As an indicator of the global economy, Alcoa’s earnings come up short

As indicators go, this one is sure tough to read. It’s not clear exactly what Alcoa’s (AA) quarterly earnings say about the global economy—except that it’s tough out there.

Yesterday, Alcoa announced third quarter earnings of 15 cents a share. That was short of the Wall Street consensus forecast of 23 cents a share but with so many special items, it’s not clear to me exactly how short of estimates earnings were. After taking out the positive items (such as an income tax benefit) and the negative (including flood damage), it looks like Alcoa’s adjusted earnings of $164 million were short of Wall Street estimates of $172 million.

But what interests those of us who own other stocks—but no shares of Alcoa—is the “Why?” of the miss. That’s where we’ll find clues to the prospects for the global economy.

The company said that demand for aluminum held up everywhere except Europe. Alcoa actually raised its projections for demand in China to 17% for 2011 from an earlier 15%. That should be enough, the company said, to offset falling demand in Europe. The company kept its projections for growth in global aluminum demand at 12% for 2011. That’s down just slightly from the 13% growth in 2010.

I have some trouble, though, putting that demand forecast together with the company’s reported drop in the price of aluminum, which has been falling since May. Yesterday’s price on the London Metal Exchange was about 22% below the May high.

That could be a sign that others in the aluminum market see demand as softer than Alcoa does—which, if true, wouldn’t be great news for the global economy. Or that those speculators that built stocks of aluminum thinking the price would go higher have been selling.

On the other hand, the drop in price could simply be a reflection of the structure of the global aluminum industry. Read more

Global stock markets wait on tomorrow’s economic numbers from China and United States for direction

Fasten your seat belts; it could be a bumpy ride tomorrow.

Two economic numbers, one from China overnight (from a U.S. perspective) and one from the United States before the New York market opens, have the power to move stocks in the current very volatile environment.

The Chinese number is the official version of the preliminary manufacturing purchasing managers index (PMI). The preliminary version, released by HSBC and Markit Economics on September 22, showed the manufacturing PMI falling to 49.4 in September from a reading of 49.9 in August. Any index level below 50 indicates that the sector is contracting.

The Shanghai Composite Index fell 2.8% on September 22 and has been dropping since. As of September 29, the index was down 5.9% from September 22.

The fear is that the drop in the manufacturing PMI signals that China’s economy is slowing more than expected and that projections for 8.2% to 8.5% GDP growth in 2012 are still too high and will have to come down, bringing company earnings and stock prices with them.

But the September 22 preliminary reading on the PMI only includes data from about 85% to 90% of China’s companies in the fuller survey that will be released tonight. That extra 10% to 15% might not seem like a big deal but the missing surveys tend to come from China’s biggest state-owned companies. And not only are these companies major exporters but also since they have ready access to financing from the country’s state-owned banks, they haven’t been hit as hard as the smaller companies in the survey by the lending slowdown engineered by the People’s Bank. Anecdotes and data from China say that smaller companies are starved of capital right now.

The market hope is that the full number from the PMI will hang above 50. Read more

Will the superior economic performance of developing economies such as China and Brazil translate into superior stock market returns over the next 12 months?

Or will the dismal performance of the world’s developed economies—as the United States and the European Union slide toward slow to no growth—drag all boats down to the bottom?

In other words will emerging stock markets decouple from developed stock markets in the last part of 2011 and in 2012?

I think that’s the most important question facing stock investors right now.

What’s decoupling? It’s when a stock market dances to its own tune rather than moving in lockstep with other markets or with the global market as a whole.

Decoupling is different—or maybe you can call it an extreme case–from relative out- and underperformance.

We’ve been through a good example of out- and under performance in the last part of 2010. In the fourth quarter of 2010, for example, the U.S. Standard & Poor’s 500 gained 10.8%. The Brazilian stock market, as tracked by the iShares MSCI Brazil Index Fund (EWZ), gained just 4%.

Sometimes the outperformance can be really extreme. From December 31, 2010 to its peak on April 29, 2011 the S&P 500 climbed to 1364 from 1258. That’s a gain of 8.4%. From December 31 to April 29 the MSCI Brazil Index Fund went from $76.23 to $76.55. That’s a gain of 0.4%.

But even then the two markets moved in the same direction—even if just barely.

Pure decoupling is different—and rarer. Like what happened in 2007. That year in the fourth quarter the S&P 500 went down by 3.6% while the Brazil Index Fund went up by 11.4%. For the year the S&P finished ahead a paltry 4.9% and the Brazil Index Fund was up 74.8%.

Could we see that kind of decoupling in the remainder of 2011 and in 2012? (Or even just extreme out performance?)

