Peak Promotions

For most of the current profit cycle, the retail industry has been burdened by overcapacity and unsettling ecommerce trends. As a result, the environment for many consumer companies has been challenging and highly promotional.

While deep discounting remains popular, not everyone has conformed to the promotional norms. In fact, based on recent earnings results and commentary, the reliance on promotions appears to be receding, while the emphasis on “full-price” sales is gaining momentum.

Two Bloomberg articles recently touched on this subject. The first article, “Clothing Retailers Are Finally Catching Some Breaks” highlights the improving same-store sales of apparel companies. While several reasons were noted, the following comment from Bloomberg’s apparel analyst caught my attention.

“The improvement likely suggests clothing retailers lately have done a better job selling full-price goods, relying less on promotions and discounts.” [my emphasis]

While the full-price model isn’t new, I believe more businesses are considering and in some cases transitioning. Ralph Lauren (RL) is the first company that comes to mind when I think of companies choosing profits over promotions. Stein Mart (SMRT), my favorite apparel retailer (for shopping, not investing), is another good example.

In March, Stein Mart reported a significant improvement in earnings, causing its stock to spike 68%! Although Stein Mart’s same-store sales remained negative, operating income rose sharply due to a 380 basis point increase in gross margins. The quarterly improvement was driven by lower inventories, fewer promotions, and “significantly increased regular price selling”.

Stein Mart’s transition from relying on promotions to improving profitability wasn’t easy. From Stein Mart’s conference call:

“As you can see from our 2017 results however, transitioning to lower and healthier inventories can have a short-term impact on sales and margins. Through the third quarter of 2017 margins were hurt by additional markdowns to clear excess inventory.”

However, its transition is finally paying dividends…

“This better mix of more regular price sales and less clearance in the quarter as well as higher mark ups resulted in an overall better margin.”

…with higher margin trends continuing.

“Our sales are now much more profitable with the lower clearance level. Our current regular price selling results are strong.”

And finally, management provided an optimistic assessment of current sales trends.

“For the month of February with spring selling underway, our sale trends have improved dramatically compared to last year driven by higher regular price selling offset by lower clearance selling.”

While competition remains fierce, pricing pressure may also be stabilizing in other areas of retail. During Dick’s Sporting Goods (DKS) most recent conference call, management stated they hope to receive “full margin” on newly released innovative products. Furthermore, as it relates to promotions and the competitive environment, management implied stability.

“But as far as getting deeper discounts or deeper into a new price battle, we don’t see that right now. But that’s as of today that can always change tomorrow.”

[Side note: I’ve recently received an unusually high number of promotional emails from DKS. The last time I noticed this, they had a poor quarter!]

Another consumer company, Darden Restaurants (DRI), also discussed the current promotional environment and the possibility of changing trends. Below are management’s comments related to the industry’s rising check average.

“But, the real change that we’re seeing…is that the check average appears to be growing and has picked up some steam. And as we look at that, we’re trying to analyze whether that is the industry taking more pricing, is it a pullback on some discounting, is it change in promotional strategy?

Highly promotional trends may also be subsiding in other sectors of the economy, such as durable goods. A recent Bloomberg article, “Americans Urge to Splurge Making Inflation Hawks Edgy” analyzed the University of Michigan’s latest survey of consumer sentiment. The survey indicated shoppers of durable goods are anticipating lower promotions and higher prices.

“More American consumers than at any time in 27 years are convinced that it’s better to make big purchases now because retailer discounts and deals won’t be around much longer.

The director of the survey, Richard Curtin, made the following comments.

“When asked about buying conditions, the appeal of low prices has largely disappeared. For durables, it has been replaced by favoring buying in advance of anticipated price increases.

Excluding companies that are not required to generate an adequate return on capital (wink, wink, you know who you are 🙂 ), the path to prosperity is rarely filled with deep discounting and price wars. As such, it’s rational to assume the number of companies exiting the promotional mud pit — dead or alive — will continue to increase.

In my opinion, increasing wages, along with elevated store closures and bankruptcies, should benefit surviving businesses attempting to kick their deep discounting habits. Assuming more companies follow the less promotional path, it will be interesting to learn how sales, margins, and consumer prices respond. As Q1 earnings roll in, peak promotions is one of many trends I plan to monitor and analyze.

