Goose Eggs

When I recommended returning capital in 2016, I felt small cap stocks were broadly overvalued. The cash in the portfolio I was managing was rising to record highs and I was unable to find investments I felt would adequately compensate clients for risk assumed. Hence, I felt the best course of action was to return capital. Two and a half years later, the investment and economic landscape has changed considerably and currently appears to be in transition.

I initially noticed a shift in the macro environment in 2017 when several companies on my possible buy list began reporting rising costs. Later in 2017 and early 2018, I also discussed and documented improving operating trends for many of the businesses I follow. During this period, short-term interest rates also began to increase. The rise in interest rates was an encouraging sign for patient absolute return investors. In my post “Patience a Possible Win Win” I wrote:

“Waiting isn’t easy, but with short-term interest rates trending upward, it’s gotten a little easier. As the later stages of the current market cycle unfolds, I believe patient investors will likely be rewarded with either higher returns on their liquidity or a more attractive opportunity set.”

Interestingly, over the past year we’ve seen both – higher rates, and more recently, an improving opportunity set. In hindsight, I don’t believe the Federal Reserve had a choice but to increase rates and implement QT. Throughout most of 2017 and all of 2018, rising wages and increasing corporate pricing power were too obvious to ignore. Negative real rates simply do not mix well with record low unemployment, signs of labor shortages, and corporations openly communicating their intentions to raise prices.

As wages and inflation picked up steam throughout 2018, the yield on the 2-year Treasury followed. During this time, I became increasingly fascinated with the 2-year and its upward sloping yield. In my post, “Tick Tock Where Does the 2-Year Stop?” I wrote:

“Since I began noticing rising corporate costs in 2017, the 2-year Treasury yield has increased considerably. Trading near 0.50% only two years ago, the yield on the 2-year hit 2.79% today! As someone patiently waiting for the current market cycle to end, I’d like to know the rate the 2-year needs to reach before something in the financial system cracks.”

Assuming the current market cycle’s peak is behind us, it appears the 2-year yield that caused something in the financial markets to crack was approximately 2.75%. Not long after stocks began to fall, the 2-year yield peaked at 2.98% (November 8, 2018). It’s not exactly a high yield for a cycle peak, but one needs to keep things in perspective. The fed funds rate was between 0-1% for nine years! A tremendous amount of debt accumulation, asset inflation, and capital allocation occurred while rates were pegged near 0%. As such, it didn’t take many rate hikes (along with QT) to cause investors to revise their “lower for longer” valuation assumption.

For many absolute return investors, it’s been an incredibly long, frustrating, and even fascinating market cycle. While I continue to be uncertain as to when this cycle officially ends, as I’ve stated in recent posts, I’ve become more encouraged and optimistic regarding future opportunity. In fact, as volatility has increased, several of the small cap stocks I follow are down meaningfully and are trading below where they were when I recommended returning capital. With prices declining and my opportunity set improving, I’ve increased my time devoted to research and finding new potential buy ideas.

After sorting through the carnage on my possible buy list and equity screens, I’ve come to the conclusion that small cap stocks, on average, remain expensive. Several aggregate valuation metrics, such as EV/EBIT, support my bottom-up conclusion. Below is a chart of the Russell 2000’s median EV/EBIT (excluding financials). I prefer EV/EBIT to P/E as it takes net debt into consideration and excludes the impact of what I believe are below normalized interest rates and tax rates.

While I researched potential buy ideas, I was also reminded of how much debt has accumulated on corporate balance sheets this cycle. As noted in my post The “V” or the “L”, one of the most glaring differences between this cycle and past cycles is corporate balance sheets.

Higher debt levels can be seen from a bottom-up and top-down perspective. From a top-down perspective, most aggregate measurements of corporate debt are elevated. For example, the median net debt/EBITDA of the Russell 2000 is currently 3.2x versus 0.9x in July 2007 (the last market cycle peak).

The increase in debt is also noticeable from a bottom-up perspective. For example, United Natural Foods (UNFI) is a company I follow and have owned in the past. Its stock has declined -74% over the past year and is trading well below the price of my last purchase. So why am I not buying? Unfortunately, due to acquisitions, the company’s debt has increased considerably and no longer passes my financial strength criteria.

In my attempt to avoid permanent losses to capital and potential bankruptcies (goose eggs), I follow a simple financial strength rule of thumb. Specifically, I require a debt-to-free cash flow ratio of 3x or less for cyclical businesses and 5x or less for non-cyclical businesses. Debt-to-free cash flow limits have saved me from multiple distressed situations in the past. And given how much corporate debt has grown, I expect the use of leverage limits will become increasingly valuable as the current credit cycle matures.

So why do I use 3x-5x debt-to-free cash flow? As an equity holder, I want to make certain a business can pay off its debt, if needed, before a large bond or credit line matures. The maturity wall for many small cap companies typically hits in 3-5 years; hence, I use 3x-5x debt to free cash flow limits. In effect, I never want to be at the mercy of a volatile credit market or fickle banker. And this is also why I use debt-to-free cash flow instead of debt/EBITDA. In my opinion, debt/EBITDA is less effective in helping me understand a business’s discretionary cash flow and ability to repay debt.

