June 2015 Market Commentary

I am starting this as the first in a series of market commentaries that I will be posting on here. Right now, I’m seeing some rocks in the road up ahead.

In this order, concerns that I have are earnings and energy, Chinese consumers, and then some other factors that I think people aren’t paying attention to, but probably should.

Earnings and energy

Earnings season was…just okay, and ultimately earnings are what drive the market. As a general rule, if you see a daily headline saying “Market was up/down today because of X”, ignore it. For the most part, daily movements are irrelevant background noise. Major trends like earnings, however, are what you need to pay attention to.

According to FactSet’s Earnings Insight publication as of May 22:

  • Q1 2015 earnings growth is only 0.3%, and revenue declined by -2.9%. This is the largest quarterly revenue decline since Q3 2009, which was -11.5%.
  • The sector with the largest YoY decrease in revenue was energy (this shouldn’t be a surprise to anyone)
  • Forward PE ratio on the S&P 500 is currently 17.0, which is above the 10-year average of 14.1

A decent sized part of the market rally over the last two of years, prior to the recent energy hiccup, can be attributed to multiple expansion rather than earnings growth, particularly on the small cap side. With revenue starting to curl, this could be a warning sign that multiples could be prone to mean revert back down.

The drop in oil prices and its impact on the US economy can’t be understated. Yes, it’s good for consumers. But, a good part of recent US economic growth has driven by capital investment in the energy space. Oil that might have been economical to develop at $80/barrel may no longer be economical at current market prices. Halliburton and Schlumberger have both announced layoffs. Keep in mind also that a number of small E&P producers have had debt trading at junk bond yields even before the oil crash.

On that note, I want to address some of the misinformed commentary on the energy markets. No, Saudi Arabia wasn’t producing more to “punish” US frackers. It’s simple game theory. OPEC may have been able to influence production when they had a larger market share, but increased North American production has turned the market into an every man for himself scenario. Yes, producers may be able to make more profit if they collaborated to restrict production, but each individual producer stands to make even more profit by cheating and producing over the limit. Point being: barring all-out war with Iran, oil prices will probably continue the slow rise that they have been on, but probably not a rapid ascent back to $100+ levels. We’re likely to see prices in their current range for a while, which is a negative for energy capital investment.

China consumer slowing?

A China “soft landing” or “hard landing” has been talked about for years, but here is some cold hard data: Wynn Resorts missed Q1 earnings and announced they were cutting their dividend by 67%, and Las Vegas Sands also missed. These companies both make the bulk of their revenue in Macau, not Las Vegas.

According to data from the Macau government, tourist visitor arrivals “decreased by 3.4% year-on-year” as of April 2015, and “Visitors from Mainland China decreased by 6.4% year-on-year.” Additionally, as of the end of Q1, total spending ex-gaming by visitors to Macau was down 16.2%.

Admittedly, Macau is only one sample, but it is useful to show trends in Chinese discretionary spending. Regardless of the cause, something is happening in China. This isn’t good for the global economy.

Other factors

Since the financial crisis, corporations have been hoarding cash. At the time, part of it may have been fear that they wouldn’t be able to access credit on the open market. Later, hoarding cash is a sign of not being able to see attractive investment opportunities.

Corporate cash levels are still high, but the ways some tech companies have been putting it to use are starting to seem more and more unusual to me. It seems like every tech company is now investing in solar projects. Yes, some of these can potentially have a nice IRR due to investment tax credits. To me, however, it goes to a bigger question of synergy. Google isn’t a power company. Peter Lynch had a term for this when businesses get into unrelated segments that he called “deworseification.”

  • What is the exit plan for this kind of investment?
  • Since the whole point of strategic treasury cash is to 1) provide readily available funds for capex and 2) support the business should a downturn occur, how readily convertible to cash are these projects?
  • If these projects are so attractive, why don’t I just go out and invest in them on my own instead of having XYZ tech company act as the middleman?

The one that raises even more red flags for me is the rumors of Apple trying to build an electric car. This one baffles me. Saying that there could be synergy with the batteries go is a huge stretch. There aren’t going to be synergies when it comes to be in dash entertainment. People aren’t going to be watching YouTube videos or playing Battlefield 4 while they’re behind the wheel, or at least I hope they aren’t. Moreover, Ford, Tesla, or whoever could just get a license the entertainment technology from Apple, Samsung, Microsoft, or anyone else.

It’s almost starting to sound like tech companies are moving from being tactfully aggressive when it comes to their treasury cash now a mentality of “that sounds cool—let’s do that!” That worries me, not even necessarily for the use of the cash—they’re free to use their funds however they want, even if it sounds unusual—but because it gives the impression that they’re not finding other exciting, synergistic projects to invest in. It also worries me from a corporate governance standpoint, where if the company truly doesn’t have better uses for its cash, then they should return it to shareholders through a buyback and reward them for investing in the company.


Investors have a number of issues to look out for. If Q2 earnings come in weak, it could be a sign of a growing trend. Investors should also monitor corporate governance and should question some of the uses that corporations have been putting their cash toward. I would tilt portfolios to a more defensive posture in this environment.

Keep hustling,

Alex Cook

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