Weekly issue: Downside Protection Critical Amid These Uncertain Conditions

Weekly issue: Downside Protection Critical Amid These Uncertain Conditions

Key points inside this issue

  • Ahead of the Fed’s latest dot blot, 2019 GDP expectations move lower.
  • With uncertainties again on the rise, we reiterate our Buy rating on the ProShares Short S&P 500 ETF (SH) ahead of the upcoming March quarter earnings season.

 

Weakening GDP Expectations for the Remainder of 2019

Looking back over the last few weekly issues, it would be fair to say they were a little wordy. What can I say, between the economic data and earnings season, plus thematic data points, there was a lot to share over the last few weeks. Today, however, I’m going to cut to the point with my comments, largely because all investor eyes and ears are waiting to see and hear what Fed Chair Jerome Powell has to say about the speed of the US economy as they look for signs over what is coming next out of the Fed.

We’ve talked quite a bit about the slowing speed of the global economy, and even though there have been some individual bright spots across the aggregated hard and soft economic data from both government and third-party sources, the slowing speed is hard to ignore. Based on the published data, domestic GDP hit 3.1% last year, and as we’ve shared recently we’ve started to see the expectations for 2019 move lower in recent weeks. Per the March CNBC Fed Survey of 43 economists and Fed watcher findings, GDP for 2019 is now expected to clock in around 2.3% — not quite cut in half compared to 2018, but dramatically lower and significantly lower than folks were looking for in the back half of 2018.

When the Fed issues its post FOMC meeting statement today, the focus will more than likely not be on the interest rate decision – almost no one expects a hike. Instead, rapt attention will be paid to the Fed’s updated economic dot plot, which will reveal how it sees the US economy shaping up. Let’s remember that one unofficial aspect of the Fed’s job is to be a cheerleader for the economy, so it becomes a question of “if they are cutting their GDP forecast” how deep of a cut could we really see?

Culprits of the slowing economy and these cuts include aspects of our Middle-Class Squeeze investing theme as consumers in the US grapple with debt levels that have risen precipitously over the last several years. The consumer spending tailwind associated with our Living the Life investing theme appears to be slowing some given the rising debt levels of Chinese consumers. Governments have also run up debt in recent years as the current business cycle has grown longer in the tooth. And of course, there is the impact of currency as well as political and trade uncertainties, including the pushout of US-China trade talks to June.

 

Downside Protection is Key Under These Circumstances

In a little over 10 days, we will be exiting March, entering the second quarter and beginning the earnings season dance all over again. My concern is that given the above and the several unknowns therein, we are poised to see another earnings season during which aggregate expectations will be adjusted lower. Case in point, with the  US-China trade agreement timetable slipping and slipping, it becomes rather difficult for a company to factor any resolution into its guidance, especially when the terms of the agreement are unknown.

Despite all of the above, the domestic stock market has continued to chug higher, once again approaching overbought levels, even though 2019 EPS cuts for the S&P 500 have made the market even more expensive than it was as we exited 2018.

The potential poster child for this is FedEx (FDX), which saw its shares take a fall last night after the company cut its annual profit forecast for the second time in three months due to slowing global growth, rising costs from a 2016 acquisition in Europe and questions over its ability to withstand U.S.-China trade tensions and uncertainty over the U.K.’s exit from the European Union.

Not to go all Groundhog Day on you, but this looks increasingly like the situation we saw in December when I added the ProShares Short S&P 500 ETF (SH) to the Select List. If we didn’t have those shares to offer some downside protection for what lies ahead, I would be adding them today. If you don’t have any of those shares in your holdings, my advice would be to add some. Much like insurance, you may not know exactly when you’ll need it, but you’ll be happy to have it when something goes bad.

  • With uncertainties again on the rise, we reiterate our Buy rating on the ProShares Short S&P 500 ETF (SH) ahead of the upcoming March quarter earnings season.

 

 

Weekly issue: Adding Even More Downside Protection

Weekly issue: Adding Even More Downside Protection

Key points inside this issue

  • Ahead of the Fed’s latest dot blot, 2019 GDP expectations move lower.
  • With uncertainties again on the rise, we reiterate our Buy rating on the ProShares Short S&P 500 ETF (SH) ahead of the upcoming March quarter earnings season.
  • We are issuing a Buy on and adding the ProShares Short S&P 500 ETF (SH) May 17, 2019, 29.00 calls (SH 190517C00029000) that closed last night at 0.25 to the Select List with a stop loss set at 0.15.
  • Given the drop in Del Frisco (DFRG) shares last week, following an earnings report with no new update on the potential takeout of the company, we were stopped out of our call position.
  • We will continue to hold our Nokia Corp. (NOK) December 2019 7.00 calls (NOK191220C0000700) that closed last night at 0.40, nicely in the green.

 

Weakening GDP Expectations for the Remainder of 2019

Looking back over the last few weekly issues, it would be fair to say they were a little wordy. What can I say, between the economic data and earnings season, plus thematic data points, there was a lot to share over the last few weeks. Today, however, I’m going to cut to the point with my comments, largely because all investor eyes and ears are waiting to see and hear what Fed Chair Jerome Powell has to say about the speed of the US economy as they look for signs over what is coming next out of the Fed.

We’ve talked quite a bit about the slowing speed of the global economy, and even though there have been some individual bright spots across the aggregated hard and soft economic data from both government and third-party sources, the slowing speed is hard to ignore. Based on the published data, domestic GDP hit 3.1% last year, and as we’ve shared recently we’ve started to see the expectations for 2019 move lower in recent weeks. Per the March CNBC Fed Survey of 43 economists and Fed watcher findings, GDP for 2019 is now expected to clock in around 2.3% — not quite cut in half compared to 2018, but dramatically lower and significantly lower than folks were looking for in the back half of 2018.

