Economics

Q&A On Earnings Season

As earnings season begins, I’ll have limited time to post over the next few weeks. As such, I thought I’d post some recent Q&As and responses to reader comments. Have a wonderful earnings season! I plan to publish a summary along with management commentary in 2-3 weeks.

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Q:   Research note from economist:  Core CPI 2% in 2018 but rising to 3% by year-end 2019.  Almost everyone but the bond market has figured out what’s going on with inflation.

A: Agree. Unless stocks decline noticeably, the economy and inflation are most likely going higher, in my opinion. 2yr USTN yield now almost perfectly correlated to stocks. It knows if stocks keep going up, Fed must raise rates. Central bankers can’t (or shouldn’t) let asset inflation and labor market “melt-up” indefinitely.

Q: WMT just increased its starting pay from $10/hr to $11/hr. This is the third time since 2015 the company has boosted minimum pay. The company also said it will expand maternity and parental leave benefits and provide a one-time cash bonus for associates up to $1k.  And they tell us inflation is less than 2%

A: I’m noticing increasing signs of rising wages and tight labor market in almost every industry. Even the Fed’s Beige book notes labor market is tight and mentions shortages. Labor shortages and Fed funds rate still below the rate of inflation??? I’d say that’s the definition of behind the curve.

Q:   Bernanke comments yesterday “the FED will over the next 18 months seriously discuss alternative policy regimes”.  Will he recommend Helicopter drops?

A: I suspect policy makers move their inflation target to a range (maybe 1-3%) from a fixed 2%. The range would give them flexibility to remain easy once their current targets are exceeded.

Q: What does any of it even matter???? Bloomberg, FactSet, research….. just lever up as much as you can and buy anything. It’s insane. The Nasdaq looks like bitcoin chart.

A: As I’ve asked frequently this cycle, “Is This Investing?”

Q: What do you think of all the cryptocurrency mania?  Every day I read about a new cryptocurrency and the founder who is now worth $5 billion dollars.

A: I don’t have a strong opinion, except we shouldn’t be surprised. Global central banks create $13+ trillion without effort or sacrifice and funny things/speculative frenzies happen.

Q:   UK November inflation was +3.1% y-o-y.  maybe you can explain to me why UK 5-yr and 10-yr notes yield only 0.7% and 1.2%.  Great idea to buy a UK 10-yr at 1.2%, pre-tax a negative 2% rate and after-tax probably a negative 2.5% rate.

A: It’s nuts. And on another note, I believe U.S. job data appears off vs what I’m reading (mainly wage growth). I think wages growing faster and job market tight. Talk to any business owner about biggest cost concern…labor/wages by far.

Q: Did you see story “Fed said to be working on plan to relax banks’ leverage ratio”?  Repeating the mistakes of the past, every cycle seemingly repeats itself.

A: Nothing surprises me now. I think things crazier now, broadly speaking, than 1999 or 2007. Watching financial television this morning…they’re saying how great higher rates are for the banks and the market. Not sure I subscribe to that theory. Labor market very tight. Higher asset prices from here = accelerating inflation. That said, I’m enjoying theses higher rates! One area where patience has paid. I have a 2yr USTN maturing yielding only 0.75%! Rolling over into 2%. Not great, but beats 0% and I consider it a raise! Higher rates will help fiscal deficits approach $1 trillion again soon. Might get some break from higher capital gains (assuming asset inflation maintained), but every 1% increase in rates is approx. $150 billion addition to fiscal deficit. Not to mention negative impact from recent tax cuts. If fiscal deficits nearing $1 trillion now, what will they be during the next bear market and recession? $2+ trillion? Who will buy our bonds? The Fed? If so, what will happen to the dollar? Some sort of cash/dollar hedge may continue to make sense, in my opinion.

Q: Wage pressure – our retail analyst speaking with retailers – store level employee wage rates +5% vs yr ago.  Good economy leads to higher wages, nothing complicated about this equation.

A: Based on my bottom-up analysis, I think this no wage growth belief is crowded and inaccurate. This is what happens when economists rely on govt data and don’t leave their desks.

Q: Great article on the Retail Industry’s future problems, top of the list too much debt.  Amazing how many industries/companies never learn that debt maturities/refinancings are the downfall for so many companies.

A: Retailers great example. Spent billions on buybacks and now many have too much debt. Based on my experience, most cyclicals should avoid taking on debt. When this cycle ends, theory of strong corporate balance sheets will be tested and possibly disproved, in my opinion. Maybe some ok, but many cyclicals that leveraged up w buybacks and acquisitions could have refinancing issues next recession.

Q:  Investors and economists have been trained over the past 30 years to believe inflation and interest rates always trend downward.  We’re probably close to an inflection point in which rates and inflation move higher, how high is anybody’s guess.  However, given the massive global debt bubble rising rates will create problems that we are unaware of – similar to the sub-prime monster in 2009.

