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Monthly Archives: September 2015

A return of the market roller coaster ride we experienced in August

A return of the market roller coaster ride we experienced in August

The calendar has officially turned to Fall here in the United States. Of course, on the East Coast, where Tematica is based, we’ve had days that haven’t felt much different than the dog days of summer. But the level of pumpkin-spice “everything” in the stores is what we call a “confirming data-point” for the changing season, even if the weather still feels like Summer.

And while the calendar never stops, so too does the drumbeat of the market and the flow of economic data.  In this week’s edition of Tematica Insights, we provide subscribers with:

  • A first look at the trifecta of flash PMI data from China, the Eurozone and the U.S. — what it means for industrials such as Ingersoll-Rand (IR), Honeywell (HON), General Electric (GE), Crane (CR) and Caterpillar (CAT)
  • As we head into the quiet period, we take a look at the impact of global manufacturing data and other economic data can have on third quarter earnings for U.S. Securities.
  • We take a look at confirming data points on several thematics, including Cashless Consumption, Safety and Security and the Connected Society.
  • Adding a couple of new names to our shopping list as we look for opportunities in the near-term market.

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COMPANIES MENTIONED

  • Amazon.com (AMZN)
  • American Airlines (AAL)
  • Apple (AAPL)
  • Caterpillar (CAT)
  • Chegg Inc. (CHGG)
  • ComScore (SCOR)
  • Corning Inc. (GLW)
  • Crane (CR)
  • Facebook (FB)
  • First Trust NASDAQ CEA Cybersecurity ETF (CIBR)
  • General Electric (GE)
  • Google (GOOGL)
  • Honeywell (HON)
  • Immersion Corp. (IMMR)
  • Ingersoll-Rand (IR)
  • Intel (INTC)
  • Kimco Realty (KIM)
  • Lifelock (LOCK)
  • Merk & Co. (MRK)
  • Microsoft (MSFT)
  • Netflix (NFLX)
  • Palo Alto Networks (PANW)
  • PayPal (PYPL)
  • PureFunds ISE Cyber Security ETF (HACK)
  • Skyworks Solutions (SWKS) Starbucks (SBUX)
  • Synaptics Inc. (SYNA)
  • U.S. Global Jets ETF (JETS)
  • United Natural Foods (UNFI)
  • Verizon Communications (VZ)
  • Walt Disney (DIS)
  • Xylem, Inc. (XYL)

Forbes: Will Government Listen to the Market and Lower Streaming Music Royalty Rates?

I have written extensively about the efforts of the recording industry to squeeze blood from the streaming music industry stone by attempting to get allies in Congress and the White House to increase the royalty rate paid by streaming companies like Pandora , Apple ([stock_quote symbol=”AAPL”]), Amazon.com ([stock_quote symbol=”AMZN”]), Spotify, Google ([stock_quote symbol=”GOOGL”]) Play Music, and other companies. The battle royale over the future of music streaming has taken a strange and potentially dangerous turn over the past month.

By the end of the year, the Copyright Royalties Board (CRB) at the Library of Congress will determine the new royalty rate streamers will have to pay record labels and artists. The CRB has been charged under statute to “establish rates and terms that most clearly represent the rates and terms that would have been negotiated in the marketplace between a willing buyer and a willing seller.” An attempt by a federal agency to set rates that accurately mimic what a competitive marketplace would yield is no easy task, however the CRB has before it approximately 30 privately negotiated royalty agreements between streamers (willing buyers) and record labels (willing sellers). These voluntary, in-market deals provide a roadmap to what the price of music should be.

Read More  >>

Forbes: Ackman’s Assault On Herbalife Risks More Hedge Fund Regulation

There has been a push by many politicians of both parties in Washington to beat up on Wall Street generally and hedge funds in particular. One need to look no further than Republican presidential candidate Donald Trump who claims hedge fund managers are not paying enough taxes. In a tirade that received accolades from liberals Warren Buffet and Sen. Elizabeth Warren, Trump claimed that the hedge fund operators “are getting away with murder” by alleging “ they’re paying nothing.”

This is nothing new as hedge funds have been a popular target for populist rhetoric. President Obama was quoted in a Bloomberg story titled “Obama Says Hedge Fund Managers Are ‘Society’s Lottery Winners” as saying “if we can’t ask from society’s lottery winners to make that modest investment, then really this conversation is for show.” President Obama wants to increase taxes on hedge fund managers and investors to pay for more federal education funding.

Read More  >>

APPLE (AAPL): Still the Epicenter of the Connected Society?

The odds are pretty high that your home or office has at least one Apple device if not more. A new report from the digital media analytics company comScore suggests that Apple’s iPhone has continued to grow its lead in the U.S. smartphone market, with just over 44 percent share of all American smartphone users in July 2015, an increase from the 43.1 percent share it held in April of this year.