When the Fed issues its post FOMC meeting statement today, the focus will more than likely not be on the interest rate decision – almost no one expects a hike. Instead, rapt attention will be paid to the Fed’s updated economic dot plot, which will reveal how it sees the US economy shaping up. Let’s remember that one unofficial aspect of the Fed’s job is to be a cheerleader for the economy, so it becomes a question of “if they are cutting their GDP forecast” how deep of a cut could we really see?

Culprits of the slowing economy and these cuts include aspects of our Middle-Class Squeeze investing theme as consumers in the US grapple with debt levels that have risen precipitously over the last several years. The consumer spending tailwind associated with our Living the Life investing theme appears to be slowing some given the rising debt levels of Chinese consumers. Governments have also run up debt in recent years as the current business cycle has grown longer in the tooth. And of course, there is the impact of currency as well as political and trade uncertainties, including the pushout of US-China trade talks to June.

 

Downside Protection is Key Under These Circumstances

In a little over 10 days, we will be exiting March, entering the second quarter and beginning the earnings season dance all over again. My concern is that given the above and the several unknowns therein, we are poised to see another earnings season during which aggregate expectations will be adjusted lower. Case in point, with the  US-China trade agreement timetable slipping and slipping, it becomes rather difficult for a company to factor any resolution into its guidance, especially when the terms of the agreement are unknown.

Despite all of the above, the domestic stock market has continued to chug higher, once again approaching overbought levels, even though 2019 EPS cuts for the S&P 500 have made the market even more expensive than it was as we exited 2018.

The potential poster child for this is FedEx (FDX), which saw its shares take a fall last night after the company cut its annual profit forecast for the second time in three months due to slowing global growth, rising costs from a 2016 acquisition in Europe and questions over its ability to withstand U.S.-China trade tensions and uncertainty over the U.K.’s exit from the European Union.

Not to go all Groundhog Day on you, but this looks increasingly like the situation we saw in December when I added the ProShares Short S&P 500 ETF (SH) to the Select List. If we didn’t have those shares to offer some downside protection for what lies ahead, I would be adding them today. If you don’t have any of those shares in your holdings, my advice would be to add some. Much like insurance, you may not know exactly when you’ll need it, but you’ll be happy to have it when something goes bad.

  • With uncertainties again on the rise, we reiterate our Buy rating on the ProShares Short S&P 500 ETF (SH) ahead of the upcoming March quarter earnings season.

 

Tematica Options+

Given the above comments, I’m adding the ProShares Short S&P 500 ETF (SH) May 17, 2019, 29.00 calls (SH 190517C00029000) that closed last night at 0.25. This strike date, unlike that for the April calls, will carry us well into the March quarter earnings season and the calls are extremely liquid. As we set a stop loss at 0.15, I will share that should we get stopped out of this position in next few weeks should the market inches higher without any real resolution to the uncertainties we discussed above, I will be inclined to recommend another, similar market hedging call trade.

 

Given the drop in Del Frisco (DFRG) shares last week, following an earnings report with no new update on the potential takeout of the company, we were stopped out of our call position. We will continue to hold our Nokia Corp. (NOK) December 2019 7.00 calls (NOK191220C0000700)that closed last night at 0.40, nicely in the green.

 

Apple’s negative pre-announcement serves as a reminder to the number of risks that have accumulated

Apple’s negative pre-announcement serves as a reminder to the number of risks that have accumulated

 

We are “breaking in” to share my thoughts with you on the implications of Apple’s (AAPL) downside December quarter earnings news last night. Quickly this is exactly of what I was concerned about in early December, but rather than take a victory lap, let’s discuss what it means and what we’re going to do. 

Last night we received a negative December quarter earnings preannouncement from Apple (AAPL), which is weighing on both AAPL shares as well as the overall market. It serves as a reminder to the number of risks that have accumulated during the December quarter – the slowing global economy, including here at home; the US-China trade war; Brexit and other geopolitical uncertainty in the eurozone; the strong dollar; shrinking liquidity and a Fed that looks to remain on its rate hike path while also unwinding its balance sheet. Lenore Hawkins and I talked about these at length on the Dec. 21 podcast, which you can listen to here.

In short, a growing list of worries that are fueling uncertainty in the market and in corporate boardrooms. When the outlook is less than clear, companies tend to issue conservative guidance which may conflict with Wall Street consensus expectations. In the past when that has happened, it’s led to a re-think in growth prospects for both the economy, corporate profits and earnings, the mother’s milk for stock prices.

These factors and what they are likely to mean when companies begin issuing their December quarter results and 2019 outlooks in the coming weeks, were one of the primary reasons we added the ProShares Short S&P 500 (SH) shares to our holdings in just under a month ago. While the market fell considerably during December, our SH shares rose 5% offering some respite from the market pain. As expectations get reset, and odds are they will, we will continue to focus on the thematic tailwinds and thematic signals that have been and will remain our North Star for the Thematic Leaders and the larger Select List.

 

What did Apple have to say?

In a letter to shareholders last night, Apple CEO Tim Cook shared that revenue for the quarter would come in near $84 billion for the quarter vs. the consensus estimate of $91.5 billion and $88.3 billion, primarily due to weaker than expected iPhone sales. In the letter, which can be read here, while Apple cited several known headwinds for the quarter that it baked into its forecast such as iPhone launch timing, the dollar, supply constraints, and growing global economic weakness, it fingered stronger than expected declines in the emerging markets and China in particular.

