April 2017 – Monthly Commentary
Last month the Commerce Department reported that the U.S. economy expanded at a 0.7% annualized rate, below consensus forecast of 1.0%. Much was made in the media that such anemic growth is an indication that the economy is at risk of tipping into recession. It seems like that proclamation is made this time every year. At first glance the outcome was disappointing, but we caution readers not to place too much credence in the report for a number of reasons. First, the initial report is an estimate that only captures a very small percentage of actual activity, with the balance based on assumptions. Moreover, both the activity they have in hand and the activity that has yet to be tallied are subject to revisions. Given the massive size of the U.S. economy, it takes a very long time to tally economic activity which means that GDP itself is revised numerous times before it is finalized. Therefore, the first look at GDP is not much more than a hunch.
The second problem is the manner in which GDP is reported in the media. The standard is sequentially, on an annualized basis. That means that we’re comparing first quarter economic activity, which is usually dampened by cold, snowy weather with fourth quarter activity, which is packed full of holiday gift giving, entertaining, and feasting. The two periods are not comparable from an economic perspective. But, undeterred, the Commerce Department attempts to adjust the disparately differing periods by seasonally adjusting activity. In essence they assume that economic activity is more robust in the first quarter than it actually is, then compare it to the fourth quarter. That makes no sense whatsoever! We think a more logical way of comparing the period is to compare activity to the same quarter of the previous year. On that basis, Q1 GDP rose 1.9%, more than twice as fast the headline would suggest.
Looking past GDP, we have been pleasantly surprised by earnings for the first quarter. Since the collapse in energy prices several years ago, aggregate earnings have been pulled lower as the bottom fell out of energy producer’s profits and the spillover effect that had on banks and lenders. At the time of this writing, 90% of companies in the S&P 500 have reported, and the average operating margin of the index has topped 10% for the first time since 2014. Moreover, the percentage of companies beating their estimate was in excess of 73%, while the percentage of companies missing their estimate fell to 18.8%. To be sure, CEO’s often play the game of low balling estimates so that they can claim a beat when they report. Nonetheless, the estimated aggregated earnings, based on companies reporting to date is $28.09, up sharply from the $21.72 recorded in q1 2016.
On the back of the better than expected earnings and the S&P 500 setting all time record highs, the VIX index traded down to a level not seen since 2006. The VIX is the weighted average implied volatility of a number of strike prices on the S&P 500 across several nearby expirations. To clarify, implied volatility is a component of an option price that is an estimate of the annualized standard deviation of the underlying security. In this case, the VIX is the implied volatility of the S&P 500. Quite often the uninitiated refer to the VIX as the fear gauge. While we are not fond of the term as it oversimplifies the information imbedded in implied volatility. But in this current market environment we view the very low VIX as an indicator that investors are complacent about the downside risks to the stock market. The message is that with the S&P 500 pushing to record highs and VIX trading close to record lows, now may be the time to protect portfolio gains with put options.