Tesla CEO's Bold Tweet

For Tesla Chief Executive Elon Musk, outside-the-norm has always been the norm. Even by those standards yesterday Mr. Musk sent shock waves throughout the business community with message he sent from his Twitter account announcing he was considering taking the company private at $420 a share. Mr. Musk also indicated that funding had been secured.

The timing of the message, during market trading hours, was highly unusual for a message of this magnitude. Also, there was no explanation for how Mr. Musk arrived at the $420 per share figure.  Mr. Musk would need to raise an estimated $60-$70 billion in debt and/or equity to take Tesla private. That is an enormous task for a company that is still rapidly burning through cash. The SEC will certainly take a close look at Mr. Musk's tweets.

Time will tell what the outcome ultimately will be, but there is no question this is one of the wildest financial stories I have seen. Tesla's stock has never traded on fundamentals, and headlines around Mr. Musk have often been surreal. 

For more analysis on this story, head over for a take from MarketWatch.
 

Apple

Last week a significant milestone was reached as Apple became the first company to reach a valuation of $1 trillion. From the WSJ:

Apple’s rise has been propelled by the sustained success of the iPhone developed under late co-founder Steve Jobs, a product visionary who helped revive the company from a death spiral in the late 1990s. His successor, Tim Cook, has turned Apple into a cash-generating giant by pushing its existing products to prominence in China and cultivating its rapidly growing services business—moves that have helped stave off concerns about the absence of a new, blockbuster device.

With a market capitalization of $1 trillion, Apple is larger than the GDP of most countries, including Sweden, Saudi Arabia, Turkey and The Netherlands. It is a remarkable achievement, especially when you consider that the company had to reinvent itself multiple times just to stay in business. Their superior innovation, technology and marketing helped them become the first trillion dollar company.

Business Investment Accelerates

As we near the halfway point of 2018 several themes are emerging. Let's take a look.

Business Investment

After years of virtually no capital expenditures, businesses have significantly accelerated investment into things new buildings, equipment, vehicles and software. One of the biggest reasons for increased investment is due to the tax cuts that took place January 1st, 2018. During 1st quarter earnings reports, company after company have cited the tax cuts when asked what was driving increased investment.

From Reuters:

"U.S. companies could plow more of the money saved from sweeping tax cuts into business investment later this year, perhaps even surpassing a jump in first-quarter capital expenditure that was the highest in almost seven years, strategists and analysts said.  
Higher spending on technology, equipment and facilities could ease worries that S&P 500 companies have reached a peak in the profit growth investors are counting on to extend the nine-year bull market in equities. 
With data in from 94 percent of S&P 500 companies, first-quarter capital expenditures total $159 billion, up more than 21 percent from a year ago and on track to be the highest year-over-year growth since the third quarter of 2011, according to S&P Dow Jones Indices data." 
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Earnings Growth

When all was said and done 1st quarter earnings grew at a blistering 26.5% pace. After earnings growth had flat-lined in 2015 & 2016 financial analysts are forecasting growth of almost 20% in 2018. This would be an impressive number on the heels of 14% growth in 2017. Tax cuts, deregulation and consumer confidence in the economy have all played a role in the earnings surge. 

Not only were 1st quarter results impressive, but we saw the highest spread between companies rasising their earnings forecast and companies lowering their earnings forecast since 2003. 

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Small Business Optimism

Given that small businesses are so critical to the U.S economy, the fact that optimism from business owners hit the highest level in 35 years should be very beneficial to the economy during the 2nd half of 2018.

Via NFIB:

“Main Street optimism is on a stratospheric trajectory thanks to recent tax cuts and regulatory changes. For years, owners have continuously signaled that when taxes and regulations ease, earnings and employee compensation increase,” said NFIB President and CEO Juanita Duggan.
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Investors could not have asked for a better start to the year for company earnings than what they have gotten. With small business optimism hitting records and a long overdue surge in business investment, the table is set for continued strength in the U.S. economy.

