Trouble in Deutschland

No time to waste today (or any day). Let me begin with the question I left off with yesterday: are corporate earnings rising, and rising fast enough to justify higher stock prices from these levels?

It’s a simple question. The trouble with earnings (as opposed to cash flows) is that they are largely an accounting fiction. But let’s proceed as if earnings projects by analysts (and the underlying earnings themselves) are numbers you can trust. If you trust them, you can make decisions on them. So what are the numbers telling you?

Well, S&P 500 companies have reported six straight quarters of year-over-year earnings declines, according to FactSet (as reported in The Wall Street Journal). It’s the longest streak of declines since FactSet began tracking such trends in 2008. Is it meaningful?

The world has hardly been normal since 2008. And it’s only, after all, eight years. Let’s call it 30 quarters. But it’s not a stretch to say that if earnings are declining on a year-over-year basis but stock prices are rising, then something else is driving stock valuations. That “something else” is cheap money. QE supports asset prices. QED.

Chart showing the evolution of the energy sector index
But wait!

The energy sector of the S&P 500 has reported eight consecutive quarters of year-over-year earnings declines. The most recent example is ExxonMobil. The global oil giant was expected to deliver 80 cents a share. It delivered 66 cents instead. Ouch.

Energy sector earnings could fall by 66% in the third quarter, says FactSet. That’s another “ouch”. You can see from the chart above that the performance of the Energy Select Sector SPDR Fund (XLE) tracks the price of West Texas Intermediate crude oil (WTI). Strip out energy sector earnings and the S&P 500 would have reported rising earnings in five of the last six quarters.

There’s a separate question here of whether the energy business is a terrible business to be in now. It’s an interesting question. Fracking technology developed in the US has made it possible for US producers to switch oil production on and off easily. This has robbed Saudi Arabia – the key “swing” producer of the past – of the ability to control prices to its advantage.

Add the removal of sanctions on Iran, plus surging Russian production, and the pricing power in the market has shifted decidedly in favour of consumers. And none of that takes into consideration the fact that renewals are becoming more cost competitive. The traditional energy sector (hydrocarbons) is also under siege from regulations (climate change).

A complete investigation into the future of the energy market is beyond the scope of today’s letter

The question I’m trying to answer is this: if you strip out the energy sector, does the earnings picture on the S&P 500 suddenly look better? And if it does, can you trust that the stockmarket is forecasting earnings growth, GDP growth, and (in a roundabout way) rising wages, prices, inflation and interest rates?

Maybe a simpler way of asking those questions is asking whether, in a market juiced by low interest rates and massive QE programmes, the stockmarket is a useful leading indicator of economic performance. And while I’m at it, if you’re measuring economic performance by GDP – a measure of the quantity of economic activity and not its quality – maybe you’re wasting your time.

That is, if you’re measuring GDP, you’re not measuring anything trustworthy or meaningful; at least when it comes to actual decisions you’ll make with your own portfolio. And that’s what it really comes down to.

If companies were borrowing money at low rates to invest in new projects which would create high rates of return and profits for shareholders, stock prices would be fully justified. But what if companies are loading up on debt because the price is right and using the debt to pay dividends or buy government bonds?

Well if that’s the case, then you can forget earnings growth (unless share buybacks improve earnings per share by reducing the number of shares outstanding). It’s a hot button issue and determines how aggressive you can or should be buying stocks right now. Meanwhile… back in Germany…

Kiss of death

Has Deutsche Bank’s CEO John Cryan given the bank a kiss of death? I’m talking about that moment when you express full confidence to the market and assure the public that the worst-case scenario isn’t possible. It’s the sort of thing you usually say right before things go cactus.

Cryan told German newspaper Bild that the bank’s capital levels were “currently not an issue.” He added that getting government support was “out of the question.” That’s good, because there is almost no political support for another government bailout of a troubled lender. There is also the little matter of EU banking regulations that came into force earlier this year, which impose a bail-in on creditors before a bank can get access to government bailout funds.

But let me back up a second and make clear the ways in which Deutsche Bank is not Lehman Brothers. Deutsche Bank’s dismal share price performance and mini capital crisis is driven almost entirely by the threat of a massive fine by the US government. That proposed fine of $14 billion would force the bank to raise capital or wipe out its existing capital.

It’s hard to imagine that US regulators want to cause a crisis as it is a global systemically important bank. Through the derivatives market, Deutsche Bank is connected all over the world. It simply can’t be their intention to artificially provoke the next crisis. Unless it is and this is part of the orchestrated crisis the conspiracy theorists have been warning about for years.

But let’s assume it’s not a crisis by design

The simplest way out of the artificial problem is for the German government to lobby the US government to reduce the fine. That accomplished, the bank can raise capital without bailing in creditors.

Problem solved! Intrepid traders would begin eyeing up the shares as a buy this very moment. Peak anxiety in Deutsche Bank shares would be peak opportunity. A contrarian delight.

There is one final twist in the tail, though. All of the above assumes Deutsche Banks’s problems stem only from the recent spectre of a multi-billion dollar fine. That there is no trouble with asset quality. No trouble with liquidity. No trouble at all. Nothing to see here!

The trouble is, with something so big and complex and leveraged, there is almost always trouble. And usually a lot more than meets the eye. Tomorrow, how the nationalisation of the banks could come about.

Dan Denning's Signature

Category: Central Banks

From time to time we may tell you about regulated products issued by Southbank Investment Research Limited. With these products your capital is at risk. You can lose some or all of your investment, so never risk more than you can afford to lose. Seek independent advice if you are unsure of the suitability of any investment. Southbank Investment Research Limited is authorised and regulated by the Financial Conduct Authority. FCA No 706697.

© 2020 Southbank Investment Research Ltd. Registered in England and Wales No 9539630. VAT No GB629 7287 94.
Registered Office: 2nd Floor, Crowne House, 56-58 Southwark Street, London, SE1 1UN.

Terms and conditions | Privacy Policy | Cookie Policy | FAQ | Contact Us | Top ↑