Per the letter, most of the “revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline occurred in Greater China across iPhone, Mac, and iPad.”

Cook went on to acknowledge the slowing China economy, which we saw evidence of in yesterday’s December Markit data for China. Per that report,

“The Caixin China General Manufacturing PMI dipped to 49.7 in December, the first time since May 2017 that the reading has been below 50, the mark that separates expansion from contraction. The sub-index for new orders slid below the breakeven point of 50 for the first time since June 2016, reflecting decreasing demand in the manufacturing sector.”

In our view here at Tematica, that fall in orders likely means China’s economy will be starting off 2019 in contraction mode. This will weigh on corporate management teams as they formulate their formal guidance to be issued during the soon to be upon us December quarter earnings season.

Also, in his letter, Cook called out the “rising trade tensions with the United States”  and the impact on iPhone demand in particular.

In typical Apple fashion, it discussed the long-term opportunities, including those in China, and other positives, citing that Services, Mac, iPad, Wearables/Home/Accessories) combined to grow almost 19% year-over-year during the quarter with records being set in a number of other countries. While this along with the $130 billion in cash that Apple has on its balance sheet exiting the December quarter, bode well for the long-term as well as its burgeoning efforts in healthcare and streaming entertainment, Apple shares came under pressure last night and today.

 

Odds are there will more negative earnings report to come

In light of the widespread holding of Apple shares across investor portfolios, both institutional and individual, as well as its percentage in the major market indices, we’re in for some renewed market pressure. There is also the reality that Apple’s decision to call out the impact of U.S.-China trade will create a major ripple effect that will lead to investors’ renewed focus on the potential trade-related downside to many companies and on the negative effect of China’s slowing economy.

In recent months we’ve heard other companies ranging from General Motors (GM) to FedEx (FDX) express concerns over the trade impact, but Apple’s clearly calling out its impact will have reverberations on companies that serve markets tied to both the smartphone and China-related demand. Overnight we saw key smartphone suppliers ranging from Skyworks Solutions (SWKS) and Qorvo (QRVO) come under pressure, and the same can be said for luxury goods companies as well. We’d note that Skyworks and Qorvo are key customers for Select List resident AXT Inc (AXTI, which means if we follow the Apple revenue cut through the supply chain, it will land on AXT and its substrate business.

All of the issues discussed above more than likely mean Apple will not be the only company to issues conservative guidance. Buckle up, it’s going to be a volatile few weeks ahead.

 

Positives to watch for in the coming weeks and months

While the near-term earnings season will likely mean additional pain, there are drivers that could lift shares higher from current levels in the coming months. These include a trade deal with China that has boasts a headline win for the US, but more importantly contains positive progress on key issues such as R&D technology theft, cybercrimes and the like – in other words, some of the meaty issues. There is also the Federal Reserve and expected monetary policy path that currently calls for two rate hikes this year. If the Fed is data dependent, then it likely knows of the negative wealth effect to be had following the drop in the stock market over the last few months.

Per Moody’s economist Mark Zandi, if stocks remained where there were as of last night’s close, it would equate to a $6 trillion drop in household wealth over the last 12-15 months. Per Zani, that would trim roughly 0.5% to 2019 GDP – again if the stock market stayed at last night’s close for the coming weeks and months. As we’re seeing today, and given my comments about the upcoming earnings season, odds are that 2019 GDP cut will be somewhat larger. That would likely be an impetus for the Fed to “slow its roll” on interest rates or at least offer dovish comments when discussing the economy.

Complicating matters is the current government shutdown, which has both the Census Bureau and Bureau of Economic Analysis closed. Even though there will be some data to be had, such as tomorrow’s December 2018 Employment Report from the Labor Department, it means the usual steady flow of economic data will not be had until the government re-opens. No data makes it rather difficult to judge the speed of the economy from all of us, including the Fed.

Given all of the above, we’ll continue to keep our more defensive positions companies like McCormick & Co. (MKC), Costco Wholesale (COST), and the ProShares Short S&P 500 shares intact. We’ll continue to watch input costs and what they mean for corporate profits at the margin – case in point is Del Frisco’s (DFRG), which is benefitting from not only falling protein costs but has been approached by an activist investor that could put the company in play. With Apple, Dycom Industries (DY), and AXT, we will see 5G networks lit this year here in the US, which will soon be followed by other such networks across the globe in the coming years. Samsung, Lenovo/Motorola and others have announced 5G smartphones will be shipping by mid-2019, and we expect Apple to once again ride that tipping point in 2020. That along with its growing Services business and other efforts to increase the stickiness of iPhone (medical, health, streaming, payments services), keeps us long-term bulls on AAPL shares.

When not if but when, the stock market finds its footing, which likely won’t be until after the December quarter earnings season at the soonest, we will look to strategically scale into a number of positions for the Thematic Leaders and the Select List.

 

Weekly Issue December 17 2018

Weekly Issue December 17 2018

Key points inside this issue:

  • The Duke University/CFO Global Business Outlook survey surprises the market
  • Costco stumbles, but it is far from down and out
  • Thematic confirmation had in the November Retail Sales Report
  • Digging into Friday’s other economic reports
  • What to watch this week
  • Holiday Housekeeping

The Duke University/CFO Global Business Outlook survey surprises the market

What looked to be shaping up as a positive week for the stock market turned on its head Friday following renewed concerns over the pace of the global economy. As we’ve talked about recently, the vector and velocity of the latest economic reports suggest a slowing economy and that is fueling questions over the top and bottom-line growth prospects for 2019.