We’ve long seen Apple sitting in the pole position of our ever increasing Connected Society, with its iPhone, iPad, Mac, Apple TV, Apple Watch, iTunes and App Store platforms, as well as iOS and HealthKit, CarPlay and HomeKit solutions. As we see it, Apple has strong assets across the smartphone and computing spaces, but a position that is far less commanding in the living room compared to Microsoft’s ([stock_quote symbol=”MSFT”]) or Sony’s ([stock_quote symbol=”SNE”]) PlayStation, and a presence that is just burgeoning in the Connected Car and Connected Home markets. Don’t get us wrong, we’ve loved our Apple TV as a video portal for iTunes videos and other streaming apps like Netflix, Hulu, Vimeo and others. But to be fair, it contributed to the console clutter sitting next to the cable set top box, DVD player, and gaming system.

That was until this past week when Apple took the wraps off several new products at what’s become its annual showcase for announcing what will be hitting the shelves in the coming weeks, in preparation for the upcoming holiday shopping season (yes folks, the holidays are not too far away). This week, there were new iPhone 6S and 6S Plus models, a new enterprise and small to medium size geared iPad Pro complete with the new Apple Pencil and detachable smart keyboard; some new features for the Apple Watch along with some new watch bands and colors; and an upgraded Apple TV complete with voice interface, an improved OS (dubbed tvOS), and it’s own Apple TV App Store.  Let’s dig into the details:

Apple Watch. Things started off with the Apple Watch, and we have to be honest: we still want-to-want one, but don’t feel compelled to buy one, simply because we’re not sure we need one. In talking with folks who have taken the plunge, they praise the ability to pay with their wrist and see messages; however more than a few quickly shoehorned into the conversation that “well, it was a gift.”

Apple did announce more fashion-related items, bands and colors, but in our view that doesn’t really move the needle like the way the new iPad Pro did. The bottom line on the watch is, at least from our perspective, there is much more to go, and companies like FitBit (FIT) and others are way ahead of them, much the way Amazon’s ([stock_quote symbol=”AMZN”]) Kindle hardware continues to have a place in the e-reader space.

Apple TV.   Long positioned within Apple as a “hobby”, Apple TV gets a much-needed upgrade. Much the way the original App Store transformed the iPhone into a digital Swiss Army knife — allowing you to play games, shop, check your finances, post to Facebook or tweet on Twitter and over the ensuing years do almost anything — we see the new Apple TV app store having a similarly transformative effect on how people use their TV. Pulling up sports stats as you watch a game, shop online via Gilt or other apps that will soon be available, downloading games to play such as “Galaxy on Fire” and Walt Disney Co.’s new Star Wars game, “Disney Infinity,” would come to Apple TV. Popular real estate sites like AirBnB and Zillow also are developing apps that would allow big-screen house hunting.

Of all the improved features, it’s the gaming potential that could be the most disruptive long-term.  Over the last few years Apple’s iPods, iPhones and iPads have demolished the handheld gaming market, much the way iTunes and iPod completely eviscerated the rest of the MP3 player market. In the console gaming market, Apple is going head to head with Amazon and Sony. But with a $149 price point, the Apple TV is well below the $250 or so sticker price of Microsoft’s current Xbox. Granted, the initial slug of games will be found wanting relative to Xbox and even Sony’s ([stock_quote symbol=”SNE”]) PlayStation, but we know Apple will continue to pack more memory and improve the chip speed in the device over time.  Let’s not forget the content leverage Apple has with the developer community — a quiet competitive advantage it has enjoyed with its tablets and smartphones and is now extending into Apple TV. We anticipate now that Apple has “figured out” Apple TV, the product will be on the annual model upgrade path that we’ve seen with iPhone and iPad. More processing power, more storage, better graphics…. Apple TV.

As part of the Apple TV unveiling, Apple CEO Tim Cook made what we found to be an interesting comment:

“We believe the future of TV is apps.” 

He probably saw the same report we did from research company Millward Brown Digital that showed 22 percent of cable subscribers also subscribe to an over-the top service, such as Netflix, Hulu and others. As consumers of content through Netflix, HBO Go, Amazon Prime and other apps, we are believers in the time shifted approach (yes you can call it binging if you want) or the app-ification of TV. Combined with its expanding global footprint (more on that on page 14), this was one of the core reasons why we used the recent market pullback to add Netflix ([stock_quote symbol=”NFLX”]) shares to our Tematica Select List.

iPad Goes Pro.  Over the last few quarters, the iPad has been one of the sore spots in Apple’s quarterly reports. Even so, Apple CEO Tim Cook has remained upbeat about the tablet category. Apple recently announced a new partnership with Cisco Systems ([stock_quote symbol=”CSCO”]) that builds on the enterprise-focused relationship with IBM (IBM). We suspect that Apple has used these and other partnerships to determine the needs and wants of the enterprise market to develop the much talked about iPad Pro.

We’ve tried several times to use the iPad in place of our MacBook products and found it to be relegated to the realm of pinch-hitting when it comes to getting any substantive work done. Editing documents and toggling back and forth between apps for example was more than cumbersome…it was downright painful compared to the notebook or desktop experience.