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With earnings season picking up steam, I may be unable to post for the next 2-3 weeks. Good luck to those who remain in equities. And for those patiently investing in cash, t-bills, and short-term Treasuries, yields are becoming more and more interesting! Yesterday the 12-month Treasury hit 2.15%, with the 2-year USTN yield reaching 2.43%. It remains a great time to check those cash balances and make sure you’re not getting short-changed by a bank or money market fund.

Sometimes I feel like the only person excited about higher short-term rates. I attended a social event last weekend and no one, I mean no one, was talking about the sharp run-up in short-term yields. They should be. Just look at the 2-year yield chart — it’s beginning to look more impressive than most FANG stocks! Now at 2.43%, the 2-year was only yielding 0.75% a couple years ago. It’s been a huge move (link to 2yr chart).

Hopefully short-term rates continue to march higher, rewarding patient investors with either higher income or an abrupt end to the current market cycle (lower equity prices).

I hope everyone has a wonderful earnings season! I’ll be back in a few weeks.

transcript source: Seeking Alpha

Q&A with Michael Lebowitz

Below is an article by Michael Lebowitz of Real Investment Advice and 720 Global. In addition to asking several questions related to absolute return investing, Michael discusses the common sense approach of buying low and selling high. I always find it fascinating how such a simple and logical investment approach can sound so contrarian, especially during market extremes.

Although buying low and selling high may appear easy, in practice it is very difficult. When prices are low and declining, fear can overwhelm investors, causing them to freeze. Conversely, when prices are high and rising, greed and adrenaline can work like a drug, causing investors to become hooked and wanting more. In effect, it is fear and greed that make buying low and selling high so difficult and surprisingly unique.

While buying low (taking risk) and selling high (avoiding risk) is an important part of my process, to be clear, I am not a market timer. My buy and sell decisions are determined by the value, or lack thereof, within my opportunity set. In other words, portfolio cash levels are valuation-based and built from the bottom-up (individual security research and selection).

Currently, valuations within my 300-name possible buy list are very expensive and in my opinion, do not provide adequate future returns relative to risk assumed. Therefore, I’ve decided to hold cash instead of what I believe are overvalued small cap stocks.

With that, I’d like to thank Michael for his interest in absolute return investing! I hope everyone enjoys our discussion.

Value Defined: An Interview with Value Investor Eric Cinnamond

The UniFirst Jobs Report

As the financial markets fluctuate on trade war headlines, there remains a building and possibly underappreciated risk in the U.S. economy and financial markets – rising wages and labor availability.

Last week the U.S. Department of Labor reported jobless claims declined to 215,000. Although I don’t follow government data closely, even I know that’s an extremely low number. In fact, according to Bloomberg, jobless claims are currently at a 45 year low and “underscore a persistent shortage of qualified workers”.

The last time I remember the labor market being this tight was in 1999, when unemployment was near similar levels (low 4%) and labor availability was also a growing issue (chart). However, interest rates were considerably higher in 1999, with the federal funds rate near 5% and a long bond trading at twice today’s yield. With similar signs of labor market stress, I find it interesting the current federal funds rate is so much lower at 1.5%-1.75% (chart) and the Federal Reserve’s balance sheet is so much higher (chart).

In my opinion, the most glaring difference between today and 1999 is two asset bubbles. Considering the consequences of the past two market cycles, it shouldn’t be surprising if central bankers prefer appearing behind the curve versus being blamed for another bubble bursting and Great Recession (see I’ll Be Gone You’ll Be Gone Central Banking).

Tomorrow the government will release the March jobs report. Will the report show the economy is in a “Goldilocks” phase (February report) or will there be growing evidence the Fed is falling behind the curve (January report)? In other words, will risk asset holders receive a hall pass for another month, or be sent directly to detention for bad behavior?

While the macro headline game is very entertaining, I have no idea or interest in what the government will report tomorrow. Instead, I’ll continue to rely on the information I gather from hundreds of operating businesses to form my opinion on the health of the economy and labor market.

