CWS Market Review – July 12, 2022

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Earnings Season Is Here

Earnings season is finally here. This morning, Pepsi (PEP) kicked off Q2 earnings season when it reported profits of $1.86 per share. That was 12 cents better than estimates. I hope this a positive omen for the rest of earnings season. Overall, we’re looking at about 5% earnings growth for this season. That’s not bad.

Like a lot of defensive stocks, shares of Pepsi haven’t been doing especially well, but they look very good when compared with the rest of the market. After all, folks generally don’t cut back on their Doritos budget just because the economy gets a little weak.

I don’t think what a soda/snack food company has to say is particularly indicative of the overall economy. However, I noticed how well Pepsi is managing itself in an inflationary environment. So far, Pepsi has been able to pass along price increases to consumers. Much of that is probably due to Pepsi’s brand name, but I don’t think many other companies are in such a position.

But it’s not just the name. Pepsi also noted that it’s working hard to cut costs internally to ensure its prices remain competitive. In fact, Pepsi has been able to increase its margins slightly this year. That says a lot about the efficiency of their operations. Pepsi also raised its revenue guidance this year. This is the second quarter in a row that Pepsi has increased its revenue guidance.

How Inflation Distorts Earnings

A big part of the increase in revenues is due to passing along higher costs. When looking at a company, we want to make sure it’s increasing its sales volume as well.

I bring these issues up because the issue of inflation is a unique challenge to business and to us as investors as well. To give you an example, let’s say you run a manufacturing company. Your company buys its raw materials at Time X. It processes its parts at Time Y. It then sells its finished goods at Time Z.

The distance between those three time points can be quite large, and if inflation is high enough, it will distort your actual profitability. Initially, inflation can give you the illusion of efficiency even when that’s not the case.

Investors should understand that not all earnings are the same, and inflation exacts a heavy toll on asset-heavy businesses. Companies with high assets relative to their profits tend to report ersatz earnings.

Inflation also benefits the borrower at the expense of the lender. The cost of inflation falls heavily on lower-income consumers and people on a fixed-income. Inflation is almost like putting a magnet near a company—it messes up all the normal readings.

Tomorrow we’ll get the CPI report for June, and it will probably be another unduly large one. The White House even conceded that it will be “highly elevated.” The CPI is heavily influenced by the rental market and those numbers could distort the actual rate of inflation. We also know that the rate of inflation falls heavier on low-income folks. For tomorrow, Wall Street expects the 12-month inflation rate to hit 8.8%. That would be another 40-year record.

Unfortunately, the Federal Reserve doesn’t have a strong track record of fighting inflation without severely harming the economy. I don’t want to speak too soon, but there may be some early indications that inflation could be cooling off. Gasoline prices, for example, have started to ease. The price for oil fell 8% on Tuesday.

The prices for other commodities like copper are also down. Copper is known to be a bellwether for other commodities. It’s down so much that it’s hurting the national economy. The Chilean peso is down over 15% in the last month.

Check out the slide in copper:

That’s not the only currency that’s getting knocked around. Earlier today, the U.S. dollar and euro reached parity for the first time since December 2002. The eurozone faces a severe energy crisis as Russia is threatening to further reduce its energy supplies. This could be an expensive winter for many German families.

The early part of earnings season is usually dominated by the big banks. JPMorgan (JPM) and Morgan Stanley (MS) are due to report on Thursday, followed by Wells Fargo (WFC), Citigroup (C), Bank of New York Mellon (BK) and BlackRock (BLK) on Friday.

Overall, the financial sector has been pretty weak this year. In February, the S&P 500 Financial Index ETF (XLF) got to $41 per share. Recently, it’s dipped below $31 per share. Not surprisingly, earnings are under pressure as well. For Q2, the financial sector is expected to see an earnings drop of 22% compared with last year’s Q2.

Our Buy List stocks will start reporting next week. Abbott Labs (ABT) is due to report on July 20. Wall Street currently expects earnings of $1.11 per share. The next day, Danaher (DHR) will report. The consensus on Wall Street is for earnings of $2.36 per share. I’m expecting earnings beats from both.

I write a lot about the yield curve, and one of the reasons is that financial stocks tend to have a close relationship with the spread between different maturities. Financial stocks have been lagging as the spread between the 2- and 10-year Treasuries reached its lowest point in 15 years.