With the debut of the iPad Pro it looks like we now have a serious productivity tool in tablet form. Hand in hand is iOS 9, which brings split screen, drag and drop, and other multitasking productivity features to Apple’s iPad — no more toggling with the home button. You can tell we’re excited about this. With Apple Pencil, Apple’s also addressed some of the annoyances with editing and marking up documents, but we’ll need to see what bells and whistles the developer community brings forth with this accessory to make its $99 price point palatable.

In our view, the new iPad Pro targets the enterprise customer segment from a tablet and app perspective rather than a stripped own notebook computer, which is pretty much what we think of the Microsoft Surface. Before we get all “boo-hoo” for Microsoft, let’s remember that outside the Xbox, hardware is a relatively small contributor to Microsoft, which has increasingly become an enterprise software play.

One announcement that Apple slipped in during all of this comes as mobile operators like Verizon ([stock_quote symbol=”VZ”]) and AT&T ([stock_quote symbol=”T”]) are moving away from the long-standing practice of signing customers up for long-term service contracts and offering subsidies to blunt the high cost of smartphones. Seeing the potential dilemma for its smartphone business, Apple introduced its own installment and leasing programs.

By buying directly from Apple, a consumer can pay $27 to $31 a month for 24 months for the iPhone 6S and 6S Plus. At the end of those two years, the consumer would own the phone outright. Cell phone service fees, of course, come on top of that.

Apple also introduced, and is displaying prominently on the Apple.com store, a new iPhone Upgrade program. You can purchase the iPhone 6S on a monthly payment plan starting at $32.41 for the 16GB model or $36.58 for the 16GB 6S Plus (going up by a little over $4 a month if you want more storage). The pricier plan includes the ability to upgrade to a new iPhone after 12 months. You would continue to pay the installments on the new phone and would just be “restarting the clock,” having to pay the monthly fee for another two years before you would own the newer phone. In this way, the customer is essentially leasing the phone from Apple.

Taking a step back and viewing Apple’s upgrade program alongside its recently introduced Apple Music, we see Apple is quietly shifting its business towards a subscription-based revenue stream. From a business perspective, subscription-based business models have great visibility, planning and consistent cash-flow attributes. From an investor perspective, those recurring payments and cash flow offer predictability and reliability, which tends to be rewarded when valuing the shares, assuming the subscriber-rate continues on an upward trajectory. Past examples include the subscription businesses of AOL dial-up service, Weight Watchers ([stock_quote symbol=”WTW”]), NutriSystem ([stock_quote symbol=”NTRI”]) and Netflix ([stock_quote symbol=”NFLX”]). We’ll need to see evidence of consumers getting onboard with this subscription approach from Apple — remember, Apple Music is still in it’s three month free trial mode, with the first automatic payments kicking in over the next month for those that were first to sign-up with the offering was released. If consumers do go for it, this could all turn Apples’ valuation on its head, and we mean that in a good way.

Does all of this make Apple shares attractive at current levels? 

With the launch of its iPhone 4s model in 2011, Apple shifted to a fall release for its smartphone business.  With each new release, Apple shares have tended to march significantly higher over the following six month period, reflecting the staged nature of launches around the globe and this impact on Apple’s earnings.

What’s different this year is, with the exception of its Mac line of products and to some extent Apple Watch, Apple is launching several new products ahead of the all important year-end holiday gift giving season and Chinese New Year, one of the biggest gift giving holidays.

Current expectations have Apple growing its earnings to $9.75 per share over the coming twelve months, up from $9.13 per share the company is expected to deliver for the twelve months ending September 2015. Given the timing of these new product announcements, expectations for revenue, profits and earnings in the coming quarters have yet to be revised.

We suspect Wall Street will wait until these new products hit the shelves so they can gauge the initial reception before adjusting their models and forecasts. With a strongly invigorated Apple TV and iPad Pro as well as the inherent iPhone upgrade cycle for those still using an iPhone 5s or earlier model we find the odds of Apple euphoria returning to be rather high.

From a stock valuation perspective, over the last few years Apple shares have peaked at an average multiple just shy of 16x earnings. Even in 2013, a year in which Apple’s earnings fell 11 percent, the shares still peaked at 14.2x earnings. Applying those two figures to the consensus expectation of $9.75 per share in earnings over the coming year derives a price target of $140-$150, or an upside of 29 percent at the midpoint.

Let’s remember, Apple is on a path to return cash to shareholders, in part with its quarterly $0.52 per share dividend payment as well as share repurchase program. While the current dividend yield is just below 2 percent, added to the $145 price target, the shares offer 30 percent upside from current levels.

On the downside, Apple shares have bottomed at 10.5x forward earnings on average over the last four-year, period which implies potential downside to $103 (which is close to where shares bounced on August 24) or roughly 8 percent from current levels. In more absolute terms, Apple shares bottomed at less than 10x earnings in 2012 and 2013, but counter balancing that today is Apple’s massive share repurchase plan. Apple has committed to returning $200 billion of cash through dividends and share repurchases over the August 2012- March 2017.  As of its June 2015 quarter, the company had more than $100 billion remaining under its current authorization. That’s a lot of dry powder to back stop the shares, and we’d note that since Apple embarked on its capital return program its share have bottomed closer to 11x earnings on average.

