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Not a Pretty Picture ... A Look At Corporate Profits, Small Caps & Bond Yields

Not a Pretty Picture ... A Look At Corporate Profits, Small Caps & Bond Yields  - Bull herd cartoon 03.18.2016

 

While the permabull marketing machine keeps churning, macro market internals are crumbling. Whether you're looking at performance of small cap stocks, declining bond yields, or the ongoing corporate profit recession, deteriorating economic data appears to be largely lost on Wall Street consensus.

 

Meanwhile, forecasts of our omnipotent Fed central planners remain disconnected from economic reality. As Hedgeye CEO Keith McCullough writes in a note to subscribers this morning:

 

"Treasury Yields stopped going down last week as Fed Heads jawboned about a rate hike (Dollar Up); immediate-term risk range on the UST 10YR is 1.84-1.98%; that’s a tight range – let’s see if they’re serious this time or just S&P 500 dependent (tightening into this Profit #Recession would be deflationary, again)."

 

 

More on the corporate profit recession reported friday...

 

It's getting pretty ugly. Corporate profits declined -10.5% year-over-year, slowing an additional -540 basis points versus Q3 when the data first went negative. We've been warning about declining corporate profits since January, with the release of our 1Q16 Quarterly Macro Themes. 

 

Declining profits have been hammering stocks since the data peaked in Q2, McCullough writes. 

 

"The Russell 2000 lagged (again) last week, dropping -2.0% on the week (vs. -0.7% for the S&P 500); at -16.8% from its all-time high in July. The RUT is back to within 330 basis points of being in crash mode (> 20% decline from the July peak); Russell 2000 peaked when U.S. corporate profits peaked (Q2 of 2015)."

 

Not a Pretty Picture ... A Look At Corporate Profits, Small Caps & Bond Yields  - russell

 

Where do we go from here?

 

Here's another callout from our 73-page 1Q Macro Themes deck. In the past 30 years, two consecutive quarters of declining corporate profits always precedes a stock market crash:

 

Not a Pretty Picture ... A Look At Corporate Profits, Small Caps & Bond Yields  - 3 28 Profits Down  Stocks Down Slide 39


MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR

Takeaway: Two consecutive quarters of contracting corporate profits have reliably signaled a meaningful NTM market downturn in the last three decades.

Key Takeaway:

Our Macro team published an interesting note late last week showing that in 4Q15 corporate profits posted their worst growth (Y/Y) since 4Q08. While U.S. 4Q GDP was revised up to +1.4%, the corporate profit component showed a -10.5% Y/Y contraction. Moreover, that marks the second consecutive quarter in which corporate profit growth was down Y/Y. Meanwhile, global uncertainty rose on the heels of the Brussels terror attacks. CDS spreads widened globally at both the sovereign and bank level, and high yield rose +22 bps to 7.89%. The chart below illustrates that in the 30 years since 1985, two consecutive quarters of shrinking corporate profits have preceded a material stock market downturn over the next twelve months in all five occurrences.

 

 

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM11 2

 

 

Current Ideas:

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM19

 

Financial Risk Monitor Summary

• Short-term(WoW): Negative / 2 of 13 improved / 5 out of 13 worsened / 6 of 13 unchanged
• Intermediate-term(WoW): Positive / 8 of 13 improved / 3 out of 13 worsened / 2 of 13 unchanged
• Long-term(WoW): Negative / 1 of 13 improved / 4 out of 13 worsened / 8 of 13 unchanged

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM15

 

1. U.S. Financial CDS – Swaps widened for most domestic financial institutions as data showed the worst rate of Y/Y corporate profit contraction since 4Q08.

