While I have draft articles nearly ready to submit on a variety of pharmaceutical stocks ranging from mega-cap to junior biotech status, the disconcerting recent behavior of the macro markets and certain individual stocks and sectors has led me to once again address these matters, but with a different topic.
The question that serves as the main topic of this article is, what's safe now in the US markets?
I ask this because, written and submitted during and after the trading day on Monday, we are seeing both Treasuries and precious metals rising in price against cash, whereas equities in Western Europe and North America are down sharply. In addition, there is a palpable "flight to safety" in individual stocks. Junior biotechs are down big, but Johnson & Johnson (NYSE:JNJ) is up strongly. Less highly-rated Big Pharma stocks (i.e. all of them) are generally down, such as Pfizer (NYSE:PFE) and Merck (NYSE:MRK). In addition, while the stock market (NYSEARCA:SPY) has sold off over the past couple of weeks, there has been a massive flight to safety into utility stocks (NYSEARCA:XLU). Notable among them is the one electric utility I ever wrote about on Seeking Alpha, namely Con Ed (NYSE:ED), which was in the $55 range when I wrote a bullish article about its price appreciation potential in 2014. It was trading at $72.56 as I write this, up close to 1%. Today's price appreciation alone is greater than the yield on a truly safe 1-year Treasury bill.
All this action smells of some degree of panic, forced liquidation, etc. But it also may represent paradigm change. This article explores where safety really is.
As I'm not an investment adviser, this represents my opinions, though I trust that when I refer to some facts, that I am correct in that regard.
I'll begin with a different sector than the ones mentioned above, and discuss a stock or two to exemplify them and use that template in following sections.
Large-cap consumer staples stocks have been providing shelter from the ongoing storm. As an example, take Coca-Cola (NYSE:KO). This stock has been a rock. Is it now safe or risky? I favor the latter on a relative basis. Here's the rationale.
KO trades at 27X TTM EPS using generally accepted accounting principles. GAAP is not perfect. It can both under- and over-estimate earnings. In KO's case, GAAP requires marking its dominant foreign operations to the changed value of the currencies vs. the USD. Over the past 40+ years, that translation, which is primarily non-cash, has helped KO's reported results. Shareholders have not seen much of the cash, however; it has remained offshore as the company has expanded its operations and engaged in various financial engineering maneuvers with its foreign bottlers. The past year has been a counter-trend one, and KO and other multinationals make sure that Wall Street knows the injustice (sarcasm alert) of this event.
The facts as KO reports them quarterly are that the company is barely growing in real terms, or is shrinking, all depending on how successful it is in raising prices or cutting costs. Unfortunately, this more-or-less no growth scenario is occurring at a corporation with a weakening financial structure:
Total Stockholder Equity 26,049,000 28,418,000 28,837,000 30,320,000 Net Tangible Assets 1,630,000 2,338,000 2,783,000 3,948,000
Total shareholder equity has been declining. With a market cap of $184 B, KO is ignoring the following risks (not exhaustive):
- rising interest rates (and rising input costs)
- falling interest rates (deflation)
- product liability suits (could Coke be found "bad for you?")
- accelerated shift from Coke and other carbonated beverages
- general forced liquidation of equities by institutions
KO is paying shareholders 3.1% and retains almost none of its earnings, as shown by the shrinking equity levels above. KO shares have none of the safety of invested principal of a cash or high-quality bond (such as its own debt), but it also appears to have demonstrated that it has no ideas for growth other than partnering with or buying other brands.
Let's move from ingested stuff to stuff you put on yourself, such as toothpaste and soap. What about P&G (NYSE:PG). This icon has been a tower of strength. Is it safe at $81.49 and a market cap of $220 B?
What underpins that market cap? Here is its summary balance sheet:
Total Stockholder Equity 61,628,000 62,287,000 62,419,000 62,733,000 Net Tangible Assets (7,024,000) (7,040,000) (11,726,000) (11,031,000)
We can say that at about 3.6X book value, but with a negative tangible book value, PG is not cheap. But, of course, it controls some famous brand names.
How many can you name?
Maybe I'm an old dolt, but I have trouble identifying which famous brand goes with which corporate owner, though I do know that Colgate-Palmolive (NYSE:CL) controls Colgate.
In other words, PG is a collection of aging brands that it may and does shuffle around with its colleagues in branded consumer staples; that's why there is so much goodwill on the balance sheet (as well as tens of billions of dollars worth of intangibles).