The Bottom Line on Apple

From several perspectives, the risk-to-reward ratio in Apple shares is compelling at a time when the company has one of its most pronounced new product cycles hitting, which will likely result in ratings upgrades and boosted earnings expectations. Ahead of that —and because of its now at the epicenter in our Connected Society thematic, we are adding Apple shares to our Tematica Select List. 


Playing Apple through an ETF

With our recent PayPal ([stock_quote symbol=”PYPL”]) recommendation, we included an ETF alternative for those that would prefer a more diversified approach. With Apple and it’s halo effect that touches many companies, including the Tematica Select List Skyworks Solutions ([stock_quote symbol=”SWKS”]), there are many ETFs involved. As we see it however, an ETF play would need to have meaningful exposure to Apple as well as several of its key suppliers in order to pack a meaningful punch.

Two such ETFs are the Technology Select Sector SPDR ETF ([stock_quote symbol=”XLK”]), which hold roughly 16 percent of its assets in Apple shares, and the other is iShares U.S. Technology ETF ([stock_quote symbol=”IYW”]) that holds more than 19% of its assets in Apple shares. Between the two we would favor XLK shares given the larger market capitalization as well as far greater average daily trading volume and higher dividend yield.

August Jolts Report and NFIB Data Confirms the Tooling and Retooling Thematic.

August Jolts Report and NFIB Data Confirms the Tooling and Retooling Thematic.

As you digest all of the economic data we dumped on your today, you’re likely getting the correct view that we tend to look at things from several different angles, with the Employment Report being one such item.

Seasonally adjusted, in thousands

Seasonally adjusted, in thousands

In addition to all of the third party metrics and the below the headline data we look at, another insightful report is the Job Openings and Labor Turnover (JOLTs) Report. The August JOLTs report, published by the Bureau of Labor Statistics showed the number of job openings in July rose to 5.8 million (versus expectations for 5.3 million), a record high since the data started to be collected in December 2000. By comparison, data from the National Federation of Independent Business showed that job creation remained flat at small businesses in July.

What we found more interesting inside the NFIB report was 56 percent reported hiring or trying to hire, but 48 percent (or 86 percent of those hiring or trying to hire) reported few or no qualified applicants for the positions they were trying to fill. In case you were wondering, much like the 5.8 million job openings, that 48 percent figure was also a record high.

Screen Shot 2015-09-10 at 4.37.34 PM

Combined what these two reports tell us is that we have plenty of companies with jobs they need to fill, but cannot find qualified applicants.  At the same time, we have a historically high percent of the population having given up looking for work.  This strikes at the heart of the need for workers to “re-tool” as part of our Tooling & Re-tooling investing thematic.

Over the long run this is good news for companies like ITT Educational Service ([stock_quote symbol=”ESI”]) and Capella Education ([stock_quote symbol=”CPLA”]), as well as Strayer Education (STRA), which have been hit hard in recent years by the lack of wage returns on higher education and scrutiny from federal regulators.  A recovering economy coupled with awareness of more and more job openings could push prospective students into taking the plunge.

One player that we’ll be watching on the horizon is McGraw-Hill Education, which has recently filed an S-1 form with the Securities and Exchange Commission for its initial public offering. The company has transformed from publishing “just” textbooks and instructional materials into producing digital learnings content and outcome-focused learning solutions, such as McGraw-Hill Connect, which Tematica Chief Investment Officer Christopher Versace uses as part of his graduate teaching.

Economics & Expectations September 2015

Economics & Expectations September 2015

We recently closed the books on the month of August, and in short, it was one of the worst August months we have seen in some time. In our view, yet to emerge forecasted earnings revisions and second half economic expectations as well as the Fed’s upcoming FOMC meeting on September 16-17 will keep the market range bound in the short-term.

Recapping the last few weeks. 

Looking back since the last edition of Tematica Insights, we’ve received quite a heaping of discouraging data, and the market has reacted accordingly. After the sharp rebound in the market on August 26th and 27th following yet another interest rate cut by China and dovish comments from several Fed officials about the timing of interest rate hikes, the market closed out the last full week of August in the green, with the S&P 500 leaping up 120 points. Still way off the soaring heights we saw back in May, but a nice little rebound from the 1,868 price level we witnessed in the S&P 500 on August 25th, wiping out nearly two years of gains.

But as quick as even this modest glimmer of hope came, renewed concerns over China and Fed interest rate hike timing saw the market finish the month with a whimper as market levels moved downward the last couple of trading days in August. All told, we exited August with all three major US stock market indices — the S&P 500 (our preferred yardstick), the Dow Jones Industrial Average and the Nasdaq Composite Index — all in the red on a year-to-date basis.

china_pmiAs we’ve cautioned, the rash of recent stimulative measures by the Chinese central bankers would have little impact in the short-term, which is exactly what was realized with a first look at the dismal China PMI reading for August (see chart).

Per the report:

Chinese manufacturers saw the quickest deterioration in operating conditions for over six years in August, according to latest business survey data. Total new orders and new export business both declined at sharper rates than in July, and contributed to the most marked contraction of output since November 2011.