The economic growth trends give decoupling a good chance. Read more

The drop in shares of Tencent demonstrates the costs of rising competition among China’s Internet leaders

Just because bad news is expected doesn’t mean it won’t hit a stock’s price hard.

Shares of Tencent Holdings (700.HK in Hong Kong and TCEHY in New York), China’s biggest Internet company by revenue, fell to a seven–month low on August 11 after announcing on August 10 second quarter financial results that missed analyst projections. After rallying briefly, the stock has resumed its decline.

Everybody should have known this was coming. China’s Internet biggest companies from Baidu (BIDU) to Tencent to Sina (SINA) are seeing costs rise as they invest in new services that will enable them to turn their huge user bases into more revenue. For example, on August 17, Sina, the owner of China’s third-most visited website, announced second quarter results that missed projection on the rising cost of adding features such as virtual currency and games t its Weibo micro blogging service as competition with a rival product from Tencent Holdings gets more intense. Sina said that costs for Weibo may climb to $100 million in 2011.

In the second quarter, no surprise, Tencent Holding reported increased spending on its micro blogging service and e-commerce website. The company reported that net income grew by 22% last quarter to 2.35 billion yuan ($366 million) from 1.92 billion yuan in the second quarter of 2010. Analysts had been expecting net income of 2.58 billion yuan for the quarter.

The problem clearly wasn’t on the revenue side. Revenue climbed 44% to 6.74 billion yuan from 4.67 billion yuan in the second quarter of 2010.

But general and administration expenses more than doubled to 1.36 billion yuan, up from 666 million yuan in the second quarter of 2010. Selling and market expenses rose 60% to 369.5 million yuan.

For the winners in this market all this spending will create profit machine as big companies with lots of user grow bigger as users are drawn to the size of the user base and the depth of services offered by the company. Tencent claims that it added 27.6 million active user accounts for its QQ instant-messaging service in the quarter to bring the total to 702 million. Investors need to take these numbers with a dash of soy sauce since Tencent’s total-account-figure exceeds the official total for all Internet users in China. But even a 50% haircut (a reasonable discount to my mind) still adds up to a lot of eyeballs that will add their yuan to the Tencent till down the road.

You can already see that in the growth of revenue from areas recently targeted for investment. Sales of Internet value-added services (which includes online games and QQ-related subscription fees) rose to 5.39 billion yuan from 358 billion yuan in the second quarter of 2010. Online advertising sales grew by 29% year-to-year.

Don’t buy shares of Tencent or Baidu if you’re looking for a quick killing. The negative sentiment about growth in investments and costs is likely to continue for a while before the market starts to focus on the income that this investment is bringing in. Use this period, two or three quarters I’d say, to build positions in the companies that you see as winners in this contest.

Tencent Holdings is now selling at a price more than 20% below its 52-week high.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Tencent Holdings as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

The last month has reordered global risk and reward.

It’s not just that the U.S. Standard & Poor’s 500 fell 18.3% from its July 21 intraday high to the August 9 intraday low. Or that the German index, the DAX, is down 15% in two months. Or that emerging markets such as Brazil and Shanghai spent time in actual Bear market territory.

But we’ve also seen EuroZone leaders unable to put a period to the euro debt crisis. We’ve seen the Standard & Poor’s credit rating of the United States go from AAA to AA. (Fitch Ratings re-affirmed the U.S. as AAA on August 16.) Japan has slipped back into recession. Inflation has topped official targets and shown itself stubbornly resistant to central bank policies. Economic growth has slowed or threatened to slow in most of the world’s economies.

Trends that investors depended upon to value stocks—or to tell them where and when to chase momentum—have been broken, damaged, or threatened.

Stocks are cheap in most of the world’s stock markets—if past trends are going to reassert themselves after a short interruption. If the trends are truly broken, however, who knows? What’s a Google (GOOG), or a Vale (VALE) or a Baidu (BIDU) worth if domestic and global rates of economic growth are about to drop by a percentage point or two points or more—or less?

You do have the option of stubbornly insisting that “things” are headed back to normal. Or that growth and stock prices will revert to the mean. But that’s just begging the question of what normal is and where the mean might be. Unless you’re willing to throw out the data from the last decade (or more, I’d argue) on economic growth and the performance of individual asset classes, it’s hard to come up with a long-term trend that can be convincingly projected a decade into the future. And even then your trend line would still have to come to terms with changes in global demographics and the global economy that, to me, say for the next decade it will indeed be different this time.

To the degree I can I prefer not to make investing a matter of faith or a gamble on alternatives with unknowable odds of success or failure.

