, a normally shaped yield curve is also a perfect indicator for the economy about 12 to 18 months later. In times of deflation, however, a normal yield curve is not reliable. An inverted yield curve in the presence of deflation is much to be feared. It has only happened twice in the last century – in 1928 and 2006.

For a detailed look with helpful graphs, here, here, and here.

The NY Times 3D graph is not animated, and not interactive.  For the last 15 years, however, Stockcharts has had the aptly named interactive Dynamic Yield Curve, a tool which I have made use of frequently over the years.  Here is a snapshot I made today comparing the present yield curve (lower) with the yield curve in Q1 2003, one year before the best YoY real GDP growth of the 2000s:

The yield curve is founded on a solid economic signal.  Since normally you would want to be paid more interest in order to take the risk of holding on to a bond for a longer time, when the curve inverts, it means bondholders think current rates are too high compared with the longer term – they expect weakness.

One statement in the NY Times article, however, looks flat out wrong: “The yield curve is fairly flat, which is a sign that investors expect mediocre growth in the years ahead.”

Not so. Below is a graph of the spread between 10 year and six month bonds, currently at 2%. The graph then subtracts 2 so that the current spread = 0.

Prof. Menzie Chinn of Econbrowser has posted a similar graph for the 10 year vs. 3 months and 10 year vs. 2 year Treasuries:

While the spread between the 10 year and 3 month bond is in the lower half of the distribution, the spread between the 10 year and 6 month treasuries (my graph) and 10 year vs. 2 year (red in Prof. Chinn's graph) is steeper than most other times during the last 30 years. 

It is also equivalent to if not steeper than almost all times between 1933 and 1954 (blue is long term government bonds, red is 3 month treasuries): 

during which time the US saw the strongest growth in its entire history:

So,*NO,* the yield curve is not telling us there will be mediocre growth.  Because we are presently in deflation, even though the yield curve is positive, it actually isn't forecasting anything.

Is 2% core inflation the Fed's target, or a ceiling?

 - by New Deal democrat

I really don't have much to add to what you have probably read elsewhere about the Federal Reserve's policy statement, except that it appears to me that 2% inflation isn't really being treated as a target so much as a ceiling.

Their estimate of NAIRU has declined to 5% - 5.2% unemployment, which is an acceptance of  the reality that there is zero pressure on inflation from wage growth at this point, and likely won't be for awhile.

All well and good, but here is the Fed's high end estimates for inflation for this year and the next two years:

Core inflation

2015 1.4%

2016 1.8%

2017 2.0%

The Fed doesn't expect core inflation to hit their 2% target for two years!  Yet here is what they say:

[T]he Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate..

....  In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. ...  The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term

Since lower gas prices are likely to cause core inflation to slightly decrease over the next year as they feed through into the broader economy, it will take well over a year for such factors to "dissipate."  But the Fed is going to raise rates in advance of 2% YoY core inflation, to ensure it does not exceed that level.

In practice that's a ceiling, not a target.

The S&P Case Shiller Index as objective evidence of a housing bubble, and a leading indicator for core inflation

 - by New Deal democrat

Recently I had a pretty good and spirited discussion about macroeconomics and forecasting the Great Recession.

One issue is, how easy or not was it to spot the housing bubble? Dean Baker certainly did. But was there objective evidence?  There was.

Home prices themselves are not part of the CPI, although "owners equivalent rent," the housing portion of CPI, constitutes over 1/3 of that index. Ideally the inflation rate for each should stay relatively close, since rent is presumably the trade-off for housing.  But in a bubble, that trade-off ends because "Everybody knows house prices only go UP!!!"

At that point, the tradeoff vanished. Rent inflation was subdued because renters wanted to become homeowners.  And look what happened to the cost of housing (via the Case Shiller 10 city index) vs. owner's equivalent rent (in the linked graph, both are normed to 100 in 1987):

House prices went from about 1.15x the rent index to 1.85x the rent index, a 50%+ increase, in just 4 years.  That is the signature of a bubble.

What did the Fed do in the face of that objective evidence of a bubble?  Nothing, until it was far too late.  Tim Iacono of "The Mess That Greenspan Made" came up with a great way of looking at housing inflation, by substituting the Case Shiller Index for the Owners' Equivalent Rent in the CPI, calling the result the CS-CPI.  The below graph shows the CS-CPI in blue, and the Fed Funds rate in red:

The Fed treated inflation as subdued, and kept the Fed funds rate at 1%,when measured by the CS-CPI it was as high as nearly 10%.  (I have always suspected Greenspan held off for political reasons, to assist the re-election of W.  But Greenspan would never be political, would he?)  Not only that, but the Fed subsequently kept the funds rate at 5% after the bubble had completely burst.

The run-up in house prices vs. rents in 2012-14, by contrast, is pretty subdued.

An interesting by-product of this is that the Case-Shiller house price index appears to lead owners equivalent rent by about 1 year:

There has been a big downturn in the growth of the Case Shiller index in the last year, that doesn't appear to have fed through into owners' equivalent rent. Nor has the recent big downturn in gas prices fed through into the direction of core CPI, which typically also takes about a year.  Together, these two trends strongly suggest that core CPI inflation, already below 2%, is going to decrease further. Which by the way means that the Fed ought to hold off on rate increases, and let (hopefully) higher wage growth and lower unemployment continue.

With a Yield Over 5%, Take A Long Look At Phillip Morris

     This article is not a solicitation to buy or sell these securities.  You might also want to do your own research into this; heck, you just might learn something.