Mark our words: this unexpectedly worse situation is going to ripple through economic and earnings expectations. 

screen shot 2015-08-21 at 9.49.41 am
Screen Shot 2015-09-10 at 3.47.02 PMCompounding all of this, new orders as well as new export orders continued to fall in the US according to the August PMI data from Markit Economics (see chart).  This provides more confirmation for what we’ve been seeing in recent weeks in data points such as the declining year-over-year weekly railcar loadings  (see Weekly Rail Traffic Data chart) and weak regional Fed reports. Those domestic findings were echoed by a weaker than expected August ISM manufacturing report, which showed declines almost across the board, including greater drops in new orders.

Despite what the talking heads in Washington would say, there is little doubt the US economy is slowing. 

As if the rash of PMI data wasn’t enough to make one raise an eyebrow about the near-term velocity of the economy, comments from the recent September Beige Book (a qualitative assessment of the U.S. economy compiling findings from each of the 12 Federal Reserve districts) point to concerns over upcoming minimum wage hike increases, as well as higher costs associated with the Affordable Care Act. Eleven of 12 Fed districts reported only “moderate” to “modest growth”, with the Cleveland district reporting only “slight growth”. This compares with 10 districts that reported “moderate” to “modest” growth in the July Beige Book. Most districts described labor demand as “no more than modest” to “moderate”, while most describe actual job growth as “no better than slight” or “modest”.

Soon after the release of Beige Book, we received the August Employment Report with its 5.1 percent unemployment rate, and that hit the market like too much lighter fluid on a blazing charcoal barbeque. This headline employment figure — the last such report the Fed will view before the FOMC meeting — turned up the flames of uncertainty about what will happen with rates. When we parsed the data, however, we once again see Wall Street over-reacting, much the way it did at the end of August.

To us it’s pretty simple. When we look at more people leaving the work force than the number of jobs being added, it becomes pretty obvious that the drop in the Unemployment Rate was due to “bad math.”

Here’s what we mean: when looking at other indicators — Gallup, and parts of the PMI and ISM data — it all helps to paint a much truer picture of the employment situation, as does payroll-to-population and labor force participation rate data of the jobs market. While politicians in Washington, DC will point to the falling Unemployment Rate as being due to “progress”, the reality couldn’t be further from the truth.  Currently, labor force participation, which includes working-age Americans that are actually working or actively looking for work, stands at 62.6 percent — the lowest it’s been since 1977. That doesn’t speak to a healthy employment situation.

LFP

Despite all the would-be euphoria over the stronger-than-forecasted upward revision to 2Q 2015 gross domestic product (GDP), the data of late points to a greater fall should the Atlanta Fed’s GDPNow forecast as of September 3rd of 1.5 percent for the current quarter proves to be correct.

The one bright spot in the all data we’ve consumed over the last few weeks? The Eurozone.

We continue to see Eurozone expansion on the back of improving conditions in Germany, Italy, Spain and other countries. Tempering our enthusiasm, however, we need to be mindful that a contracting China is apt to weigh on the activity in the Eurozone. We’re only now starting to hear about the “China Ripple” — and no, it’s not the latest flavor from Ben & Jerry’s — but the ripple effect from the accelerating China slowdown. Australia’s growth came in at half of expectations, and now German factory orders dropped a larger than expected 1.4 percent in July compared to the previous month, dragged down by flagging foreign demand.

In our opinion, there are too many data points — better known as reasons — that make it hard to see Janet and the Fed’s pulling the rate trigger amid an increasingly uncertain environment. The table on page 5 details our thinking on this.

So, what does all this data point to?

With the unofficial end of summer and back-to-school shopping all rolled into one we find ourselves in “return to work” mode with just three weeks left in the quarter. Soon companies will begin hiding behind the “quiet period” and before too long it will be earnings pre-announcement season. Where did the time go?

As the Labor Day holiday weekend faded away, we see expectations for S&P 500 earnings have seen little change over the last four weeks — that’s in spite of the rash of global economic data we just plowed through, all pointing to slower growth. Let’s go over the numbers, shall we?

On September 3, we saw 2015 earnings expectations at $119.34 per share, down all of just 0.25 percent versus the $119.65 per share forecasts called for as of August 6, according the data from FactSet.

Drilling down a bit deeper into expectations for the current quarter, we see the rising China weakness reported in the July and August PMIs, which also hinted at more to come in September — given new order weakness. The FactSet data also shows third-quarter expectations for the S&P 500 at $29.18 per share. That’s down 0.7 percent from the $29.40 per share forecast on August 6.

Flip it around, and it means the S&P 500 group of companies will need to grow earnings by 7 percent to hit current fourth-quarter expectations of $31.23.

The only times in recent history that the group grew earnings even close to that level was 8.7 percent in 2009 and 5.7 percent in 2013. Both times they managed it without facing the headwinds we now are experiencing.

Color us a tad crazy — and yes we realize that China does not “own” the revenue and profit stream of the S&P 500 — but considering ripple effects, the odds are high that we’ll see a greater impact on the S&P group of companies than just 0.25 percent on the back of China weakness.