One of my favorite labor market indicators comes from the uniform companies. UniFirst (UNF), a market-leading uniform company that provides uniforms for nearly 2 million workers, often discloses useful data and commentary. UniFirst reported earnings last week, providing investors with a summary of their operating results and the current labor market.*

For the quarter, UniFirst’s uniform business generated organic revenue growth of 5%. Management noted the company continues to benefit from new accounts as well as “positive price adjustments”. Profitability also benefited from pricing, as operating margins increased to 10% from 9.2% a year ago. Offsetting several positive contributors to margins, were higher healthcare claims and payroll costs. Energy costs were also higher.

Management expects margins to moderate in the second half of the year due to difficult comparisons, partially from “positive price adjustments” made during the second half of last year. Furthermore, management noted, “…employee wages continue to be impacted by the low unemployment environment. As we continue to invest in our people and infrastructure, we anticipate higher payroll costs as a percentage of revenues. Rising energy prices are also forecast to provide a headwind in the second half of the fiscal year.”

And finally, management had some interesting commentary on the current labor market as it relates to their uniform adds and reductions.

“It’s very similar compared to a year ago. So, we’re not really seeing any significant pull from big adds hiring within our customer base. I think that’s a little bit of indicative as the economy and the low unemployment environment and the competition and the difficulty to find labor. And we’re seeing some of that on our side as well.” Management went on to note that they are seeing some improvement in their Texas markets due to improvements in the energy industry.

UniFirst’s quarter and commentary supports many of the recent trends I’ve been noticing and documenting. First, the labor market is tight, with some businesses having difficulty expanding or “adding” new employees. Second, corporate costs, on average, are rising. And finally, I’m noticing an increasing number of companies responding to higher costs and making “positive pricing adjustments”.

Although I’m uncertain as to what Friday’s job report will show, if I was using UniFirst as a guide, I would estimate a lower jobs gain number (down from 313k+ in Feb) and a higher average hourly wage number (up from +2.6%). In effect, fewer hires and rising wages would reflect the growing difficulty businesses are having finding qualified labor. While this is what I would expect, I have 0.0001% confidence in my prediction 🙂 . Although it can be fun to play “guess the macro number”, I’ve found government data to be very unpredictable and frequently more volatile than the underlying trends in the economy (see You’re Hired You’re Fired).

Regardless of the actual number, the government’s assessment of the labor market will not influence my opinion on the economy and decision making. I’ll continue to form my macro and profit cycle opinions from the bottom-up. With Q1 2018 earnings season quickly approaching, I’m looking forward to learning and reporting more soon.

*UniFirst transcript source: Seeking Alpha

Reader Comments and a Few Questions

With little company-specific news to discuss, I thought it would be a good time to do another Q&A post. However, instead of questions, lately I’ve been receiving more reader comments. Below are a few I thought were interesting along with my responses.

Q: Don’t worry the new FED guy is reported to have said the FED won’t worry if inflation exceeds 2% for a while.

A: I think that’s why stocks are up today…the Fed (or Bloomberg article) is hinting to the markets that maintaining asset inflation will take priority over fighting increasing signs of inflation in the economy. Not a surprise given what happened the last two cycles. They’re moving much slower this time. Lesson learned – policies that encourage asset bubbles are acceptable, but letting them pop is not!

Q: The Vanguard Long-Term Treasury bond fund is down 7.8% ytd. I’ll bet many investors thought that interest rates only move in one direction, now they are beginning to realize that at low rates bond duration increases and when rates rise you actually lose money in your fund.

Vanguard’s LT Treasury fund started in May 1986 when rates were much higher, its annualized return is 7.5% since its inception 32 years ago. Now that rates won’t continue their decline the long-term return of this fund is maybe 2.5-3%, the good old days of 7.5% are over. And after-inflation and tax your return will be zero.

A: Interesting. Just as stocks and bonds went up together for most of this cycle, if rising corporate costs eventually spill over into government data, it’s possible stocks and bonds could go down together. In effect, rising rates threaten all asset classes. As such, diversified portfolios founded on passive pie chart allocations may want to take note. Especially, as you state, if they’re plugging backward-looking/historical assumptions (7.5% for long bonds) in their models.

Q: You talk a lot about market cycles. How will we know when this cycle is officially over and a new one begins?