Next, we will look ahead to some of the challenges the market could face in the 2nd half. We will tackle the ongoing tariff negotiations currently taking place between China and the United States as well as the decision by the Federal Reserve to hike interest rates once or twice by the end of the year. We will also take a look at which investments have been the leaders and which have been the laggards in the first half of 2018.

Strong Earnings Growth Faces Off With Rising Interest Rates

Market volatility has persisted as wide intraday swings in stock prices have continued to be the norm following the stock market correction in early February. 

There has been a tug-of-war for the market's attention between higher interest rates and strong earnings growth. On one side the interest rate on a 10-year U.S. Treasury Bond topped 3% this week for the first time since early 2014. Coming into 2018 the 10-year rate was 2.40%. Remember that when interest rates go up that means that bond prices are declining. The Barclays Aggregate Bond Index, which is viewed as the S&P 500 of the bond market, is down 2.67% year-to-date and Long-Term U.S. Treasuries have declined 7.07% year-to-date. It has been several years since we owned Long-Term Treasuries as the risk of interest rates going higher outweighs the reward of earning a slightly higher yield. 

Also taking it on the chin this year:

Consumer Staples      -10.20%

REITS                        -9.02%

Utilities                      -3.05%

What these investments have in common is that all three doubled in price between 2011 and 2016, outperforming the S&P 500 as investors searched for high-paying dividend stocks with bond rates and money market rates extremely low.  

The valuation of these "bond-proxies" are still not cheap and if interest rates continue to go higher there will likely be more pain ahead for this group.

The high yield for the 10-year U.S. Treasury in 2014 was 3.03%. Earlier this week that level was tested again and rates subsequently backed down to under 3%. The issue for some investors isn't necessarily higher interest rates, but the concern is the potential for interest rates to quickly move higher making it more difficult for the market to adjust.  

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As we approach the halfway point for first quarter earnings reports, revenue and earnings growth continue to be sensational. Earnings are on pace to grow 21.1% with revenue increasing 7.6%. It was not too long ago that some analysts said that low single digits growth was the best that could be expected and that the days of faster growth across the board were gone. 

As of January 1st, 2018 the projected growth rate for first quarter earnings was 12.2%. Actual results are going to be nearly double those projections. 

A theme from 2011-2016 was that analysts were overly optimistic each year in their forecasts for earnings growth (and economic growth as well) and as the year progressed would have to cut their forecasts. 2017 earnings growth came in slightly below the initial forecast and so far in 2018 analysts have significantly raised their forecasts.

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Let's briefly touch on a few more issues. 

The Cass Freight Index gives valuable insight into the level of economic activity by tracking freight expenditures and freight volumes. This chart does a good job of illustrating the dramatic turnaround that has taken place in the U.S. economy since the beginning of 2017.

This index is a leading indicator of economic activity so the March reading is a positive for future economic growth. 

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The U.S. consumer continues to feel very good about the economic outlook. When consumers are more confident in the economy they tend to spend more.

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Part of the reason for the consumer's positive outlook is that their take home pay is increasing at the highest rate in over ten years thanks to the recent tax cut. March saw an increase of 7.5%, up from the 2%-3% range previously seen.

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As first quarter earnings season continues to unfold we will closely track not only the earnings themselves, but also companies outlook for the rest of 2018. We will also monitor interest rates with particular attention around the 2014 high yield of 3.03%. Keep in mind that strong economic data does not guarantee more upside for the stock market. That said, 20% earnings growth on the back of double-digit earnings growth in 2017 provides a strong foundation for stocks. 

February Jobs Report Blows Past Estimates

Stocks soared last Friday as the February jobs report showed 313,000 new jobs were added in February, blowing past economists projections for 212,000 new jobs. This is an extremely strong showing considering the unemployment rate is already near historical lows at 4.1%. Also, labor force participation grew 0.3% to 63%, its largest one month increase since 1983. Over 800,000 workers came back into the work force. This is a very positive development for the economy and one that should continue. 

