TheChek News Flow

S&P pushes more US retailers deeper into junk

18% of retailers’ debt now rated ‘CCC’ or lower

Nearly one in five US retailers are now rated in deep junk territory by S&P — double that of the start of the year, as bankruptcies like Toys R Us have amplified concern over the industry in recent months.

About 18 per cent of US retailers’ debt is rated in the ‘CCC’ or lower category by rating agency S&P Global, with the agency in a new report listing “difficulty adapting to online retail” and “shifting consumer tastes” as the reasons behind the distress.

The S&P report comes after Toys R Us filed for bankruptcy last month, rattling the industry and raising questions about who is next. S&P warned that “the risk of further defaults and downgrades for retailers is high”, noting that Toys R Us “adds stress to an already distressed retail sector”. 

About 21 per cent of retail and restaurant companies are now on S&P’s “distressed” list, making it the most distressed US sector. Telecommunications was second, with 15.5 per cent. 

“Even a year ago, oil and gas companies dominated the distressed list,” says Dianne Vazza, analyst with S&P. “The big difference is oil and gas was clearly triggered by lows in commodity prices, and that was going to eventually steady in some way. But the retailing environment is not going to go back . . . these are permanent changes.”

The rise of online shopping has ravaged many traditional retailers, leading to an uptick in bankruptcies this year, particularly among companies which took on large debts in the years leading up to the 2008 financial crisis. 

Before Toys R Us, more than 20 US retailers had already filed for bankruptcy in the first half of the year, compared with 18 for all of 2016. The bankruptcies included companies like Gymboree, Payless and Aerosoles — with the accumulated liabilities of all retailers that filed for bankruptcy rising to over $5bn in aggregate, according to accountancy firm BDO. 

Enticed by the idea of a tax overhaul, investors pushed equities higher once again this week, sending the S&P 500 (+0.7%), the Nasdaq (+1.1%), and the small-cap Russell 2000 (+2.8%) to new record highs. The Dow lagged this week, but still managed to eke out a modest gain (+0.3%). The S&P 500 finished the third quarter with a gain of 4.0%.

Technology stocks weighed on the broader market on Monday as investors engaged in a sector rotation trade that left the S&P 500's technology sector lower by 1.4%. Technology names were weak from the jump, but selling accelerated following comments from North Korea's foreign minister, who said that President Trump effectively declared war against North Korea in his U.N. speech last week and, therefore, Pyongyang has the right to take countermeasures against the U.S.--including shooting down U.S. strategic bombers, even if they're not in North Korean airspace.

Investors turned their attention to Fed Chair Janet Yellen on Tuesday as she gave a speech entitled "Inflation, Uncertainty, and Monetary Policy" at the NABE's annual meeting. Ms. Yellen defended a gradual path of rate hikes despite continued uncertainty in the area of inflation, but her comments didn't move the financial markets; equities finished the session flat.

Things turned around for the equity market on Wednesday as investors cheered the GOP's tax reform outline, sending equities into positive territory for the week. Some of the most notable highlights of the plan include cutting the corporate tax rate to 20% from 35%, doubling the standard deduction, and reducing the number of tax brackets to three from seven. The plan calls for trimming the highest tax rate to 35.0% from 39.6%, but Congress will have the option to add a fourth bracket for the very top earners.

Details on how the government will make up for the immediate loss in tax revenue were limited. This topic will likely be an area of contention for the GOP going forward as many conservatives are opposed to the idea of driving up the federal deficit, which would probably be necessary to fund the tax overhaul--at least in the short term.

Market-moving headlines were scarce on Thursday, but that didn't prevent the S&P 500 from ticking up and registering a new record close. Roku (ROKU) opened for trading on the Nasdaq exchange on Thursday and had a solid first day, settling 67.9% above its IPO price of $14.00 per share.

Investors pushed stocks higher once again on Friday after the core PCE Price Index--the Fed's preferred gauge for inflation--for August came in below expectations, showing a month-over-month increase of 0.1% ( consensus +0.2%). On a year-over-year basis, the core PCE Price Index is up 1.3%, down from 1.4% in the prior reading, and still a ways below the Fed's target of 2.0%.