Now that the balance sheet has been revealed, what about EPS?
Well, it's similar to KO. There is no organic growth, because PG is in some trouble. Thus it sells some brands off, the worst ones in general, so that the remaining ones can be dubbed "organic" (to the company, not in their manufacture) and thus a pretense of growth can be propounded. As is KO, PG is trading at 27-28X TTM EPS. With no growth.
There's no need to list the vulnerabilities for anyone paying today's price for PG. You get a better product buying almost any of its products. It makes good stuff, but the stock under any sensible view of its vulnerabilities to inflation, deflation, recession, rising dollar, falling dollar, etc. should be at 10-12X. Then it could both reward shareholders with a comfortable dividend and also retain enough earnings to grow.
The magic trick of showing "organic growth" along with share buybacks plus dividend increase keeps stock up so long as the institutions play along, but here's how executives have been voting with their money (insider transactions):
Maybe they bought some LinkedIn (NYSE:LNKD)? But not PG.
To summarize, the "safe" consumer products mega-cap stocks trade at almost infinite PEG ratios, because to the extent they are growing at all, it is through asset sales, price increases, shrinkage of the float, and borrowing to help make it all happen at all-time low costs for "blue chips."
But the price of their equity has as a result decoupled from the values available in other parts of the marketplace. If the economy turns up in its old inflationary, "growthy" fashion, these companies have no upside leverage and their P/Es will be quickly recognized as far too high relative to the market. So they are guaranteed underperformers in that circumstance. Yet, if global recession appears, not just threatens, their earnings can drop, and their dividends can be threatened; at the least, the pace of dividend increases can drop to zero or close to zero.
And in that case, buyers will recognize that a "junk" bond yielding 8% with only a 5-year average life yields more than a 3% dividend from a no-growth liquid or soap/household products company.
Only in a continuation of a flight to safety but no crisis or no upside resolution can PG and KO achieve alpha at their current relative valuations. Who wants to bet that this situation can go on forever without resolving in one direction or the other? I do not.
Let's move on to utilities.
Are electric and gas utilities safe havens?
In speaking of these companies that provide our juice, one major difference from the above names is that they are domestic. There are no foreign currency issues to speak of. That means that all earnings are fully taxed. To me, that's a good thing. That the main companies I follow and that most of us invest in are entirely US-based or nearly so is a positive for XLU and the individual names I trade.
That does not change the basic thought process. These are operating companies, not bonds, but as with many consumer staples stocks, they are now being traded as bond substitutes. Yet aside from M&A, they not only have limited growth prospects, they may have shrinkage prospects. If the era of low growth and low interest rates on high-quality bonds continues, public service commissions may come under pressure to lower allowed rates of return on capital. Remember that most utilities are highly leveraged, say with equal amounts of long-term debt and equity, and that their return on capital is only granted on their equity. So, it that return is lowered from, say, 10% to 9%, it has an outsized effect. In addition, leaving Con Ed aside, almost every other utility has a material problem from the seemingly inexorable rise of solar power. The technical advances and the perceived environmental advantages over fossil fuel generation are difficult for electric utilities to overcome. And to the extent that natural gas competes with solar, that problem applies to that industry as well.
Finally, most utilities are sensitive to the economy. Many have industrial clients that use large amounts of highly profitable power or nat gas that the utilities deliver. All electric utilities have commercial clients. If office vacancies rise in a recession, less of this highly profitable business will be generated.
In fact, you can regress XLU against the SPY going back to the formation of XLU in 1998 and find that XLU dropped sharply with SPY in the 2000-2 and 2007-9 major bear markets. It's not immune.
So that brings us valuations. XLU closed Monday at $46.41, with a stated average P/E of 16X per Yahoo! Finance and a dividend yield of 3.5%. I have not done the math, but I wonder about the P/E. The leading stock in XLU is NextEra (NYSE:NEE), which trades at a 19X multiple. Duke Power (NYSE:DUK) is the next leading position, with a 23X P/E. Southern Co. is the third largest position, with a 19X P/E. These three stocks comprise over 25% of XLU. The fourth leading position is Dominion Resources (NYSE:D), at 22X.
These facts made me go to the source. SPDR, the sponsor, maintains a web site for XLU that reveals a 17X forward P/E for the ETF. Whether this uses GAAP or non-GAAP is not immediately apparent.