Almost 100,000 of the new jobs created were in construction and manufacturing. That continues a revival in those industries that has taken place over the past year.

Another key aspect of the jobs report was the growth in wages of 2.6%. The stock sell-off in February was initiated when the January jobs report was released and showed wage growth of 2.9%. This led investors to become concerned that higher wages would lead to a significant increase in inflation. A significant increase in inflation would lead to a quicker pace of rate increases by the Federal Reserve. The decline in wage growth from 2.9% in January to 2.6% in February should help ease the concerns about inflation.

The Federal Reserve's target inflation rate is 2% for the Personal Consumption Expenditures. Looking at the chart below it is notable that inflation has run well short of the Fed's target over the past 10 years.   

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Time will tell if investors really need to be concerned about rising inflation. For now the U.S. economy continues to show real strength with low inflation as the latest jobs report and Core PCE report confirms.

Stock Market Decline Jolts Investors

The peace and calm the stock market saw in 2017 has officially come to an end as the Dow Jones Industrial Average fell 1,175 points today. This was a decline of 4.60%. Over the last six trading days the Dow is now down 8.54%.

This has shocked a market that had not experienced a decline of 5% in over two years. 2017 was characterized by extremely low volatility in the stock market. Everyone knew such low volatility could not continue but no one knew when volatility would spike.

Many times during declines like we have seen in the last week, analysts rush to assign blame for the decline. The bottom line is that often times there is no major reason for the decline other than this kind of thing just happens from time to time in the market. 

Tonight some of the top reasons given for the decline are:

1) Fear of interest rates rising too quickly

2) Will rising wages trigger a significant increase in inflation?

3) Did computer/machine trading cause indiscriminate selling?

4) Will the new Fed Chair, Jerome Powell, look to increase the pace of Fed rate hikes from what we have seen from Janet Yellen?

In October of 1987 the Dow fell 508 points, which was 22.6%. That was a much more significant decline than what we experienced today and many investors still don't know the reason that decline was so steep. 

It is important to keep in mind that this decline has returned the market to levels last seen in mid-December, or less than two months ago. The positive data that drove the market higher in 2017 and early 2018 are still in place. Namely, strong earnings growth, improving economic growth both in the U.S. and abroad, interest rates that are still low on a historical basis and the tax bill that has already greatly benefited companies and workers. 

That being said, stock market declines and market volatility are still unpleasant. Obviously, no one has a crystal ball, so we will continue to closely monitor your portfolio and make any necessary adjustments should they be needed. 

One last thing, do not be surprised if tomorrow morning (Tuesday) stocks open down an additional 2%-3%. If that occurs we would then see if traders become buyers and restore some calm to this frazzled market.

U.S. Economy Continues To Gain Steam

As 2017 winds down recent economic developments have heated up. Let's dive in.

Tax Bill

Only time will tell what the ultimate impact of the tax bill will be. There is little doubt however that the reduction in the corporate tax rate from 35% to 21% will be beneficial. At 35% the U.S. had the highest corporate rate in the developed world. The 21% rate will make U.S. companies much more competitive on a global scale. A recent trend was for companies to move their headquarters out of the U.S. to countries with lower tax rates. With the new 21% rate there should be a dramatic reduction in these corporate inversions. 

Another very positive change was reducing what has been called the repatriation tax. Under existing law companies have paid the 35% tax rate on profits they had made overseas that they brought back to the U.S. This tax was in addition to companies paying taxes to the country in which the profits were earned. The tax bill reduces this rate to 15.5% and going forward the U.S. will not tax foreign profits brought back home. Estimates are that there is anywhere from $3 trillion - $5 trillion in cash that could be brought back into the U.S. by this change.

The ink is not even dry on the tax bill and we are already seeing companies reacting positively to the passing of the bill:

AT&T has announced that due to the tax bill passing Congress they are giving 200,000 employees an immediate $1,000 bonus and they will be spending an extra $1 billion in capital expenditures. 