     Recently, Morningstar wrote a story titled, "The Ultimate Stock Pickers Top 10 Dividend Stocks" which contained a total list of 20 stocks whose dividend was higher than the S&P 500 and whose shares were owned either by a leading manager or leading fund.  Topping one of the lists was Phillip Morris (PM). 

     Let's start by taking a look at the weekly chart:

 

     The chart is certainly not one to get excited about.  It's been trading in a fairly tight range of 75-89, with a tighter range of 79-89 over the last three years.   However, the stock price has recently dropped to the 78 level, making it attractive.  So, let's take a deeper look at the company.

     According to their latest 10-K, Phillip Morris and "[o]ur subsidiaries and affiliates and their licensees are engaged in the manufacture and sale of cigarettes, other tobacco products and other nicotine-containing products in markets outside of the United States of America. Our products are sold in more than 180 markets and, in many of these markets, they hold the number one or number two market share position. We have a wide range of premium, mid-price and low-price brands. Our portfolio comprises both international and local brands."  Their market cap is about 120.5 billion, making them the largest cigarette company according to the Finviz.com website.  They are one of the top three cigarette makers, with British American Tobacco and Altria group close second and third runners-up.

     Their operations are entirely international, with the following regional breakdown (click for larger image):

In the last three years, the Eastern Europe segment has gained 7.9% of the companies overall sales while the Asian market has decreased 10.3%.  Consider this situation in relation to the high level of the dollar, and the negative impact that will have on earnings.  Many multi-national companies have stated that the strong dollar is seriously impacting their financial performance; don't expect anything different from PM.

     The biggest risk the company faces is litigation and the potential downside of a massive award against the company.  As this table shows, the company currently faces 93 different lawsuits (click for a larger image):

But, the company has been very successful at defending these causes of action.  From the 10-K:  "Since 1995, when the first tobacco-related litigation was filed against a PMI entity, 433 Smoking and Health, Lights, Health Care Cost Recovery, and Public Civil Actions in which we and/or one of our subsidiaries and/or indemnitees were a defendant have been terminated in our favor. Ten cases have had decisions in favor of plaintiffs. Nine of these cases have subsequently reached final resolution in our favor and one remains on appeal."

     While this is no guarantee that future litigation will lead to the same result, it does indicate that Morris' litigation team has been strikingly effective. 

    PM is a leading brand with very high barriers to entry.

Financials

     The chart above indicates this is a pure dividend play.  While there is upside potential on the current chart, the fairly predictable trading range of the security over the last three years indicates that once the stock hits the mid-80s, bears will take over.  This means the most important consideration for any investor is dividend safety.  Obviously, the insure a continual payment of the dividend we need, at minimum, revenue and margin predictability.

 

     For the last 5 years, revenue has risen a bit going from $27.2 billion in 2010 to $29.7 billion in 2014.  Revenue was higher between 2011-2013, coming in a bit over $31 billion.   Expenses have been very predictable over the same period:

 

COGS: 33%-35%

Operating expenses: 23%-25.6%

Net Income: 25%-28%

 

     The above numbers indicate that revenue and expenses have been very predictable and should continue to be so over at least the next year.

 

     The dividend payout ratio has fluctuated between 55.7% in 2011 to 80.5% in 2014, meaning the company pays out a large percentage of its net income to shareholders.

 

     Just as importantly, PM is a company that prints money, with free cash flow to the firm of between $6.5 billion in 2014 to $9.6 billion in 2011.  Their primary operating expense is property investment, which is very predictable, with the figure right around $1.1 billion over the last three years.  This is only 14% of the lowest number for operating cash flow for the last five years, meaning the company is flush with cash.

 

     The only drawback to the balance sheet is the company has loaded up on debt, with their long-term debt totals increasing from $13.3 billion in 2010 to $26.9 in 2014.  This makes their long-term debt position a whopping 76% of total assets.  But, their interest coverage ratio at these high levels is 10.86.  And with EBITDA reported at between $12.1 and $14.7 over the last five years (not to mention the company's very strong cash flow position), a default isn't on the horizon.

 

Conclusion

 

     In a record low interest rate environment, high paying dividend stocks become exceedingly attractive, so long as there is a consistency to the underlying company's financial performance.  PM has such a profile, with steady earnings and expenses, a more than adequate cash flow and a strong policy of passing earnings onto shareholders.  These factors make PM a solid stock for dividend investors, especially at these levels.

 

 

 

 

 

  

 

 

Ignore housing starts, housing permits were encouraging

 - by New Deal democrat

You don't need decent weather to get a housing permit.  You need decent (or at least not horrendous) weather to actually start building a house. That makes winter housing starts particularly volatile.

In general, housing starts (red in the graph below) are twice as volatile as housing permits (blue). I've squared the results so that they are all positive, making it easier to see the volatility:

That's why I focus on permits rather than starts.  Plus permits tend to lead starts by a month.  

So what is going on with permits?  Here they are in absolue terms:

And here is the YoY trend:

Housing permits in February were only exceed by last October.  And the YoY trend has turned up mildly.  So consider me unperturbed by the morning's housing starts miss, and encouraged by the good permits number.

February may have seen a sharp intensification of deflation

 - by New Deal democrat

I have a new post up at XE.com.  According to the Billion Prices Project, consumer prices fell sharply in February.

If so, that puts entirely different gloss on the February decline in nominal retail sales, and suggests that real Q1 GDP will not be as poor as feared.

International Economic Preview For the Week of March 16-20

This is over at XE.com

US Equity Market Review For the Week of March 9-13; Hey, It Looks Like More Consolidation, Edition

This is over at XE.com