Tossing some logs on the that fire late last week was the new survey findings from the Duke University/CFO Global Business Outlook survey that showed almost half (48.6%) of US chief financial officers believe the United States will be in recession by the end of next year while 82% of CFOs surveyed believe that a recession will begin by the end of 2020. That’s quite different than the Wall Street consensus, which per The Wall Street Journal’s Economic Forecasting Survey sees the speed of the economy slowing from 3.5% in the September 2018 quarter to 2.5% in the current one to 2.4% in the first half of 2019 followed by 2.2% in the back half of the year.

This revelation has added to the list of concerns that I’ve been discussing of late and adds to the growing worries over EPS growth prospects in 2019.

 

Costco stumbles, but it is far from out

Last Thursday night, Costco Wholesale (COST), our Middle-Class Squeeze Thematic Leader, reported an EPS beat by $0.05 per share for the quarter, but revenue came in a tad short at up 10.3% year over year, or $34.3 billion vs. the expected $34.66 billion. Same-store sales for the quarter rose 8.8% (+7.5% ex-gasoline and currency), which is well above anything we’ve seen for the September-November period per Friday’s November Retail Sales report save for digital shopping (Non-store retailers) and gas station sales – more on that shortly.

Despite the positive EPS, COST shares fell 8.6% on Friday.

The issue with Costco was the margin profile as reported operating income was essentially flat year over year. When combined with the top line increase vs. the year-ago quarter it means the company’s operating margin hit 2.7% vs. 3.0% in the year-ago quarter, and 3.2% this past August quarter. Part of the issue was the jump up in pre-opening expenses for new warehouse locations which rose by 6% quarter over quarter. The real culprit was the step up in merchandising costs, which climbed 10.8% year over year for the November quarter vs. 5.4% year over year in the September quarter. Clearly, Costco is seeing the impact of not only higher prices but also the impact of tariffs associated with the U.S.-China trade war.

Despite that, the core basics at the company – foot traffic, renewal rates, and membership growth – continue to fire on all cylinders. That to me makes Costco one of the best-positioned retailers, and the fact that its e-commerce business continues to blossom is positive as well. In all of 2019, Costco looks to open 20-23 net new warehouses, which equates to an increase of 2.5%-3.0% year over year. This will likely drive pre-opening expenses higher in the coming months, but given the favorable metrics associated with each new location over the medium to longer-term, we’ll take it, especially if the economy slows more than expected. Odds are that will drive more consumers to Costco than not.

  • Our long-term price target on Costco Wholesale (COST) shares remains $250.

 

Thematic confirmation in the November Retail Sales Report

Looking over Friday’s November Retail Sales Report, core Retail Sales rose 4.0% year over year with strong performance as expected for Non-store Retailers (+10.8% year over year), Gasoline Stations (+8.2%) and Food Service & Drinking Places (+5.6%). To me, those first and third categories ring positive for our Digital Lifestyle and Living the Life investing themes. That means I see those as positive signs for our thematic and holiday shopping positioned companies, which includes the aforementioned Costco, but also Amazon (AMZN), United Parcel Service (UPS), McCormick & Co. (MKC), International Flavors & Fragrances (IFF) and Del Frisco’s Restaurant Group (DFRG).

Back to the November Retail Sales report, while the sequential overall retail comparisons came in either as expected or slightly better depending on the forecast one is looking at, what’s likely to catch the market’s attention is the sequential drop in year over year retail sales growth that was had in November. Again, year over year November retail sales growth rose 4.0%, which was down compared to the October year over year increase of 4.5%.

Given the growing amount of data that points to a slowing domestic economy, one that is driven meaningfully by the consumer, odds are market watchers will not love what they saw in those year over year comparisons. Add to it that a recent Gallup poll found that Americans plan to spend less on holiday gifts today than they expected back in October and less than they expected to spend in 2017. The $91 decline in expected spending since October is “one of the steeper mid-season declines, exceeded only by a $185 drop that occurred in 2008, as the Wall Street financial crisis was unfolding, and a $102 drop in 2009 during the 2007-2009 recession.”

Clearly, those latest data points weighed on the overall stock market last week, but those weren’t the only ones.

 

Digging into Friday’s other economic reports

The November Retail Sales report wasn’t the only set of key data that weighed on the market last Friday. The November Industrial Production Report showed a flat manufacturing economy following the modest dip in October. On the December Flash PMI reports, the U.S. hit a 19-month low for the month with softer new order growth, while “Lower oil-related costs contributed to the slowest rate of input price inflation since the start of the year.” Turning to the eurozone, its Composite Output PMI hit 51.3, down from 52.7 in November, and reached a four-year low. The Flash Manufacturing PMI data for Japan was better, as it rose to 52.4 for December up from 52.2 in November, but that is hardly what we would call a robust figure given the expansion/contraction line at the 50.0 level. While new orders activity improved in Japan, new export orders fell, signaling a change of direction, which supports the notion of a slowing global economy.

This data along with the back and forth on U.S.-China trade, Brexit developments, Italy budget concerns, protests in France, and the potential government shutdown have all raised investor uncertainty levels. We see this in the current “Extreme Fear” (9) reading on the CNN Business Fear & Greed Index, which is little changed over the last few weeks. We’ve seen this play out in the stock market as the number of stocks hitting new highs pales in comparison to hitting 52-week lows. As one likely suspects, we saw this play out in small cap stocks, which per the Russell 2000 last week, were once again the hardest hit of the major stock categories. Quarter to date, small cap stocks are down just under 17% quarter to date.

