A naughty or nice 2019?

They say if you keep making the same prediction, at some stage it will come true. Well, my 2018 post a year ago on the return of volatility eventually proved prescient (I made the same prediction for 2017!). Besides the equity markets (multiple posts with the latest one here), the non-company specific topics covered in this blog in 2018 ranged from the telecom sector (here), insurance (here, here, and here), climate change (here and here), to my own favourite posts on artificial intelligence (here, here and here).

The most popular post (by far thanks to a repost by InsuranceLinked)) this year was on the Lloyds’ of London market (here) and I again undertake to try to post more on insurance specific topics in 2019. My company specific posts in 2018 centered on CenturyLink (CTL), Apple (AAPL), PaddyPowerBetfair (PPB.L), and Nvidia (NVDA). Given that I am now on the side-lines on all these names, except CTL, until their operating results justify my estimate of fair value and the market direction is clearer, I hope to widen the range of firms I will post on in 2019, time permitting. Although this blog is primarily a means of trying to clarify my own thoughts on various topics by means of a public diary of sorts, it is gratifying to see that I got the highest number of views and visitors in 2018. I am most grateful to you, dear reader, for that.

In terms of predictions for the 2019 equity markets, the graph below shows the latest targets from market analysts. Given the volatility in Q4 2018, it is unsurprising that the range of estimates for 2019 is wider than previously. At the beginning of 2018, the consensus EPS estimate for the S&P500 was $146.00 with an average multiple just below 20. Current 2018 estimates of $157.00 resulted in a multiple of 16 for the year end S&P500 number. The drop from 20 to 16 illustrates the level of uncertainty in the current market

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For 2019, the consensus EPS estimate is (currently) $171.00 with an average 2019 year-end target of 2,900 implying a 17 multiple. Given that this EPS estimate of 9% growth includes sectors such as energy with an assumed healthy 10% EPS growth projection despite the oil price drop, it’s probable that this EPS estimate will come down during the upcoming earnings season as firms err on the conservative side for their 2019 projections.

The bears point to building pressures on top-line growth and on record profit margins. The golden boy of the moment, Michael Wilson of Morgan Stanley, calls the current 2019 EPS estimates “lofty”. The bulls point to the newly established (as of last Friday) Powell Put and the likely resolution of the US-China trade spat (because both sides need it). I am still dubious on a significant or timely relaxation of global quantitative tightening and don’t feel particularly inclined to bet money on the Orange One’s negotiating prowess with China. My guess is the Chinese will give enough for a fudge but not enough to satisfy Trump’s narcissistic need (and political need?) for a visible outright victory. The NAFTA negotiations and his stance on the Wall show outcomes bear little relation to the rhetoric of the man. These issues will be the story of 2019. Plus Brexit of course (or as I suspect the lack thereof).

Until we get further insight from the Q4 earnings calls, my current base assumption of 4% EPS growth to $164 with a multiple of 15 to 16 implies the S&P500 will be range bound around current levels of 2,400 – 2,600. Hopefully with less big moves up or down!

Historically, a non-recessionary bear market lasts on average 7 months according to Ed Clissold of Ned Davis Research (see their 2019 report here). According to Bank of America, since 1950 the S&P 500 has endured 11 retreats of 12% or more in prolonged bull markets with these corrections lasting 8 months on average. The exhibit below suggests that such corrections only take 5 months to recover peak to trough.

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To get a feel for the possible direction of the S&P500 over 2019, I looked at the historical path of the index over 300 trading days after a peak for 4 non-recessionary and 4 recessionary periods (remember recessions are usually declared after they have begun), as below.

Note: These graphs have been subsequently updated for the S&P500 close to the 18th January 2019. 

click to enlarges&p500 q42018 drop compared to 4 nonrecession drops in 1962 1987 1998 & 2015 updated


click to enlarges&p500 q42018 drop compared to 4 recession drops in 1957 1974 1990 & 2000 updated


I will leave it to you, dear reader, to decide which path represents the most likely one for 2019. It is interesting that the 1957 track most closely matches the moves to date  (Ed: as per the date of the post, obviously not after that date!) but history rarely exactly rhymes. I have no idea whether 2019 will be naughty or nice for equity investors. I can predict with 100% certainty that it will not be dull….