Widened the least/ tightened the most WoW: LNC, ACE, AGO
Widened the most WoW: MET, PRU, ALL
Tightened the most WoW: AIG, AXP, HIG
Widened the most MoM: JPM, RDN, MMC

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM1

 

2. European Financial CDS – Swaps mostly widened across European financials last week following the tragic terrorist attack in Brussels and poor corporate profit data out of the U.S.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM2

 

3. Asian Financial CDS – Swaps mostly widened for Asian financials following the global reaction to the Brussels terrorist attack and poor U.S. corporate profits. China Development Bank Corp CDS widened the most, by 33 bps to 149. Meanwhile, Mizuho Corporate Bank in Japan tightened the most, by -14 bps to 97.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM17

 

4. Sovereign CDS – Sovereign Swaps mostly widened over last week. Portuguese swaps widened the most, by 30 bps to 273.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM18

 

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM3

 

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM4


5. Emerging Market Sovereign CDS – Emerging market swaps widened across the board last week. Brazilian sovereign swaps widened the most, by 29 bps to 395.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM16

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM20

6. High Yield (YTM) Monitor – High Yield rates rose 22 bps last week, ending the week at 7.89% versus 7.67% the prior week.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM5

7. Leveraged Loan Index Monitor  – The Leveraged Loan Index rose 4.0 points last week, ending at 1852.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM6

8. TED Spread Monitor  – The TED spread rose 1 basis point last week, ending the week at 35 bps this week versus last week’s print of 33 bps.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM7

9. CRB Commodity Price Index – The CRB index fell -0.9%, ending the week at 172 versus 174 the prior week. As compared with the prior month, commodity prices have increased 6.5%. We generally regard changes in commodity prices on the margin as having meaningful consumption implications.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM8

10. Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread tightened by 1 bps to 10 bps.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM9

11. Chinese Interbank Rate (Shifon Index) – The Shifon Index was unchanged last week at 1.99%. The Shifon Index measures banks’ overnight lending rates to one another, a gauge of systemic stress in the Chinese banking system.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM10

12. Chinese Steel – Steel prices in China rose 2.3% last week, or 54 yuan/ton, to 2419 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity and, by extension, the health of the Chinese economy.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM12

13. 2-10 Spread – Last week the 2-10 spread tightened to 103 bps, -1 bps tighter than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM13

14. CDOR-OIS Spread – The CDOR-OIS spread is the Canadian equivalent of the Euribor-OIS spread. It is the difference between the Canadian interbank lending rate and overnight indexed swaps, and it measures bank counterparty risk in Canada. The CDOR-OIS spread was unchanged at 40 bps.

MONDAY MORNING RISK MONITOR | ANOTHER NEGATIVE INDICATOR - RM14


Joshua Steiner, CFA



Jonathan Casteleyn, CFA, CMT



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USD, Rates and Russell 2000

Client Talking Points

USD

It didn’t take much of a Dollar Up move (+1.2% on the week) to get everything inversely correlated to it to fall last week. Commodities and Oil were down -2.4% and -4.1%, respectively, last week (USD is back to flat on a year-over-year basis so whoever is looking for a “big USD tailwind to earnings” should remember that).

RATES

Treasury Yields stopped going down last week as Fed Heads jawboned about a rate hike (Dollar Up); immediate-term risk range on the UST 10YR is 1.84-1.98%; that’s a tight range – let’s see if they’re serious this time or just S&P 500 dependent (tightening into this Profit #Recession would be deflationary, again).

RUSSELL 2000

The Russell 2000 lagged (again) last week, dropping -2.0% on the week (vs. -0.7% for the S&P 500); at -16.7% from its all-time high in July. The RUT is back to within 330 basis points of being in crash mode (> 20% decline from the July peak); Russell 2000 peaked when U.S. corporate profits peaked (Q2 of 2015).

 

*Tune into The Macro Show with Hedgeye CEO Keith McCullough live in the studio at 9:00AM ET - CLICK HERE

Asset Allocation

CASH 70% US EQUITIES 0%
INTL EQUITIES 0% COMMODITIES 5%
FIXED INCOME 21% INTL CURRENCIES 4%

Top Long Ideas

Company Ticker Sector Duration
CME

CME Group (CME) put up a decent fourth quarter earnings print with a slight revenue and earnings beat. Not that we put much weight on what happened last quarter but trends into the new operating period are looking even better. The exchange guided to just a +1% operating expense increase for 2016, guided to slightly lower annual taxes for '16 (with more activity coming from abroad), and again announced that open interest was setting a new record, at over 111 million contracts.