In summary, while many small cap stocks are down meaningfully from their highs, I believe valuations, on average, remain elevated. Nevertheless, given it’s been so difficult to find value for so long, it’s understandable to want to research and possibly buy a beaten-down stock. For absolute return investors diving in and searching for new ideas, happy hunting! Just watch those balance sheets. Financially distressed businesses and potential goose eggs can be devastating to performance and full-cycle absolute returns.

Are All Bets Off?

For my final post of 2018, I planned on writing a detailed post on the consumer sector. Unfortunately my blogging time has been limited, so instead I thought I’d at least provide a brief summary.

Based on recent operating results, the consumer continues to spend; however, results do not appear as consistent and vibrant as Q1-Q3 2018. Furthermore, interest rate sensitive sectors are showing further signs of slowing. It’s possible, in my opinion, that rising wages are sustaining consumer spending in certain areas, while rising interest rates (and now declining equity prices) are causing other consumer-related businesses to slow. In effect, consumer business conditions have become more mixed versus the first three quarters of 2018, when operating results were broadly trending higher.

We’ll have a clearer picture after Q4 earnings season; however, based on recent results, there are signs that certain economic variables may be in transition. For example, the following comments from Toll Brothers (TOL) suggest a possible shift in labor availability and wages:

“…we believe we will likely see some relief on the labor front. While it is still early, we expect to see some softening on labor pricing and increased availability in some of our markets. We are actively rebidding jobs with the goal of reducing our costs.”

Toll Brothers’ comments are noteworthy as a “softening” labor market would represent an abrupt shift in recent trends. During 2018, the majority of companies on my possible buy list were experiencing a tightening labor market, not softening. Inflation and other macro variables have also been trending higher.

For most of 2018, I expected rising wages and inflation, along with elevated asset valuations, to support the Federal Reserve’s decision to continue increasing interest rates. However, there was one important caveat. Specifically, I noted if asset prices declined sharply or something in the financial markets broke, then all bets were off.

With many of the major stock indices down considerably from their highs, we’re approaching the formal definition of a correction, or even bear market, in certain sectors and benchmarks (as of December 17, 2018 the Russell 2000 is down -20% from its highs).

To what extent has the decline in equity markets influenced economic activity and corporate profits? It’s a good question that I’m currently unable to answer as my recent sample set is too small and does not reflect December’s sharp decline in equity prices. And it’s why I’m extremely interested in Q4 2018 corporate operating results and 2019 outlooks. In order to better measure the effect recent asset deflation has had on the economy, I need additional information from the front lines.

Regardless of the potential impact on the economy, it appears asset prices have moved enough to catch the attention of the Federal Reserve. Based on “The Fed Cheat Sheet”, the Federal Reserve will likely implement a wait and see approach (or pause) after raising rates tomorrow. If their cry of “monetary uncle” isn’t enough to appease investors, I expect the Fed will eventually communicate their intention to end QT and possibly cut rates. Per my cheat sheet (wild guess), I expect the next olive branch will be extended to investors near 2,300 on the S&P 500.

In summary, the financial markets, and possibly the economy, appear to be in transition. With uncertainty increasing and equity prices declining, it’s not surprising 2018 is shaping up to be a good year for investors practicing patience and prudence. Of course 2018 isn’t over. It’s possible recent declines in equity prices will cause the Fed to refrain from raising rates tomorrow, sparking a violent year-end rally. Given how much is at stake (how dependent we’ve become on asset inflation), nothing would surprise me. Nevertheless, in my opinion, the days of making money with little effort and risk to capital appear to be fading (at least for this aging cycle).

For patient absolute return investors rooting for a more favorable opportunity set, the past few months have been refreshing and encouraging. As I’ve stated in recent posts, I’m becoming increasingly optimistic regarding future opportunity.  Will 2019 be the year capital can be allocated at prices that adequately compensate investors for risk assumed? I don’t know, but I’m hopeful and can’t wait to find out!

I’d like to wish readers a Merry Christmas and Happy Holidays! Here’s to a wonderful 2019 filled with considerable volatility and opportunity! 🙂 

I’ve Been High

I’m not sure what surprises me more. The fact that I’ve been writing a blog for over two years or that I haven’t fit America’s best rock band (according to Rolling Stone) into one of my posts. Of course I’m talking about R.E.M.  

I don’t remember exactly when I was introduced to R.E.M., but I remember the first song. It was “Radio Free Europe”. It was like nothing I’d ever heard. I went on to discover other R.E.M. gems such as “Gardening at Night”, “Driver 8”, and “So. Central Rain”. I was hooked and soon owned all their albums (or cassette tapes).      

While R.E.M. was initially known as an alternative college band from Athens GA, after the release of their album Document, the band became more well-known. And after their albums Green and Out of Time were released, they became famous.

