Evla Hills May 2016 Newsletter

A couple of years ago, I took a vacation in Bali. I had the bright idea of renting a car so that we can visit various sites with ease. To my great surprise, nearly 30 years of driving experience in the United States in no way prepares one to drive in Indonesia. Traffic was chaotic and rules were for the most part ignored. In fact, any driver who wished to follow traffic rules would risk being frequently cut off and hopeless crawling at a snail’s pace. After only two days, my rental car had suffered multiple dents and scratches not to mention a broken side mirror. For the rest of my stay, I hired a driver.

Rules are of course a necessary part of living in a society. However, when breaches to such rules are not enforced. Pretty soon more violations will follow to the detriment of society in general. Traffic fatalities per one hundred thousand vehicles average 37 in Indonesia. In comparison, it is 13 in the United States. It turns out the roads in Indonesia are relatively safe compared to other South East Asia countries as the whole region averages 101 deaths per one hundred thousand vehicles. Meanwhile, nations known by their law obeying reputations have even lower traffic fatalities than the United States. For example, Japan and United Kingdom come in at 6.5 and 5.1 respectively.

On the subject of rules, the US Department of Labor issued a set of new fiduciary rules with broad implications since it requires any investment advisor who works with IRA accounts to follow the fiduciary rule. A fiduciary is a person who owes his allegiance to the client; therefore, must prudently consider what is in the clients’ best interest when a decision is made. While registered investment advisors have always followed the fiduciary rule, brokers and independent broker dealer representatives are under no such obligation. In the view of DOL, many financial advisors failed to serve the best interest of the retirement investors. During the later 90’s internet bubble, Henry Blodget, then Merrill Lynch’s internet analyst was asked what was interesting about a company his firm was about to take public. He famously responded nothing except for the banking fees. Today it has become common for brokers to recommend non traded REITs or complex variable annuities into retirement accounts. For the financial advisors, the interest is the fat commissions and for the sponsoring financial institutions, their interests are the high fees. These kinds of practices are not only detrimental to investors, but also hurt the industry as a whole. One may find it surprising that the fiduciary duty has not become the norm in a highly developed financial system like the United States. Alas, better late than never. We certainly hope it will soon become the norm.

Late April and early May tend to mark the peak of the first quarter earnings reporting season. As of the end of March, S&P 500 as a whole was expected to report near double digit EPS declines over Q1 of 2015. As of the end of April, nearly half of the S&P companies had reported. The result, not surprisingly came in ahead of expectation. According to Zacks Investment Research, of the companies already reported, earnings were down a mere 5.5% on revenue decline of 1.6%. Nearly 75% of the reported companies beat their Wall Street earnings expectation compared to the normal beat ratio of around 70%. More importantly, earnings estimate for the remaining quarters of 2016 are not coming down nearly as much. Current estimate calls for second quarter earnings decline of 5.1%. Then we shall finally see earnings growth again with third and fourth quarter estimated increase of 1.5% and 8.4%.

After four consecutive quarters of earnings decline, a little skepticism, especially to the 8.4% growth estimate of fourth quarter, may be justified to the scenario currently envisioned by Wall Street pundits. Richard Bernstein, a former Merrill Lynch quantitative strategist laid out a case in his eponymous firm’s newsletter that the profit cycle was in the process of troughing. When I was a fund manager, I had diligently read Mr. Bernstein’s work especially his quantitative work on market cycle. His ideas are always based on objective data and highly credible. Here is what he said.

Nothing unique going on: it’s still interest rates and profits the combination of the Fed’s hesitancy to tighten monetary policy and the profits cycle’s potential trough indicates two things to us: 1) this cycle isn’t different and 2) the odds are the bull market continues. Of course, if one wanted to posit that the Fed will be aggressive and the trough in the profits cycle is several quarters away, then we’d be very wrong because that would be a terrible environment for equities (i.e., the Fed tightening into a deepening profits recession). However, that combination would be highly unusual relative to history, and we think it is an unlikely outcome.

While I do hope his remark would be proven correct, I would only like to point out that four consecutive quarters of profit decline in the midst of an economic expansion is already highly unusual.