We saw a number of these concerns brewing as we exited September and entered the September- quarter earnings season. We have been careful in making additions to the Select List given what I’ve viewed as an environment that has been more skewed to risk than reward. Odds are that will continue to be the case between now and the end of the year, which means we will continue to be overly selective when it comes to deploying capital. For that reason, last week we added the ProShares Short S&P 500 ETF (SH) shares to our holdings to add some downside protection.

 

What to Watch This Week

Following last week’s rash of economic data, don’t ask me how or why but the Atlanta Fed saw fit to boost its GDP Now forecast for the current quarter to 3.0% from 2.4% last week. As subscribers know, I prefer the far more solid track record at the NY Fed and its Nowcast report, which now calls for the current quarter to be +2.4%, down from +2.44% last week. That’s in line with The Wall Street Journal’s Economic Forecasting Survey, but again that Duke poll is likely to be in the forefront of investor minds this week as more data is had. This includes several pieces of housing data — the November Housing Starts & Building Permits as well as November Existing Home Sales and the October NAHB Housing Market Index — as well as the November Durable Orders Report and November Personal Income & Spending data.

As I mentioned above, the number of economic numbers suggesting the global economy continues to slow are growing, which likely gives the Fed far more room to issue dovish comments after next week’s all but done December rate hike. In recent weeks as the Fed has once again signaled it will more than likely remain data dependent in 2019, we’ve seen a change in the futures market, which is now pricing in less than 20 basis points of rate hikes next year versus over 55 basis points just a few months ago. But we have to consider the reason behind this slower pace of rate hikes, which is the suggestion by recent data that the economy is far from overheating, which also adds to the core question we suspect investors and the market are asking: how fast/strong will EPS growth be in 2019?

As we prepare for Fed Chair Powell’s remarks, it’s not lost on me that we could very well see a “buy the rumor, sell the news” event following the FOMC meeting next week.

Heading down the final stretch of 2018, I’ll be looking at well-positioned companies relative to our investment themes that have been hard hit by the quarter to date move in the market. As of Friday’s market close, the S&P 500 was down X% quarter to date, while the tech-heavy Nasdaq Composite Index and the small-cap heavy Russell 2000 were down 14% and nearly 17%, respectively, on that basis. One of the criteria that I’ll be focusing on as I weed through this growing list of contenders is favorable EPS growth year over year relative to the S&P 500. And, yes, when I say that I do mean to “real” EPS growth due to rising profit margins and expanding dollar profits instead of those lifted largely by buyback activities.

With that in mind, I’ll be paying close attention to a number of key earnings reports coming at us next week. These include Nike (NKE), Carmax (KMX), ConAgra (CAG), General Mills (GIS), Micron (MU), FedEx (FDX) and Darden Restaurants (DRI). Inside these reports and company commentaries, I’ll be looking for data points that to confirm our investment themes, the question of inflation vs. deflation and where it may be, and a last-minute update from FedEx on digital commerce for this holiday shopping season that we are all in the thick of. Also, among those reports is Del Frisco’s competitor – The Capital Grill, which is owned by Darden. I’ll be paying extra close attention to that report and what it means for our DFRG shares.

 

Holiday Housekeeping!

And that brings us to our Housekeeping note, which is this – given the way the Christmas and New Year’s holidays fall this year, barring any unforeseen issues that will require our attention and immediate action, we here at Tematica will be in “get ready for 2019” mode. That means we’ll be using the quiet holiday time to review the Thematic Leaders as well as positions on the Select List to ensure we are well prepared for the coming months ahead.

As such, we’re likely to be back the week of January 7th, although I can’t rule out the urge to share some thoughts with you sooner. For example, if the Fed says something that rolls the stock market’s eyes later this week, I’ll be sure to weigh in and share my thoughts. The same goes for the Darden earnings report I mentioned above and what it may mean for our DFRG shares.

We will have a new podcast episode or two before then, and we will be sharing a number of Thematic Signals over the coming weeks – if only those confirming signs for our investment themes would take a break. I’m only kidding, but of course, I love how recognizable and relatable the themes are in and around our daily lives.

To you and your loved ones, Merry Christmas, Happy Holidays, and Happy New Year! See you 2019!!

 

 

Options+ Weekly Issue

Options+ Weekly Issue

Key points inside this issue:

 

The Duke University/CFO Global Business Outlook survey surprises the market

What looked to be shaping up as a positive week for the stock market turned on its head Friday following renewed concerns over the pace of the global economy. As we’ve talked about recently, the vector and velocity of the latest economic reports suggest a slowing economy and that is fueling questions over top and bottom-line growth prospects for 2019.

Tossing some logs on the that fire late last week was the new survey findings from the Duke University/CFO Global Business Outlook survey that showed almost half (48.6%) of US chief financial officers believe the United States will be in recession by the end of next year while 82% of CFOs surveyed believe that a recession will begin by the end of 2020. That’s quite different than the Wall Street consensus, which per The Wall Street Journal’s Economic Forecasting Survey sees the speed of the economy slowing from 3.5% in the September 2018 quarter to 2.5% in the current one to 2.4% in the first half of 2019 followed by 2.2% in the back half of the year.

