The Eurozone Could Be A Problem For Stocks

by Lance Roberts

"The following chart is food for thought. There are extremely high expectations that the U.S. economy will achieve “lift off” in terms of economic growth eventually achieving 3-4% annualized growth rates. The chart below shows the nominal GDP of the Eurozone and U.S."

Is it possible, that in globally interconnected economy, the U.S. can stand alone?

It certainly seems that the answer to that question is currently "yes" as financial markets hit "new all-time" highs and economic data has rebounded in the second quarter following a sharp Q1 decline. However, as is always the case, the issue of sustainability is most critical.

Sy Harding recently wrote an interesting piece entitled "The Eurozone Is A Growing Problem For U.S. Economy?" in which he cited three very crucial points relating to the issue of sustainability:

• The 18-nation euro-zone is the largest economy in the world, eclipsing that of the U.S.
• The euro-zone is the largest trading partner of the U.S. (the largest importer of U.S. goods, the largest exporter of goods to the U.S.).
• The euro-zone is in an economic crisis.

The chart of GDP above clearly illustrates the importance of Sy's points. Importantly, the economic conditions in the Eurozone are getting "worse" rather than "better." According to Sy:

"It slowed further to 0.0% quarter-over-quarter in the second quarter.

Worse, Germany, the euro-zone’s largest and previously strongest economy, unexpectedly saw its economy contract to negative -0.2% in the second quarter. France, the second largest euro-zone economy, saw its growth slow to 0.0% for the quarter. Italy, Europe’s fourth largest economy, slid back into recession, its GDP at negative 0.8% in the second quarter, its second straight quarterly contraction.

Reports this week indicate the problems are worsening in the third quarter.

Retail sales in Germany plunged 1.4% in July, after declining 0.4% in the second quarter.

Germany’s Ifo business confidence index fell in August for the fourth straight month, to its lowest level since July 2013. Market research group GfK reported its German consumer expectations index 'collapsed' in August to its most pessimistic level since 1980. Perhaps for good reason, since the overall euro-zone’s unemployment rate remained in double-digits at 11.5% in July, just 0.5% lower than its peak of 12% in 2013."

The following chart of wages, labor costs, and price inflation clearly shows the increasing problems facing the Eurozone economies.

The negative feedback loop to the Eurozone economies from declining wages and overall deflationary pressures has nullified attempts by the European Central Bank to spark some inflation across economies. While there is continued "hope" that the ECB will launch further successive rounds of monetary interventions, there is clearly a diminishing rate of return of each dollar spent.

Furthermore, given the fact that the ECB, unlike the Federal Reserve, relies on the"generosity" of its member countries to fund its "coffers," which primarily falls on the shoulders of a weakening German economy, there is a limit to what ECB can achieve.  There is also the question of when Germany will just say "Nein" to continued bailouts of its failing neighbors with respect to its own economic prosperity.

The rising deflationary pressures in the Eurozone economy will also reduce the nascent inflationary pressures domestically. The uptick seen domestically was primarily a function increased economic activity during the second quarter rebound which was primarily an inventory restocking cycle. With deflationary pressures increasing in the Eurozone, the feedback to the U.S. will reassert itself in the coming quarters ahead.  (Chart below shows the high correlation between domestic and Eurozone inflation)

Given Sy's points with respect to the size and importance of the Eurozone economy, exports comprise roughly 40% of domestic corporate profits; it is unlikely that U.S. profits will remain unaffected. As I have discussed recently, corporate share buybacks have been a major boon to increasing profits on a per share basis over the last couple of years. Share buybacks have also been an important driver of asset prices in conjunction with, and due to, the expansion of the Fed's balance sheet and suppression of interest rates.

"The boom in buybacks also owes much to the Federal Reserve’s suppression of long-term interest rates via quantitative easing and stagnant growth in Europe, an important foreign market for many S&P 500 global companies.

Record-low interest rates in the corporate bond market have helped fund large buybacks, but with the central bank on course to conclude buying bonds under QE in October, fuel for buybacks is ebbing and non-financial debt issuance has slowed.

Andrew Lapthorne at Société Générale says companies have exploited the generosity of financial markets to fund their share buybacks and as that fades,the equity bull market faces losing a key source of support.

Share buybacks have grown by $1.56 Trillion since 2011, but those repurchases peaked during the first quarter of this year at 159.28 billion before sliding back to $120.21 billion in Q2.  The risk for the markets here is that with the Federal Reserve reducing the flow of cheap liquidity, and potentially raising borrowing costs in 2015, two of the major supports of the markets will be removed."