 

Even assuming some mean reversion to just over 16.5 million contracts (depending on product group), 1Q is running at ~$1.20 per share in earnings, which means the Street will need to perk up its current $1.06 estimate. Simply put, this is one of the few growth stories in the current macro environment within Financials.

GIS

We continue to like General Mills (GIS) as one of the best large cap names in the packaged food space. With that being said, the third quarter was not without its noise surrounding the numbers; Green Giant divestiture, Walmart clean store policies, foreign currency exchange, and grain merchandising just to name a few, muddied the waters. But digging through the noise, this is a business that is truly turning a corner. When they set sail on fiscal year 2016 back in June of 2015, we knew this was not going to be an easy ship to turn towards success. Now, with many key product platforms turning (through strong product innovation and renovation) in the right direction and operational improvements implemented through cost savings initiatives, GIS is on the cusp of success. We will be measuring this success by realization of sustained top line growth in the low single digit range.

TLT

In our model the second quarter is the toughest compare on both GDP and U.S. corporate profits so we want to be very careful going into that and be positioned defensively. Stay long Long-Term Treasuries (TLT).

 

While small/mid cap U.S. Equities reverted to their bear market mean last week (Russell 2000 down -2.0% on the week and -16.7% since US Corporate Profits peaked in Q2 of 2015), so did a few other US Equity Market Style Factors that had had a big 1-month bounce:

  1. High Beta stocks were -2.0% on the week
  2. High Leverage (Debt/EBITDA) stocks were -1.9% on the week
  3. High Short Interest stocks were -1.7% on the week

Three for the Road

TWEET OF THE DAY

NEW | Howe:‘Foreboding’ Election Implications https://app.hedgeye.com/insights/49938-howe-a-foreboding-election-and-its-implications… @HoweGeneration @KeithMcCullough @HedgeyeDDale @Hedgeye

QUOTE OF THE DAY

No profit grows where no pleasure is taken.

William Shakespeare

STAT OF THE DAY

The total number of female billionaires fell to 190 from 197 last year, women make up 10% of the world’s 1,810 ten-figure fortunes.


CHART OF THE DAY: Corporate Profits' Worst Decline Since 2008 Financial Crisis

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye CEO Keith McCullough. Click here to learn more.

 

"... If only the bulls of the 2015 peak warned you that Q415 corporate profits would slow another -540 basis points sequentially (vs. Q3 when they first went negative) to -10.5% year-over-year.

 

As Darius Dale wrote to our Institutional clients on Friday, you have to go all the way back to the depths of the 2008 Financial Crisis (Q4 08) to find a worse year-over-year decline in US Corporate Profits."

 

CHART OF THE DAY: Corporate Profits' Worst Decline Since 2008 Financial Crisis - 3 28 Profits Down  Stocks Down Slide 39


The Taming of Profits

“No profit grows where no pleasure is taken.”

-William Shakespeare

 

And, generally speaking, no multiple expansion grows when there’s no corporate profit growth. Rather than The Taming of the Shrew (i.e. where that Shakespeare quote comes from), USA is seeing The Taming of Profits.

 

No, I’m not talking about the taming of US stock market profits and/or returns (i.e. the ones that were negative in 2015 and mostly negative for 2016 YTD) – I’m simply talking about US Corporate Profits, which were reported to have remained in #Recession on Friday.

 

No worries. We’ll probably be the only ones on Wall St. writing about it this morning. If only the bulls of the 2015 peak warned you that Q415 corporate profits would slow another -540 basis points sequentially (vs. Q3 when they first went negative) to -10.5% year-over-year.

 

The Taming of Profits - recession cartoon 02.22.2016

 

Back to the Global Macro Grind

 

As Darius Dale wrote to our Institutional clients on Friday, you have to go all the way back to the depths of the 2008 Financial Crisis (Q408) to find a worse year-over-year decline in US Corporate Profits.

 

“More importantly, Q4 marked the 2nd consecutive quarter of declining corporate profit growth… such occurrences have been proceeded by stock market crashes in the subsequent year for at least the past 30 years (5 occurrences).”