Still, the fed funds futures market projects that the next rate hike will occur at the December FOMC meeting with an implied probability of 77.9%, up from 72.8% last week.

- Iranian official says a joint military exercise between Iran's armed forces and units from the Iraqi army will be held in the coming days along the shared border. The exercises will take place at several crossings on Iran's border with Iraqi Kurdistan. 

5 Reasons to Doubt the Rally

Skeptics warn investors that developing markets still hold dangers.

Nothing succeeds like success, especially on Wall Street. A 27% surge this year in the major emerging markets index has brought out a flock of analysts to explain why the developing world is back to stay as an outperformer. Not everyone agrees, though. Before you jump on the bandwagon, it might be wise to consider these five die-hard emerging market bear arguments.

There Is No China Reform. As President Xi Jinping nears the end of his first five-year term, his promised structural changes have proved a nothing burger, says J.P. Smith, a former Deutsche Bank and Pictet emerging markets analyst who now runs Ecstrat, a political and global markets consultant in London. State-owned enterprises and the financial system that feeds them are as bloated and opaque as ever. “We’ve seen bailout after bailout, and the underlying debt system is very fragile,” says Smith.

Xi goosed China’s gross-domestic-product growth a bit with new government stimulus that is turning to tightening, adds David Donabedian, Baltimore-based chief investment officer at CIBC Atlantic Trust, which manages $40 billion in private wealth. China accounts for 29% of the global emerging markets index itself, and drags along smaller economies that sell it commodities. So a downturn there would rock the whole asset class.

The Dollar Has Hit Bottom. Impotence in Washington has driven the greenback’s trade-weighted value down more than 8% this year, creating a bonanza for ex-U.S. investments. But it may steady or rebound from here. The Federal Reserve had a muscular Sept. 20 meeting, reiterating tightening pledges and committing at last to balance-sheet reduction. The euro’s short-lived luster meanwhile faded, thanks to Angela Merkel’s underperformance in German elections. “[Emmanuel] Macron’s victory in France revived talk of a more cohesive euro zone, but that isn’t going to happen after Germany,” Smith says. The dollar gains by default as a global safe-harbor currency.

Low Valuations Are an Illusion. The average trailing price/earnings ratio for the MSCI Emerging Markets Index is still less than 16, compared with 25 for the Standard & Poor’s 500 index of U.S. stocks. But for many of the state-owned whales that dominate emerging markets—think Chinese banks or Russian oil companies—“there is no reason to believe the E,” Donabedian says. More-transparent private-sector companies that are firmly linked to the great middle-class growth story already trade at P/Es above 20, he notes.

Governance Still Stinks. Emerging market governments have made impressive strides on macro fiscal and monetary policy—arguably more impressive than their highly developed brethren. But corporate governance often remains a black hole down which investors throw their money and hope for the best. “Everybody likes to talk about high-quality emerging market companies, but there may be, like, two of them,” says Richard Bernstein, who runs his own investment advisory and made a prescient bear call in Barron’s in 2011. Bernstein is tactically overweight on emerging markets “as a cyclical beta play on global profit acceleration.” But he rejects arguments that they’ve improved structurally.

India Can’t Do It Alone. Even bears are more hopeful for Narendra Modi’s India than for its fellow BRICs (Brazil, Russia, and China). But Indian equities make up less than 9% of the global emerging markets index, not enough to bolster the asset class against a broad sentiment shift. And Mumbai markets are already “priced for perfection,” Donabedian says, a term that seems out of place in a chaotic nation of 1.2 billion.

Watch Out, Tesla. The Competition is Gaining

One analyst believes electric cars will be cheaper than traditional cars by the early to mid-2020s—and that could spur rivals.

It turns out that cleaning up traditional cars is an expensive proposition.

At its investor day last week, auto-parts maker Delphi Automotive (ticker: DLPH) estimated it would cost $3,000 to $4,000 per car to achieve the reductions in carbon dioxide mandated by governments around the world. Cowen analyst Jeffrey Osborne notes that on average, global regulators are seeking to reduce automotive CO 2 emissions 30% to 40% by 2025.

