The Strong USD Is Negatively Impacting US Trade

Exports have been a solid contributor to US GDP growth for the last few years, while consumption and residential investment have been more restrained.  Recently, with consumption firming and likely to improve further from the tail-wind of lower oil prices, and exports faltering, it appears the drivers of the US economy are trading places.  It appears that we should expect trade to subtract from growth in the coming quarters.  Driving the weakness in trade is weakness in goods exports.  In the chart below we show the year over year change in goods and services exports.  Goods exports are down almost 4%.



We calculate an export diffusion index measuring the net number of countries in which US exports are increasing/decreasing.  Over the last three months, the index has plunged to -33.



Over the last years, the index has plunged to -15, breaking out of the 2011-2014 range and hitting the lowest level since November 2009.



The three month moving average of the ISM new export index has fallen from 57.2 to 50 since December 2013 pacing the drop in real exports.



With the export index continuing to drop recently, it is probably fair to expect trade to mildly subtract from GDP growth in the coming quarters.



Likely at the root of the US export weakness is the strong US Dollar.  The recent surge in the USD highlights the risk that exports could experience a material drop in the coming quarters.

A Technical Assessment of Analyst Ratings

Regular readers are aware of the place that point-and-figure technical analysis plays in our investment process (for more details on the methodology, including information on our proprietary modifications to the discipline, see here).  We find this tool particularly useful in helping us identify investment opportunities where, in spite of decent (or even very good) fundamentals, the market disagrees.  As we have outlined before (see here), analyst ratings are not always consistent with the trend in a particular stock's price.  Taking a look at the handful of equities for which ratings changed today, we can see just where this tool becomes helpful.

On the positive side, price targets for both JC Decaux (France/ Advertising) and Schroders (UK/ Asset Management & Custody Banks) were upgraded.  In the case of the latter, that assessment seems reasonable enough-- providing 'C' does not turn out to be resistance, of course.  For the advertiser that continues to remain locked in a multi-year trading range, and is approaching the upper bound of said range, a higher price target might be more of a stretch.

Downgrades to the price target and estimate for Embraer (Brazil/ Aerospace & Defense) and Admiral Group (UK/ Property & Casualty Insurance), respectively, also seem to have mixed validity when we consider the chart patterns.  While it seems reasonable to assume the airplane manufacturer will remain in its trading range (and thus warrant a more conservative price estimate), the pattern for Admiral is more constructive and would suggest that, having broken a downtrend to form a multi-year base, estimates could improve.

Finally, we have the the rating change to outperform from market perform for Citigroup (US/ Other Diversified Financial Services).  The uptrend (within a long-term trading range) remains intact but has struggled to overcome resistance, calling into question whether or not accumulative forces can prevail-- and, thus, leading us to question whether or not such an upgrade could be, at the very least, a bit early.

USD and Purchasing Power Parity

We mentioned yesterday that the US dollar is again breaking out and that tends to be negative for most stocks around the world. Today, we thought we would continue to look at US dollar strength.

The nominal trade-weighted dollar index by major currencies is again very close to breaking out to 11+ year highs.



The real trade-weighted dollar index by major currencies had its 7th consecutive monthly rise in February. It just reached its highest level since March 2003.



Our Purchasing Power Parity diffusion index has fallen to +2. This means that out of the 18 currencies that we track, 10 are overvalued on a PPP basis and 8 are undervalued on a PPP basis. Compare this to June 2014, when our diffusion index was at +12. At that time, 15 currencies were overvalued on a PPP basis and only 3 were undervalued.



The Canadian dollars is a notable currencies that has very recently flipped from being overvalued to undervalued on a PPP basis. The CAD was 27% overvalued in the middle of 2011. It has been on a steady decline since and is now 4.5% undervalued.



The Australian dollar is still overvalued on a PPP basis. However, the extent of how much it is overvalued has fallen from 46% in 2011 to 6% overvalued now.



Lastly, the Euro is now undervalued by almost 13%. This is the most undervalued it has been relative to the USD since 2003.

ECB Asset Purchases = (Big) Equity Decline?

We have commented quite a bit on the dismal revisions to sales and earnings estimates (see here, here, and here for just a few examples).  As we have noted, European stocks have excelled in the downgrade department, led by the Energy sector:



Keeping in mind that changes in estimates have remained in the top 10 important factors driving performance for MSCI Europe over the past year...



...as well as the close relationship between those estimates and movements in the EUR...



...it is a bit disconcerting to watch as the EURUSD exchange rate flirts with a decisive breakdown below long-term support:



Furthermore, investors seem to have taken notice of the fairly extended nature of the market, as evidenced by a sharp drop (to ~40% from ~70% a month prior) in the percentage of companies trading at a premium to longer-term valuation metrics.




All of this would seem to lend support to the relationship we showed between ECB asset purchases and stock performance a while back-- namely that MSCI Europe looks vulnerable to a 35% decline from current levels:

Putting The Recent Bond Market Selloff Into Historical Context - Hint It's Rare!

The recent move higher in longer dated US treasury bonds has been sharp and fast and has caught plenty of people off guard. The 10-year bond yield has moved from 1.68% to 2.12% while the 30-year has moved from 2.25% to 2.72% in a little over a month. On a percentage change basis this translates to +26% and +21%, respectively. That is a big move in a month!

To show just how big of a move this has been, we point the reader to the two charts below showing the 1-month percent change in yields and the three standard deviation trendlines about that 1-month percent change. For both the 10-year and the 30-year, the percentage change in yields has been a three standard deviation event. In other words, moves of this magnitude (in either direction) over a 1-month period have occurred less than .3% of the time going back to the bond market yield peak in 1982.