FedEx's Chairman Frederick Smith said that the tax bill will prompt the company to increase hiring as well as new business spending as the tax cut will give them an extra $1.3 billion in profits. 

Fifth Third Bank announced that with the passing of the tax bill they will be raising minimum wage at the bank to $15/hour and will be giving over 13,000 employees a $1,000 bonus.

Economic Growth

The New York Fed just raised their 4th Quarter GDP estimate to 4%. This is coming on the back of 3Q GDP rising at the fastest level in 3 years. A narrative by some economic analysts in 2016 was that the U.S. economy had entered a new normal where GDP growth couldn't exceed 1.5%-2%. We have seen this year that pro business policies have buried that narrative. We expect GDP growth to continue above 3% in 2018.

Consumer Confidence

Since the election in 2016 a common theme has been a major increase in confidence in the economy both by consumers and businesses. 

U.S. Consumer Confidence just hit a 17-year high in November as U.S. consumers are more and more confident in the economy and the jobs market. This increased confidence has led to a major increase in U.S. retail sales. Holiday spending is off to a fantastic start. 

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It isn't just the U.S. consumer whose confidence is soaring:

The NFIB's Small Business Optimism Index hit a 34-year high in November. Small business owners are the top job creators in the U.S. so this is a very positive development.

U.S. Homebuilder confidence hit the highest level since 1999. New home sales also recently hit their highest level since 2007.

Earnings

The final number for 2017 earnings growth will not be known until 4th Quarter numbers are reported by companies in January and February, but based on real numbers in 1Q, 2Q, 3Q as well as 4Q estimates, 2017 earnings growth for the S&P 500 will be close to 12%. 

Earnings growth has been a significant driver of U.S. stocks in 2017. The earnings outlook for 2018 is also very strong and with the passage of the tax bill some analysts are expecting 13%-15% earnings growth.

The U.S. economy has heated up in 2017 with consumer and business confidence soaring and strong corporate earnings growth exceeding expectations. The passage of the tax bill will mean lower tax rates for many U.S. companies which will lead to higher earnings in 2018. However, one factor that will be critical to market returns in 2018 will be the movement in interest rates. We will address this issue and more in an upcoming post. Merry Christmas.

Social Security Checks Rising in 2018

The Social Security Administration has announced that recipients will be receiving an increase of 2% in 2018. This is an announcement that will be welcomed by retirees who saw only a .3% increase in 2017 and no increase in 2016. 

Unfortunately many recipients of Social Security who are also on Medicare will find that the Social Security increase is eaten up by higher premiums for Medicare Part B. 

Since 2000 the average Social Security increase has been 2.2%. 

The Wall Street Journal has more.
 

China Update

Over the past decade cash from China has been deployed into assets such as stock, bonds and real estate around the globe. The Chinese government, concerned by the level of cash leaving the country, has put capital controls into place to slow this flow of cash leaving the country.

From the Wall Street Journal:

China’s seemingly insatiable demand for foreign assets has driven up prices for everything from U.S. Treasury bonds to global companies to luxury real estate. Now, a combination of market forces and capital controls are choking off the flow of Chinese cash. Asset markets around the world will have to adjust.

As Chinese exports boomed starting in the early 2000s and foreign investment flooded into the country, the central bank recycled these inflows into foreign government bonds, mostly Treasurys, to keep the yuan from rising. The buying persisted for over a decade, driving bond prices up and driving yields down globally.

Earnings Heat Up

As we head into the back half of summer, company earnings are heating up while market volatility has declined to an all-time low. We also have an update from the continued fallout in retail after Amazon's purchase of Whole Foods. Let's dive in.

Earnings

An important issue for the market coming into 2017 was the quest for a return to strong growth in company earnings. After 5 quarters of flat or negative earnings growth, the 1st quarter of 2017 saw growth of 14%, a blockbuster number. The next question was whether the 1st quarter number was a fluke or if the strong growth would continue?