Their cycle of popularity likely peaked in the early 1990’s. As the band matured, they experimented with different sounds and song writing. Later albums such as Up, Reveal, Accelerate, and Collapse into Now, were all good in my opinion, but never caught a bid from the mainstream. It’s possible their newer music deviated too far from R.E.M.’s earlier and familiar sounds to please the masses.  

While their later albums contained fewer top hits, it’s where many of my favorite songs are located. One of my favorites, and I believe most underrated R.E.M. song, is on their album Reveal. It’s called “I’ve Been High”. Unlike “It’s the End of the World as We Know It”, “Orange Crush”, and “Losing my Religion”, it’s not a particularly catchy or upbeat song. Nevertheless, I find its flow, vocals, and lyrics mesmerizing.

Similar to most R.E.M. songs, the lyrics are open to interpretation, but unlike their older songs, the lyrics are clear and can actually be understood! The last four verses below:

So what in the world does R.E.M. and their song “I’ve Been High” have to do with absolute return investing? Everything!

In order to achieve attractive absolute returns over a full market cycle, it’s very important to avoid permanent losses to capital. Based on my experience, an effective way to limit large mistakes is to generate accurate asset valuations.

A common error made in business valuation is related to extrapolation, or assuming current operating conditions will persist far into the future. Instead of extrapolating and thinking of a company’s profit cycle as linear, I believe most business results are cyclical, with profit margins gravitating towards their mean.

To take the cyclical nature of business into consideration, I typically use a normalized cash flow assumption in my discounted cash flow model. In effect, I want to avoid being too optimistic during the peaks and too pessimistic during the troughs. In my opinion, a normalized cash flow assumption provides investors with a more accurate valuation than extrapolating current trends far into the future.

Similar to businesses, I view the economy and stock market through a cyclical lens. As is the case with many things in life, there are natural highs and lows. Despite the natural cyclical tendencies of the market and economy, a significant amount of effort and capital has been allocated towards maintaining the current cycle’s high.    

In my opinion, the desire to maintain this cycle’s high originates from the 1999 stock market bubble. The high created from that cycle’s asset inflation was exhilarating. Record equity prices contributed to strong economic growth, rising wages, and a fiscal surplus. Unless you were a short seller or disciplined value investor, it was very easy to make money. All you needed was a brokerage account and a cash advance from your credit card!

Things were so good in 1999, some economists, including Alan Greenspan, were concerned the United States would eventually pay off its debt (concerned because the Treasury market would disappear)! It was truly an amazing and prosperous period few had ever seen – so unique, it was labeled the “New Economy”. Unfortunately for many, the boom couldn’t be maintained, the bubble popped, and reversion defeated extrapolation.

Ever since the 1999-2000 bubble peak, it appears to me that we, as a society, have been trying to relive that high. Policy makers in particular have increased their focus on the wealth effect and financial stability. Once used mainly as an economic indicator, the financial markets have become the go-to lever to pull when the economy needs a boost. Reflating asset prices has become synonymous with reflating the economy. If a stock market bubble pops, replace it with a housing bubble. If a housing bubble pops, cut rates to 0%, buy trillions of assets (global QE), and watch everything fly.      

In my opinion, the tremendous amount of effort and resources used to sustain the current cycle stems from the desire of investors, corporations, and policy makers to live their lives on high. Unfortunately, as nice as it would be for profits and asset prices to remain near peak levels indefinitely, it’s not how the markets, or life for that matter, typically works. Eventually “the light washes over” and the cyclical nature of business, markets, and the economy is revealed.  

The Fed Cheat Sheet

In a recent post I noted, “…barring a consequential decline in asset prices, I believe the Federal Reserve will be forced to continue increasing rates and unwinding their bloated balance sheet.” While I did not have a number in mind when I used the word “consequential”, I certainly didn’t believe a flat YTD number on the S&P 500 would cause the Fed to alter their plans. And that, of course, is what markets were led to believe yesterday after Jerome Powell stated the funds rate is “just below” the Fed’s theoretical neutral rate.

Now that we have a better understanding of the Federal Reserve’s tolerance for financial instability (not much), I believe investors are in a better position to gauge future policy responses related to further declines in equity prices. I put my best guess together in the Federal Reserve Cheat Sheet below:

S&P 500 YTD       Policy Response
5%+                      Gradually raise rates
+5% to -5%          Hint at a pause
-5% to -15%         Pause
-15% to -20%       Hint at rate cut/ending QT
-20% to -25%       Cut rates and end QT
-25% to -30%       Hint at QE4
-30% or worse    Implement QE4

Source: Conversation with myself on the way home from grocery store
Margin of error: +/- a lot

So there you have it. Of course this is just a wild guess from an unqualified guesser of monetary policy. And I’ve certainly been wrong in the past. In fact, before yesterday I thought Chairman Powell might be different. Not Paul Volcker different, but possibly less willing to backstop the financial markets relative to Greenspan, Bernanke, and Yellen. However, after yesterday, I’m now leaning towards more of the same. And I suppose I can’t blame him. Powell inherited a tremendous amount of asset inflation. Similar to a banker with a large book of loans, no one wants to see the loans go bad on their watch (especially if they weren’t the underwriter).

