Equity Solutions for Financial Markets

by Scott Martindale
President, Sabrient Systems LLC

Last week was the market’s worst since March. After Q3 had zero trading days with more than 1% move (up or down), our cup runeth over in Q4 with the stock rollercoaster so far offering up 22 days that saw a 1% move. Volatility seems rampant, but the CBOE Volatility Index (VIX) has not even eclipsed the 30 level during Q4 (whereas it hit 50 back in February). Even after Friday’s miserable day, the VIX closed at 23.23. Of course, the turbulence has been driven primarily by two big uncertainties: the trade dispute with China and the Federal Reserve’s interest rate policy, both of which have the potential to create substantial impacts on the global economy. As a result, investor psychology and the technical picture have negatively diverged from a still solid fundamental outlook.

For about a minute there, it seemed that both situations had been somewhat diffused, with Presidents Trump and Xi agreeing at the G20 summit to a temporary truce on further escalation in tariffs, while Fed chairman Powell made some comments about the fed funds rate being “just below” the elusive neutral rate. But investors’ cheers soon switched back to fears (soon to be tears?) with the latest round of news headlines (e.g., Huawei CFO arrest, Trump’s “Tariff Man” comment, Mueller indictments, and the imminent federal debt ceiling showdown). The uncertainty and fear-mongering led to a buyers’ strike that emboldened the short sellers, which in turn triggered forced selling in passive ETFs and automated liquidation in quant hedge funds, high-frequency trading (HFT) accounts, and leveraged institutional portfolios, which removed liquidity from the system (i.e., no bids), culminating in a retail investor panic. As it stands today, the charts look woefully weak and investor psychology has turned bearish, with selling into rallies rather than buying of dips.

Ever since June 11, when the trade war with China escalated from rhetoric to reality, stocks have seen a dramatic risk-off defensive rotation, with Healthcare, Utilities, Consumer Staples, and Telecom the only sectors in positive territory and the only ones outperforming the broad S&P 500 Index. It’s as if investors see the strong GDP prints, the +20% corporate earnings growth (of which about half is organic and half attributable to the tax cut), record profitability, and record levels of consumer confidence and small business optimism as being “as good as it gets,” i.e., just a fleeting final gasp in a late-stage economy, rather than the start of a long-awaited boom cycle fueled by unprecedented fiscal stimulus and a still-supportive (albeit not dovish) Federal Reserve. As a result, forward P/E on the S&P 500 is down a whopping -19% this year, which is huge – especially considering this year’s stellar earnings reports and solid forward guidance.

But has anything really changed substantially with regard to expectations for corporate earnings and interest rates (the two most important factors) to so severely impact valuations? Not that I can see. And Sabrient’s quantitative rankings imply that the economy and forward guidance remain quite strong, such that the market is simply responding to the proverbial Wall of Worry by offering up a nice buying opportunity, particularly in beaten down cyclical sectors and in solid dividend payers – although there might be some more pain first. Over the past 10 years of rising stock prices since the Financial Crisis, there have been eight corrections of roughly -10% (including nearly -20% in 2011), and this year’s correction has led to the fourth major drawdown for Sabrient’s Baker’s Dozen annual top picks list (1Q2009, mid-2011, 2H2015, and now). But selling at each of those previous times would have been the wrong thing to do, and this time seems no different.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings remain bullish, while the sector rotation model remains in a defensive posture due to the persistent market weakness. Read on...

by Bradley Cipriano, CPA
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

At Gradient Analytics, our forensic accounting analysis includes assessing the quality of a company’s reported earnings and the strength of its balance sheet. A key element of this process is understanding whether recently reported growth is sustainable and whether forward expectations are reasonable. New GAAP (Generally Accepted Accounting Principles) standards – such as Contracts with Customers (ASC 606), which went into effect at the beginning of this year – have distorted year-over-year growth figures, such that it has become routinely necessary for an investor/analyst to adjust income statement and balance sheet accounts to get a clearer like-for-like comparison. For example, ARRIS International plc (ARRS) has grown 2018 YTD GAAP EPS by $0.17, which includes an $0.18 benefit from ASC 606. So, while ARRS is showing earnings growth on the surface, its comparable YOY earnings have actually declined. Understanding how new accounting standards can be manipulated to positively impact earnings can help investors better assess reported results.

While such new standards are often viewed as “a wash” since there is no change to the underlying economics of a business, the changes under the new leasing standard Leases (ASC 842), which is coming into effect in 2019, may prove quite material for certain corporate filers. The new leasing standard follows a convergence in accounting principles between International Financial Reporting Standards (IFRS) and U.S. GAAP to improve comparability among different filers. Currently, operating leases (which are similar to debt) are disclosed off-balance sheet in the footnotes with limited qualitative or quantitative disclosures. But following the adoption of the leasing standard, this debt must be brought back onto the financial statements along with increased disclosure requirements. It is important to question why a company has relied on off-balance sheet debt in the past to better understand the risks that may surface once this debt is brought back onto the statements.

In this article, I explain ASC 842, summarize the major changes it introduces and its expected impact on corporate financial statements, and discuss how this new leasing standard allows for management subjectivity that might be used to distort earnings growth and disguise a firm’s sustainable operating performance. Read on….