The end result is likely to be more-expensive gasoline cars, one more boon for the electric-vehicle market.

Electric vehicles currently sell for about $8,000 more than gas guzzlers, but Osborne believes they will be cheaper than traditional cars by the early to mid-2020s. “That’s driven by two colliding powers, which is that battery costs are falling, and internal combustion engines have to become cleaner,” he tells Barron’s.

That could mean that Tesla’s (TSLA) new, cheaper Model 3 ultimately looks even less expensive than its $35,000 price tag, since the traditional gas alternatives are likely to rise in cost. The company is the global leader in electric-vehicle sales, with an estimated 11% market share, and Osborne sees that rising in the next two years, given that the Model 3 is about half the price of Tesla’s signature Model S.

But he also cautions that the increasing affordability of electric vehicles isn’t all good news for Tesla, as there’s now more incentive for rivals to take the space seriously.

“We see the competitive tides shifting in 2019 and beyond as European [car makers], roiled by the diesel scandal and loss of share to Tesla in the high-margin luxury segment, step on the gas and accelerate the pace of electric-vehicle introductions,” Osborne wrote in his update to clients last week.

TESLA HAS GOTTEN USED to having the luxury electric-vehicle market largely to itself, helped by the fact that BMW, General Motors, and Nissan have imbued their electric cars with eccentricities that have undermined sales.

A turning point could be coming. Audi is planning three new electric cars over the next three years. Eventually traditional car makers will start electrifying their existing fleets, much like they did when they added hybrid options. That means more-attractive vehicles to challenge the Model 3.

Although Tesla cars are spiffy, Osborne argues that “a significant amount of the purchase price of a Tesla comes through vanity,” whereas luxury rivals “have spent years perfecting the interior of their vehicles.” Tesla cut the cost of the Model 3 by creating a no-frills interior. That’s an opening for the traditional car makers, who know something about bells and whistles.

Bears, Return to Your Caves—at Least for Now

High valuations alone don’t cause bear markets. There must be other factors, too. And the biggest concerns probably won’t arise in 2017.

This old bull market, the second longest in history, continues to be mocked, doubted, and just plain vilified. OK, the last is an exaggeration, but investor euphoria is absent, even as stocks hit new highs after new highs in September. Instead, investor sentiment is neutral at best, not the kind of thing that dispatches an aging bull.

One measure of skepticism is that short sellers are back in force. According to IHS Markit, a market data and analytics research firm, average shorting across Standard & Poor’s 500 index constituents stands at 2.7%, the highest level since before last year’s elections.

Meanwhile, institutional investors are “tormented bulls,” David Kostin wrote in a recent report. The Goldman Sachs chief U.S. equity strategist noted that equity mutual funds hold 3.2% of their assets in cash, not much different from the five-year average of 3.5%. Big investors, then, don’t appear overinvested financially or emotionally.

And what of Joe Six Pack? The individual investor is not high on stocks and hasn’t been all year. According to the most recent weekly survey from the American Association of Individual Investors, some 33% of respondents describe their short-term outlook as bullish, below the 38.5% average. It has been that way for nearly the entire year. Pessimism actually increased slightly in the latest survey.

WORRIES ABOUT A BEAR MARKET or significant correction in the fourth quarter seem misplaced. Here’s why.

U.S. economic growth is accelerating and continues to come in better than expected, a bracing factor for stocks, says Keith McCullough, CEO of Hedgeye Risk Management, an independent research firm. Moreover, the third quarter should prove to be another strong profits season, he adds. Earnings reporting begins in mid-October, and the consensus sees a 6% rise in S&P 500 earnings per share, but we’re guessing many companies will beat analysts’ estimates.

History doesn’t always repeat itself, but it’s often instructive. In the final quarter of a year in which the market made highs in September—statistically the market’s worst-performing month—stocks have typically finished with flair.