A: And what happens when the 10yr reverts to a historical real yield? Can asset prices be maintained with a 5% 10yr yield? How do 3-4% cap rates on risk assets work in such an environment??? And why isn’t such a real possibility being priced in by equities? I’m avoiding REITs…and high quality equities priced as risk-free perpetual bonds.

Q: Did you read Hussman’s piece on why rates don’t justify current valuations?

A: Interesting, but when does valuation math matter again??? I wish I knew! Lots of energy names I was considering having a nice bounce past few months. I got close to buying a couple. Fortunately with energy/commodity stocks you almost always have a second chance (usually either loved or hated). Can’t wait to own normal operating businesses again…never intended to become a commodity analyst, but it’s one of the few areas of the market where cycles/markets still appear to function (go up AND down).

Q: Business risk? In our industry? What risk — success is easy. There are 3 strategies to amassing billions. Doesn’t matter which one you pick. A) Long only FAANG B) Long any index w/ modest leverage C) Short vol. No risk business strategy – start firm, adopt A or B or C, watch $ come in.

A: You got it!!! But what’s the alternative? Remain disciplined and you may find yourself sitting in Starbucks sipping on a latte writing a blog!

Q: I am still grappling with the question of whether it’s better for investors to hold onto cash than investing in stocks. Are we being overly confident in our ability to predict a stock market decline in the reasonable future?

A: I’m not very confident when the market declines next…actually have no idea when this cycle ends. It could end tomorrow or in several years. We’ve never been here before…with a cycle being sponsored by global central bank asset purchases. But I’m confident the stocks I follow are overvalued. And that matters a lot to me.

Q: Is it better to pursue a long/short or market neutral strategy than just holding cash?

A: A L/S neutral strategy may make sense if you’re a good short seller. Unfortunately, I am not.

Q: Is it worthwhile to focus on finding undervalued opportunities in the international markets while U.S. small cap remains extended?

A: Intl seems cheaper but I try to stay focused on a fixed opportunity set (familiarity has historically provided me w an advantage and ability to act decisively).

Q: Does comparing current multiples to the long-term history ignore the fact that the U.S. business composition has shifted to higher ROIC businesses?

A: I understand, but don’t completely agree with the higher ROIC argument. Most of my companies are mature and have been around for decades. Their businesses haven’t changed considerably but many of their valuations have doubled or tripled this cycle. Many valuations cannot be justified using realistic assumptions, in my opinion. And how has the debt cycle influenced ROIC and profits? What % of profit expansion is a result of credit growth? And where would margins be without elevated levels of debt? You may find pulling up a chart of corporate profits and US credit growth interesting.

Q:  I’m curious why you have chosen to implement a 2 year U.S. Treasury Bond Ladder instead of 1 year or 5 year?

A: I’m staying very short and liquid as I want to reallocate money to small cap stocks that I’m following once the cycle ends. While I’m buying some 2yrs each month to boost yields slightly, most of my SMA is in cash/very liquid. If my goal was to generate income I’d probably be less cash and go out on the curve more. But my goal is to be opportunistic once cycle ends.

Q: Eric, a little top-down employment data to compare/contrast with your micro analysis. [attachment on jobs report I couldn’t attach]

A: Interesting. Thanks! It will be interesting to see how often weather is mentioned in Q4 commentary. Last cold winter (2014) we had a weak Q1 followed by stronger Q2-Q3. 2014 was the last time it looked like the economy was going to enter “escape velocity”…only to discover it was just a rebound from cold weather driving growth in middle of 2014…it wasn’t sustainable growth. Currently I actually believe we were moving to several consecutive quarters of 2-3% GDP (assuming asset prices remained inflated) from 1-2%…but extreme cold weather may delay this. I’m not sure about this and I’m looking forward to learning more when earnings season starts. In meantime, robust asset inflation should at least keep investors…and possibly economy…warm enough to get through the winter!

Q: Eric – Things are finally getting wacky and reminding me of 1999 again with crazy tech valuations, now crypto-craziness, etc. In 1999, I needed sinus surgery and my doctor was world renowned and once he found out that I was a research analyst at Morgan Stanley, he confessed to me that he wished that he wasn’t in surgery for so many hours a day as he needed more time to use charts to trade tech stocks. I can’t make this up! Made me feel great that he was about to perform surgery on me for 5 hours after hearing his confession.  Instead of my MRIs on the screen as he was performing surgery, he probably had “Pets.com” stock charts slapped across the x-ray holders!

A: Hilarious re your surgeon. I had sinus surgery during the housing bubble. I wonder if the frequency of sinus infections for disciplined value investors is correlated to asset bubbles?!

Q: Is holding a lot of cash the right answer for investors now? For example, what if inflation takes off and our cash value is eroded?

