Step Forward, Step Back, Repeat

Step forward, step back, repeat.  Markets bounced about yesterday in a volatile session that ended in a mixed close for equities.  The start of the session saw long maturity treasury yields continue to slide with equities opening soft.  The situation quickly reversed itself as the treasuries stabilized themselves receding 10 year yields from their morning high of 3.25%.  Equities attempted a rally despite a pre-open earnings warning from materials supplier PPG Industries. The rally however was short lived as sellers came in pushing stocks into the red… and then it happened again… and again… and again.  Ultimately stocks closed mixed with technology stocks being the winners of the day.  By peeling back the surface it is evident that investors are somewhat fearful as they clamor to buy more defensive sectors such as utilities and consumer staples.  Hard hit sectors were ones which benefit from a strong economy such as materials and industrials.

The result of the move saw the S&P500 and the Dow Jones Industrials close slightly down and tech heavy NASDAQ 100 close slightly in the green.  The positive close for the NASDAQ kept the index from receding into the neutral zone, though its still on neutral watch.  The small cap Russell 2000 continued its struggle yesterday closing right on its 200 day simple moving average and just below a Fibonacci support line.  The 200 SMA is the final line of defense for the index and if we get a close below that, it would indicate a risk off signal.  That means “sell” to quant traders, many of whom use the moving average to trigger selling (though they will have you believe that they have a more complex model).  Adding to the woes of the index is its mid-term momentum, which is negative and trending down and is also a key signal for quant traders (see orange and blue lines in the bottom panel on chart 7 in my attached daily chartbook).

The positive in all of this is that the S&P and Dow remain constructive despite the undulations.  But it is important to note the changes in sector dynamics indicating that investors are perhaps taking a foot off of the accelerator.  With earnings season unofficially beginning this week, much focus will be placed on real corporate health, which will ultimately set the pace for the final quarter.  Investors will look carefully for EPS (earnings per share) growth and quality seeking early warning signs of weakness.  Because it is geek-out Wednesday on the beginning of earnings season, I thought a quick primer on EPS would be in order.

Earnings per share, or EPS, is perhaps one of the most quoted indicators of a company’s health for many good reasons, the least of which being that its a critical input in share price and other key value metrics such as the P/E ratio.  EPS is the amount of earnings attributed to each share of outstanding common stock and is calculated simply as follows:

EPS = Net Income / Outstanding Shares of Common stock

The Net Income can be found on the Income Statement and the outstanding shares of common stock can be found on a companies Balance Sheet.  So it is a simple calculation and its inputs can be easily found on publicly available financial statements.  Simple right?  Of course that is a trick question, so don’t answer it until we are finished.  As you might guess, there are different types of EPS and one of the most common alternatives is the diluted earnings per share which accounts for not only outstanding common stocks, but also warrants, stock options, or restricted stock units. These are instruments which can be converted into common stock, thus increasing the total number of outstanding stock.  The result of the conversion would be a “dilution” of earnings per share, hence the name.  There are many others, but these two, simple and diluted, are the most common.  Analysts and investors alike will look at EPS to determine a company’s health and profitability and while the actual number is important it is actually its quarter over quarter and year over year change that is of most interest.  So for example, PPG industries (mentioned in my opening paragraph), which is due to announce earnings next week is expected to report 3rd quarter earnings of $1.469 per share.

What investors really want to know, besides whether they miss or beat expectations, is whether EPS grew, how much it grew relative to its peers, what went into the earnings, and whether or not the earnings growth is sustainable.  The first one is easy – anything above the $1.469 would be considered a “beat”, which is a good thing.  Once we know the actual number we can determine its annual growth, which in the case of PPG would be a -2.4% year over year growth.  That growth, or in this case fall, is weaker than its industry peers which are expected to grow around +4.68% on average.  Not so good.  Now perhaps the most important thing investors will look for is the quality and sustainability of the earnings.  Let’s go back to basic accounting for a second.  Earnings is calculated as follows:

Revenue – Cost of Goods = Gross Margin
Gross Margin – Operating Expenses – Taxes = Net Income (aka earnings)

In the case of PPG, cost of goods would include the costs of raw materials used to make the products they sell.  So unintended increases in costs of raw materials would decrease the company’s gross margin.  PPG produces paints and industrial coatings that rely on petroleum products which have gone up in price with the rising price of oil.  The ultimate result is a decrease in Gross Margin and ultimately Net Income.  Now on to expenses.  Some expenses can be controlled by the company and some can’t.  They can lay off workers and decrease their employment costs but a tightening labor market and rises in wages would certainly increase the company’s expenses.  Additionally, the company relies on logistics (shipping and warehousing) to move materials and final products.  Rising fuel costs and logistics slowdowns associated with the ongoing trade disputes causes logistic expenses to go up.  The ultimate result would be a decrease of… you guessed it, earnings.  PPG announced yesterday that its earnings will be softer for the quarter as a result of those very two things: raw materials and logistics expenses.  The result:  the stock traded down 10% in yesterday’s trading helping to pull down the whole materials sector by 3.3%.  So understanding earnings and EPS is important.  The S&P500 earnings are expected to grow by 21% for the 3rd quarter, slightly slower than the 23% from last quarter, which is still quite good.  Well, it is estimated that 10% of those earnings are a result of last years tax package, so it will be important to look further into the constituents of those earnings before we jump to conclusions. And now you know just how to do that (or least how to start).

Today we get the producer price index which tracks prices paid by producers (like the one I just wrote about) and that is expected to grow at +2.7% year over year and +2.5% not including food and energy.  We will get earnings from industrial products manufacturer Fastenal (FAST) before the bell and investors will surely be wondering if PPG’s warning yesterday will also apply here.  A miss with FAST would only serve to further weaken the materials sector in the wake of yesterday’s trade.  Traders will also continue to take cues from the bond market which has somewhat stabilized and the ten year will start today’s session at 3.22%.  Expect another day of volatility as investors continue to contemplate the effects of higher interest rates.  Remember as interest rates go up, so does the cost of financing for companies and consumers.  For companies… interest is an expense.

daily chartbook 2018-10-10