Finally, we note that six of seven instances of one of these three standard deviation selloffs since 2000 has resulted in some sort of intermediate peak in yields. In all cases yields except one, yields were materially lower within a few months.

When $75 Billion In Intangible Capital Goes Unnoticed

One of the flagship principles of our investment process is an investment in intangible capital should be treated the same from an accounting standpoint as an investment in physical capital . Said differently, we are firm believers in the symmetry principle for capital accounting. In order to properly treat intangible investments according to the symmetry principle, one needs to capitalize R&D (and other intangibles) and create a long-term asset on the balance sheet. Once the asset has been created, it must be carried at historic, depreciated cost just as all tangible assets on a balance sheet are carried. By doing this, one gets a much fuller and richer view of the ENTIRE capital stock of a company. And as all investors know, a company's unique capital stock (or moat as Warren Buffet would call it) is what drives future profits. Thus, without having an understanding of just how big a company's capital base is, it is very difficult to forecast the amount of future profits that may be derived from that capital stock.

Let's take a real-life example from the systems software sub-industry to illustrate how much capital is currently going unnoticed by the financial community.

There are nine companies that make up the MSCI US systems software sub-industry. This sub-industry is made up of very well known companies such as Microsoft, Oracle, Symantec and VMWare.  It's a very profitable industry as the average gross margin is a very healthy 75% and three of these companies have managed to deliver gross margins above 80%. Oracle, Microsoft and Symantec have increased sales, EPS, BV per share, and cash flow per share by at least 15% a year for over two decades. It goes without saying that this is group of highly profitable, stable, long-term growth oriented companies.

It doesn't surprise us then to see that this group of companies are major investors in intangible investments.The average company in this sub-industry spends nearly 20% of its sales on R&D and another approximately 16% of its sales on other intangible investments. These intangible investments are not a one-off phenomena either. These companies invest large amounts into intangibles every single year in order to keep their respective competitive advantages. Over the past decade, this group of companies has invested about 20% of it sales into R&D and another 15% of its sales into other intangible investments. This means that over time these companies have built up a HUGE intangible capital stock that currently goes completely unaccounted for under traditional accounting practices. The question becomes, how big?



R&D Investment As A % Of Sales


Intangible Investment Ex-R&D As A % Of Sales


According to our work, the total capital stock of these nine companies is actually $75.5 billion more when intangible investments are properly accounted for. Or approximately 25% larger than is generally recognized. And remember, this is the depreciated, historic cost level of this asset. As a group, the "as-reported" level of their assets is $307 billion. Microsoft makes up over half of this as their "as-reported" asset level is $172 billion. If you include Oracle, then Microsoft and Oracle account for 85% of the "as-reported" assets in this sub-industry. When you look at it from intangible-adjusted perspective, the overall capital stock rises to $382 billion. Because Microsoft and Oracle are such consistent and persistent intangible investors, they continue to account for about 85% of the overall intangible-adjusted asset base of this industry.

As-Reported Balance Sheet Levels


Intangible-Adjusted Balance Sheet Levels

For more information on intangible capital please see these other blog posts and videos.

Video - Why Knowledge Is Undervalued

Becton Dickinson Intangible Case Study

Emerging Market Intangibles

Video - How Intangibles Affects Intuit's Profitability Ratios

The Intangible Case For Autodesk

Why Intangibles Matter - An Amazon Case Study

Video - Gavekal Knowledge Leader Indexes

The Dollar Is Breaking Out Again And What That Means For Stocks

The ICE US dollar index looks to have broken out of what has been a rather short-lived consolidation after the massive move since the middle of 2014. If this is in fact the start of another round of dollar strength, then stock investors should carefully consider where in the world to deploy cash into stocks. For a variety of cyclical and structural reasons, certain regions of the world tend to outperform in periods of USD strength and others lag. We'll try to shed some light on that with the below charts.

As the first chart shows, the USD index has broken out of its consolidation to make another cycle high. In the six charts that follow we compare the USD index (blue line, left axis, inverted) to the relative performance of stocks in a region vs the MSCI ACWI (red line, right axis) calculated in USD. We also show the 5-year daily correlation between the USD index and the relative performance of the regional index. A positive correlation implies that stocks in that region tend to outperform in periods of USD strength and vice versa.

As is obvious from the charts, stocks in North America tend to be the relative beneficiary of USD strength while stocks in other regions generally, but not always, tend to underperform. The negative correlation is especially strong for European stocks.

For unhedged USD based investors, then, owning foreign stocks in periods of USD strength can be detrimental to the value of one's investment account. The US has been outperforming other markets for a long time now, but if history is a guide then another move up in the dollar likely means more of the same.



MSCI North America Relative to MSCI ACWI in USD:


MSCI Europe Relative to MSCI ACWI in USD:


MSCI Pacific Relative to MSCI ACWI in USD:

MSCI EM Asia Relative to MSCI ACWI in USD:


MSCI EM EMEA Relative to MSCI ACWI in USD:

MSCI EM Latin America Relative to MSCI ACWI in USD:

Energy And Utilities Have Been The Most Volatile Sectors

Volatility, as measured by the standard deviation of the the daily percent change in stock prices, has fallen since the beginning of the year in the MSCI World Index. The one month moving average of volatility has dropped to 0.54 from a high 0.86 on January 23rd.



The energy sector, unsurprisingly, has been the most volatile of the ten sectors. Volatility peaked at 2.01% on January 9th, the highest level since late 2011, but has since steadily fallen to 1.37%.



What is surprising, however, is that the utilities sector currently has the second highest volatility and it's currently on a rising, not falling, trend. Volatility in the utilities sector hit a low of 0.40% on 5/1/2014 and has since risen to 0.90%.



Charts of the remaining eight sectors are below.