A: It’s a valid point. Holding cash has its own risks, including negative real rates and opportunity cost. We won’t know if patience is the right course of action until the market cycle ends. Patience makes sense to me, given valuations…it’s an important part of my absolute return process – only take risk when getting paid. But given the difficulty to remain patient in a raging and extended bull market, I acknowledge it’s not for everyone. Based on current prices, valuations, and average portfolio cash levels, apparently it’s not for most!

Q: Happy New Year. I hope that valuation finally resets for you this year and gives you a great opportunity to come back and join us in managing OPM.

A:  Happy new year to you too. The way the year is starting, it appears Mr. Market wants me to mow lawns (which I actually enjoy)! Hope all is well. Brutal cold here. Got into the 20s last night and they closed schools…only in FL!

Q: Is a flattening yield curve at all at odds with your prior post on inflation perking up?

A: As long as asset prices remain inflated I think rates, economy, and inflation continue to go higher. Inflation may be the catalyst that makes asset prices crack, I don’t know. But it’s something to watch closely, especially wages. In effect, the yield curve/long bonds may be looking several moves ahead (post inflation realization and post mkt decline). But until markets respond to higher inflation or rates, looks like more of the same…so I’m just waiting. We’ll get an update on corporate costs and wages in about a month or so as q4 results are released.

Q: I thought you would appreciate this article from the Denver Business Journal that highlights labor shortages and rising wages for Denver home builders.

A: Great article! One more reason (high building costs vs. existing home prices) we’re not selling the house and renting this cycle like we did in 2005. That and rents have gone up so much/are outrageous where we live!

Q: Just saw this in the Richmond fed survey, more and more manufacturers are experiencing and (even more) expecting both wage and price increases.

A: Great charts! Thanks for sending. Lack of interest in growing signs of rising wages is amazing to me given how much is riding on assumption of perpetually low rates.

Q: I have enjoyed your thoughts on wage pressures. Just to add more fuel to your fire, we notice it in our business in a few additional ways:

1.) Regulatory/legal pressure

2.) Worker quality

With regards to #1, an example would be a ruling recently in our state that suggests that we might be exposed to legal liability if we are not providing cell phone reimbursement to certain classes of employees at our stores. The ruling interpretation from our lawyers is that even if we don’t REQUIRE them to conduct business on their personal phones, if not doing so would put them at a “competitive disadvantage”, then we are essentially liable to provide compensation to them by reimbursing them for part of this expense. So now we’re spending an additional $150K/yr across the company to reimburse. This is essentially an increase in their wages. There are other examples like this where a regulatory or legal event leads to additional compensation pressure. And I think that these things are possible only in a “tight” labor market because that is where these kinds of social policies or court cases arise from. No one is filing class action lawsuits over cell phone reimbursement when they’re desperate for a job, etc.

With regards to #2, this isn’t really a new point and you’ve covered it at length in recent posts but we’ve just noticed the quality of potential hires declining significantly at each price point. The simple economic solution, of course, is to raise your bid until you find what you’re looking for, but it isn’t that simple in practice because we can’t also just shift our ask up on our final product offering (ie, what we sell). So we get squeezed on the margin! So it’s not just that there are less applicants, but the ones we see are lower and lower quality to the point that often times we find most applicants simply unhireable and even those we ultimately select prove to be mediocre compared to earlier “vintages”.

A: Excellent points/examples…thanks for sharing. By the way, a consultant firm I follow is doing very well in their compliance consulting division!

Q: What do you think of the possibility of reluctance to raise rates because of the debt burden? If true, how long could that go on in light of what you report?

A: I’m not sure about timing. If reported wage inflation picks up things will get very interesting. But agree policy makers would prefer going very slow given asset prices and debt levels. That said, the 2yr may be telling us policy makers will be forced to raise rates as long as asset prices inflate (strong correlation now with short-end and stock market).

Q: I really like your bottom-up macro views and think they are a valuable input, but I would like to make a few points especially about wage inflation. You have observed many instances about high payed job offers and a tight labour market. However isn’t it an inherent feature of the labour market that rising wages one can observe are not representative?

A:  My view is the trend has shifted. I don’t believe inflation is spiking higher, I’m just noticing many more signs of tight labor mkt than year ago. Things were more deflationary in 2015-2016. Different now — noticeable change in 2017. Definitely something to follow more closely. Consensus on perpetual low inflation/rates is very crowded, in my opinion.

Q: 10-yr at 2.6% and moving higher.  Are we at the final end of the 30-yr bull market in bonds/rates?

A: My wild guess is rates keep going up until risk assets crack…then comes threat of recession, along with the cover to introduce more policy intervention (QE4?). Unless rising fiscal deficits, weak dollar, and inflation doesn’t allow an unlimited central bank bid (a significant risk to investors relying on the Fed put, in my opinion). Things are getting interesting! Although I’m not participating, I sure am enjoying the show.

Article by Absolute Return Investing with Eric Cinnamond