I also believe the recent decline in certain commodities is providing the Fed with some cover to pause. In fact, it’s beginning to feel a little more like 2015-2016. It will be interesting to monitor the impact from the recent decline in energy prices. Similar to the last decline in 2015, will we have another earnings recession? And let’s not forget the high yield market and credit spreads. As can be seen in the charts below, energy prices, along with the health of the energy industry, can have a considerable effect on the economy, the credit markets, and earnings growth.


2018 is turning out to be a very interesting year — there are many important variables in motion influencing the profit and market cycles. I’m looking forward to analyzing Q4 2018 corporate operating results to learn more. In the meantime, I’m currently in the process of reviewing recent quarterly results of many of the consumer businesses I follow. I should have an update soon, providing timely information on the health of consumer businesses and trends in consumer spending.

The Bottom-Up Economist Q3 2018 Report

Below is a link to The Bottom-Up Economist Q3 2018 Report. Q3 was a very interesting quarter with some operating trends continuing, while others taking a noticeable turn. Although the report is a very thorough analysis of Q3, given the recent decline in asset prices and hints of a slowdown in certain industries, I’m very alert to possible changes in trends and outlooks in upcoming quarters.

This will be our last quarter publishing The Bottom-Up Report (BUE). My good friend and colleague who was working on the report with me accepted an opportunity that will require significant time and focus. The BUE report includes a tremendous amount of company-specific information — it’s very labor intensive to accumulate and organize. Because of its time requirement, we’ve decided it will be necessary to place BUE in hibernation at this time. We plan to leave the website up and running for those interested in the practice of bottom-up economics, or viewing the economy through the eyes of business.

I continue to believe bottom-up economic analysis is a viable alternative for investors and economists dependent on top-down data. While it won’t be as organized and detailed as the BUE report, I plan to continue providing a quarterly update on the economy based on the operating results and outlooks of my opportunity set (300 name possible buy list).

I’m looking forward to Q4 2018 – it should be a very informative quarter. Will the recent increase in financial instability affect demand and cause corporations to alter their 2019 investment plans and expectations? While it’s too early to know for certain, things are clearly becoming more interesting! As a patient absolute return investor, I’m encouraged and looking forward to learning more.

The Bottom-Up Economist Q3 2018 Report

Happy Thanksgiving!

Got Some Splainin’ to Do

In recent posts I mentioned I was becoming increasingly optimistic regarding future opportunity. Does this mean a sharp decline in stock prices is imminent? I wish I knew, but I don’t. As a bottom-up investor focused on small cap equity analysis and valuation, I remain unqualified to time markets. Regardless of my inability to determine when the bids disappear and the current cycle ends, recent market trends have been encouraging.

When I recommended returning capital in 2016, interest rates were near 0%, inflation was subdued, and global central banks were buying over $2,000,000,000,000 a year in assets (that’s a lot of zeros!). The investment environment has changed considerably since then. A growing number of objective and subjective variables that influence asset prices are in motion, with most indicating the current market cycle’s clock is once again ticking.

Objectively, inflation and interest rates are on the rise. The 2-year U.S. Treasury continues to move higher, reaching 2.95% last week, or up approximately 230 bps from its 2016 lows. Short-term Treasuries have suddenly become very competitive relative to normalized earnings yields of equities and other risk assets.

While some investors point to an improving economy (bullish) to explain rising interest rates, increasing wage pressure and inflation (bearish) have also contributed. From a bottom-up perspective, signs of inflation have been building noticeably over the past year. Labor availability/shortages, wage growth, and company responses (higher prices), are finally beginning to show up in the government data. Given these trends, and barring a consequential decline in asset prices, I believe the Federal Reserve will be forced to continue increasing rates and unwinding their bloated balance sheet. With the ECB in the process of ending QE and the Bank of Japan questioning the effectiveness of its asset purchases, the days of unlimited central bank bids may finally be coming to an end (at least for now).

In addition to influencing monetary policy, inflation is beginning to affect demand in certain industries. For example, several homebuilders recently blamed affordability (asset inflation), higher building costs, and rising mortgage rates as possible reasons for the recent slowdown in demand. While it’s too early to determine if the slowdown in housing (along with other interest sensitive industries) will accelerate, early indications suggest some spillover into corporate earnings could be expected.

In addition to objective variables, such as inflation, interest rates, quantitative tightening, and earnings growth, there are subjective variables emerging that also appear to be influencing the markets. For example, investor sentiment weakened during the Q3 2018 earnings season as investors appeared to be in a less forgiving mood. There are many examples of investors punishing stocks 10-20% in response to lower than expected operating results. For most of this cycle, that wasn’t the case. In fact, I remember many instances when poor results were met with a yawn and in some cases shareholders were actually rewarded!

There are many possible reasons why investors and stocks are behaving differently at this stage of the market cycle. In addition to variables already discussed, sometimes it’s as simple as markets getting tired and falling on their own weight. At higher market caps, and without the price insensitive bid from global central bankers, it’s likely becoming more difficult to muscle asset prices higher.

