In The Headlines
Are U.S. Stocks Dangerously Overvalued?
While the S&P 500 is reaching all-time highs on optimism over the newly elected administration’s economic agenda, some Wall Street strategists are increasingly worried about a widely followed valuation measure that has reached levels that preceded most of the major market crashes of the last 100 years.
“The cyclically adjusted P/E (CAPE), a valuation measure created by economist Robert Shiller, now stands over 27 and has been exceeded only in the 1929 mania, the 2000 tech mania and the 2007 housing and stock bubble,” Alan Newman wrote in his Stock Market Crosscurrents letter at the end of November. Newman said even if the market’s earnings increase by 10% under Donald Trump’s policies “we’re still dealing with the same picture, overvaluation on a very grand scale.”
Using P/E (price/earnings) ratios to predict the future direction of stock indexes is nothing new. Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years.
In recent years, Yale professor and Nobel laureate Robert Shiller, the author of Irrational Exuberance, has popularized the concept to a wider audience of investors and has selected the 10-year average of “real” (inflation-adjusted) earnings as the denominator. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10. His research found future 10-year stock market returns were negatively correlated to high CAPE ratio readings on a relative basis. He won the Nobel Prize in economics in 2013 for his work on stock market inefficiency and valuations.
Other academics agreed the current extreme CAPE ratio of 27.7 is a worrying sign for future returns versus bonds. “Only when CAPE is very high, say, CAPE is in the upper half of the tenth decile (CAPE higher than 27.6), future 10-year stock returns, on average, are lower than those on 10-year U.S. Treasuries,” Valentin Dimitrov and Prem C. Jain wrote in paper entitled “Shiller’s CAPE: Market Timing and Risk” on November 17th of this year.
Some analysts, however, believe the CAPE model may be too pessimistic. In a recent paper in the Financial Analysts Journal, economist Jeremy Siegel wrote, “Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be over-pessimistic because of changes in the computation of GAAP (Generally Accepted Accounting Principles) earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.”
Even based on the more common price-earnings ratio, the market looks rich. The S&P 500’s P/E based on earnings of the last 12 months is 18.9, the highest in more than 12 years, according to FactSet. “U.S. valuations start off as being high both on a historical basis and also on a peer group. Certainly based on the Shiller PE, the equity market seems expensive,” Sean Darby, Chief Global Equity Strategist of investment banking firm Jefferies, wrote on November 29.
Citations
1. http://cnb.cx/2hpPsam – CNBC
2. http://cfa.is/2gjOTyg – Financial Analysts Journal
Costco Continues to Prosper in the Age of Amazon
While seemingly every other retailer looks for how it can change in order to take on Amazon, Costco keeps succeeding by staying true to what it has always done. The warehouse club, which has largely ignored the internet, has remained a draw to its loyal audience by offering a combination of value and shopping experience. It is a formula that has driven traffic to the company’s stand-alone stores on a remarkably steady basis.
In the chain’s first quarter of fiscal 2017, which ended on Nov. 20, it saw net sales come in at $27.47 billion, an increase of 3% from the year-ago quarter. In addition, same-store sales were up 1% in the United States, up 4% in Canada, flat internationally, and up 1% for the total company. Those numbers look even better when you factor out lower gas prices and foreign exchange, with U.S. comparable sales coming in the same at plus 1%, Canada rising to 5%, international moving to positive 2%, and the whole company posting a 2% gain. During Q1, Costco saw net income rise to $545 million, or $1.24 per diluted share, compared to $480 million, or $1.09 per diluted share, last year. These are solid numbers that show that the company has put any problems related to its switching rewards credit card providers well in the past. In addition, these results, which cover the time leading up to the critical holiday shopping season, suggest that while Amazon has taken market share from other retailers, Costco has remained more or less immune.
While stronger sales do help Costco’s bottom line, membership growth is the company’s most important metric. Since about 75% of profits come from people joining the warehouse club, adding members, even if they never buy anything, remains critical. In Q1, the company saw a 6% increase in membership fees.
Renewal rates came in at 90.3% for the U.S. and Canada and 88% worldwide. Those numbers are strong and CFO Richard Galanti explained during the Q1 earnings call how they show that any lingering impact from the reward card switches in both the U.S. and Canada have faded. “As you know it’s been probably almost two years in Canada when we converted to the MasterCard and with that we saw as we would have expected a slight decline in renewal rate,” he said. “In Q4 2016 this past summer, we saw that finally reverse, and saw an uptick in renewal rates in Canada and that continued in Q1 of this fiscal year too. We are now seeing the same thing in the U.S.”
Overall membership has continued to rise with household memberships climbing slightly to 47.9 million at the end of Q1, up from 47.6 million at the close of fiscal 2016. In addition, since many homes have more than one card, the total number of cardholders rose from 86.7 million at the close of Q4 to 87.3 million when Q1 ended. Galanti also reported that since the U.S. credit card switch on June 20, more than 1 million people have been approved to receive the chain’s new Visa rewards card.
There might be a day when Amazon saps business from Costco, but that is clearly unlikely to happen under current circumstances. In many cases, the online retailer offers cheaper prices and more choices, and does not force people to buy in bulk, yet people keep flocking to Costco. That is partly because the warehouse club has a high perception of value and partly because people like shopping at Costco. The chain has mastered the concept of being a destination where it is about more than what you go home with. Visitors to Costco value not only the prices, but also the experience of discovery where you might enter looking for shampoo, but come home with an 8-foot stuffed bear.