With over half the companies in the S&P 500 reporting 2nd quarter numbers, profits are on pace to grow by 11%. It is this growth that has helped to power the stock market to record highs. 72% of companies in the S&P 500 have beaten their earnings estimates compared to the long-term average of 64%. 

Another piece of good news is that revenue growth is up 5% for these companies with 69% beating expectations vs a long-term average of 59%. 

As long as healthy earnings growth continues, the path of least resistance for the market is higher.

Volatility

One of the most important measures of market volatility, the CBOE Volatility Index(VIX), hit an all-time low within the last week. The VIX tends to spike higher when stocks sell-off or when market participants are fearful. With the VIX at record lows there is a debate about whether investors have become too complacent. However, according to Bank America investment managers are holding above-average levels of cash in their portfolios. Also, there is a high level of "short interest" in stocks, that is betting that stocks decline in value. These are not signs of a market with excessive optimism. Typically when the market is close to a near-term top investment managers have very little in cash and short interest is low.  

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Amazon Impact

Since Amazon's announced purchase of Whole Foods on June 16th, many companies from all walks of retail have seen their stocks sell-off. 

Here is a look at how far some strong companies have fallen from their 52 week highs in large part due to concerns of competition with Amazon:

Costco -17%

Kroger -31%

Auto Zone -30%

Ulta Beauty -20%

Target -27%

There is no question that Amazon has disrupted the business model of many retailers. Many department stores as well as specialty retailers have gone up in flames as they were unable to adjust to Amazon.

That said, there is a limit to how many business segments Amazon can dominate before the government becomes concerned with a monopoly status. We aren't there yet, but as the retail shakeout continues there will be some buying opportunities in the space as the baby gets thrown out with the bathwater.   

With the majority of companies in the S&P 500 having reported 2nd quarter earnings, the results have been very good, extending the earnings recovery that began in the 1st quarter. The market response to earnings has been to move higher with low volatility. Whether investors have become too complacent or not will become clearer as we head into the fall. While there will still be values to be found, whether related to the Amazon impact or not, we will continue to closely monitor your portfolios. 

Amazon Upends Grocery Industry

This morning news broke that Amazon.com is buying Whole Foods Market for $13.7 billion. This move will give Amazon a foothold into the brick-and-mortar side of retail that Amazon has significantly altered. The potential impact of this deal could be as large as anything we have seen in decades.

Investors voiced their approval of the deal sending Amazon's stock up 2.44%. Often the acquiring company's stock declines upon deal announcements. However, in this case investors, at least initially, are excited about the opportunity ahead for Amazon given the fact that the size of the grocery market is $800 billion per year. 

Kroger, Target, Walmart and Costco were all among the companies that had significant sell-offs on the news. There is a question about whether the depth of the sell-offs were overdone. The grocery industry typically has slim profit margins, and with Amazon now taking aim at the industry competitors are going to have to figure out how to innovate if they don't want to lose market share to Amazon. 

Currently online sales makes up only 2%-3% of the grocery business. That has always been expected to increase but with Amazon now in the business that should accelerate this shift. 

In other news, the U.S. dollar has declined 6.5% from the five-year high it set last December. 

 Source: Bloomberg

Source: Bloomberg

The dollar's decline has been beneficial to many of the large U.S. firms that get a majority of their sales from overseas. When the dollar is too strong it leads to lower earnings by the multi-nationals. Other benefactors of a weaker dollar are emerging market economies. Many borrowers in these countries accumulate dollar-denominated debt which becomes cheaper to repay when the dollar weakens vs the particular emerging market currency. 

As long as the dollar doesn't make a strong move in either direction from current levels it shouldn't have a significant impact on the economy.

The recent decline of the dollar has benefited large U.S. multi-nationals and the dollar will continue to be carefully watched. Also, Amazon's purchase of Whole Foods will have a ripple effect across multiple sectors and will offer some investment opportunities. I believe this story will continue to be the focus of the financial media until second quarter earnings reports begin in July.