“To the degree I can” isn’t a very large measure right now. For example, I think the most likely range of U.S. economic growth is somewhere between 1% and 2.5% for 2011 and 2012. Doesn’t sound like much? Just 1.5 percentage points? Certainly but the swing is 150% from the minimum and 60% from the maximum. And, of course there’s no guarantee that the actual outcome will fall within that “most likely” range. (We’ve got some recent experience in results that fall into the narrow tail of improbable outcomes but that nevertheless turned into very real outcomes.)

And the United States isn’t by any means the hardest economy to handicap right now. Brazil is inflating its own credit bubble, the government’s will to restrain wage increases is certainly questionable, and inflation is not under control. In the EuroZone the European Central Bank has seriously damaged its credibility leaving the restoration of confidence to political leaders who won’t lead and an untested European Financial Stability Facility that isn’t yet ready to go into operation. Indian politics make U.S. politics look like a model of rational discourse and while the Reserve Bank of India may be the last adult in the room, any parent will tell you that batting the children around doesn’t usually produce good behavior.

I could go on. But I think you get the point.

I don’t think there’s a magic method for bringing reasonable certainty to our projections about the global economy and about most national economies. We’re stuck with the fact that these are uncertain times. The result of that, unfortunately, as that I think it’s very hard to tell in most parts of the financial markets, and especially in the global equity markets, what the risk might be. You can calculate the reward, but not the risk. That’s the investing equivalent of dividing by zero.

But I do think there are three pieces of the global equity markets where the risk/reward proposition is not just calculable but is actually running in investor’s favor at the moment.

First, there are dividend-paying stocks. If the global economy continues to slow, global interest rates will be headed down and that will make dividend yields worth more. (The value in a 3.5% (or better) dividend yield on a stock such as EI DuPont (DD) or Abbott Laboratories (ABT) when the 10-year Treasury is hovering near 2.2% should be clear to most investors.) The proposition gets even more attractive when the dividend is paid in a strong currency such as those of Norway, Sweden, Switzerland, Australia or Canada. Take a look at the 5% yield from Norway’s Statoil (STO in New York and STL.NO in Oslo.) Australia’s Westpac Banking (WBK in New York and WBC.AU in Sydney) pays even more, 7.3%.

I can think of two kinds of downside risk. The individual company won’t be able to keep up dividend stream. I think you can minimize this risk by buying shares with strong cash flows behind them. The global economy might do better than expected leading to higher interest rates and higher inflation, both reducing the value of your dividends. Which is why you’re also looking to buy strong businesses—shares of these stocks should go up if the economy grows more quickly than is now anticipated.

Second, there are shares of domestically-oriented Chinese companies. I’m not sure I’d say that China is enjoying the global economic slowdown—Chinese exporters are seeing sales fall—but the Chinese economy—and especially the Chinese domestic economy–comes out on the plus side when everything is added up.  A slowing global economy probably means an end fairly soon to China’s interest rate increases. The consensus, which can, of course be wrong, is that the People’s Bank won’t risk China’s economic growth during a global slowdown by raising interest rates more than once more. (And end of rate increases would remove a big weight from stock prices.) The government in Beijing seems to be picking up the inflation-fighting slack by allowing the yuan to appreciate slightly more quickly. That has the effect of reducing the growth of the country’s money supply—and of increasing the buying power of Chinese consumers. I think adding to positions in domestically-oriented Chinese companies such as Baidu (BIDU) and Tencent Holding (700.HK) or in overseas companies that sell to Chinese consumers such as Yum! Brands (YUM), Sands China (SCHYY), and Coach (COH) would be a good way to play China’s relative growth advantage.

Third, there are the shares of U.S. exporters, especially those that sell to China. A stronger yuan—and a weaker dollar (How long can the safe haven effect balance out a slowing U.S. economy?) elsewhere in the world—makes U.S. products cheaper to customers. I think this will help U.S. companies pick up some more market share, which in many cases should be more than enough to offset any slowing in an economy such as China’s. That is, in fact exactly what Cummins (CMI) said in a recent conference call where the company talked about a temporary slowdown in Chinas sales but a gain in market share over the slightly longer time frame. Besides Cummins I’d look to shares of Johnson Controls (JCI), Joy Global (JOYG), Borg Warner (BWA), and Timken (TKR).

No guarantees that these stocks will go up. If there’s a global sell off, they’ll go down with everything else. But if the global economy just stumbles along, these shares should beat the market indexes. And, in my opinion, the risk/reward ratio comes out on the right side of the wager.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Baidu, Coach, Cummins, DuPont, Johnson Controls, Joy Global, Statoil, Tencent Holding, Timken, and Westpac Banking as of the end of June.  For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/