A: That’s an easy one. Current investment geniuses will look like idiots and current idiots will look like geniuses! 🙂

Q:  PPI up 0.4% and 2.7% y-o-y. Companies realize this is the first time in a decade you can ask for a price increase from customers. At the same time, employees also realize it’s time to ask for a more significant raise.

A: It’s interesting…government data may finally be acknowledging inflation trends are in the process of shifting. Quite a lag from what companies have been reporting since 2017, but better late than never! Based on operating results and management commentary, I believe current cost trends will continue…at least in Q1 2018. I’m very curious about wage trends. Wage pressure appears more obvious to me than corporate pricing power, especially in certain industries…but labor remains subdued in much of the data (relative to what I’m noticing).

Q: 10-yr at 2.91% is now 86 bps off its September lows. I’ll bet some of the strong housing market data is due to consumers realizing rates may never be this low again (absent a market crash) therefore it’s time to buy a home and lock in a cheap 30-yr mortgage.

A: You may be right. Bonds could be in trouble with one big exception – barring the stock market tanking (as you note). Funny thing I noticed today…an asset manager on financial television was saying inflation is good for stocks. The marketing departments of some of these Wall Street firms never cease to amaze me! 🙂

Q: Avg hourly earnings up 2.9% y-o-y, the fastest wage growth since 2009. No wage inflation??  Some commentary about the new FED chair Powell is that he is not a disciple of the asset bubble troika Greenspan/Bernanke/Yellen – good luck speculators if he raises rates.

A: The tight labor market seems pretty obvious when reviewing business results and management commentary. In my opinion, viewing the economy from the bottom-up has many advantages to relying on economic reports. However, after nine years of only up markets, how many investors are performing the necessary bottom-up work these days vs. buying into passive allocations built on past returns? There are many unintended consequences of eliminating down markets.

Q: Two funny article titles today: WSJ “Global Bonds Swoon as Investors Bet on Inflation, Growth” and Bloomberg “Market Euphoria May Turn to Despair if 10-Year yield Jumps to 3%”. US treasury rates remain less than 3% while many European country rates are close to zero in addition to Japan. The global economy has improved therefore inflation picks up and rates rise, Economics 101. The global asset bubble financial economy has made many leveraged bets on expensive assets under the assumption the global central banks will always keep rates low and if we have a correction bail investors out. These are the periods when you have the greatest risk of a market correction.

A: The assumption that rates will remain low indefinitely appears to be extremely popular. How else can investors, including the value type, justify remaining fully invested during the later stages of the current cycle? Higher inflation and higher rates doesn’t sit well with the bulls or the bears, in my opinion. It conflicts with many of their views and portfolio positioning.

Q: I thought tariffs and trade wars lead to economic slowdowns/recessions or did I read the wrong textbooks in college

A: After this cycle, I suspect many of the economic and investment textbooks will need to be rewritten. 🙂

Q: In today’s WSJ? Logistics section [article on tight trucking market]. Not new news, of course, but I don’t think many investors (that I talk to) understand how serious the cost-push issue is for most US companies that have to ship a tangible product from Point A to B.

A: The recent rise in transportation costs is one of the quickest and most aggressive I’ve ever seen. It’s a real issue for many of the companies I follow that rely on others for transportation and just in time inventory. They often have no choice, but to take higher rates and figure out a way to pass it on.

Q: [a question from me to a reader] What do you think of recent hints of weak dollar policy? Seems to me with lower tax revenue, we’ll need our creditors’ cooperation/funding. Assuming inflation eventually shows up in government data + weak dollar = bond market air pocket potential. Is the bond market discounting this and its impact on equities? In effect, short-end appears to be acknowledging rising inflation/rates, while the long-end is predicting the deflationary aftermath of higher rates/declining prices of risk assets. Or maybe we shouldn’t depend on information from the bond market until central banks lose their privilege to buy bonds/assets?

A: It’ll be a long time coming before CBs run out of innovative ways to prop up/fund budget deficits or ramp up the monetary base. I’m not worried about that.