Since 1928, there have been 29 Septembers in which the S&P 500 made a 12-month high. Following those 29 instances, the market rose over 80% of the time in the fourth quarter, averaging a 3.7% increase, says Doug Ramsey, chief investment officer of the Leuthold Group. Better still, 15 of those 29 September price highs were also accompanied by 12-month advance/decline line highs—as is the case now. Stocks increased an average 5.9% in the fourth quarter in those 15 instances.

The sustainability of a new high is related to its underlying technical, monetary, and economic underpinnings, Ramsey says. “We expect higher highs in the fourth quarter,” he adds.

WHERE CAN THIS GO WRONG? We don’t pretend to foresee black swans, which, by definition, are unpredictable. So take your pick of unlikely but not-impossible scenarios. A hot war in North Korea, or worse? Tax reform goes the way of “repeal and replace”? Federal Reserve Chair Janet Yellen suddenly wakes up one day from a fever dream and abandons the Fed’s gradualist approach to raising interest rates?

There are two likelier possibilities we worry about. Exchange-traded fund assets have grown exponentially in size in the past five years, and these passive investments have never been battle-tested by panicked selling. What if ETF investors begin to abandon their shares in reaction to a run-of-the-mill market correction? Perhaps that turns into a nasty rout, as ETFs are forced to dump stocks, too, potentially initiating a vicious cycle of stock selling.

Another concern is a potential slackening in corporate share buybacks. It’s not well recognized, but share repurchases over the past five years—much of them fueled by borrowing at artificially low interest rates—have been an important boost to stock prices. For now, this activity is likely to continue because interest rates—even as they inch higher—remain low enough that taking on debt to buy back stock is still an effective way for managements to juice EPS growth.

According to a recent report from Ned Davis Research, nonfinancial companies have been “huge stock buyers consistently.” Their $2.3 trillion of liquidity suggests there is “great potential [for companies] to continue to buy back stocks, or spend on capital improvements.” At some point this might stop, but no one knows when.

What about those high stock market valuations, you ask? Isn’t that troubling? The S&P 500 trades at about 19 times consensus estimates of $131.38 this year, according to Thomson Reuters. That’s above the market’s long-term average of about 15. Not cheap. We get it.

Yet high valuations alone don’t cause bear markets. There must be a factor change, such as—but not limited to—some of those described above. To convince investors tomorrow that a 19 market multiple is too expensive when it isn’t today, there needs to be a material and decisive shift to the negative. A fourth-quarter rally isn’t a lock, but absent a big change in economic and monetary conditions, the bear case isn’t strong.

Bear markets are generally caused by recessions. The evidence for that anytime soon is weak. We’re neither Pollyannas nor Cassandras. The bull will die, but probably not in the fourth quarter. The holiday season should be a good one for equity investors.

Tech Giants Play the Game of Thrones

Serial entrepreneur and NYU marketing professor Scott Galloway talks about the dominance of Alphabet, Apple, Facebook, and Amazon.

Chimps, babies, Taylor Swift—these are common subjects of viral YouTube videos. Marketing professors, not so much. Yet New York University’s Scott Galloway has racked up millions of views talking about brands, big tech, and who’s disrupting whom. Part of the appeal is his deadpan delivery of peppery one-liners. Google Glass, the head-mounted display shaped like eyeglasses, isn’t a wearable, he once told a conference: “It’s a prophylactic, ensuring you will not conceive a child, as no one will get near you.” But the former Morgan Stanley bond analyst and serial entrepreneur, who runs a business-intelligence firm called L2 when he isn’t teaching, also has a reputation for prescience. “I can’t imagine why they wouldn’t buy Whole Foods Market,” he said of Amazon.com (ticker: AMZN) in a June interview. Five days later, Amazon announced the deal.

Barron’s recently sat down with Galloway to discuss the rising power of America’s tech giants, which he writes about in a new book, The Four: The Hidden DNA of Amazon, Apple, Facebook, and Google. Our talk has been edited for space and clarity. Videos of the full conversation are available at Barrons.com.

Barron’s: Let’s start with “Amazon the Destroyer,” as you call it. You say Amazon’s core competency is storytelling. What do you mean by that?