Just a guess by looking at what I believe to be the GAAP trailing P/Es: the approximate 3.5% dividend yield may represent something like a 70% payout ratio.
It is unclear to me that the dividends of utilities are safe.
Even if they are safe, utility stocks have frequently traded at a 7% yield. Given the historic CAGR of utility dividends of 2%, in 36 years the XLU could be unchanged as dividends compound at that rate. In the interim, even if dividends grow at that rate, in the interim, the stocks and XLU could trade anywhere and yield 7% much sooner than 36 years.
I am definitely not trying to talk anyone out of anything. My point is there is no safety in utility stocks. They may do OK, but they are quite rich to their historical norms. They have inflation, deflation, regulatory and technological risks, among others.
What about gold?
The very few readers who knew my work as a blogger know that I wrote almost interminably from the start of my blog in December 2008. An article on gold and one related to oil were amongst my very first articles on Seeking Alpha three years ago. I've read the prospectus for what is now called SPDR Gold Shares (NYSEARCA:GLD) with skeptical, even suspicious eyes - was the gold really there, or had it been lent out?
In case I wasn't clear, I have a lot in common with fans of gold. I want "hard" or "sound" money. But I also want to invest successfully. While I briefly gave gold and oil a chance in the early days of QE3 in early 2013, when they dropped when they should have popped, I went back to believing that we needed to watch out for deflation. This was a theme that went back to 2011, when in a Sept. 25 blog post titled Gold on Hold; The New Play May Be in Munis, I began by saying:
On Monday, Sept. 19 , I suggested that the price of gold was vulnerable, and also suggested that the stock prices of miners were a better intermediate-term bet. This was two days before the FOMC meeting, which much of the "smart money" expected would produce a Jobsian "one thing more" in addition to the expected Operation Twist. Mr. Market was expecting something more like Twist and Shout rather than simply Twist Again.
After the Fed failed to meet expectations, and issued a downbeat assessment of economic prospects, however, it was risk off with a vengeance in the DoctoRx financial environs.
As you may remember, September 2011 was only the third month after the inflationary QE2 had ended. Then as I began saying last year, the end of QE3 and the lack of inflationary signals from oil and precious metals meant to me that the taper and withdrawal from QE when the taper ended all made commodity deflation and return to the same recessionary or quasi-recessionary conditions that prompted each round of QE the outcomes with the greatest probability.
And so it is. Gold but not oil is rallying sharply. I am cautious on gold around $1200/ounce, for these three reasons:
- gold may not even remain a store of wealth in this digital, fiat currency age (or it may resume its primacy)
- the gold:oil ratio, and the gold:silver ratio, are extreme
- there is way too much bullishness already on silver, which trades as gold on steroids, amongst futures traders
For the last point, this was striking when I found it on FINVIZ:
This chart shows the price of silver on the main US futures exchange. The bottom panel shows the net positioning of the two types of speculators in the red and blue lines. The green line is the equal and opposite of the sum of the net positioning of all speculators. When the speculators are bullish and long silver, the commercials, represented by that green line, are by definition short the metal. The extent of the deviation of the green line above (exceedingly rare for many years) or below the green line suggests the intensity of speculative bets.
To my surprise, the net bullish bets on silver are near their highest level in over 5 years. That is, the negative level of the green line is near its lowest for that time frame. Since 2011, this has been an unerring contrary indicator.
To summarize my thoughts on gold (and silver), yes, they are interesting as they are much more depressed than the SPY. Silver is back within its 1979-80 price range, and gold is roughly 40% above its spike high in 1980. Meanwhile, the SPY is up dozens of times counting dividends.
However, the topic of this article is not what is speculatively interesting, it's whether an asset or asset class is a safe haven right now from all the turmoil in various asset classes.
I have to judge gold, and other metals, as interesting but far from safe. If oil were to rise to $40/barrel and the gold:oil ratio were to revert merely to an above-average level of 20X (one ounce to one barrel), gold would be down to $800/ounce.
So, what is safe?
First, here's what I think is not safe:
My opinion is that no US equities really are safe. Perhaps for very long-term investors, meaning decades, the SPY is as good as it gets. However, I have documented that a reversion to the mean of corporate profit margins and a P/E drop to 10X would imply a price drop of 2/3 or so, or to lower lows than were reached at the bottom of the Great Recession. That's not a prediction, and it's a moving target as sales increase, but I see no undervalued sectors of the stock market based on historical norms of undervaluation versus fair value. This is what happens almost 20 years after it was first reported that the US had for the first time more stock funds than individual stocks.