I’m worried about the quality of financial leadership in DC. We have a Treasury secretary (who’s never impressed me with his grasp of global macro) making very cavalier statements about the dollar, and a POTUS who understands even less about the significance of the USD to the global CB system. These are not the kind of statements that will inspire confidence at BIS meetings in Basel, and CB governors/chairmen do have other alternatives than buying a dollar that is being talked down. And if “talked down” is too harsh a term, treated quite cavalierly.

If the global financial system is a shell game, so be it, but everyone is in the game together. We, as a country, need the world to have confidence in us. Confidence is a fragile thing and should be handled with care.

With budget deficits being what they are (and what they will be after the tax cut takes hold), I think we need the world to support the dollar, not give it reasons to sell. Or buy less.

I think the bond market is now primed to react at the faintest hint of anything less than robust Treasury auctions and the inflationary impact of a cheaper dollar. And gold will react too, it has too.

Q: The NDX/Composite is in full-fledged parabolic mode. A blow-off top is fast approaching, I think.

A: The 2yr yield is also on the rise! Inflation perked up in today’s GDP report. One of these days I wouldn’t be surprised to see wage inflation showing up in a jobs report too. Should get very interesting when it does. Hope you’re right about a blow-off top. That said, at this point, one 25bps hike every few months doesn’t appear to be intimidating many investors in risk assets. It appears the Fed is on a set course of raising rates gradually until they discover the straw (hike) that breaks the cycle’s back (similar to last cycle). No one knows which hike it will be…or at least I don’t.

Q: If this feels like almost a perfect analog to ’99-00, then I expect a 10-15% pullback in the market very soon that will scare out the weak hands on the bull side, and reassure the bears that they were right all along and that this party is over.

Remember the 10% corrections we had in the NDX in the early part of ’99? Those corrections set us up for the final insanity of Nov 99 to March ’00. In that case, I expect a final blow-off top in spring/summer to emerge after a 10% correction soon.

A: Good memories! Fingers crossed this is the final phase of the cycle. I agree w you…sure does feel like it, but I’m a horrible market timer, so I’m remaining patient instead of taking a stab on the short side.

Q: Seeing the same thing [rising wages] here! Snapped this picture when I dropped the dogs off at the boarder. I asked the lady at the front desk about it and she said they’ve never found it more difficult to fill positions.

A: Labor availability and quality of labor is a growing issue for many businesses. I recently spoke with a large electrical contractor who said they’re turning down work due to their inability to find qualified labor. They’re focusing on higher return projects (higher pricing) and not even bidding on lower margin work – smart.

Q: How does a bond PM explain to a client that they own European country debt at 0% yield?

A: “Everyone was doing it” “no one saw it coming” “it was a 100 year flood” “TINA” “FOMO” etc 🙂 But most likely career risk/benchmark dispersion risk. The relative return game is played globally, not just in the U.S.

Q: I would love your thoughts on the unemployment & labour force participation dynamics currently playing out?

A: I’m more confident in my belief the current labor market is tight than how it plays out going forward (except near-term: outlooks and commentary suggest trends will continue in Q1). I’m more of an observer through the eyes of the companies I follow vs. an economist guessing where we go next.

That said, I believe labor market trends will be partially tied to asset prices, as I believe the current economic cycle has been influenced by significant asset inflation. If stocks and bonds were to decline meaningfully, I believe the economy (and employment) would be impacted.

In my opinion, somewhere in 2017 something changed with labor. Things started getting tighter and comments regarding tight labor become more noticeable. At that time I noted I felt short-term rates would no longer cooperate with rising asset prices and an improving economy. And they haven’t (see two year treasury yield since mid-2017). I suspect this trend will continue as long as asset prices remain inflated.

Q: [question from me to reader]: What do you think of the reported rising wage growth? I think “front line” skilled blue collar wages are growing noticeably. Maybe bond mkt actually is set free…we’ll see. There’s hope anyway.

A: Oh yes, as we said last fall, I don’t know whether it will come this Thursday or next, but come it will. And it did. In the end, a lot of micro pressures eventually add up to one big macro headline number.

I had to dissuade a few of my friends who thought the jump was because of these $1k bonuses that are being handed out by every company you can think of….the survey actually excludes one-off wage receipts.

