Countdown to recession…

  • Grab your earphones
  • A high price for goodwill
  • Another warning
  • In the mailbag

The potential Australian recession nears.

At 11:30am this Wednesday, the news will be out of the bag.

Will the Aussie economy rebound from the previous quarter’s downturn? Or will this be the second month in a row where the economy has contracted?

Oh, the speculation!

We’ll find out for sure this week. Until then, check this strategy for how you could play it if a recession strikes.

Markets

Over the weekend, the Dow Jones Industrial Average gained 11.44 points, or 0.05%.

The S&P 500 added 3.53 points, for a 0.15% gain.

In Europe, the Euro Stoxx 50 index closed down 29.87 points, or 0.9%. Meanwhile, the FTSE 100 fell 0.38%, and Germany’s DAX index lost 1.2%.

In Asian markets, Japan’s Nikkei 225 index is down 219.11 points, or 1.14%. China’s CSI 300 is down 0.27%.

In Australia, the S&P/ASX 200 is down 7.79 points, or 0.14%.

On the commodities markets, West Texas Intermediate crude oil is US$54.08 per barrel. Brent crude is US$56.13 per barrel.

Gold is trading for US$1,256.83 (AU$1,635.88) per troy ounce. Silver is US$18.38 (AU$23.93) per troy ounce.

The Aussie dollar is worth 76.82 US cents.

Grab your earphones

One quick thing: We recently recorded a 12-minute video with a top trader. He traded billions of dollars for a Wall Street investment firm.

Now he’s helping ordinary Aussie investors, showing them how to trade the market like Wall Street trades the market. It’s an illuminating story…and it’s only 12 minutes long. (It’s not one of our long sales videos either, so don’t panic!)

To find out what this top trader has to say, go here. You won’t regret it.

A high price for goodwill

If ever there was a real-life example of hubris, then surely the case of Slater & Gordon Ltd [ASX:SGH] is it.

As The Age notes today:

The clock is now ticking on the financial future of the ailing law firm Slater and Gordon, with a 90-day deadline to finalise negotiations with its bankers to ensure its survival.

The company has until May 26 to complete the negotiations, it said, which is likely to see the investment of shareholders wiped out.

Earlier on Monday, the company disclosed more heavy losses amid a warning from its auditor about the “material uncertainties” over the company’s financial survival.

In a filing with the stock exchange, the company disclosed that losses have now reached $1.3 billion, which exceeds the $1.1 billion of equity on its balance sheet, so that all of the shareholder funds have now been wiped out. The underlying value of each of its shares on issue is now minus 36c, since the lawyer had a negative net worth of $126 million as of December 31.

The stock listed at a dollar in May 2007. It was a law firm. What could possibly go wrong?

For a while, it seemed as though nothing could go wrong.

It paid its first dividend as a listed company three months after listing. It then continued to pay a dividend twice a year, all the way through to September 2015.

That was around the time the proverbial wheels started to fall off, after the purchase of UK-based professional services firm Quindell.

Slater and Gordon paid $1.3 billion for the company. That was a hefty sum, seeing as the law firm’s market cap at the time was barely the same amount.

And quite how Slater and Gordon would pay for the takeover is another part of the story, considering how, at the end of the 2014 financial year, the law firm had cash of just $25.3 million on the books.

Enter the entitlement offer for shareholders to dip into their pockets to help fund the takeover…

In April 2015, ‘lucky’ shareholders were invited to stump up $6.37 per share to help pay for the Quindell takeover.

In addition, it became necessary for Slater and Gordon to increase its debt load. At the end of the 2013 financial year, Slater and Gordon’s long-term debt stood at $32 million. At the end of the 2014 financial year, it was $117.3 million.

By the end of the 2015 financial year, it had ballooned to $707.4 million. At the end of the 2016 financial year, it had increased further, to $761.1 million.

What’s telling in particular is the ‘goodwill’ expense on the company’s balance sheet. This can be a warning sign that a company has overpaid with a takeover.

In simple terms, ‘goodwill’ is the amount that a company has paid for an asset that is in excess of its current value.

For instance, let’s say you buy a business for $100,000, but it’s only actually worth $50,000, based on that business’ current earning capacity.

In that case, $50,000-worth of that transaction is counted as ‘goodwill’ on the balance sheet.

Why would you pay above the odds for a business? One reason is because you think you know of a way to increase the earning capacity of the business. So that, one, two, or three years from now, the increased earnings-power of the business could value it at $200,000, or more.