This revelation has added to the list of concerns that I’ve been discussing of late and adds to the growing worries over EPS growth prospects in 2019. For that reason, even though our ProShares Short S&P 500 Jan 2019 30.00 calls (SH190118C00030000)are up 30% since we added them roughly 10 days ago, we’ll continue to hold them for the duration. Given the upward move, however, I will boost our stop loss to $0.65 from $0.35.

 

Costco shares stumble and we’re jumping on board!

Last Thursday night, Costco Wholesale (COST), our Middle-Class Squeeze Thematic Leader, reported an EPS beat by $0.05 per share for the quarter, but revenue came in a tad short at up 10.3% year over year, or $34.3 billion vs. the expected $34.66 billion. Same-store sales for the quarter rose 8.8% (+7.5% ex-gasoline and currency), which is well above anything we’ve seen for the September-November period per Friday’s November Retail Sales report save for digital shopping (Non-store retailers) and gas station sales – more on that shortly.

Despite the positive EPS, COST shares fell 8.6% on Friday.

The issue with Costco was the margin profile as reported operating income was essentially flat year over year. When combined with the top line increase vs. the year ago quarter it means the company’s operating margin hit 2.7% vs. 3.0% in the year ago quarter, and 3.2% this past August quarter. Part of the issue was the jump up in pre-opening expenses for new warehouse locations which rose by 6% quarter over quarter. The real culprit was the step up in merchandising costs, which climbed 10.8% year over year for the November quarter vs. 5.4% year over year in the September quarter. Clearly, Costco is seeing the impact of not only higher prices but also the impact of tariffs associated with the U.S.-China trade war.

Despite that, the core basics at the company – foot traffic, renewal rates and membership growth – continue to fire on all cylinders. That to me makes Costco one of the best-positioned retailers, and the fact that its e-commerce business continues to blossom is a positive as well. In all of 2019, Costco looks to open 20-23 net new warehouses, which equates to an increase of 2.5%-3.0% year over year. This will likely drive pre-opening expenses higher in the coming months, but given the favorable metrics associated with each new location over the medium to longer-term, we’ll take it, especially if the economy slows more than expected. Odds are that will drive more consumers to Costco than not.

We’ve seen setbacks like this before with COST shares, and as it continues to operate as smartly as it does and open additional locations it continues to deliver enviable same-store sales figures month after month. With more new warehouses to be had in 2019, I strongly suspect this will once again be the case. This has us adding the Costco Wholesale (COST) April 2019 $210 calls (COST181221C00210000)that closed at 2.03 to our holdings. This will allow for the capture of December as well as first quarter holidays as well.  We’ll give this a wide berth initially, which means setting our stop loss at 1.00 for now. As the company’s monthly same-store sales figures confirm our thesis, I’ll look to boost that stop loss.

 

Holiday Housekeeping!

And that brings us to our Housekeeping note, which is this – given the way the Christmas and New Year’s holidays fall this year, barring any unforeseen issues that will require our attention and immediate action, we here at Tematica will be in “get ready for 2019” mode. That means we’ll be using the quiet holiday time to review the Thematic Leaders as well as positions on the Select List to ensure we are well prepared for the coming months ahead.

As such, we’re likely to be back the week of January 7th, although I can’t rule out the urge to share some thoughts with you sooner. For example, if the Fed says something that rolls the stock market’s eyes later this week, I’ll be sure to weigh in and share my thoughts.

We will have a new podcast episode or two before then, and we will be sharing a number of Thematic Signals over the coming weeks – if only those confirming signs for our investment themes would take a break. I’m only kidding, but that, of course, I do love how recognizable and relatable the themes are in and around our daily lives.

To you and your loved ones, Merry Christmas, Happy Holidays, and Happy New Year! See you 2019!!

 

 

Weekly Issue: Continued Volatility Puts Us in a Holding Pattern

Weekly Issue: Continued Volatility Puts Us in a Holding Pattern

Volatility returned to the market this week, but unlike the last several it wasn’t driven primarily by trade war and concerns over escalating tariff. This time it began with concerns over Turkey, its flip-flopping currency and contagion concerns with other emerging markets and spread with tumbling oil and metal prices reigniting concerns over a global slowdown due in part to China’s slowing economy.

One of the more closely watched metals as a leading indicator of the economy is copper — or as it’s known in the financial markets as Dr. Copper— because it is utilized in a number of different sectors, from home construction and consumer products to manufacturing. Yesterday, copper prices hit their lowest levels in 13 months, entering a bear market, potentially signaling an economic slowdown is happening around the world.

 

 

The culprit of that downward price move? This week, China reported weaker-than-expected industrial production and retail sales growth, raising worries that the second-largest economy in the world could be headed for a slowdown.

Against that backdrop and the escalated tariffs against China, it appears the Chinese government may have blinked last night as it was the Chinese Commerce Ministry announced a delegation will travel to the United States later this month for talks for another round of trade talks. The Chinese delegation will be led by Vice Commerce Minister Wang Shouwen, who will hold talks with David Malpass, the US Treasury Department’s undersecretary for international affairs, according to the Chinese statement.

That news led to a rebound in Asian markets earlier today, and as I write this US futures are up nicely, looking to reverse yesterdays’ losses. While there is reason to be hopeful, we also know the devil will be in the details as both the US and China will be looking to claim victory in the upcoming round of trade talks…. Assuming they are able to hammer out a new pact. Mixed with the seasonally slow trading volume, we are likely to see the volatility continue.

