It drives me crazy when I see people writing about growth in a company’s EPS without knowing what is driving that growth.

That one specific number cannot be your sole reason to buy or sell a stock! WHAT DRIVES EPS is so much more important than the actual number itself.

For example, cutting costs can drive EPS – that is until there’s no more costs to cut. EPS can also be manipulated via things like inventory levels (see GMCR) or gains and losses from assets/subsidiary holdings. It does not necessarily tell you the strength of the underlying & continuing business operations.

However, when you look at what is driving a company’s EPS – the trends in revenues, costs, margins, leverage etc. – you will be able to build a much more robust & accurate thesis by understanding the company’s core business.

(Although the blog is called MICROfundy, and I plan to write about many companies using this type of analysis; on this post, I will focus on the MACRO a bit.)

During QE(1) the market rose considerably (especially after the purchases were expanded in March 2009). Similarly, after QE2 was hinted at during the notorious Jackson Hole meeting in Aug 2010, over the following several months, the S&P rose approximately 30%.

To me, instead of focusing on the rise or decline of the overall market, I like to focus on the INTERNALS of the market. WHAT DROVE the market up or down. During both of these timeframes the market was considered to be in “risk on” mode, meaning higher beta / more risky names led the market. There was considerable outperformance by cyclical & economic sensitive names. I believe this was due to the belief that QE will “work” – lower borrowing costs was supposed to stimulate the economy. (How naive we were!)

While some things haven’t changed (we’re still in a ZIRP world), the internals of the market – showing what’s leading these QE based market rallies – have.  Even in the tail end of QE2, it seems people started realizing that it wasn’t leading to sustainable growth, it was more akin to beating EPS via cost cutting. Look at 2011 as a whole, it was a year led higher by high yielding blue chips that keep on becoming more attractive the lower interest rates get.

In other words, while there are many byproducts of QE, (it is still creating a wealth effect, and (I believe) it will accomplish inflating “away” some of our debts, but) the key goal of getting the economy back on track seems to have failed. This is quite disturbing.

This is the story the internals are telling. Back in QE1 & (the beginning of) QE2, we HAD faith that all the easing that’s going on around the world will actually stimulate the economy. Therefore cyclical names led. Once we realized that it was all an unfortunate pipe dream, we still had QE based rallies, but the driver of those rallies were names that benefited – not from a stronger economy – but from lower yields!

Look at Jan-Mar 2012 – There was a major economic recovery “head fake”. We had lots of positive economic data points that showed some large upside surprises, and the markets responded by catapulting up over 10% in just the first couple of months of the year (the best start to a year since 1991)! But look at those high yielding blue chips, they were actually DOWN in that same time frame! “Risk on” was in full force – not because of QE this time – rather because of good economic data.

(In the following two charts I used XLB & XLI (Materials & Industrials) to represent the cyclical / higher beta names vs XLU & XLP (Utilities & Staples) to represent the High Yielding (low beta) blue chips.)

When the data started disappointing in Mar-Apr 2012, these “risk on” names lost some, and in some cases all of the gains for the year. But since we were still in middle of Operation Twist (& continuing speculation of QE3), rates were hitting new all time lows, so high yielding blue chips bounced back up, and took over market leadership yet again.

Forwarding to where we are today. Mario Draghi’s infamous speech on July 26th hinted at more asset purchasing/easing causing the markets to roar higher. As you can assume, taking a look at the internals of that two day rally, you would see out-performance by the high yielding blue chips. THIS WAS NOT A GOOD RALLY! It’s akin to EPS growing via cost cutting. I don’t care if the S&P goes to 2,000 by year end, if it is led higher by XLU & XLP, that’s telling me that it is a QE fueled rally that is not being sustained by growth or a economic recovery etc. It is being caused by the powerful “hunt for yield”, and the unfortunate belief & wager that we are Japan! That is not a rally to be celebrated, because just like cost cutting… it’s unsustainable!

Last week however, we had very good jobless claims numbers on Thursday, GDP was a bit higher than anticipated on Friday, and some other good economic data. This mini rally was led higher this time by high beta, cyclical names. This was a rally for the right reasons. Whether it’s another head fake / short term blimp (as I would guess), or a sign of better things to come, we don’t know yet, but by analyzing the internals, and understanding the reasons of WHY things are happening, this will enable you to know the results even before we get there.

Conclusions:

• (Just like EPS gains via cost cutting,) Don’t get overly excited by QE based rallies.
• Fade high beta rallies which are based on QE announcements/speculation.
• If you do buy into these rallies, don’t go to “risk on” names (like in prior QEs), rather buy high yielding blue chips (because the markets are saying QE won’t work)
• and of course, ALWAYS analyze!

- MicroFundy

PS. I do realize that this post seems to somewhat conflict a prior post of mine titled “Blue Chip Utilities = Red Portfolio?“. I plan to address this with a third post sometime soon. IE - Are high yielding blue chips at this stage a good or bad investment? (Short answer: They SHOULD be much lower, but are you willing to fight the Fed?)