The correlation between the Eurozone financial markets has been, and remains, extremely high. As shown in the chart below.

The current divergence between the two markets, and given the underlying weakness in the economic underpinnings of the Eurozone itself, brings the question of sustainability into focus.

I have to agree with Sy's conclusion:

"It has also been more than three years since the market experienced even a normal 10% to 15% correction, while on average it does so every 12 months. And of the 25 bull markets of the last 100 years, this is the fourth longest running since 1929.

You do have to at least ask yourself if that is justified, especially given the still anemic economic recovery. The market is higher than in 2000 and 2007. Even in those years of booming economic conditions, the market was not able to drive even higher, the S&P 500 instead losing 50% of its value in those apparently forgotten bear markets.

I know, it’s all about the Fed’s easy money policies and near-zero interest rates.But still, at those market tops, and indeed all market tops, there were also reasonable explanations of why ‘this time is different’."

While anything is certainly "possible," given the weight of evidence, keeping a watch on the "probable" seems to be the more prudent course of action.

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Draghi Sharpens “Three Arrows” for Europe

by Darren Williams

When the European Central Bank’s Governing Council convenes tomorrow in Frankfurt, there will be plenty of talk about Mario Draghi’s recent speech at Jackson Hole. Not only did this open the door to a large-scale quantitative easing (QE) programme, it may in time be seen as a pivotal moment in the evolution of the euro area’s policy framework as it attempts to fend off the forces of deflation.

The speech by ECB president Draghi, on unemployment in the euro area, was controversial in two key respects. First, he warned that extraordinarily high rates of unemployment in some euro-area countries could lead to the eventual break-up of the monetary union. Second, he argued that structural reform needs to be accompanied by policies aimed at lifting aggregate demand if the battle against unemployment—and, by extension, the risk of corrosive deflation—is to be won.

Mix of Monetary and  Fiscal Policy

Perhaps even more surprisingly, Draghi suggested that monetary and fiscal policy should work in concert to lift aggregate demand, claiming that “the way back to higher employment… is a policy mix that combines monetary, fiscal and structural measures at the union level and at the national level.”

Seem familiar? To us, this sounds a lot like the far-reaching and bold “three arrows” approach pioneered by Japan’s Prime Minister Shinzo Abe in that country’s attempt to defeat persistent deflation. So, does the speech signal the onset of Japanese-style “Draghinomics” in the euro area?

QE on the way

Only time will tell, and much will clearly depend on the extent to which euro-area governments heed Draghi’s warning. But there’s little doubt about the message Draghi wants to convey about the near-term direction of ECB policy. Not only did he make special reference to the recent sharp decline in inflation expectations in the euro area, he also argued that the risks of “doing too little” in the current environment outweigh the costs of “doing too much.”

This is a big change for the ECB, suggesting that it’s moving closer to the thinking used to justify more aggressive and proactive policy responses in the US, the UK and Japan, each of which have already launched large-scale QE programs. If so, it would herald another dovish shift in the ECB’s reaction function—which has already changed markedly under Draghi’s stewardship.

A few weeks ago, we put the probability of a large-scale QE program in the euro area at 30%–40%. However, lackluster data, rising geopolitical risk and Draghi’s speech all suggest this should now be higher. Indeed, we now think a QE program is more likely than not. And while this week’s meeting of the ECB’s Governing Council is probably too early for such a controversial move, we doubt it will be long before Draghi fires the first arrow if the outlook for price stability continues to deteriorate.

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Leverage And Operational Challenges Result In Real Risks

by Bob Evans Farms

Summary

• Investors in Bob Evans have been disappointed, as the company posted a small first quarter GAAP loss.
• The company remains challenged as I perceive quite some risks from the rapid built up in leverage amidst pressured earnings.
• The valuation is rather high in my opinion, despite a correction from last year's high. The risk-reward at current levels is not attractive in my opinion.

Investors in Bob Evans Farms (NASDAQ:BOBE) were not happy after the company posted a modest loss for the first quarter of 2015, triggering a 10% sell-off.

Amidst struggling core operations, a high valuation and a leveraged balance sheet I would be very hesitant to buy into the recovery story with activist investors already onboard.

I continue to shun the shares despite a 30% sell-off from last year's highs.

Difficult Start To 2015

Bob Evans posted first quarter sales of $326.3 million which is a 0.9% drop compared to the year before. Restaurant sales were down by 1.8% to $240.2 million which was largely the result of a 2.0% decline in comparable store sales. The BEF Foods business posted a 1.5% increase in sales to $86.2 million amidst its quest to boost the number of stock-keeping units and points of sales. Adjusted for a sold production facility, sales at BEF were up by 5%.