I remain optimistic that President Trump and his team will be able to negotiate a better trade deal with China. Odds are it won’t be perfect, but that doesn’t mean it can’t be better. At the same time, however, Trump is once again threatening to shut the US government down and has tied funding the government to a showdown on the border wall. The Senate returned to work yesterday, and the U.S. House will return Sept. 4. With the federal fiscal year ending on Sept. 30, Congress a short time frame to find a fix. We could very well be in for another game of chicken, and one that could put some additional indigestion in the mouths of investors.

As I look ahead, next Thursday (Aug. 23) brings the IHS Markit Flash August PMI data, which should inform us as to the impact of tariffs that have been enacted of late. Between now and then, we should get some additional details on the upcoming round of US-China trade talks. For now, the risk is the market overreacts to the news US-China talks will resume. As I said above, I’m hopeful but as someone that looks below the headlines, I’m holding off doing anything with the Tematica Options+ Select List until we have more details on what those conversations may bring as well the true speed of global economy.

 

Housekeeping

As I shared earlier this week, Dycom Industries (DY) took a hatchet to its top and bottom line forecast for the back half of 2018, which sent the shares tumbling. We took advantage of that, adding to the DY shares position on the Tematica Investing Select List. That same plunge, however, stopped out our Dycom (DY) December 2018 110.00 calls (DY181221C00110000) at 3.00, generating a return of -25.0%.

The Rise of the New Middle-Class theme lets India air traffic take off and much more

Month to month economic and industry data can fluctuate, which is why we look at the data over a longer term. While passenger air traffic spiked in February, we see the annual growth rate of more than 20% over the last several years reflecting the growing economy and rising disposable income that are drivers of our Rise of the New Middle Class investing theme. In addition to incremental spending on travel, other areas benefitting from this theme include leisure spending, housing and furnishings, premium branded apparel, higher end autos, restaurants and connected devices. In short, those devices and activities that denote some degree of status have been achieved.

Even though Goldman Sachs (GS) lowered its real gross domestic product (GDP) forecast on India for the year to March 2019 to 7.6% from 8%, the level of growth is far stronger than anything expected in the US, a country that sees more signs of our Middle-Class Squeeze investing theme.

 

Passenger air traffic in India grew at the fastest pace in 13 months in February, even as fears mount over demand weakening due to rising air fares.

The number of passengers flown last month jumped almost 24% on-year to 10.7 million, according to government data.Air travel in India traditionally records a spurt from October through March, rebounding from a lean period in the previous months.

The country’s air travel has grown at an annual pace of more than 20% in the past few years as rising incomes and the advent of no-frills carriers prompted more people to shun trains for long-distance travel.

The south Asian nation is already the third-largest aviation market behind the U.S. and China with domestic traffic of more than 100 million passengers.

Source: India aviation traffic rises at fastest pace in 13 months- Nikkei Asian Review

Japan, China, and the U.S. working-age populations a headwind to global growth

Japan, China, and the U.S. working-age populations a headwind to global growth

A new report from Deloitte highlights one of the downsides of our Aging of the Population theme – the simple fact that economic growth is tied to the number of working-age people in a country’s population. Given prospects for a rising working population, India is widely expected to be the driver of global growth in the coming years while Japan, China, and the U.S. contend with a shrinking working age population. According to Gallup, worldwide 32% of working-age adults are employed full time, and that likely means global growth will be challenged in the coming years as that working-age population shrinks further.

A new report by Deloitte Insights, however, says that China will soon be playing second fiddle to India as the biggest driver of global growth.The report, entitled Ageing Tigers, hidden dragons, argues that there is a “third wave” of economic growth in Asia.

The first wave was led by Japan in the 1990s before China took over. But the Chinese-led second wave has already peaked, making way for a third wave driven by India.

The third wave will be mostly driven by a massive increase in workers. Over the next decade, India’s working-age population will rise by 115 million. This is more than half of the 225 million expected across Asia as a whole.

Within two decades, India’s potential workforce will rise to 1.08 billion.

But it’s not just an increase in workers that will help propel the Indian economy. The new workers will be “much better trained and educated than the existing Indian workforce”, says Deloitte.

Meanwhile, Japan’s working-age population will shrink by more than 5 million, and China’s by 21 million, over the next 10 years.

In fact, India’s working population will soon outstrip China’s. While China’s population is already ageing, this won’t happen in India until halfway through the century.

China’s ageing problemImage: DeloitteChina’s ageing population will slow down its growth potential. While its one-child policy is no longer in force, the effects are still being felt. Soon, there will be fewer people of working age. Not only that, but because of the one-child policy, China’s population has aged faster than elsewhere.

As a result, China won’t feel the full benefit of its years of economic growth. “This is yet to seep into the consciousness of most of the world, which still regards China simply as a country with an extremely large population,” states Deloitte.

Source: China will grow old before it gets rich. | World Economic Forum

Gallup data confirms the rising middle class in Asia is more than China & India

Gallup data confirms the rising middle class in Asia is more than China & India

Nothing better than having an organization like Gallup issue confirming data for our Rise & Fall of the Middle-Class investing theme. While most tend to understandably focus on China and India given the size of their respective populations, Gallup’s finding remind us upward economic mobility is occurring in other emerging Asian economies. This target market expansion is poised to attract U.S. companies looking to offset waning growth in more mature economies that are contending with the falling middle-class as well as Cash-Strapped Consumer.

Majorities in most Asian economies surveyed in 2016, including some of the region’s least-developed countries, expect that children today will have better living standards when they grow up than their parents did. This includes more than 90% of residents in poor countries such as Bangladesh and Myanmar.