Costco has remained relevant by staying true to its roots rather than adapting to fight its key digital rival. That should serve it well during the holiday period where it may not be a Black Friday or Cyber Monday winner, but it should benefit from steady traffic as the season progresses. Costco has shown that slow and steady can win the race. The company never posts massive gains, but its results tend to be very consistent.
Citations
1. http://fxn.ws/2hv1aAR – Fox Business News
2. http://bit.ly/2csulov – The Motley Fool
The Good News Is . . .
• U.S. consumer spending increased in October and remained sufficiently strong to support economic growth in the fourth quarter. The Commerce Department said that consumer spending, which accounts for about 70% of U.S. economic activity, increased 0.3% after an upwardly revised 0.7% gain in September. The data came on the heels of a string of reports on manufacturing, the housing market, the labor market and inflation that have suggested the economy sustained its momentum early in the fourth quarter after growing at its quickest pace in two years in the July-September period.
• Lululemon Athletica, Inc., a leading athletic apparel company, reported earnings of $0.47 per share, an increase of 8/8.0% over year-earlier earnings of $0.43 per share. The firm’s earnings topped the consensus estimate of analysts by $0.04. The company reported revenues of $544.4 million, an increase of 13.0%. Management attributed the results to strong direct to consumer revenue and improved overall gross margin.
• Alaska Airlines has won Justice Department approval to acquire Virgin America for $2.6 billion on the condition that it scale back its ticket-selling agreement with American Airlines. The merged company would be the fifth largest United States carrier, after American Airlines, Delta, United Airlines, and Southwest Airlines. The sale of Virgin is the latest instance of deal-making in an industry that has shrunk drastically over the past decade, concentrating power in the hands of a few major airlines. The top four airlines control more than 80 percent of the air travel market in the United States, and the Justice Department is hoping that a stronger Alaska Air can compete with the giants.
Citations
1. http://reut.rs/2gl12ql – Reuters
2. http://cnb.cx/1gct3xa – CNBC
3. http://bit.ly/2hdZNd6 – Lululemo Athletica Inc.
4. http://nyti.ms/2gm4BOg – NY Times Dealbook
Planning Tips
Tips for Investing in Cuba
During 2016, the U.S. began the process of normalizing relations with its Caribbean neighbor, Cuba. With time, the easing of economic sanctions should be a substantial growth catalyst, and below are several ways you might take advantage of the unique investment opportunity this change presents. Please note that the companies discussed here are only presented as examples of ways to invest in this opportunity, not recommendations. It is important to consult with your financial advisor before making any investment to determine whether it is consistent with your financial goals, risk tolerance, and economic circumstances.
Cruise lines – The cruise industry is frothing at the mouth for travel restrictions to be lifted, and for all intents and purposes, they have. The White House has given the thumbs-up to ferries and cruises between the U.S. and Cuba within the past year, and expects companies like Royal Caribbean to take full advantage. In 2006, the firm acquired Pullmantur, a Spanish cruise line with a home port in Havana, perhaps unknowingly foreshadowing its eventual return to Cuban shores. Ten years later, that day is almost here. Norwegian Cruise Line is another cruise company based in Miami that includes tours to the Caribbean as one of its offerings.
Hotel chains – When it comes to betting on Cuba, do not scoff at hotel chains like Marriott, one of a few prominent U.S. companies that have lobbied lawmakers to drop the embargo sooner rather than later. Why? Not only are there more than 300 million Americans 90 miles north of the island nation, but there are millions of Cuban-Americans who would love to legally visit their relatives, and they may need a place to stay when they get there.
Airlines – Certainly airlines will be a beneficiary of less restricted travel to Cuba. For example, two companies that stand to benefit in a substantial way are Copa Holdings and JetBlue. Copa Holdings might not be a household name in the U.S., but this Latin American airline is primed to profit nicely from Cuba’s reignited economy. Investors will be happy to know that Copa already operates in Cuba, so there is no speculation about whether the company will have exposure. JetBlue meanwhile had more exposure to the Caribbean than any other U.S. airline, and by a pretty substantial margin. The company controlled 12.5% of the market, while American Airlines Group controlled 9.7%, followed by the field. JetBlue’s focus on the Caribbean is clear, and the fact that it is significantly smaller than rivals like American Airlines and United Continental means Cuba’s impact is likely to be more meaningful to its revenue and earnings.
Banks – If you are looking for a longer-term investment, you might to consider banks that would benefit from normalized relations with Cuba. Stonegate Bank is a small-capitalization Florida bank that is already pursuing the Cuba opportunity. It grew during the Great Recession by snapping up several distressed competitors between 2009 and 2011. Today, it has embarked on a new growth strategy by establishing relations with both the Cuban embassy and Cuba’s central bank. With those connections, Stonegate is positioned to handle business for U.S. companies licensed to do business in Cuba.
Investment funds – If you wish to avoid the risk associated with investing in a single company, you may want to diversify via an investment fund. Investment funds such as the Herzfeld Caribbean Basin Fund may be the right opportunity. This closed-end fund holds stocks positioned to do well in the normalization of relations between Cuba and the U.S. It tends to react positively to any encouraging developments in U.S.-Cuban relations.
Citations
1. http://cnb.cx/1SxJYWs – CNBC
2. http://bit.ly/2gtQtk5 – Investopedia
3. http://bit.ly/2hcTu74 – US News & World Report
4. http://bit.ly/2gjPOOS – Kiplinger
5. http://bit.ly/2hedcBX – The Street