Another theory I’ve considered relates to the natural rotation of capital that occurs throughout a market cycle. As a portfolio manager who has generated some very good and very bad relative returns, I’ve seen my share of capital inflows and outflows. Inflows often occur after periods of strong performance, while outflows typically occur after periods of poor performance. As I’ve noted in the past, I’ve often been hired when I should have been fired and fired when I should have been hired.

The rotation of capital away from underperforming managers and towards managers with strong performance is nothing new. Chasing top performing managers isn’t much different than investors crowding into the best performing stocks. Similar to stock cycles, the capital transition cycle eventually runs its course as the number of managers remaining to pull capital from dwindles. I call it capital allocation capitulation – when asset allocators give up on a set of managers, style (includes active vs. passive), or asset class. I’ll never forget 1999 when many value managers I respected stepped down or were fired. By early 2000, there weren’t many disciplined value managers still in business! The capital transition cycle was complete, just as the market cycle was about to turn.

Based on the duration of the current market cycle, along with its elevated valuations, I believe a tremendous amount of capital has already been transitioned away from lagging managers. After a raging ten year bull market, many managers unable or unwilling to keep up with their benchmarks and peers have likely been replaced. And even if they’re still around, their assets under management (AUM) have certainly declined. As the market cycle ages, so does the capital transition cycle. Eventually capital becomes concentrated, breadth narrows, and the funds winning the AUM game become increasingly crowded in the “best” securities.

Near the later stages of a market cycle, portfolio managers who apply thorough bottom-up analysis and have strict valuation disciplines, may find it difficult owning the best performing securities. As a result, it is not unusual for disciplined active managers to lag during periods of significant asset inflation and overvaluation. As such, I believe it’s rational to assume much of the capital rotation this cycle has moved away from disciplined active managers and into funds and ETFs that are less analytically rigorous and valuation sensitive.

And this finally gets back to a theory of mine as to why certain stocks are beginning to act differently, especially after reporting weaker than expected operating results. As a portfolio manager, holding a stock that has a large unrealized loss isn’t easy. It requires a tremendous amount of research, analysis, and conviction. It also requires frequent and detailed communication with clients – expect to be grilled during the next quarterly meeting! 🙂

One way to avoid having to defend positions with losses (and time required to know positions well), is to refuse holding them. Why go through the pain when you can simply sell? For funds and managers that are less likely to have the necessary process, discipline, and conviction to defend losing positions, selling can be a tempting and easy solution. And that’s the foundation of my theory. As the current capital transition cycle matures, fewer portfolio managers and investment strategies remain that are willing or able to defend losing positions. As a result, I believe the capital transition cycle has contributed to the rising number of price gaps lower as stocks that require “some splainin’ to do” are sold and forgotten (easy) instead of held and defended (hard).

For patient absolute return investors, the recent shift in investor behavior has been refreshing and encouraging. As capital has moved away from disciplined active managers and into funds or ETFs that have little loyalty or conviction in individual holdings, I’m hopeful the current “gap down” phenomenon in equities increases in frequency and magnitude.

The Four Gross Margin Horsemen

As Q3 2018 earnings season comes to a close, there are several important themes and trends I’m looking forward to discussing in our upcoming The Bottom-Up Economist (BUE) quarterly report. While there were many similarities between Q3 and Q2 2018, there were some subtle, but important shifts in trends. One in particular relates to corporate costs.

I’ve been discussing and documenting rising corporate costs for over a year. While the upward trend in corporate costs continued in Q3 2018, the growth rates of the major cost components fluctuated.

On its Q3 conference call, Tennant Company (TNC) addressed this earnings season’s most frequently discussed corporate costs. Management noted,

“ There are…several macro factors impacting gross margin. These take the form of higher freight costs, raw material inflation, labor shortages that periodically impact productivity and tariffs.”

I thought Tennant’s comments were a good summary of the top four gross margin headwinds most corporations are currently facing: freight, raw materials, labor, and tariffs. The effectiveness of management’s responses to these rising costs is often determining whether or not companies are winning the quarterly “beat the earnings estimate” game. Some companies have done very well by addressing rising costs in an aggressive and timely manner (probably BUE readers 🙂 ). Meanwhile, other companies waited too long to respond and fell behind the rising cost curve (probably government data readers 🙁 ).

While we’ll review the four profit margin horsemen in more detail in our upcoming BUE quarterly report, I thought I’d provide a brief summary of this quarter’s important cost trends.

First, transportation and logistics. Conventional wisdom suggests freight costs are plateauing and will possibly decline as comparisons become easier. While rate increases are expected to moderate year over year, the freight market (and truck driver availability) remains very tight. As such, unless the demand environment changes abruptly, moderation in rate increases can be expected, but not declines.

Second, raw material increases were mentioned frequently again in Q3, but similar to freight, these costs will soon lap higher increases from a year ago. Therefore, assuming there isn’t another leg up in commodity prices, the rate of increase is expected to slow in upcoming quarters.

Third, responses to tariffs increased during the quarter and are clearly inflationary. We’ll spend considerable time discussing tariffs in upcoming reports. There are literally hundreds of examples of how companies are being impacted and responding to tariffs – most are raising prices.