The pace of economic progress explains much of the difference between opinions in countries at the top and bottom of the list. Countries at the top of the list, where residents are most optimistic about the next generation’s standard of living, enjoyed strong gross domestic product (GDP) growth rates of over 6% last year. Their economies have seen dramatic improvements recently, aided by increased foreign investment and low labor rates.

Bangladesh’s economy, for example, has grown by more than 6% in 10 of the past 12 years.However, among countries at the top of the list, current per capita income levels are low compared with those of other countries. According to the World Bank, Bangladesh ranked 145th in the world in terms of per capita income last year, and Myanmar ranked 146th. These are two of the world’s least-developed countries, where people have relatively short life expectancies. Yet, residents in Bangladesh and Myanmar express great hope for rising living standards — not because of their country’s current level of development, but because of the positive trend and momentum of its development.

Source: Many in Asia See Better Living Standards for Next Generation

The Tematica take on Fed hikes, balance sheet contraction and other works of creative fiction

The Tematica take on Fed hikes, balance sheet contraction and other works of creative fiction

As we all know by now, the Fed exited its September monetary policy meeting yesterday. Chairwoman Janet Yellen said that in the Fed’s view, the domestic economy is on solid enough footing to handle another Fed rate increase before the end of the year as well as the initiation of the Fed’s plan to unwind its $4.5 trillion balance sheet. This view effectively brushes aside the fact that the Fed’s inflation target has yet to be realized, despite its herculean monetary policy efforts, and in the near-term, the economy is headed for a tumble following hurricanes Harvey and Irma, and maybe more depending on how Hurricane Maria develops.

In recent days, we’ve seen several cuts to GDP expectations for the current quarter, including from the Atlanta Federal Reserve as well as several investment bank economists. The general thinking is that Hurricanes Harvey and Irma trimmed roughly 1% off of economic activity. With the bulk of the damage coming in September, including what we have yet to experience with Maria, we’ll have a fuller sense of the trifecta’s extent in October when we get the September data.

The market reaction to the FOMC statement is that it was more hawkish than what had already been priced in. While the market was priced at a 50/50 chance for a rate hike before the end of the year, the now infamous dot-plot shows that 12 of the 16 members expect one more hike this year, with one expecting two. In sharing the committee’s view Chairwoman Yellen remarked, “The median projection for the federal funds rate is 1.4 percent at the end of this year, 2.1 percent at the end of next year, 2.7 percent at the end of 2019, and 2.9 percent in 2020.”

This means the next rate hike, which is now likely to occur in December,  will be a quarter point in nature, and based on the Fed’s forecast the three targeted rate hikes in 2018 are likely to be of the same magnitude. As Yellen shared this, she once again cautioned the Fed will remain “data dependent” in its thinking. As the markets recalibrate from a 50% likelihood to the new 70% that we will see another hike in 2017, gold lost $10 per ounce, the dollar gained some strength and the yield on the 2-year rose 4 basis points while the long bond has barely moved, flattening the yield curve.

From our perspective, with a recovery that is increasingly long in the tooth (something that is not likely lost on Yellen and the Fed heads), we see the Fed looking to regain monetary stimulus firepower ahead of the next eventual recession. To be clear, we’re not calling for one, just recognizing that at some point one will happen – it’s the nature of the business cycle. As we share that reality, we’d also note that historically the Fed has a very good track record of boosting rates as the economy heads into a recession.

We’d like to point out that while most are viewing these minutes as more hawkish than expected, the phrasing of their economic analysis has become more sedate. Oh for the days when we didn’t need to analyze every little word out of the Fed like a bunch of teenagers assessing the meaning of their crush’s every utterance! The Fed’s assessment of unemployment has dropped the reference to “has declined,” leaving just “unemployment rate has stayed low.” With respect to spending, the wording has gone from “continued to expand” in July to “expanding at a moderate rate.” As for the dot plots, of the four FOMC members who expected two more hikes in 2017, only one remains.

As much as the Fed will likely try to avoid that and preserve Yellen’s time as chairwoman, it’s different this time. Next month, the Fed will begin unwinding its balance sheet that bulked as a result of its quantitative easing measures. The Fed admits to “months of careful preparation,” but let’s be real here, this is unlike anything we have seen before as the Fed expects to boost interest rates further. Yes, the Fed will baby step with its balance sheet as its targets selling no more than “$6 billion per month in Treasuries and $4 billion per month for agencies” in 2017. In 2018, however, those caps will rise to “maximums of $30 billion per month for treasuries and $20 billion per month for agency securities.” Given the Fed’s balance sheet weighs in at a hefty $4.5 trillion, this is poised to be a lengthy process and we suspect that as well intended as the Fed’s thinking on this is, odds are there are likely to be some unintended consequences.

The question we continue to ponder is whether the economy is strong enough to not falter as the Fed ramps its selling while boosting rates. Even the Fed sees GPD falling from its 2.4% forecast this year to “about 2 percent in 2018 and 2019. By 2020, the median growth projection moderates to 1.8 percent.” To get to that 2.4%, we need the Atlanta Fed’s GDPNow forecast for 2.2% in Q3 to materialize, which we think is going to be tough given the impact of this season of insane storms, as well as at least a 3% bump in Q4. Our bets are that’s about as likely as either of us giving up chocolate.

As we mull this forecast vs. the business cycle, we must keep in mind the Fed is ever the cheerleader for the economy and tends to be optimistic with its GDP forecasts. We prefer to be Rhonda Realist vs. Debbie Downer or Cheery Charles, and when we triangulate the Fed’s comments, we continue to think it’s underlying strategy is to re-arm itself for the next downturn.