On Tuesday, the 2/10 Spread got to -0.12%. I should caution you that an inverted yield curve can precede a recession by several months. I’ll give you an example. Near the turn of the millennium, we had a fairly mild recession, and the 2/10 served as an early warning sign, but it took some time. The 2/10 Spread turned negative in February 2000. The recession didn’t officially begin for more than a year. During the financial crisis, the 2/10 Spread went negative two full years before the economy started to wobble. The 2/10 Spread is good but not very timely.

Why does the 2/10 Spread seem to work? That’s hard to say, but it’s probably because the two-year yield is the best indicator of Fed policy while the 10-year yield is a good indicator for economic growth. It’s the intersection of these two that can be so important.

Musk Dumps Twitter

If you think the stock market is having a tough year, be glad you aren’t an investor in the crypto hedge fund, Three Arrows Capital. The fund went kablooey last month. This was a knock-on effect of the stablecoin, TerraUSD, also going kablooey.

That’s a common story in these kinds of things. It’s one thing when a single firm goes under, but soon you learn who was also exposed to that firm. Already, one digital asset broker had to file for bankruptcy because Three Arrows couldn’t pay them. Everything gets so interconnected that you’re never sure who is tied to what.

The Three Arrows Capital story gets more interesting as the founders have apparently disappeared. Or maybe not. No one’s really sure at this point. In court papers, the creditors allege that the founders aren’t cooperating and that their whereabouts are unknown.

Not so fast. Today, one of the founders dramatically reemerged—or at least his Twitter account did—and he denounced the creditors as baiting. In March, Three Arrows was managing $10 billion. Now it’s all gone.

I can’t leave without giving you an update on Elon Musk and Twitter. Shares of Twitter (TWTR) dropped 11% on Monday after Elon Musk called the merger deal off. It’s hard to say this was a huge surprise since shares of TWTR have drifted pretty far from Musk’s offer price of $52.20 per share.

After the market closed, Twitter officially said it’s suing Musk to force him to go along with the agreed-upon deal. Hmm. I’m skeptical such a legal case can win. That is, forcing Musk to buy a company he doesn’t want to own even though he signed an agreement.

Musk claims that Twitter hasn’t been honest about its spam and bot problem. This strikes me as a highly convenient and timely excuse. Everyone knows about Twitter’s bot problem.

I’m still surprised that Twitter took Musk’s offer so seriously. The price was certainly good but it’s highly speculative to think Musk would have stayed with it.

There’s also a $1 billion termination fee in play. According to the agreement, either side would have to pay if it backed off. My guess is that Musk will eventually pay a watered-down fee to Twitter. I know Twitter will argue its case that the buyout must continue, but I doubt a judge would sign off on that.

I’ll quote myself from this newsletter from last month:

I think it’s clear that Musk wants out of the deal and he’s using this as a convenient excuse. This is speculation on my part, but I suspect that Twitter employed an investment banker to give them an honest assessment of Twitter’s true value, and the answer they provided was very low. As a result, Twitter saw Musk’s offer as a great deal. Bear in mind that Musk has said that “having a public platform that is maximally trusted and broadly inclusive is extremely important to the future of civilization.”

I think Musk enjoyed the fun of making the Twitter execs and employees nervous. He’s got a 12-digit fortune, so why not have some fun? Plus, he has a valid point that Twitter’s banning policies seem arbitrary.

If both sides take the matter to court, then it may not turn out well for Musk. According to the deal, Twitter is allowed to sue and force the acquisition. That is, assuming Musk’s financing remains in place.

You’ll notice that there tends to be a big difference between what Musk tweets and what his lawyers say in official documents submitted to the SEC.

This deal isn’t going to happen and Twitter shareholders will lose out. On the plus side, a small number of lawyers were very well-paid.

Adding to the drama is that Twitter will report earnings later this month. Or rather, the lack thereof. No matter how you look at the issue, you can never get away from the fact that Twitter simply isn’t that profitable.

Wall Street expects Twitter to report earnings of 15 cents per share. That’s down from 20 cents per share for last year’s Q2.

There’s even a conspiracy theory that Musk engineered all this so he could sell off his Tesla (TSLA) stock without drawing too many questions. Interesting theory, but call me a doubter.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. I’m going to be a guest on AlphaNooner this Thursday at noon ET. You can see it live at the AdvisorShares twitter feed. Please join us!

Posted by on July 12th, 2022 at 7:24 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.