The company posted a GAAP loss of a million, for a loss of $0.04 per share. This compares to last year's earnings of $8.4 million.

Adjusted for certain items, earnings came in at just $2.3 million, or $0.10 per share. Adjusted earnings fell sharply as well compared to the $15.2 million reported last year.

A modest positive result of the restaurant business was offset by a small loss at BEF Foods, while the profitability of both segments fell compared to the year before.

August Presentation

In accordance with the first quarter earnings release, Bob Evans presented itself to the investment community.

The company currently operates 562 restaurants in nineteen Mid-Eastern States. At the same time the company has the sausage, refrigerated sides, frozen and food service business which is sold at over 30,000 locations.

The company stresses its ambitions and goals to develop its regional brands into national brands. For the long run the restaurant business is targeted to grow sales by 3-3.5% thanks to comparable store sales growth and a planned 10 openings a year. A pro for the business, roughly a third of sales are generated for both breakfast, lunch and dinner.

The food business is expected to grow by 6-7% thanks to greater stock-keeping units and more service points anticipated in the future. All off this should be complemented with lon term margin expansion, allowing earnings per share to improve by 10-12% per annum.

Of course these are predictions and management does not have a great track record on delivering on its expectations.

2015 Outlook

For the full year of the new fiscal year the company continues to foresee 1.5-2.5% growth in comparable store sales. After falling in the first quarter, comparable sales are seen flattish in the second quarter, followed by an anticipated growth in the high-single digits for the final two quarters of the year.

All in all, sales are foreseen at $1.38 to $1.40 billion as the company anticipates adjusted earnings of $1.90 to $2.20 per share. Note that in the first quarter alone there was already a $0.14 discrepancy between GAAP and non-GAAP earnings.

Valuation

With some 23.6 million shares outstanding at the end of the quarter, after repurchasing a substantial portion of the outstanding share base in recent quarters amidst activist investor pressure, the equity in the business is valued at around a billion.

Note that the company has some $463 million in debt, and holds just $3 million in cash which results in a rather sizable net debt position.

The $1 billion equity valuation values the business at roughly 0.7 times anticipated sales for the upcoming year and 21-22 times adjusted non-GAAP earnings. Given the discrepancy in the first quarter already, the valuation multiples based on GAAP metrics will be much higher.

The debt position is rather high, especially in relation to net earnings and trailing EBITDA of about $100 million. Earnings are especially on the high side if earnings continue to be under pressure.

Long Term Challenges

The company has seen a great deal of challenges in recent years with sales improving from $1.5 billion in 2005 to peak at $1.75 billion in 2009, to fall to little over $1.3 billion on a trailing basis.

Earnings have been very volatile, ranging from anything between a tiny profit and peak earnings of $70 million in 2010, although trailing earnings total just $35 million by now.

It should be noted that the business has retired a third of its shares outstanding over this time period while leverage has risen a lot. Worse, much of this debt is of a shorter term nature posing significant risks given the leverage if the business does not improve.

Takeaway For (Potential) Investors

I must say that I am not at all impressed with the company's performance. If the company can improve its margins to historical highs, the valuation might be more appealing yet there are quite a few issues.

The competitive fields for dining is very difficult and margins are very low with Bob Evan's restaurants easily being qualified as ¨old-school¨ despite the rejuvenation of its restaurants. This makes a structural improvement in comparable stores sales unlikely in my eyes while the rapid increase in debt not only poses real dangers to investors, it also limits earnings attributable to them going forwards.

As such shares continue to trade a very rich multiples in a structurally difficult situation, an already very leveraged balance sheet and amidst the presence of activist investors in the form of Sandell Asset Management.

While the near 3% dividend yield might look appealing, the high leverage and pressured earnings could already cast doubts about the viability of this payout if operations stagnate any further.

Despite shares being down by nearly a third from a peak at close to $60 in 2013, to levels in the low forties at the moment, I fail to see any appeal on a stand-alone and historical valuation basis. Also note that the company already guides for high single digit comparable sales growth as soon as two quarters from now, leaving real risks to the downside in my opinion.

While activists and Sandell Asset Management in particular cite the room for improvements, I fail to see how much value can really be created. The risks on the other hand are very much apparent given the in my eyes reckless built up in leverage.

Shares remain a no-go in my opinion.