Given that Brightwater’s pure Alpha fund has reportingly returned an impressive 14.6% for 2018 net of fees, I will leave the last word to Ray Dalio, who has featured regularly in this blog in 2018, as per his recent article (which I highly recommend):

Typically at this phase of the short-term debt cycle (which is where we are now), the prices of the hottest stocks and other equity-like assets that do well when growth is strong (e.g., private equity and real estate) decline and corporate credit spreads and credit risks start to rise. Typically, that happens in the areas that have had the biggest debt growth, especially if that happens in the largely unregulated shadow banking system (i.e., the non-bank lending system). In the last cycle, it was in the mortgage debt market. In this cycle, it has been in corporate and government debt markets.

When the cracks start to appear, both those problems that one can anticipate and those that one can’t start to appear, so it is especially important to identify them quickly and stay one step ahead of them.

So, it appears to me that we are in the late stages of both the short-term and long-term debt cycles. In other words, a) we are in the late-cycle phase of the short-term debt cycle when profit and earnings growth are still strong and the tightening of credit is causing asset prices to decline, and b) we are in the late-cycle phase of the long-term debt cycle when asset prices and economies are sensitive to tightenings and when central banks don’t have much power to ease credit.

A very happy and healthy 2019 to all.

Apple Crush

The news just keeps getting worse for Apple (AAPL) with all the negative rumours being confirmed by the top-line warning announced last night. In my last post on AAPL, I ruminated that the stock could fall as low as $160. Well, it was trading below that figure prior to last night’s warning and it looks set to possibly test $140 today. The only bright side of the announcement is that it quantifies the bad news which is the first step towards reaching a bottom. The enviable round of analyst downgrades means the next few weeks will likely be choppy for both AAPL and the market.

In the interim, I quickly revised some numbers in my model, as below.

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Based upon my historical forward multiples excluding cash, whilst reverting to a straight average multiple of 9 compared to an increasing multiple (that was in another era now!), my new estimate of how low AAPL can go is $115 per share, a near 30% drop from last night’s close.

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Whether I will be a buyer around the $120 level will depend upon what the overall market is doing. Best to wait on the side-lines for this drama to unfold.

Enervating Market

Wow, what a December this has been in the equity markets! Not a buyer in sight as we (effectively given the Christmas break) end the year at the S&P500 close today of 2,417. This really is a market to stay well away from. I suspect Q1 2019 will again be volatile until we get into earnings season and get a taste of the sector 2019 EPS projections (a minor relief rally from institutional funds allocating capital followed by more programme selling is my guess).

This recent post postulated that with small single digit EPS growth for 2019 and 2020, a slowing but non-recession scenario, a range of 2,500 to 2,300 on the S&P500. Well, we’re bang in that range now!! And the consensus is for more downside with the probability of a recession beginning next year raising by the day. Not even dovish statements today from John Williams of the New York Fed could tempt the buyers out of hibernation. The prospect of the demise of the Fed put has freaked the market out this week. My crude calculations estimate that a slow drop in operating EPS over 2019 of 6%, likely in a mild recession scenario, could result in the S&P500 testing 2,000.

I have been bearish on this market for several years (here, here and here are just recent examples) and although the majority of my assets have been in cash throughout 2018, the graph below from BoA Merrill Lynch, sends a shiver down my spine. As with most people, my equity positions have been hammered. According to BoA ML, the last time there was positive cash and negative equity, credit, and government returns in the same year was 1969. To plagiarize the old investing adage, it would take some monkey to call a bottom on this equity market any time soon.

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The outlook for 2019 is highly uncertain at the current point in time, nobody really knows how it will pan out and I’ll leave the musing over that topic to future posts. As this post in January highlighted, I do think quantitative tightening and the great unwinding of Central Bank easing experimentation is having some nasty unintended consequences.

At this time, I do find it insightful to look at recent movements in a historical context. If you look at the number of months with moves greater than or equal to +/-1% in the S&P500, the comparison between the decades is as below. The number of such moves are surprisingly consistent across the decades.

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If we assume that the 1970s and the 2000’s were extraordinary decades with the oil and financial crises respectively, then there could be more up months than down months due in the remainder of this decade for it to look more like the 1980s or the 1990s. A pretty flimsy analysis admittedly!