The bond market has finally broken out of Alcatraz. I was actually surprised that the equity market didn’t react faster or harder because 2.70-2.72 (depending on which technical analyst you’re listening to) is one of the most well-defined, obvious and well-publicized chart levels in the world over the last many years. You know that bond trading desks and CTAs trade completely off charts and I expect the wall of money that’s in CTA/systematic strategies to pile on and press the trade. That’s what systematic trading is all about – you look for trend and you pile on. The trend, after breaking through 2.70-2.72, is clearly upward in the intermediate term.

Oddly enough, I don’t think this week’s breakout in the 10Y is the end of the equity bubble. Fevers take a long time to break (I should know, I’ve been down with the flu for the last week) and I think there will be one more surge higher in spring/summer this year. But we’re going to have a short correction before that, just long enough for bears like us to feel good for a New York minute.

Q: You mention you like to receive notice of research or other writing on the profit cycle and related items. Below the link to a quarterly research letter from an investment bank in Luxemburg. I have no idea if it will give you any new info, but it is well structured, to the point and gives a good global overview.

On another note, here in Belgium all pundits and media can talk about lately is the historically low unemployment rate yet very high rate of job vacancies that don’t seem to get filled in. Our most widely read economics magazine just devoted their latest issue to these topics. Maybe we’re on the verge an uprise in demand for higher wages as you’re also noticing. Just thought I’d let you know.

A: Thanks for the report and charts. Very interesting. I think labor costs will remain an issue as long as asset prices/economy remain elevated. We’ve finally reached a point where labor will get their share. Of course if asset prices tank, all bets are off. We’ll see…at least things are getting more interesting! Thanks again for the charts.

Q: [reader sent chart of the number of market declines without a recession]

A: Very interesting. In 2015 we were close to having a market decline w recession, but the energy credit bust wasn’t big enough to drag entire economy negative (but earnings were for several qtrs). Global QE and the ECB deciding to buy corporate bonds certainly helped keep asset prices inflated…not to mention encouraging overseas capital into the US…including reflating energy credit availability. What will stop central bank intervention and end this cycle? Not positive, but my best guess remains inflation…and possibly the bond and currency markets’ response to a Fed reluctant to confront.

Q: Looking forward to getting your feedback on our letter [qtrly letter attached].

A: Great letter and I agree! You covered it all on valuations. It’s interesting at this stage of cycle – it’s often disciplined value investors who have to defend themselves for not overpaying. Why? Given the facts, as you laid out succinctly, why isn’t it the fully-invested crowd needing to explain their positioning. Of course it’s possible they’ll ultimately need to…and I’m not sure what they’ll say considering how past cycles with similar valuations ended.

Also good point on private equity. I think a lot of institutional investors may be pouring money into PE thinking it’s less risky/expensive…and an effective diversifier. BRO had some interesting comments on the topic last conference call. Anyway…great letter. I know they’re not easy to write. Oh…and great performance too given amount of capital at risk.

Q: I understand it’s an accounting practice to add D&A back to net Income because technically it’s not an actual cash expense when calculating Operating Cash Flow (OCF). However, Buffett & Munger (link below) indicate D&A are actual expenses, and if that is true isn’t that a ‘flaw’ for reported OCF, and hence Free Cash Flow.

A: Great points on valuations. I like to exclude depreciation and also believe it’s an expense. While I don’t use multiples for valuations, if I did I’d probably look more towards EV/EBIT.  I prefer using a discount rate, fcf (typically near normalized net income), and mature growth rates. Traditional FCF/k-g.  I don’t like multiples as it’s difficult to know the exact implied discount rate and growth rate…I like to see both assumptions. Hope this helps. Everyone has their own methodology. Whatever makes most sense to you probably makes the most sense!

Q: Thanks for sharing your observations. Indeed, the financial repression for the past several years has been unavoidable for savers both in US and here in Denmark, unless one was willing to take bigger and bigger investment risks. Today 2-year Danish government bond yields -0.37%. One would think, that inflation down the road is inevitable, however, I’m struggling to come up with ideas, how to protect me and my clients in inflationary world, when:

  1. a) short term rates are negative
  2. b) most real assets (real estate, infrastructure) are funded with historically low rates and maximum gearing, thus, when rates rise – would asset prices really hold and increase with the rate of inflation? A big if…
  3. c) gold seems no longer to be a safe house for rich people, when cryptos are available…
  4. d) bond proxies (Nestle, Coca-Cola, …) – dirty expensive, slow growth, lots of debt on balance sheets

I would appreciate if you could type couple lines to your colleagues/followers outside US, that don’t have the pleasure of 2% government rates J of how to protect from inflation?