And finally, labor costs. Rising wages and labor availability is a growing issue and is showing no signs of slowing. Therefore, while freight and raw material inflation may be moderating, wage growth remains resilient and elevated. Thanks to a reader who recently sent the following visual example of wages increasing in real time (starting wage at distribution center increased from $15.35 to $16.85 — not bad!).

And from another reader…humorous, but also illustrates the frustration many employers are having finding qualified labor.

In summary, certain corporate costs are moderating (freight and materials), while others remain elevated and are showing signs of accelerating (labor and tariffs). With so many costs in motion, it’s becoming an increasingly tricky environment for those attempting to measure and respond to inflation. In fact, I can’t remember the time in my career when the risk of misjudging inflation has been this high for corporations, investors, and policy makers.

Policy makers are in a particularly precarious position. Underestimate inflation and risk losing the confidence of the bond market and the ability to implement future financial market bailouts (asset purchases). Overestimate inflation and risk bursting this cycle’s asset inflation boom and sending the economy into a recession. It’s quite the predicament.

The unpredictability of inflation and interest rates, in opinion, remains one of the largest risks to asset prices and the popular belief that the next bear market will be promptly rescued by another round of aggressive monetary policy (The V or the L).

While I can’t predict the future, I can see current trends in corporate costs and pricing clearly – they are rising. And if corporate costs and pricing power are on the rise, when and how will these inflationary trends reverse? Is it even possible for corporate costs (especially wages) and inflation to recede without a meaningful decline in asset prices and economic activity? It’s a good question and one I’d be asking myself if I was invested in risk assets.

Based on the valuation of my opportunity set, I remain uninterested in most small cap stocks. Until I believe I’m being adequately compensated to assume risk, I’ll be watching this market cycle age from a safe distance. With inflation and interest rates on the rise (see below), I’m becoming increasingly optimistic in future opportunity.

Short-term Treasury yield update: 3-month 2.34%, 6-month 2.52%; 12-month 2.68%; and 2-year 2.92%.

Capital Guilt Management

It’s that time of the year again. Of course I’m talking about tax loss selling season.

As a fund manager, I tried to avoid allowing capital gains or losses to interfere with my investment process. For example, if I incurred an above average amount of capital gains YTD and had a stock trading over fair value, I’d sell the stock regardless of the tax implications.

My rational was simple. First, I had a healthy mixture of taxable and non-taxable clients. While delaying the sale of an overvalued security would lower the tax bill for taxable clients, it would also increase the valuation risk assumed for non-taxable clients. Valuation risk was and remains the overriding factor. In effect, I believe the risk of holding an overvalued asset outweighs the tax implications of assuming capital gains.

While my process places a greater emphasis on valuation risk than capital gain management, I understand why portfolio managers attempt to avoid sending clients a large and possibly unexpected tax bill. It can be bad for business and in some instances it’s just plain rude!

This year’s capital gain setup is becoming increasingly uncomfortable and possibly awkward for many managers. For most of the year, the equity market was decidedly positive and ripe for assuming capital gains. And after a ten year bull market, there were plenty of gains to take! However, as the current cycle’s legs have begun to wobble, large YTD gains have disappeared and in many cases have turned to losses (50% of the stocks in the S&P 500 are down -20% from their highs).

Imagine for a moment you’re a fund manager invested in many of this cycle’s leading stocks, such as those in the Nasdaq 100 (QQQ). Now imagine it’s September 30, 2018 and your fund is up 20% and you’ve taken considerable gains throughout the year. Although you’re aware of the large tax bill you’ve been racking up, given the fund’s impressive YTD performance, you’re not concerned. Client meetings have been going great — filled with smiles and applause.

Now fast forward to today. The realized taxable gains you incurred earlier in the year are still there, but your YTD gains have disappeared. In fact, your fund is currently showing a loss YTD!!! You’re staring to feel a little guilty and your marketing department is becoming anxious. What do you do? I know one thing you probably don’t want to do — send your clients a large tax bill after losing their money!

The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill. As such, and assuming the current decline in stocks continues, I expect this year’s tax loss selling season could add additional pressure to many of the market’s laggards.

For patient absolute return investors, this could turn into an interesting opportunity. I have several stocks on my possible buy list that are down considerably YTD that I’m closely monitoring. While I believe the average small cap stock remains expensive, I’m hopeful an amplified tax loss selling season could provide investors with the opportunity to pick up a few discounts heading into year-end.

Disappearing Tenders

Every year since 1978, central bankers, leading economists, and prominent investors, have gathered in Jackson Hole, Wyoming to discuss economic and policy related issues. Considerable research and human capital is allocated to the conference. The research is technical, thorough, and thought-provoking – enlightening stuff for top-down macro economists.

Instead of making the long trip to Jackson Hole this year (my invitation was lost in the mail again!), I attended a slightly less prestigious, but in my opinion, a more valuable economic symposium. It was held in Orlando, Florida a few weeks ago. Leading participants included the parents, coaches, and players of over 50 softball teams.

