US Corporate Profit Margins Are Coming Back Down To Earth

Today wasn't the best day for US economic releases. The 2nd revision of 1Q GDP was (unsurprisingly) revised down from 0.2% to -0.7%. The release that caught our eye, however, was the initial release of corporate profits in the US for the first quarter. After-tax corporate profits did rise by 2.7% year-over-year in the first quarter but this was on the heels of the 2014 4Q revision that reduced the growth rate of corporate profits from +2.9% to -2.5% during that quarter. Corporate profit margins have now dropped below 8% for the first time since 2009. Margins, as measured by after-tax profits divided by nominal GDP, hit an all-time record of 10.06% in 4Q2011. Margins have since steadily fallen to the its current level of 7.97%.

 

Inflation Expectations Are Turning Back Over In The US

TIPS derived breakeven inflation expectations have started to fall once again in May. For a little context, starting in last June, breakeven inflation started a steady march lower that lasted until January of this year. Since that time, we have seen a rebound in inflation expectations. For example, five-year TIPS derived breakeven inflation fell from 205 basis points on June 25th, 2014 to just 105 basis points on January 13th, 2015. Inflation expectations rebounded over the next several months and five-year TIPS derived breakeven inflation eventually hit 172 basis points on May 5th, 2015. Since then, inflation expectations have fallen back towards 154 basis points. The story is similar using 10-year TIPS and 30-year TIPS.



One of the Fed's preferred inflation measures, the 5-Year, 5-Year Forward Breakeven Inflation Rate, remains at the low end of its range over the past 12 years. It currently sits at just 2.06%. It is interesting to note that while TIPS derived inflation expectations were increasing for most of this year, they were increasing across different time dimensions (i.e. the 10-year TIPS and 5-year TIPS) at relatively the same rate. Consequently, the 5-Year, 5-Year Forward Breakeven Inflation Rate only rose as high as 2.16% on May 5th.

Knowledge Leaders Are Outperforming YTD

In our white paper "The Knowledge Effect: Excess Returns Of Highly Innovative Companies", we identified a stock market pricing anomaly in highly innovative companies.  The tendency of stocks of highly innovative companies to experience excess returns can be traced back to two main factors:

1. A surge in the pace of knowledge produced catalyzed by the release of the first commercially available semiconductor in 1971. Due to the cumulative nature of knowledge, this acceleration has resulted in an exponential increase in humankind's total knowledge.
2. A mandate by the US Financial Accounting Standards Board in 1974 which ruled that companies must expense knowledge investments in the period incurred. This deprived investors of relevant financial information on corporate knowledge spending at the dawn of this massive surge in pace of knowledge production. 

Based on 20 years of academic research, we have captured the Knowledge Effect by using a proprietary process designed to overcome the informational shortcoming of traditional financial statements. As regular readers know, we view the world through an "intangible-adjusted" lens. We have created two indexes, that are priced daily, to track the performance of Knowledge Leaders. One index tracks Knowledge Leaders in the Developed Markets and the other tracks Knowledge Leaders in the Emerging Markets. In the first chart below, we plot our Gavekal Knowledge Leaders Developed World Price Index (red line) against the MSCI World Index (green line).  It has outperformed the MSCI World Index by a little over 3% YTD. In the second chart below, we plot our Gavekal Knowledge Leaders Emerging Market Price Index (red line) against the MSCI Emerging Market Index (green line). So far our Gavekal Knowledge Leaders Emerging Market Index has outperformed the MSCI World Index by a little over 2% YTD. 

Another way we can look at performance is by splitting up the global equity universe into companies that follow a strategic innovation strategy (Knowledge Leaders) and companies that follow a strategic mimicking strategy (Knowlegde Followers). Developed Market Knowledge Leaders have returned on average about 9.2% YTD while Developed Market Knowledge Followers have returned on average about 6.9%. In the emerging markets, Knowledge Leaders have returned about 9.1% YTD while Knowledge Followers have returned about 8.6% on average YTD.

Developed Market Knowledge Leaders Performance By Sector


Developed Market Knowledge Followers Performance By Sector


Emerging Market Knowledge Leaders Performance By Sector


Emerging Market Knowledge Followers Performance By Sector

Decline in Sentix Euro Break-Up Survey

The 1,000 or so participants in Sentix's monthly survey of whether or not a country will leave the euro collectively decided that the risk has subsided (slightly):



The decline to 41% (from nearly 50% in April) was mostly attributable to risks related to Greece's membership in the common currency (black line):



Cyprus (in grey) was also determined to be less likely to exit the Euro zone, while the number of respondents who believe that Italy (in light blue) might exit rose ever so slightly:

San Francisco Real Estate Is 75% Above Housing Crisis Lows

The latest (March) Case-Shiller Home Price Index was released this morning and there were several noteworthy data points in the report. First, our 3-month diffusion index that measures the number of cities where prices are higher now than they were three months ago increased by six cities in March to a six-month high of 18. This means that 18 of the 20 cities tracked by Case-Shiller HPI have higher prices now than they did three months ago. All 20 of the cities have higher prices now than they did a year ago according to our yearly diffusion index. Second, Dallas and Denver remain the only cities that have increased past their housing bubble peak price point. However, Boston, Charlotte and San Francisco are only a few more strong months away from making new highs. Finally, speaking of San Francisco, house prices there have been booming. San Francisco house prices are now a staggering 75% higher than they were at the bear market low in March 2009. No other city comes close in mounting such a rebound off of the housing crisis lows.

European And Asian Stocks Are Approaching Overbought Levels

Unlike the majority of this six year old bull market, European and Asian stocks are outperforming North American stocks in 2015 (yes even measured in USD). Asian stocks are nearly 12% higher, European stocks are nearly 10% higher and North America stocks are just about 3%. This surge in Asia and European are starting to hit overbought levels judging by the the % of stocks above its 100-day and 200-day moving average.

Three weeks ago, 89% of Asian developed market stocks were trading above its 100-day moving average. This has fallen back a bit, to 76%, but still remains at an elevated level. 75% of Asian stocks are trading above its 200-day moving average.





83% of European developed market stocks are trading above its 100-day moving average. This is basically the highest level reached for European stocks in a year and a half. 76% of European stocks are trading above its 200-day moving average.





Finally, we have the bull market leader North America. Here we are seeing a slight breakdown in momentum. 65% of North American developed market stocks are trading above its 100-day moving average and 66% of stocks are trading above its 200-day moving average.

Longer Term Trends Have Reasserted Itself In May

Remember back in April when we noted how equity trends had completely flip-flopped during the first several weeks of the second quarter and we wondered aloud whether this was a trend change or simply a counter-trend rally? Well, so far in May the market is signalling that equity trends observed in April may have just been oversold (and well overdue) bounce.

To quickly review, at the end of April the performing sectors were energy, telecom and materials. These had been three of the worst five performing sectors over the past four years. Conversely, tech, consumer discretionary and health care were the three worst performing sectors in April. Meanwhile, they had been the three best performing sectors over the past four years.

Through yesterday, bull market leadership has reasserted itself. The best performing sectors MTD are health care, tech, and consumer discretionary. And the two worst performing sectors? You guessed it, energy and telecom. Materials have bucked the trend so far in May and are the fourth best performing sectors in May.

Even with the weakness in the energy stocks in May, the energy sectors continues to have the best performance in the second quarter. However, YTD, the energy sector is still the second worst performing sector just ahead of utilities and just behind telecom. As we approach the final month in the second quarter, it will be interesting to see if long-term leaderships continues with its May momentum.

Equity Returns As Of Tuesday, April 28th


Equity Returns As Of Tuesday, May 20th