Adding to our skepticism is the latest round of “will they-won’t they” Fed coyness over interest rates — this time by John Williams, president of the Federal Reserve Bank of San Francisco. In an interview with the Wall Street Journal just last week, Williams said:

All of the data that we have had up until now has been, I think, encouraging. It …has been about as good, or better, than I was expecting, in terms of the U.S. economy. But there are some pretty significant—and I would say have now grown larger—headwinds that have developed.

Put all this together and it seems, at least to us, that we are waiting for the mythical other shoes to drop. We, like everyone else in America will be watching the Fed and what it will do, or not do, with interest rates next week, which will then be quickly followed by earnings pre-announcements.

All this will provide a glimpse of what we will see in September quarterly earnings. Fasten that seat belt, have your hands on 10 and 2, and make sure your crash helmet is within arms reach!

Keeping powder dry with some exceptions like PayPal

Keeping powder dry with some exceptions like PayPal

As we get through the current storm of uncertainty and into calmer waters, we’ll continue to build out our Tematica Select Investments List. We recognize the current choppiness will likely be with us until we move past the Fed FOMC meeting in a few weeks time, but we also know volatile times like this can offer entry points that come along sparingly.While we continue to stay in a holding pattern on higher beta thematic candidates like Netflix ([stock_quote symbol=”NFLX”]) for our Connected Society thematic, the 10% drop over the last month in mobile payment company PayPal ([stock_quote symbol=”PYPL”]) puts the shares in the buy zone for our Cashless Consumption thematic that focuses on the accelerating move by consumers around the globe away from cash and checks to other forms of payment such as credit and debit cards, online payments and increasingly mobile payments.Most of us in the developed world are using credit and debit cards, and MasterCard ([stock_quote symbol=”MA”])and Visa ([stock_quote symbol=”V”]) are very happy every time you swipe one of their cards. We’ve also seen some movement toward mobile payments with the Google Wallet from Google ([stock_quote symbol=”GOOGL”]), whileApple ([stock_quote symbol=”AAPL”]) introduced Apple Pay almost a year ago. According to Gallup’s analysis, the push worked, at least to create awareness of this new product: Nearly two-thirds (65%) of consumers are at least somewhat familiar with Apple Pay. Awareness among current digital wallet users jumps to 78% and is highest (89%) among current Apple Passbook users.

In 2014, PayPal moved $228 billion in 26 currencies across more than 190 nations, generating total revenue of $7.9 billion, and the company ended the year with 162 million active user accounts, up some 13% year over year. Flash forward six months and PayPal exited 2Q 2015 with 165 million active customer accounts in 203 markets handling more than 100 currencies across its payments ecosystem that allows consumers and businesses to transact with each other online, in stores and on mobile devices.

Over the last several years, PayPal has used acquisitions to enhance its product offering and improve its competitive position in the payments industry. Past acquisitions include Braintree, an online-payment gateway used by other companies; Paydiant, an online storefront that retailers can use; and Venmo, an e-mail buddy network aimed at Millennials.

More recently, PayPal acquired Xoom to participate in the giant “remittance economy”, which refers to folks, mainly immigrants, sending money across borders. In 2014, people sent $436 billion in remittances to developing countries according to the World Bank, which projects that by 2016 global remittances will rise to $681 billion, with remittances to developing countries landing at $516 billion. Despite that growth, JPMorgan Chase ([stock_quote symbol=”JPM”]), Citigroup ([stock_quote symbol=”C”]) and Bank of America ([stock_quote symbol=”BAC”]) have scrapped low-cost services that allowed immigrants to send money to their families across the border. Remaining competitors in the remittance arena include Western Union ([stock_quote symbol=”WU”]) and Moneygram International ([stock_quote symbol=”MGI”]).

As impressive as those figures are, we find the following figure to be far more interesting — PayPal Payment Services process 30% of U.S. e-commerce transactions. Now think of how consumers are shifting their buying from brick and mortar stores to online offering such as Amazon ([stock_quote symbol=”AMZN”]), Macy’s ([stock_quote symbol=”M”]) QVC, Zappos and other e-tailors as their shopping medium moves from walking the mall to pinching and scrolling on a tablet or smartphone.

How does PayPal make money?

Like Visa, MasterCard and other by bank-sponsored credit-card operators PayPal operates within the interchange network, which charges a merchant a “take rate” of about $2.80 per $100 transaction on average. Most of that take goes to the card issuer and the rest to processors such as PayPal for facilitating the transaction. On about 40% of its transactions, PayPal takes the full 2.8%, because customers have transferred the money directly from their bank accounts. In these cases, PayPal runs the payments through its own network, away from the card companies’. Last year, transactions of these types accounted for 89% of the company’s net revenues of $7.9 billion. The remaining revenue was derived from a variety of services, such as interest and fees on credit receivables, subscription fees, and revenue sharing.

Think about it: Every time a person upgrades to a newer iPhone model, that’s another potential Apple Pay user. And as Apple adds more banks to the program and expands around the globe, that should mean more Apple Pay users, too. The same holds for Uber, Airbnb and others that like Apple Pay utilize PayPal’s Braintree payment gateway to complete transactions. Just because we don’t see people paying with PayPal in stores doesn’t mean it’s not being used. This makes PayPal a bullet play on mobile payments guns like Apple Pay and others.

