Some Common Cents for July 28th, 2017

Recently, on Mondays, I have been sending out a quick memo to our client advisors about the potential news items for the week. Here is what I out this week:

Gang:

The big news this week will be the FOMC meeting on Wednesday. FOMC is an acronym for ‘Federal Open Market Committee,’ which is the committee which sets interest rate policy at the Federal Reserve. All too often, the media mistakenly refers to the FOMC as simply “the Fed.” So, put that in the ‘for what it is worth file.’

In any event, the futures markets is currently putting a 0.0% likelihood the FOMC will raise the overnight lending target this week and a 0.1% chance it will cut. Essentially, the markets aren’t anticipating any real action out of the FOMC, but there will be a lot of interest in what the official statement will say after the meeting is completed. Specifically, folks will want to gain any insight into how, when, and how fast the FOMC intends to unwind a portion of the quantitative easing program(s). While this seems to be pretty straight forward to me: allow securities to mature, collect the money, fork over the profit to the Treasury, and delete the remainder through a keyboard strike. Shoot, if ‘they’ can create money out of thin air, they can delete it just as easily.

Typically, they release the statement around 1:00 central….so be looking for it if you have interest. For grins, the markets put the chances of another rate hike by the end of the year at a ‘coin flip.’  Perhaps the statement will give some insight one way or the other, but the markets aren’t expecting it to do so.

Also, we will get the first stab at 2Q 2017 Gross Domestic Product (GDP). The consensus estimate is the economy grew at a 2.5% annualized rate during 2Q, after a very pedestrian 1.4% rate for 1Q. Unless the headline is way off the mark, one way or the other, the GDP report probably won’t move the markets significantly, as it seems most folks don’t delve into the details of the report to get a true understanding of the health of things.

Finally, the Durable Goods Orders report and the sentiment gauges come out this week. Like the GDP report, these won’t move the markets if they come in somewhat close to expectations. The Durable Goods Orders report has the potential for the biggest vagaries, as the markets are estimating a pretty gaudy 3.7% for June. This HAS to be due to aircraft orders, as the auto industry has been slowing this entire calendar year. We shall see.

In the end: the FOMC dominates; GDP comes in second, and the Durable Goods Orders report comes in a distant third (but does have the potential to cause some problems).

Oh yeah….one more thing: Amazon releases its 2Q earnings on the 27th, and this will get a lot of press.

Take care, and have a great week.

Norris

As you can tell, this is somewhere in between travelogue and in depth academic analysis. However, I don’t intend for it to be the latter. Also, if you followed the economic reports and FOMC this week, you will see I was directionally accurate regarding, well, just about all of it. Full disclosure, predicting this stuff is almost like writing horoscopes: you make it broad and vague enough to be mostly right on most things. Unlike horoscopes, I rarely write about “meeting someone new in business,” or stuff along those lines.

What I got wrong or, better put, gave short shrift to was Amazon’s earnings release. I also failed to mention Alphabet’s (Google). The latter was a rookie mistake, and I am no longer a rookie. No excuses.

In case you have missed the headlines, both Alphabet and Amazon disappointed the markets with their 2Q 2017 earnings. I won’t mince words: Amazon whiffed and Alphabet didn’t, in my opinion. In fact, I have been kind of at a loss as to why the markets have treat Alphabet the way they have this week. After all, we ALL knew the company was going to take an earnings hit due to a recent EU ruling against the company, to the tune of, literally, $2+ billion. Apart from that, you know, the report looked pretty good or, worst case, within proverbial “spitting distance” of decent. I guess that is what happens when investors expect perfection, or close to it, as opposed to pretty good or spitting distance.

By comparison, Amazon’s revenue was slightly better than expected, slightly, but the company’s net income was well off estimates, well off. In fact, Earnings Per Share (EPS) were something like 72% less than what analysts had forecasted. The reasons for this are, not in any particular order: 1) an increase in sales & marketing expenses (second highest quarter); 2) a sharp increase in research & development (all time high by far), and; 3) a surprisingly high, to the point where it doesn’t make sense to the naked eye, income tax expense (again, another all time high).

Regardless of the reason(s), at the end of the day, the only thing that matters is what the company drops to the bottom line. Will the sharp increases in sales & marketing and research & development lead to increased revenue in the future? Probably, but we don’t know that right now. Is the 66% income tax rate for 2Q a “make whole” for previous quarters? While I haven’t read the official explanation, this undoubtedly something to do it. At the end of the day, a 72% negative earnings surprise will get folks’ attention, and it did.

As I type, Amazon is down a little over 1.5% in today’s trading, which is actually quite an improvement on where it opened the session, about $30 per share. Really? How can a company perform so much worse than expectations, and be down as little as it is at 12:30 CDT. While 1.5% in the red isn’t fun, the company reported net income was over $500 million less than Wall Street thought it would be. What’s more $197 million in profit on $37.995 in total revenue is so many peanuts, a net income margin of around 0.50%. I mean, investors would take just about any other ‘consumer cyclical’ stock behind the proverbial woodshed for a miss such as this.