 

Since Q4 ended on December 31st (they haven’t been able to centrally plan a change in the calendar dates yet), has anyone considered why we just saw the worst 6 week start to a stock market year ever? Yep, it’s the Profit vs. Credit Cycle (within the Economic Cycle), stupid.

 

Ok. If you’re not stupid, but really super smart and still blaming “the algos and risk parity funds” for the AUG-SEP and DEC-FEB US stock market declines, but giving them 0% credit for the JUL, OCT, and MAR decelerating volume bounces… all good, Old Wall broheem, all good.

 

Many who missed the economic cycle slowing from its peak (and the commensurate profit #slowing and credit cycles that always come along with such a rate of change move) will blame the US Dollar for that.

 

They, of course, wouldn’t have blamed Ben Bernanke devaluing the US Dollar to a 40 year low for the all-time high in SP500 Earnings (2015) though. That would be as ridiculous as blaming the machines and corporate buy-backs for market up days.

 

Last week the US Dollar came back, and the “reflation” trade didn’t like that. With the US Dollar Index +1.2% on the week:

 

  1. The Euro (vs. USD) fell -0.9% on the week to +2.8% YTD
  2. The Yen (vs. USD) fell -1.4% on the week to +6.3% YTD
  3. The Canadian Dollar (vs. USD) fell -2.0% on the week to +4.3% YTD
  4. Commodities (CRB Index) fell -2.4% on the week to -2.3% YTD
  5. Oil (WTI) fell -4.1% on the week to -1.3% YTD
  6. Gold fell -2.5% on the week to +15.3% YTD

 

Yeah, I know. Those 5 things are just the things that have immediate-term inverse correlations of 79-99% vs. the US Dollar, but there’s this other big thing called the SP500 that now has an immediate-term (3-week) inverse correlation of -0.80 vs. USD too.

 

Imagine that. Imagine the machines stopped chasing the hope that the Fed fades on their rate hike plan, the US dollar gets devalued (again), and all of America keeps arguing about the “inequality” gap having nothing to do with Fed Dollar Policy?

 

You see, when you devalue the purchasing power of a human being:

 

A) Almost everything they need to buy to survive goes up in price as the value of their currency falls

B) A small % of human beings (i.e. us) get paid if they own the asset prices we are “reflating”

 

And if you’re not a human being (i.e. you’re a US corporation) and your profits are falling, all you have to do is lever the company up with “cheap” US debt, buy back the stock with other people’s money, lower the share count, and pay yourself on non-GAAP earnings per share.

 

#America

 

While small/mid cap US Equities reverted to their bear market mean last week (Russell 2000 down -2.0% on the week and -16.7% since US Corporate Profits peaked in Q2 of 2015), so did a few other US Equity Market Style Factors that had had a big 1-month bounce:

 

  1. High Beta stocks were -2.0% on the week
  2. High Leverage (Debt/EBITDA) stocks were -1.9% on the week
  3. High Short Interest stocks were -1.7% on the week

*Mean performance of Top Quintile vs. Bottom Quintile (SP500 companies)

 

At the same time, Consensus Macro positioning remained what most US stock market bulls would have to admit they want/need from here (Down Dollar => Up Gold, Commodities, and Oil):

 

  1. Net LONG position in USD (CFTC futures/options contracts) was -2.16x standard deviations vs. its TTM average
  2. Net LONG positions in Gold and Oil held 1yr z-scores of +2.45x and +1.33x, respectively

 

In other words, in the face of both the economy and profits slowing, Wall St. wants to go back to that ole story of Burning The Buck, I guess. It’s sad and it probably won’t work… but, as Shakespeare went on to say about profits and pleasures, “study what you most affect.”

 

Our immediate-term Global Macro Risk Ranges are now:

 

SPX 1
RUT 1060-1107
USD 94.68-97.01
Oil (WTI) 36.06-42.91

Gold 1

 

Best of luck out there this week,

KM

 

Keith R. McCullough
Chief Executive Officer

 

The Taming of Profits - 3 28 Profits Down  Stocks Down Slide 39


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