Galloway: Despite the fact that this company hasn’t always been profitable, and has hit certain bumps in the road, whether it’s their phone or attempts at auctions, the market keeps bidding the stock up. As a result, Amazon plays by a different set of rules. It has replaced profits with vision and growth. Typically, tomorrow at some point has to become today in terms of investors’ patience, but we’ve never seen a company with access to capital this cheap in the history of modern business. Amazon can now borrow at a lower rate than China.

I believe that every time Amazon makes a mistake and becomes profitable one quarter, Chief Executive Jeff Bezos calls his management team into a room and says, “You screwed up. Greenlight everything.” That’s because they’ve changed the compact with the markets through storytelling. They have never got the markets used to the crack cocaine of profits, because once you go profitable, you take that crack cocaine back away from the addict and he or she—the market—gets very irritable. Amazon never fell into that trap, with amazing storytelling.

What’s next for Amazon that we’re not watching?

Going right after Netflix [NFLX]. There is talk of their acquiring some television networks to get scale and content quickly and fill in some niches, because those assets have been beaten down from a valuation standpoint and Amazon has the ability to monetize them. Not just with advertising, because if they create more intensity across their Prime relationships, which are now 60% of U.S. households, then they can sell more stuff to them.

There are about 1.3 billion self-identified Catholics. There are 1.4 billion Chinese. If you look at the number of people who adhere to some form of capitalism, it doesn’t get near the two billion people who have a meaningful relationship with Facebook. It is bigger than communism, capitalism, the Kardashians. It is the most successful thing in the history of mankind if you look at the intensity of the relationship across Facebook and Facebook-owned properties.

That was all of the Kardashians together?

All of them, yeah.

If it’s that big, where does it go from here? Where does it find growth?

Facebook has pulled off this incredible hat trick with what is arguably the best acquisition in technology in the past 20 years, and that’s Instagram. At the time, people were saying that the child-CEO has really screwed up here and paid $1 billion for a company with only 19 people. By most standards, if you try to value Instagram now, it’s probably worth somewhere between $60 billion and $150 billion. So it has put an afterburner effect on the company, as has likely WhatsApp. They keep finding growth.

Where do you come down on the issue of Facebook, fake news, and the presidential election?

This could be, if they handle it poorly, the moment Facebook goes into structural decline. I don’t think they are owning up to the fact that they are a media company. You produce content. You run advertising against it. You have large influence over society. Boom, congratulations. You’re a media company. The fourth estate has extraordinary influence and, with that, some responsibilities. Facebook seems to be comfortable with the former, not the latter.

It looks as if Facebook has been co-opted rather cheaply by Russians. And the notion that they can’t put in place safeguards to check this, such as when an advertising account is paid in rubles? I mean, that is literally a red flag. So they need to get out in front of this issue. Martha Stewart wasn’t put in prison for insider trading. She was put in prison for denying the issue.

Now, Google. You talk about it in religious terms.

I believe Google is a modern man’s god. Our species throughout time has needed a superbeing to fill in gaps around huge questions we are unable to answer. However, as a society becomes more affluent and educated, church attendance goes down. So we have this void. Google has filled that void. If we were to look at everything you have ever put in that search query box, we would probably come to the conclusion that you trust Google more than any priest, rabbi, boss, mentor, coach, professor. If something goes wrong with your kid, your whole world stops. You start praying and you look for some sort of divine intervention that sees everything and then sends you back an answer. Will my kid be all right? So you type “symptoms and treatment of croup” into Google. We trust Google more than any other entity. It is our god.

Google’s parent, Alphabet, also owns YouTube. Now Facebook wants to do more video. How does this competition shake out, and what does it mean for television?

Facebook, by virtue of its huge audience, is immediately a player overnight. These two can peacefully co-exist. The bleeding carcass of traditional broadcast advertising is so big. TV advertising in the U.S. is $60 billion. There is enough baffled prey for both of them to go after. It is bad news for broadcast media. I believe we are experiencing the death of the advertising-industrial complex. The last firewall of broadcast TV was sports, and when you look at how sports viewership is aging—you are soon going to see the deeper-pocketed Amazon, Apple, Facebook, or Google go after and get the World Cup or the Super Bowl—it is just bad news for any ad-supported media.