Get the point?

Well, at the end of the 2014 financial year, Slater and Gordon’s goodwill on the balance sheet amounted to $108.5 million. One year later, it was $1.27 billion.

In other words, pretty much the entire value of the takeover was recorded as goodwill, suggesting the law firm had vastly overpaid for its new ‘asset’.

What’s more, only a year after that, goodwill had been slashed to just $332.9 million, as the company wrote down the value of its purchase.

Even worse than that, you have to wonder about the sanity of the takeover in the first place, given the size of the debt required to fund the acquisition.

In 2016, Slater and Gordon recorded interest charges of $42.5 million. That’s a big sum. That compares to just $6 million in interest charges two years prior.

Not only that, but consider also the company’s profitability. In 2014, before the takeover, Slater and Gordon’s net profit amounted to just $68 million.

In other words, a simple crunching of the numbers would tell you that it may not be the brightest decision in the world to allocate 75% of your net income towards interest repayments.

We’re certain that even the ravenous Aussie mortgage industry would think twice about letting a customer go into that much debt.

Whenever we see terrible corporate stories like this, it always reminds us of the wise words of colleague Vern Gowdie. As he often says: ‘There’s no new way to go broke. It’s always due to debt.

Right again.

Alone

Here’s a story which sends a shudder of complacency down our spine. From Business Insider Australia:

Australia is likely to avoid a technical recession — defined as two consecutive quarters of negative economic growth — when the ABS releases its December quarter GDP report next Wednesday, March 1.

All 25 economists polled by Bloomberg expect a positive growth quarter, forecasting a rebound following the shock 0.5% contraction — the largest since the GFC — in the September quarter.

The median estimate is centred around an increase in real GDP of 0.7% for the quarter, leaving the year-on-year growth rate at 1.9%.

Who knows, maybe the consensus view of the mainstream economists is right. The Aussie economy may rebound. The streak of recession-less growth could continue.

But, perhaps, for no other reason than being stubbornly contrarian, we continue to believe that this week will witness the end of that recession-less run.

On the off chance we’re right, here’s how to play it.

Another warning

You won’t find us denying that, every day, we search for news items and data supporting our view of impending financial-markets doom.

The latest comes from the Wall Street Journal:

Stocks and bonds are again moving in tandem after diverging in recent months — a sign some investors may be losing faith in the so-called reflation trade.

The Dow Jones Industrial Average has soared more than 1,000 points so far this year and closed at a record 20821.76 Friday. Bond prices, too, are rising, driving down the yield on the benchmark 10-year Treasury note to 2.317% Friday, the lowest since late November, from 2.446% at the end of 2016.

Our interest is with the yields on junk bonds; specifically, the SPDR Bloomberg Barclays High Yield Bond ETF [NYSEARCA:JNK]. It’s an exchange traded fund which tracks the performance of a number of high-yielding bonds.

Because bond prices move inversely to bond yields, the rising share price of this ETF indicates that junk bond yields are falling.

If you check out the white line on the chart below, you can see how the yield now sits at around 6% (left-hand axis):



chart image

Source: Bloomberg
Click to enlarge


The only time in the past eight years when yields were lower was in mid-2014. That was just before this junk bond ETF fell nearly 25% in the 20 months that followed.

The difference then was that stock prices increased as investors switched from high-risk assets to lower-risk assets (emerging markets took a lot of the punishment at the time).

Will events repeat? As always, everything is possible. Only this time, our bet is that, when investors shift out of riskier assets, it will be out of all risky assets — including the supposedly ‘safe’ blue-chip stocks.

In the mailbag

Subscriber CA writes:

While we are ingesting our radioactive fish from Fukushima, the climate will continue to change, not from us burning coal etc. but because the earth’s magnetic poles are moving. The north pole is heading for Russia and the South pole has left Antarctica and is heading for Perth. They will meet off Indonesia sometime. This pole reversal last happened 786,000 years ago. The earth’s magnetic field is decreasing in strength and the movement of the poles is picking up speed. Although scientists think this can take 80 years, the changes induced while they move can lead to extreme weather, super floods, earthquakes and leave earth vulnerable to electromagnetic pulses from the sun. It won’t matter how much humans change to renewable energy and tax carbon, the poles are on the move.  

MagneticReversal.org has good videos to explain it. Maybe we can stop feeling guilty about the climate and learn to live with it instead.

The flipping of the poles. Colleague Jason Stevenson, of Resource Speculator, has been banging on about this for years.

Cheers,
Kris