Much like Visa and MasterCard, this means dollars go to PayPal whenever a transaction crosses the company’s Braintree-powered platforms. To me, that makes PayPal far more interesting as a “Buy the Bullets, Not the Gun” play on the Cashless Consumption thematic than many other options.

Over the next several years, Forrester Research sees US mobile payments growing from $52 billion in 2014 to $142 billion by 2019, and with new entrants such as Facebook ([stock_quote symbol=”FB”])entering the fray, PayPal’s behind the scenes gateway opportunities look promising, particularly for mobile payments.

The combination of this rising tide and bullet position that could expand the number of merchant and retail relationships now that PayPal is freed from eBay bodes well for continued top and bottom lie growth.  Today PayPal services roughly 75 of the top 100 online merchants and closing that gap could add meaningfully to 2016 expectations and beyond.

PayPal shares are currently trading at 23.5x expected 2016 earnings of $1.49 per share (up 20% year over year), inline with similar multiples for MasterCard and Visa, the latter of which is only slated to grow its earnings 14% year over year in 2016. Applying a discounted price to earnings growth (PEG) ratio relative to those accorded to Visa and other competitors suggests upside to $45 for PayPal over the coming 12-18 months.

With only a limited trading history for PYPL shares, to assess the downside we’ve looked at trough multiples for Visa over the last seven quarters and applying those multiples implies potential downside to $32 for PayPal shares in the coming quarters. Given last night’s closing price of $35.07 and a risk-to-reward ratio skewed to the upside, we are adding PYPL shares to our Tematica Select Investments List as part of our Cashless Consumption thematic. In the expected market chop, the closer to $32 PYPL shares get, the more aggressive our recommendation becomes.

 IPAY is Our ETF Play on Cashless Consumption 

For those looking to place client funds in a more diversified play on the Cashless Consumption thematic, in lieu of PayPal shares we’d recommend PureFunds ISE Mobile Payments ETF ([stock_quote symbol=”IPAY”]), which debuted in mid-July, and counts Visa (V), MasterCard (MA), American Express (AXP), and PayPal among its top holdings. On a combined basis those four positions account for 24% of IPAY’s overall holdings.
An Opportunity out of the China Situation that Next to No One Is Talking About

An Opportunity out of the China Situation that Next to No One Is Talking About

What very few are talking about is what happened just after China’s devaluation of its currency on Aug. 11 and how it could affect the U.S. going forward.

When China loosened its grip, its currency fell more than China wanted. To stop the slide, the People’s Bank of China was forced to liquidate more than $100 billion of its reserves to support its currency, effectively engaging in a reverse of quantitative easing.

What asset did China primarily dump? U.S. Treasuries!

Back when the Fed was buying up Treasuries in order to put more money into the economy, a.k.a. quantitative easing, China was continuing its unprecedented reserve-accumulation exercise, which, starting in 2003, amassed almost $4 trillion in foreign assets! That is more than all of the Fed’s QE programs combined. So what we really experienced on a global level was hyper-QE.

If China finds it needs to support its currency even further, as the rest of the world sees its economy slowing and puts downward pressure on the Yuan, it will need to sell more reserves to support its currency, and it has a lot of Treasuries along with other assets available for sale. That will increase the amount of Treasuries on the market, which will push prices down and yields up — again a reverse of what we saw in QE.  And so we are on the cusp of entering the era of quantitative tightening!

Now if that didn’t get your attention, perhaps this geek-out will. A recent working paper published by the Bank for International Settlements titled “Global Dollar Credit and Carry Trades” found that one of the unintended consequences of the Federal Reserve’s quantitative easing program was the significant increase in issuance of dollar-denominated corporate bonds by emerging-market companies where the proceeds primarily fed into existing cash balances, a form of corporate dollar carry trade. The paper cites a 2015 study that estimates that the outstanding dollar-denominated debt of non-bank entities located outside the U.S. was around $9.2 trillion at the end of September 2015, an increase of more than 50% from the beginning of 2010.

In early August we pointed out just how much the dollar has appreciated relative to most every other currency since the end of QE, making this carry trade increasingly untenable. We’ve seen more and more slowing across the globe, with commodity-heavy countries like Australia, New Zealand and Canada (who just reported that it is now in a recession after two quarters of negative GDP growth) engaging in pretty aggressive easing cycles, which will only further weaken their currencies relative to the dollar. What is even more concerning is that a rather large percentage of these firms are in mining, oil and gas sectors, and we all know what has happened to prices for those commodities!

This means we have companies whose domestic currency is sliding further and further against the dollar in sectors that have been utterly slammed, with outstanding dollar-denominated bonds, making those bonds more and more expensive every day — pushing an unwinding of this dollar carry trade. We suspect traders on Wall Street aren’t the only ones stocking up on Mylanta these days, giving Johnson & Johnson ([stock_quote symbol=”JNJ”]) a tailwind in the midst of a tough market!