I’ve always appreciated the demographic and economic diversity of softball families. If you want an update on the stock or real estate markets, you’re better off signing your kid up for a soccer, lacrosse, or tennis tournament. However, if you’re searching for a timely report from the front-lines of the U.S. economy, softball tournaments can’t be beat.

Attendees of softball economic symposiums have experience in a variety of industries and occupations. Presentations are informal and are typically given after games and during team dinners. Topics and Q&A sessions are broad-based, current, and very informative. So what did I learn at this year’s gathering of economic doers? Quite a bit, actually.

The common theme of this year’s symposium (by far) was rising wages and labor shortages. Given this year’s theme, it was fitting the symposium’s dinner was held at an insufficiently staffed Applebee’s. Instead of their normal eight server crew, the restaurant could only find four servers willing to work on this busy Saturday evening. On the bright side, one server per 30-40 hungry customers made for very long, but informative dinner!

My favorite presentation was given by a parent and restaurant manager titled, “Modern Monetary Policy, Labor Costs, and Disappearing Chicken Tenders”. The presentation began with a discussion on the tight labor market and the difficulty in finding adequate labor. As a manger responsible for recruiting, training, and retaining approximately 200 workers, he had a good feel for the current labor market. The manager pointed to the ceiling to illustrate the direction of labor costs, explaining, “These large retailers are picking off my employees by offering $12/hour. They’re trying to upgrade the quality of their workers, but they’re really just raising the costs of the same labor pool for everyone.”

I had a front row seat of the presentation and knew immediately this presenter was an expert on the real economy. Move over PhDs and monthly jobs reports, this is the guy I want to listen to for an up-to-date summary of the labor market. He continued, “And people think these wage increases are somehow free. Nah, not true. What do you think we do when I’m forced to increase wages?” I eagerly answered, “You raise prices!” While I was expecting a “You damn right we do!” he instead replied, “When we can we will, but not always.” He explained, “We have some crazy competitors that will be bankrupt soon if they keep giving food away. But until they go under, it’s tough to raise prices on everything.” I asked, “If you can’t fully offset rising costs with price increases, what are you doing?” He replied, “We cut back.” He provided an example, discussing how the company recently reduced the number of chicken tenders in their chicken salad.

Providing less for the same price is often referred to as lightweighting. When I think of lightweighting, I typically think of a manufacturer using less material or altering a product’s composition. However, lightweighting is a common practice in a variety of products, services (think longer lines and wait times), and industries – including restaurants.

As a young analyst, I’ll never forget the first time I listened to a management team explain their lightweighting strategy. I was on a conference call of a leading trash bag manufacturer. The manufacturer explained how it planned on offsetting rising resin costs by reducing the number of trash bags in each box. An analyst on the call pointed out the obvious, “This strategy doesn’t seem sustainable. At some point you won’t be selling trash bags, you’ll be selling empty boxes.” Management acknowledged the analyst’s logic stating, “You are quite right. Next question please.”

Whether it’s trash bags or chicken tenders, the key to successful lightweighting is to reduce the quality or quantity of a product (or service) without it going noticed. I asked the restaurant manager if anyone noticed the missing chicken tenders. He said he was aware of one complaint, but explained, “So I have one guy notice there’s less chicken in his salad. That’s not nearly as bad as the response I’d receive if we raised the price of the salad by a dollar.”

His comments caused me to think about the government’s inflation data and how it’s calculated. Specifically, does the U.S. Bureau of Labor Statistics (BLS) account for lightweighting? If so, do they go as far as counting the number of chicken tenders in a salad? It’s an interesting question that few presenters at our softball economic symposium were qualified to answer (myself included).

The restaurant manager’s Q&A session eventually concluded and was followed by presentations from a retail maintenance manager, electrician, and truck driver. All supported the theme of this year’s symposium – the labor market is very tight and wages are rising. However, to be fair, there were other presenters who were less supportive of a strong job market, including a marijuana stock day trader and absolute return fund manager — both were unemployed!

Whether it’s in the form of rising prices or disappearing chicken tenders, there is growing evidence that companies are taking action as it relates to higher corporate costs and rising wages. It’s an environment I’ve been reporting on consistently over the past year and it’s why the Federal Reserve has been forced to raise rates and implement quantitative tightening. Until something in the financial market breaks (consequential asset deflation), I continue to believe the trend in short-term interest rates will remain higher. As such, patient investors, in my opinion, will likely remain the beneficiaries of either higher rates or lower equity prices (Patience – A Possible Win Win).

The BUE Consumer Report

Based on the valuations of my opportunity set, I’ve been bearish on small cap stocks. However, unlike your typical bear, I haven’t been negative on the economy – at least over the past year. In fact, I’ve been relatively positive on the operating environment for most small cap businesses. I began noticing the improving economy, along with rising wages and corporate costs, during the second half of 2017. Since then, the majority of the businesses on my possible buy list have performed well.

