Sterling Insights: Our Blog


Red Lobster, Cost Cutting, and Corporate Profits


Red Lobster recently decided to reverse its year-old policy of requiring servers to handle four tables apiece, rather than the previous three tables.  Apparently, the decline in worker and customer satisfaction from the increased work load more than offset the savings in labor costs.
 
As U.S. corporations cling to the cash on the balance sheet and continue to struggle growing revenue in a stagnant recovery, the record corporate profit levels of recent years may be running into a wall.
 
In the most recent quarter, companies are beating their earnings estimates, but the revenue growth isn’t keeping pace.  According to a recent Bank of America Merrill Lynch report, 56% of S&P 500 companies have beaten expectations on EPS (earnings per share) while only 44% have beaten on sales.  Overall, analysts were expecting sales to decline 0.4% on a year-over-year basis in the first quarter while earnings were expected to increase 3.4% year-over-year.  The sectors with the best performance in revenue growth year-over-year while also exceeding expectations are consumer discretionary and utility stocks.
 
If cost cutting is indeed reaching its limits, the companies with revenue growth opportunities should be the beneficiaries.  As we evaluate current equity positions and search for new ideas, we will be looking for companies that are growing the top line as well as the bottom line.  As Red Lobster’s parent company, Darden Restaurants (DRI), has discovered, at some point cost cutting becomes counterproductive to profit growth.



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Are Stocks Sending Us a Message About Economic Growth?


There has been considerable debate lately about whether the economy is strengthening or continuing to sputter.  Data can be cited to support either case.  Perhaps we can get some clues by looking at the performance of various market sectors.  For our purposes, sector performance is perhaps most meaningfully illustrated by relative strength price charts.
Relative strength charts do not track the absolute price movements of a stock but the price movement of the stock compared to the price movement of another stock or index.  If the price of a stock is outperforming the S&P 500, for example, its relative strength chart will be moving upward, even if the price of the stock is going down.  All that matters is how the stock is doing relative to the S&P 500.
The charts of exchange traded funds (ETFs) that track the movements of sectors provide us with the easiest way to see how certain sectors are doing compared to the S&P.  Over the past few weeks, the relative strength lines of ETFs that include companies from economy-sensitive sectors and industries, such as basic materials, trucking, ocean shipping, energy, homebuilding, and technology, have turned upward.  These companies, also called cyclicals, historically tend to do well when the economy begins to expand.
On the other hand, the relative strength lines of sectors that generally outperform in a weaker economic environment have recently turned downward.  Among these defensive sectors are consumer staples, utilities, and healthcare.
Figure 1 shows the chart of an example of an economy-sensitive ETF, the Basic Materals iShares, which includes companies that make products used in industrial applications.  As you can see by examining the relative strength line (the solid black line at the very bottom of the chart), the basic materials sector has been in a long downtrend versus the S&P since the beginning of the year.  But the decline has, at least temporarily, reversed.  Since April 15, the relative strength line of the basic materials ETF has been going up.
Figure 1.  (Click image to expand.)

Figure 2 uses a chart of the Consumer Staples Select Sector ETF to illustrate the recent change in relative strength of defensive stocks.   As the solid line at the bottom of the chart shows, the strength of this ETF relative to the S&P has been in decline the last three weeks after rising most of 2013.  Included in the consumer staples sector are stocks of companies that make food, personal, and household products.  These products are usually purchased by consumers regardless of the economic environment.  As a result, the companies that manufacture these products generally outperform during tough economic times but underperform as the economy turns around.  The relative strength charts of other defensive sectors look very similar to the one below.
Figure 2.  (Click image to expand.)

       (Charts courtesy of stockcharts.com)
Some analysts do not believe that these recent relative strength changes are meaningful.  They argue that the price action in these sectors simply reflects a correction of valuation differences and is not forecasting an economic upturn.  The strength in basic materials and other economy-sensitive sectors, they argue, will be short-lived.
But the changes in the relative strength of economy-sensitive and defensive stocks should not be ignored.  Because they generally occur before the changes in the economy become apparent, they can be valuable forecasting and investment strategy tools.
We will be keeping our eyes on these stocks in the coming weeks.
 
 



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A Volatile Cardinal Bullpen and Sluggish Real GDP Growth


Yesterday, we attended First Bankers’ Banc Securities Annual Investment Seminar in downtown St. Louis.  First things first–one of the speakers was St. Louis Cardinal manager Mike Matheny.  He addressed the two worries fans have about this year’s Cardinals: their offense and their bullpen.  Matheny believes the offense isn’t a legitimate concern and said the Redbirds will eventually start hitting.  However, he did say that he shares the fans’ concern about the bullpen.  If the manager’s predictions are correct, Cardinal fans can look forward to some high-scoring games with late inning drama this summer.  But will the Cardinals be playing in the fall?
On a less exciting note, but certainly more relevant to your portfolio, assistant VP and economist at the St. Louis Federal Reserve Bank William Emmons also gave a talk.  This was the fourth year in a row where he has addressed the seminar, and he looked back at his previous predictions and how they have panned out.  The following chart shows his predictions for Real GDP growth as well as those of the Federal Open Market Committee (FOMC) and the Congressional Budget Office (CBO).  Mr. Emmons subscribes to the New Normal view of substandard growth in our economy for the foreseeable future.
 

 
Interestingly, the FOMC continues to rachet down their growth estimates as the years go on.  Perhaps they are starting to come around to the New Normal view.  The real outlier here is the CBO estimate of robust growth in the 2015-2017 time line.  Emmons noted that the last time the U.S. economy grew at this predicted pace for three years was the early 1980s.  One obvious problem with this prediction is that in the 1980s the U.S. economy was coming off sky high interest rates and had the promise of reduced interest rates to spur the economy.  Today, we already have record-low interest rates, and there isn’t much gunpowder left in that gun.
On a more positive note, Emmons did say that stock valuations were at their most attractive levels in twenty years and are especially attractive relative to the low treasury yields of today.

 



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Economic Policy Uncertainty and the Stock Market


Terms like fiscal cliff, debt ceiling, and sequester have entered everyday vocabularies over the last year.  But what exactly does Washington have to do with the stock market?  Joseph Mezrich and Yasushi Ishikawa, quantitative strategists at Instinet, are out with a note this week entitled “The Uncertainty That Matters–the Drag on the Market” that attempts to answer this question.
The Instinet strategists overlay the Economic Policy Uncertainty Index with their own implied long-term earnings growth of the S&P 500 and find that there is a heavy negative correlation between the two measures (i.e. when the Uncertainty Index is up, the implied long-term earnings growth goes down and vice versa).

The Uncertainty Index was introduced by three academics at Stanford University and the University of Chicago.  The index is constructed of three main components: 1) quantification of newspaper coverage of policy-related economic uncertainty; 2) the number of federal tax code provisions set to expire in the near future; and 3) the level of disagreement among economic forecasters.
According to Mezrich and Ishikawa, “Our analysis indicates the market is pricing a very subdued 0.2% annualized earnings growth over the next five years.  That is in sharp contrast to the 11% growth priced at the 2007 market peak, which was well above the average historical growth of 7% delivered by S&P 500 companies since World War II.”
So, next time your eyes glaze over watching the latest shenanigans in Washington, DC, you might remind yourself that if our nation’s leaders could get their act together for once and provide some more economic certainty, it just might be the spur to more economic growth and a higher stock market.



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Welcome to Sterling Insights


Welcome to our website’s blog. We hope you will take a little of your time to check in occasionally to view our posts on a wide range of market- and economy-related topics. We will try to keep them brief and informative.
See you soon.



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