Why aren’t they?

Obviously, you can’t get into the minds of every investor but I imagine it has to do with two things in particular: 1) folks believe Amazon is a ‘disruptive’ company which is fundamentally changing our lives and how we conduct business, and; 2) because of this investors don’t want to realize a significant tax bill over one quarter of disappointment, much of it due to things which could increase company performance moving forward.

Consider this: assume you bought 50 shares of AMZN on 12/31/2014, less than 3 years ago, at $310. You cost basis would be $15,500. As I type, again, a share goes for around $1,030. So, your investment is now worth $51,500. Congratulations on your $36,000 gain!!! If you own it in a taxable account and hit the 25% Federal marginal tax rate, you will pay at least 15% Federal tax and 5% state tax. So, expect to write checks totaling $7,200 or so. That would make your “beak even” share price on your Amazon holding equal to $886….or an extra 14% back from your sales price.

That is a hard call to make when you believe in the company, any company. What can you buy which will guarantee you a 14%, or higher, return than Amazon over a short period of time? Say 4% annualized over a 3-year window? Since we don’t guarantee anything in the investment industry, the answer is simply nothing. Therefore, lots of folks are taking their beating today, and maybe even into next week, because they will take a more severe beating next April IF they don’t.

Foolishness, this tax.

This is the problem with the capital gains tax. It inhibits the free flow of capital throughout the financial system. It penalizes you for making the right decision, or at least the right decision for you at any given time. As such, it is an incredibly punitive tax, and, quite possibly, my least favorite of the lot. Yes, I dislike the capital gains tax even more than the estate tax, particularly from an economic and investment perspective.

Basically, I would argue the capital gains tax encourages detrimental behavior. If I had a dollar for every person I knew who held onto dot.com stocks until it was “too late” between 2000-2002 and the folks who kept their ‘bank’ stocks during the worst of it in 2008, I would have a nice tidy sum of money. The story was always the same. Initially, they didn’t want to sell it and pay the tax. Then, they figured they had already lost so much money, on paper, they might as well hold onto it in the hope ‘it would come back.’ Some did and others didn’t.

A perfect example is the gentleman a co-worker of mine went to visit in Atlanta back when I was with another employer at the very start of 2000, the first week in January. His tech company had recently gone public, and his private banker invited us over to explore hedging options for him and his $25-30 million worth of stock and options. Since it was a new, small company, an exchange fund probably wasn’t an option, scratch the probably. Further, a derivatives market didn’t exist. So, buying a whole bunch of puts wasn’t an alternative; not that he had the cash to do so in any event. He was company stock rich, and that is about it.

What to do? Well, we had studied the company and had a pretty firm suspicion there wasn’t anything to it. There was NO way it would ever grow into its valuation with its business model and primary products. There were too few of the latter and not enough potential clients, period. It was a very finite target market. I forget the specific numbers, but it was losing something like $2.0 million on $1.0 million in revenue. However, it still had a market capitalization approaching $2-3 billion, if not more.

It was a completely ridiculous situation.

So, we recommended he sell as many shares and cash out as many options as he could as soon as he could. At the time, it was trading around $20/share, or thereabouts, and he looked at us like we had a 3rd eye in the middle of our forehead. Naw, he was visibly angry with us, as was his private banker (technically our co-worker). What kind of advice is paying, quite literally, millions of dollars in tax? If the dull memory serves, our advice would have netted him something like $8-9 million, with a tax bill of between $3-4 million (he couldn’t do all of it for legal reasons). Had we lost our blankety-blank minds? Who makes such a preposterous recommendation? Pay the government $3-4 million dollars? Brother, he was indignant

While he didn’t physically throw us out of his office, the meeting was over pretty soon thereafter, as in about 5 minutes. Unfortunately for the guy, so was his fortune. By the end of the year, the stock was trading at $0.66. I mean, it turned over fast, going from $22 on 1/7/2000 to about $6 on 6/30, then $2 at the end of 3Q 2000. Brother.

While the company never went completely under, it was touch & go for long years, before selling to another company for $1.85 in 2008. At worst, he would have been around $6 million better off had he listened to what we said. According to the banker, which we called late in that year, he rode that bad boy all the way down. So much so, he was no longer even a prospect for the bank. Craziness.

I am certain you can think of other examples, and I have digressed mightily this afternoon.

In the end, this week largely went as anticipated, with the possible exception of Amazon’s earnings release and Alphabet’s… to a lesser degree. However, I would stop short of calling either worrisome, at least at this time.

So, there you have it. The predictions can be  pretty vague by design, just as the explanations are boring for the same reason.

 

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