One of the interesting aspects of rising growth rates throughout 2017 and early 2018, was how consumer companies lagged their more cyclical peers (in growth and pricing power). Companies involved in transportation, energy, heavy industry, and construction, generated noticeably higher growth rates. However, the dispersion between cyclicals and consumer businesses appears to narrowing as organic growth of many consumer businesses has risen throughout most of 2018.

To help readers analyze the current consumer operating environment, The Bottom-Up Economist published a report today detailing the economy through the eyes of consumer businesses.

The report, on average, was slightly more positive than I expected. In fact, it was so positive, I reached out to my former analyst and BUE colleague and asked, “Are consumer businesses really doing this well, or have you been reading Tony Robbins again?” He replied, “Funny. But this is what our companies are reporting and what managements are discussing.” I responded, “With interest rates increasing, corporations responding to tariffs, and financial instability on the rise, our next consumer report may not appear as rosy.” He agreed, but reminded me that we are bottom-up economists, not economists for a sell-side firm. As such, it isn’t our job to predict the future or mold a narrative to fit our business needs. We should avoid subjectivity and describe the environment as it is, not as we want it to be. As bottom-up economists, we are simply relaying what businesses are reporting and communicating. In effect, we are messengers of real world economic data, company forecasts, and the opinions of management (but never ours).

Although I knew my BUE colleague was right, I remained reluctant to publish a bullish report on the consumer. My hesitation is likely a result of my history with asset bubbles. I know all too well what happens to the economy and consumer spending when an asset inflation boom abruptly turns to bust – consumer demand plummets.

With the financial markets finally responding to the sharp and consistent increase in short-term interest rates, I’ve become increasingly confident in my belief that the clock on the current market cycle is ticking (Tick Tock). As such, I’m also growing more concerned about the future operating results of many of the small cap businesses on my possible buy list.

While interest rates remain very low, there are already early indications that demand for large ticket items may be moderating. Although there are few signs of sharp declines, as Lennar (LEN) recently reported, home sales (I’d also include autos and RVs) may be taking a “pause” as sales and traffic trends slow. The degree and duration of any consumer pause remains unclear, but it is something I plan to monitor closely during the current earnings season. I’m also very interested in how companies are responding to rising interest rates, tariffs, wages, and inflation.

Speaking of inflation, last week the CPI and PPI reports came in low and below expectations. The Consumer Price Index only increased 0.1%. While I don’t analyze the government’s inflation data closely, a headline alerted me to the fact that according to the government’s data, used car prices declined -3% in September, or the most since the 1960s! The headline caught my attention as I just read CarMax’s (KMX) conference call, which described a different used car pricing environment. On the call, management did not talk about used car deflation, but instead was surprised by how well prices were holding up.

Management explained, “…we’ve seen unusual depreciation curves. In other words, normally, you see continued depreciation during this time of year, and we just really didn’t see that. It’s very different than in past years. It’s been very flat.”

Management had an interesting explanation as to why used car prices haven’t declined, stating, “I think there’s probably — and, this is just my belief — some of what’s driving that may be anticipation of tariffs on new cars and people speculating and trying to buy up used cars, but to be honest with you, I don’t really know why that is. New car prices are obviously still as high as ever, and they continue to go up.”

Bloomberg also picked up on the dispersion between the government’s data and other measurements of used car prices. In the article “Used-Car Price Plunge in CPI Contrasts with U.S. Industry Data”, Bloomberg pointed to the Manheim Consulting’s Used Vehicle Value Index, which set a record for the third straight month. Bloomberg quoted Stephen Stanley, a chief economist, who said, “This is one of the weirdest CPI reports that I can remember.” He went on to state the government’s used car data was “entirely at odds with the underlying reality in that market.”

Based on my bottom-up observations and analysis, I’m not convinced inflation is as low as advertised. And I’m not alone. While turning on CNBC last week to assess the media’s reaction to the recent stock market decline, I unexpectedly caught an interesting interview with Tilman Fertitta, CEO of Landry’s and owner of the Houston Rockets.

As a CEO and operator in the economy, Mr. Fertitta is very aware of rising costs and prices. As such, it shouldn’t be a surprise that he doesn’t buy into the “no inflation” narrative. In addition to pointing out wages are rising, Mr. Fertitta discussed his disagreement with the Federal Reserve’s view on inflation, stating, “People say there’s no inflation, but why does it cost us more to go to a restaurant, more to buy a car, more to stay in a hotel like this? There is inflation out there, and that’s where I disagree with the Fed.” Mr. Fertitta’s views on inflation are very similar to other CEO’s and management teams as we described in the BUE Inflation Report.

In summary, based on operating results released to date, many of the trends discussed in our Q2 2018 report, such as improving consumer demand and rising inflation, remain intact. Nevertheless, with many economic and market variables becoming increasingly volatile and uncertain, I believe the next two earnings seasons will be extraordinarily important and informative. I’m very interested in gathering timely information and data on inflation, wages, tariffs, and rising interest rates.

We plan to release our Q3 BUE quarterly report in November. I expect it to contain a tremendous amount of interesting and useful information. Until then, I hope everyone enjoys The Bottom-Up Economist Consumer Report.