The Bottomline on all this . . .
Based on the data over the last few weeks and months, in our view the renewed global economic uncertainty —China as well as Russia (thanks to the drop in oil prices) as well as issues in Brazil plus mounting data that points to a slowing domestic economy — will see the Fed hold off hiking interest rates until later in the year if not 2016.

Let’s remember, too, that inflation remains far closer to 0% than the Fed’s 2% target rate, at least for now. While all of that is rather clear to us, for the market the issue is the coy nature of the Fed heads of late. We rather doubt the Fed will want to the tipping point that turns the current slowdown into something worse.

What does this mean for you?
Welcome to the macro jungle! Between China and the enormous dollar carry trade unwind, there are forces that can easily overwhelm any little rate hike the Fed may launch, which we still think is highly unlikely. So, as we see it:

  • The dollar is likely to continue to dominate — which is good for PowerShares DB US Dollar Index ([stock_quote symbol=”UPP”]) or WisdomTree Bloomberg USD Bullish Fund ([stock_quote symbol=”USDU”]).
  • Volatility is not disappearing any time soon — good for those willing to brave iPath S&P 500 VIX Futures ETN ([stock_quote symbol=”VXX”])
  • Emerging-market corporate bonds could get hit hard — not good for funds like iShares Emerging Markets Corporate Bond ETF ([stock_quote symbol=”CEMB”]).
An August We’d All Be Happy to Forget

An August We’d All Be Happy to Forget

Earlier this week, we closed the books on the month of August, and in a word it was one of the worst August months we have seen in some time.

After the sharp rebound higher following yet another interest rate cut by China and dovish comments from several Fed officials about the timing of interest rate hikes, the market closed in the green for the week, but renewed concerns over China and Fed interest rate hike timing saw the market finish the month down with a whimper yesterday. Exiting the month, all three major US stock market indices – the S&P 500 (our preferred yardstick), the Dow Jones Industrial Average and the Nasdaq Composite Index were all in the red on a year to date basis.

As we’ve cautioned, the rash of recent stimulative measures by the Chinese central bankers would have little impact in the short-term and that’s exactly what was realized Tuesday with the dismal China PMI reading for August. Per the report – “Chinese manufacturers saw the quickest deterioration in operating conditions for over six years in August, according to latest business survey data. Total new orders and new export business both declined at sharper rates than in July, and contributed to the most marked contraction of output since November 2011.”

Mark our words; this unexpectedly worse situation is going to ripple through economic and earnings expectations. 

Compounding it, new orders as well as new export orders continued to fall in the US according to Tuesday’s August PMI, providing more confirmation for what the declining weekly railcar loadings and weak regional Fed reports in recent weeks have told us. Those domestic findings were echoed by a weaker than expected August ISM manufacturing report, again published this morning, that showed declines almost across the board with greater drops in new orders. Despite what the talking heads in Washington would say, there is little doubt the US economy is slowing.

The one bright spot in the data this morning was the Eurozone, which continued to expand on the back of improving conditions in Germany, Italy, Spain and other countries. I’ve shared that the weak euro is benefiting net export demand in the region and that continues to happen.  Tempering our enthusiasm, however, we need to be mindful that a contracting China is apt to weigh on the activity in the Eurozone. As we learned overnight, Australia’s economy expanded last quarter at half the forecasted pace as a slowdown in key trading partner China weighed on exports. Given the importance of China as a trading partner for the Eurozone and to the US, the ripple effect on those two economies will soon be felt.With that in mind, let us share two observations.

  1. Despite all the would-be euphoria over the stronger-than-forecasted upward revision to 2Q 2015 gross domestic product (GDP) that occurred last week, the data of late points to a greater fall should the Atlanta Fed’s GDPNow forecast of 1.2% for the current quarter prove to be correct.
  2. Although we had a few very good days in the market, the return of volatility this week on the contracting China news (which wasn’t really all that unexpected given the monetary policy goosing of late) and weakening trajectory of the US economy, should serve as a reminder that rarely do the causes behind such sharp moves lower dissipate so quickly. That means we should expect forecasts for global growth and earnings to be revised as we exit the summer.
In addition to all that unnerving PMI data, this week bring the last set of employment data before the Fed’s next FOMC meeting set for September 16-17. Despite the reported 5.3% unemployment rate from the Bureau of Labor Statistics (BLS), which we see as solid as Swiss cheese, other metrics (payroll to population, labor force participation rate) and the low quality of jobs being created suggest all is not right with the BLS’s findings. That’s why we go one step deeper and look at the employment data found inside the ISM reports, regional Fed PMI reports and other third parties like Gallup.
Buried inside yesterday’s ISM report we learned the employment component once again slowed in August. While ADP’s August Employment Report found an uptick in hiring during August, we’d note the number of jobs created remained below the 200K line and the expected China shakeout and increasing global economic uncertainty is once again like to hit the pause button on hiring and other capital spending plans near-term. As we always say, be sure to look under the hood of the August Employment Report on Friday to get a more accurate read on what it means for the changing economic and demographic landscape here in the US.