Let’s talk about Apple [AAPL]. You have a slide that you show where you have various body parts. Google is the brain, because that’s where people go to ask things. Facebook is the heart, because people keep their relationships there. Amazon is the stomach because it’s all about consumption. Apple is the private parts. What’s the connection?

Apple draws on the second most powerful instinct behind survival—procreation. The luxury industry has created more wealth in the past 20 years than any other industry with the exception, I think, of finance, and this taps into our need to procreate, our need to feel more attractive to the other sex. The watch you are wearing isn’t a timepiece. It’s an attempt to signal to people that, if they mate with you, their kids are more likely to survive than if they mate with someone who’s wearing a Swatch.

Apple is the new signal of wealth, of creativity, and that you’re part of the innovation class, and that you have better genes. The price premium is irrational, but we’re willing to pay a lot of money to seem more attractive to other people. So, it’s kind of the opposite of having ad-supported Pandora or paying with a Discover card, which I think says to potential mates you have bad genes. I think this is the way you say mate with me. If you have an iPhone, it means you come from a wealthier household and will pay a $1,000 for a phone you can get for $200 elsewhere.

You have a part in the book where you talk about what Apple should do with its cash. You say start a college.

The way you identify an industry ripe for disruption is you look at whether the price increases are greater than inflation and justified with underlying innovation. The one industry that is most ripe for disruption is education. I think Apple’s roots in education give it unbelievable license to go into that business. I mean, my class generates $160,000 in tuition for each night I teach. They don’t pay me that much. My agent, NYU, takes a 97% commission on that. But when you think about that, it’s ridiculous, and it has some very negative outcomes for our society in the form of debt on young people. So what could Apple do to really change their role and to think different? Start the largest creatively driven low-cost university in the world.

Let’s play Game of Thrones. These are four impressive companies, but they can’t all be the best in everything they do, and increasingly, they are starting to compete against one another. Who’s going to come out on top?

So, who ascends to the Iron Throne, if you will? Right now, the good money is on Amazon. Where the others are bumping up against Amazon, they are losing. In search, you think of Google. That’s their domain. But in terms of product searches, Amazon’s share went up from 44% in 2015 to 55% in 2016. Some people would argue that Amazon is becoming a search engine with a warehouse attached to it. In hardware, Apple has given up a lead in voice with Siri, which is now getting the crap kicked out of it by the buttery voice of Alexa. The most innovative hardware product of 2015 and 2016 wasn’t the Apple Watch. It was Amazon’s Echo.

If you look at trying to garner digital marketing dollars from the corporate world, Amazon’s media group is now growing faster than Facebook or Google. A billion and a half dollars in revenue last year—triple the size of Snapchat, creeping up on Twitter. The most profitable, fastest-growing business in tech is the cloud. Who is No. 1? Amazon. The infrastructure, the moats, the momentum. It was No. 7 in video streaming in 2015, and now it’s No. 3, going after Apple iTunes and Netflix. This company is just going everywhere and swallowing industries whole.

Does Amazon become so powerful at some point that government has to step in and break it up?

I believe it will, unless Amazon spins off its web-services business first. One of the four—or all of them—is going to have regulatory intervention because the worm has turned on big tech. The left doesn’t like them because of job destruction and because it looks as if elections were circumvented. The right doesn’t like them because they don’t feel like they have a seat at the table of this new kind of political leadership. So you are going to see one of these companies come under attack, and it could be any of the four.

Margrethe Vestager, the commissioner on competition in the European Union, seems to be the only regulator in the world who is levying real fines against these people. You are going to see the first $10 billion-plus fine against one of these four companies in the next 12 months, and it is going to come out of Europe. The real estate isn’t going up in Hamburg. It’s going up in Palo Alto. America gets a lot of the benefits of these four companies, with some of the downside. Europe gets all of the downside and not much upside. The war is going to start, as it has throughout history, on the continent of Europe.

Thanks, Scott.

The Volatility Paradox

Everywhere you look, someone is saying that volatility is too low. But what if it isn’t low enough?