By the early days of this fascination with equities, i.e. the Tech/Internet bubble (version 1.0), this was so new that numerous industry groups were ignored in the late '90s. By the time the Nasdaq peaked in early 2000, many Old Economy stocks and sectors actually hit bottom, and trended upward through the nasty bear market in the SPY that did not bottom for another 31 months.
However, by the time of the collapse post-Lehman, there was already too little differentiation for any group to hold up. And after multiple QE rounds and other pro-equity interventions by the Fed, by 2013-14, it became widely noted that by some mainstream valuation measures, the median stock was at a record valuation.
What I am left with as safe, but not especially attractive, are money itself, such as an insured bank deposit with a financially strong and conservative bank or S&L. Or, a Treasury bill, note or bond, given that unless the government chooses to default, it can create the reserves to redeem the debt issue at will; or the Fed can do it.
Beyond that, very high quality debt issuers have the advantage in troubled times. The creditor can count on return of principal, and at least in the US, a "thank you" from the borrower in the form of an interest payment.
You may object that this is a platitude that could be said at any time. But situationally, one would have been almost a loon to have said that in 1974, 1979, 1980, 2006, etc. - and many other times when inflation was accelerating, cash was trash, bonds were trash, etc. So I say this based on my assessment of the current situation.
Let me summarize. The SPY is at $185.42. It is below where it was in June 2014 when I wrote a Seeking Alpha article calling investors overly complacent but basically saying that the "right" stocks (i.e. biotech) were investable. I was also pushing Treasuries hard since Feb. 2014, and as we know, they have done very well since then. The SPY is well below where it was when in June 2015 I wrote that the stock market was arguably bubbly. It has dropped sharply since my December 2015 article titled Bear Afoot? No Recession Needed For A Possible Sighting.
So far as I can see, the US and global markets, and the US economy, are following the Fed cycle in similar ways as occurred in 1999-2000 and 2006-8. The Fed giveth with money-printing, which manifested as interest rate cuts in 1998 and in 2001-3, then morphed into QE (and Operation Twist in 2011-2) when ZIRP came into being. Then the Fed and the late stage of the economic cycle taketh away, typically with interest rate increases as occurred in December 2015.
I therefore do not think the current pattern of the markets is confusing or surprising in any way.
What has made me especially concerned about the extent of price declines for the SPY and all other US stock market indices is that the massive and unnecessary QE3, which lasted 22 months and injected about $1.5 trillion new dollars right into the financial markets (some of that found its way into the economy as well, such as to finance shale drilling), sent financial asset prices to all-time bubble levels.
Even the redoubtable Jeremy Grantham misses the point in his latest missive. The point is not whether the SPY was quite at "bubble" levels. That's a question similar to how many angels fit on a pin's head. It's the overall picture: stocks, junk bonds (and to a lesser degree high quality bonds), speculative real estate, commodities, emerging markets, etc. At least since 1900, never has the US seen a concatenation of so many heavily overpriced assets of different types occurring at once.
And now there are serial bursting bubbles (or, near-bubbles: it doesn't matter other than semantically). The bursting began with commodities in 2011, which were sensible because their bubble began to inflate between 1999 and 2001; so it was getting old. However, the Street resuscitated the Tech bubble in 2011, and except for Facebook (NASDAQ:FB) which IPO'ed in 2012, all the hot tech IPOs in 2011/2 have cratered. Undeterred, the Street brought out new IPOs which have now cratered. So, commodities are now toast; emerging markets are toast, biotechs have been slaughtered, and finally just this year, the "FANGs" plus Tesla (NASDAQ:TSLA) have gotten slaughtered.
And investors are seeking shelter in defensive stocks.
That brings me back to the topic of this article. With QE money flowing everywhere, why should anyone think that so many well-studied, liquid, "attractive" names as were discussed or alluded to above would have been magically overlooked?
Anything can be in the markets, of course, but my view and my course of action remains to note the valuations of consumer staples stocks, utility stocks, and the remaining havens and expect that a reasonable possibility is for the big bad bear to come and eat them up too.
So, without recommending that anyone perform any specific investment action, my general sense is that cash or cash-like assets are king until valuations and economic trends look more attractive.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.