A: Great points and questions. It’s unfortunate real rates remain so low and in many cases negative. There just aren’t a lot of great options currently. Even cash has its own set of risks. In addition to remaining patient, the idea of owning some hard assets as a cash hedge may make sense for some absolute return investors. I wrote a post on this about a year ago. I know people who own farmland, antique cars, wine, real estate, art, gold/silver, miners, energy producers, etc. Currently I’m doing work on some precious metal miners that I’ve owned in the past. I’ve also owned energy E&Ps. But that’s me…each investor’s expertise, needs, and comfort levels are different.

Q: Thought you might find this of interest if you hadn’t seen it already. Maybe a subject for a future post. Curious to know your thoughts. [article titled: Waiting for the Market to Crash is a Terrible Strategy]

A: Maybe. Maybe not. I’m not positive how this cycle ends, but being patient while valuations are expensive and aggressive when valuations are cheap has worked well for me over the last two cycles. No guarantees it will work again this cycle…but it’s what makes the most sense to me.

I also believe the last three cycles have been extreme (rotating asset bubbles) and has made measuring the effectiveness of many investment strategies trickier. For example, buy and hold passive vs absolute return active may look great or awful depending on the performance measurement ending date. In 1999 buy hold looked great. 2002 it looked awful. 2007 great. 2009 awful. 2017 great. Once this cycle ends how will it look??? We’ll see, but things are definitely getting more interesting!

But regardless of the near-term direction of equity prices, I have no interest in knowingly overpaying simply to keep up with the crowd. In other words, I have no FOMO. 🙂

Q: BKD forecasting 5.5% to 6% increase in labor costs in 2018. This 2018 forecast followed 6% labor increases in 2017. Maybe you are right that labor pressures are building.

A: Great data point thanks!  I’m surprised by how bold investors have become as it relates to implications of inflation. There may not be a Fed backstop/more QE in an environment with rising inflation (at least initially). No Fed put + higher fiscal deficits = rising discount rates on most risk assets. 2yr ustn now 2.19%…I like it and hope yields continue to rise. Higher rates help patient investors enjoy the show more comfortably!

Q: Generally, I’m a bit surprised, that new oil/gas shale projects have access to capital so easy, while gold miners such as NGD can come under severe stress, when it had ramping hick-ups. But as you’ve mentioned, b/s is critical for these companies, especially in the coming years, if my expectation of higher corp credit spreads (which are absurdly low right now) will be true.

A: It’s a great point about energy’s access to cheap capital vs many of the miners. I think it’s due to how most investors are raised or taught to “know” miners are bad businesses. Miners are nearly career killers to own. In my opinion, our industry hates these things. Hence, the difficulty miners have raising capital.

Believe it or not, I’d rather own a developed mine that’s fully paid off with a 15 year operating life (AGI’s Young Davidson good example) and is cash flow positive versus lending to a leveraged energy E&P that’s focused on growing production with a short reserve life. A lot of it is industry perception, in my opinion.

Q: 10-yr rates: UK 1.62%; France 1.00%; Germany 0.76%; Spain 1.46%; Japan 0.08%. The Bank of England is threatening to raise rates from 0.5% to 1% by year end, wow, courageous central bankers.

A: It’s interesting. With a Fed going extremely slow, it seems the only thing that may reverse rising inflation/wages/interest rate trends in the near-term is a bust in asset prices. The stock market appears to be in a bind – if it goes higher, so does inflation and rates; making it tough for stocks to go considerably higher. The economy and earnings were relatively sound in Q4, I thought. And based on outlooks, I’m not expecting major changes in Q1 2018.

Q: Hope you’re doing well.  Looking forward to more on your take re tightness of labor market.  A big question for me is how much the growing demand for labor will pull those that “are currently out the labor force (i.e., not seeking employment)” back in.  How much of the increase in the proportion not in labor force due to boomers retiring, opioid addiction, other disabilities, etc. that will remain outside the workforce no matter how much labor demand surges? The skills mismatch thesis hasn’t played out yet? Will it? Will be interesting to watch how all this develops if economy continues to grow, and immigration continues to decline.