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The S&P 500 Can Reach 2300 to 2400

by Greg Harmon

Or maybe not.  Forget about multiple expansion or CAGR of earnings. These measures may be good for spinning a tale to justify an end number. And the may give you a ‘fair value’ for the equity markets. But the markets are about capitalism and inefficiency, not fair values. For example, you do not walk into a car dealer and ask for the cost of all the parts and labor and then give them and extra 10% to get to ‘fair value’ for your new car. You do some research as to what others have paid and work on a discount from the sticker. The dealer shows you the inflated sticker and lets you negotiate off a small amount to make you feel better. The he tries to add back undercoating or other nonsense, and increase his profit by offering you financing in house. Nobody knows what the car is exactly worth until you sign on the dotted line for $30,000 with a 5 year 1.9% loan. And then the next guy walks in and the negotiation starts over. Fair value is a nice term that does not exist.

But what does exist is price history and psychological reaction to it. The price history in the S&P 500 has a lot to tell you. The chart above going back to 1980 can have many deep and complex interpretations. But it is the simplest that can help give you a direction. There are two methods of price extension shown that take prior price history into account. The first is the Measured Move. This is as simple as looking at the move from the base in the early 1980′s to the middle of the consolidation zone from 1197 to 2013 and projecting that it happens again higher. This method targets the S&P 500 at 2300. The second is to look at the consolidation pattern itself, a broadening wedge. As it breaks the top the technician then will project the price difference from the widest point as a move again higher. This method targets 2416 for the S&P 500. Nether method is a guaranty but both are methods that traders and investors will be following.

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WTI: Evening star shows sun is setting on last week’s bounce

By Matt Weller

One of our persistent biases last week was that the U.S. dollar rally was due for a breather after strengthening dramatically over the previous few weeks.

That theme played out nicely in some markets (USD/JPY, USD/CAD, AUD/USD, gold (COMEX:GCV14) and oil), but failed to develop in other markets (EUR/USD and USD/CHF). Regardless, the scene may now be set for another leg higher in the greenback across the board, assuming this week’s high-impact US data cooperates.

One of the most actionable setups at this point could be in WTI (NYMEX:CLV14), which is in freefall today after bouncing back to 96.00 last week. As we noted two weeks ago, a multi-month Head-and-Shoulders pattern suggests that the commodity could still see further downside toward 90.00 over the medium-term. More immediately, prices are putting the finishing touches on a clear Evening Star candlestick pattern; this relatively rare 3-candle reversal pattern shows a shift from buying to selling pressure and is often seen at near-term tops in the market.

Beyond the price itself, the other technical indicators are also painting a bearish picture. Last week’s bounce stalled out directly at the shallow 23.6% Fibonacci retracement and the downward-sloping 20-day MA, which has consistently put a cap on oil over the last two months. Meanwhile, the MACD remains well below the “0” level, showing generally bearish momentum, while the RSI has bounced out of oversold territory, potentially opening the door for another leg lower from here.

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Grains Drop as Export Prospects Improve as Ukraine Tensions Ease

By: Bloomberg

Wheat fell to the lowest in almost three weeks in Chicago and corn declined amid speculation that tension between Ukraine and Russia will ease, improving the prospects for the Black Sea region’s grain exports.

Russian President Vladimir Putin and his Ukrainian counterpart Petro Poroshenko largely agreed on steps toward easing the conflict in Ukraine, Putin’s spokesman said, denying Ukraine’s assertion that the leaders reached agreement on a truce. The two countries account for about 21 percent of world wheat exports, U.S. Department of Agriculture data show, and grain shipments have continued from the region even amid unrest.

"We’ve just got to wait and see how things develop," Dave Norris, an independent grain broker in Harrogate, England, said by phone. "The markets certainly seem to think it’s bearish news" that the countries may reach an agreement, he said.

Wheat for delivery in December fell 1.3 percent to $5.48 a bushel at 5:11 a.m. on the Chicago Board of Trade. Earlier the price touched $5.4475, the lowest since Aug. 14. In Paris, milling wheat for November delivery dropped 0.6 percent to 172.50 euros ($226.70) a metric ton on Euronext.

Corn for December delivery fell 1 percent to $3.60 a bushel in Chicago, after touching $3.59, the lowest since Aug. 12 when it reached a four-year low of $3.58 a bushel. Soybeans for November delivery declined 0.7 percent to $10.2475 a bushel.

Unrest in Ukraine has roiled grain markets in recent weeks even amid prospects for bumper global harvests. Ukraine, the U.S. and Europe accuse Russia of dispatching soldiers and backing pro-Russian rebels in fighting. Russia, which is facing further sanctions as early as this week over the unrest, has repeatedly denied involvement.

Wheat prices also fell today before Egypt, the world’s biggest importer, issues a tender to buy the grain. The country last bought 175,000 metric tons of Romanian and Russian wheat in a tender Aug. 26.