Continuing the theme of trying to end the year on a positive note, if we look at the historical months with moves of +/-5%, as below, it could be argued that the recent volatility is healthy as extended periods of reduced volatility prior to the dotcom bubble and the financial crisis didn’t end well!!

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That’s a happier note to end on (albeit rather pangloss).

A very happy and healthy Christmas to all who have spent any time reading my musings this year.

Paddy Horribilis

Since I last posted on the gambling sector in March, the bad news just keeps on coming for the sector. The one bright spot has been the opening of the US market although, as my last post highlighted, the US business is on the lower end of the margin spectrum and there is considerable investment needed as the market opens. William Hill (WMH.L), GVC (GVC.L) and Paddy Power Betfair (PPB.L) are down 50%, 30% and 15% since my March post.

Some of the issues hitting the sector include the UK reduction in stake limits to £2 on gaming machines, the UK increasing the rate of remote gaming duty from 15% to 21% in 2019, new point of consumption taxes and restrictions on advertising in Australia, and increases in betting taxes in Ireland. Compounding these issues is a fiercely competitive environment with operators such as the privately owned Bet365 being very aggressive in sectors such as horse racing.

To illustrate the impact on PPB, my estimates below show a declining EPS for 2019 (the firm estimated all the changes impacting EBITDA by £115 million against their 2018 EBITDA midpoint estimate of £472 million, that’s a 24% hit!). My 2018 and 2019 EPS estimates are now down from £4.36 and £4.51 to £3.70 and £3.25 respectively. That’s an approx 15% and 30% cut for 2018 and 2019 respectively.

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At the closing price today of £63.85, my 2019 EPS estimate implies a PE multiple of 20, way too scarily high given the headwinds in this sector and the overall market direction. The US represents the one bright spot in terms of top-line growth although I would be skeptical about the US business having a major bottom line benefit for a few years yet.

I did say previously that his sector is haunted by regulatory risk, haunted to the point of being scared to death!

Net Zero Fantasy

As we enter a week where further market turmoil is likely against a background of further tensions between the US and China over the Huawei arrest, the climax of the Brexit debacle, and the yellow vest protests in France. All these issues can and will be resolved eventually but they pale in comparison to the political inaction over the latest climate change reports.

The US government, in the form of the United States Global Change Research Program (USGCRP), in a report in November concluded that “the evidence of human-caused climate change is overwhelming and continues to strengthen, that the impacts of climate change are intensifying across the country, and that climate-related threats to Americans’ physical, social, and economic well-being are rising” and warned that “these impacts are projected to intensify—but how much they intensify will depend on actions taken to reduce global greenhouse gas emis­sions and to adapt to the risks from climate change now and in the coming decades”. Of course, the Orange One again demonstrated his supreme myopic attitude with the dismissal “I don’t believe it”.

We now have the black comedy of oil producing states such as the US, Russia and Saudi Arabia arguing over whether to “welcome” or just “note” the latest IPCC report this week at the UN climate talks, known as COP24. The IPCC report on the impacts of a temperature rise of 1.5°C was launched last October and is a sobering read. The IPCC again states with a high level of confidence that “human activities are estimated to have caused approximately 1.0°C of global warming above pre-industrial levels, with a likely range of 0.8°C to 1.2°C” and that “global warming is likely to reach 1.5°C between 2030 and 2052 if it continues to increase at the current rate”.

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In order to avoid warming above 1.5°C, the world needs “global net anthropogenic CO2 emissions decline by about 45% from 2010 levels by 2030 (40–60% interquartile range), reaching net zero around 2050 (2045–2055 interquartile range)”. For limiting global warming to below 2°C, emissions need to “decline by about 25% by 2030 in most pathways (10–30% interquartile range) and reach net zero around 2070 (2065–2080 interquartile range)”.

Let’s face it, given the current political leadership across the globe, such declines are just fantasy. And I find that really depressing. The plea of David Attenborough at COP24 last week for leaders in the world to lead looks set to fall on deaf ears. Attenborough worryingly stated that “the continuation of our civilisations and the natural world upon which we depend, is in your hands (i.e. our leaders)”.

We’re pretty much toast then….