A: Great questions on unemployment and the true participation rate. I’m not certain. I’m more of an economic reporter (what I’m seeing through the eyes of business) than an economist guessing where things are headed next. That said, based on my observations, if you want a job right now you can find one. What will it take to entice the remaining unemployed to get off the couch? $15-$20/hr min wage??? I can’t speak for my fellow unemployed, but for me to return it will take considerably lower small cap valuations! 🙂

Q: Some corroborating top-down stuff…

A: Thanks for sending! Here’s my unqualified economic prediction. Asset prices remain inflated = economy good. Asset inflation deflates = economy bad. I should write a blog!!! Wait a minute…  Although possible, I think it will be tough for the market to go considerably higher as that would likely maintain current corporate cost pressures/tight labor market and drag rates higher. And the most effective way to get rates to go down is for stocks to decline…bonds would bounce. It’s an interesting game of financial market chicken. In any event, it’s good to know patient investors are getting paid a little more (1yr tbill now yielding 2.05%) to watch the greatest show on earth. I’m enjoying it!

Q: Article on rising inflation.

A:  I think inflation first and deflation later could happen. I don’t have a strong opinion, except about what the companies are reporting — I’m confident corporate costs are rising. However, if stocks and bonds were to tank, I suspect the inflation picture would change.

Q: I’m still refining my own valuation process, but prices these days don’t make much sense to me no matter how I slice it. And I really can’t see what a way that this great monetary experiment ends well for any asset class.  But, I eagerly await the opportunities that I know all of this capital misallocation will one day create.  My only cause for doubt is that the bear case seems so obvious. The dot com and housing bubbles were before my time, so maybe the red flags then were just as prevalent.

A: I feel your pain on difficulty finding value; however, I suspect, as you do, “this great monetary experiment will end” at some point. And yes, the tech and housing bubbles were just as obvious, but in a mania no one seems to care…the assumption is it will continue and when it doesn’t, investors playing along can react properly and in time. But it’s so tough to do. I prefer being patient during periods of elevated asset prices and attempt to make money after the cycle ends…or buying 50 cent dollars, instead of hoping 150 cent dollars go to 200 cent dollars!

Q: Article on why it’s right to warn about bubbles.

A:  He has good points. However, I also believe during every cycle there is a time to get aggressive. There was tremendous value in 2008-2010 and moderate areas of value in 2011-2012. Post QE3 is when things got nutty, in my opinion. Thanks for sending!

Q: Small cap stock idea (start-up business).

A: Thanks for the email and research idea. It gave me something to read during my daughter’s basketball practice! It looks very promising, but I don’t buy exciting young businesses. I tend to stick with old boring fuddy-duddy small caps that have been in business for decades.

Not very exciting, but it allows me to know the businesses well over time and value the businesses with a higher degree of confidence. While I’ve missed a lot of home runs investing this way, my relatively fixed opportunity set has allowed me to meet my absolute return goals over the past three cycles. However, considering how expensive my opportunity set has become, I’m now just waiting and waiting some more.

Q: I understand your frustration about losing clients, especially when clients often focus on storytelling and chase 5* funds after the fact. When investing in value companies in our fund, I often feel like an idiot trying to explain, how great it is to buy something that everyone else is selling. Oh..It’s so difficult to make marketing on value investing…

A: Investment banks are supposed to have a firewall between their research and investment banking departments. Maybe asset management firms, or the buyside, should have a firewall between research/portfolio management and their marketing departments! I bet money would be managed a lot differently 🙂

Unexpected Events

I’ve been unable to post over the past three weeks due to some unexpected events. While “life happens” is a constant theme for most of us, lately things seemed to have piled on quicker than normal.

The first unexpected event occurred after a large pickup truck slammed into the back of our minivan. Thankfully no one was seriously hurt, but our van (below) wasn’t as fortunate and was determined to be a total loss.

With the “minivan dream” in jeopardy, I quickly began to search for a replacement. For a starved value investor, shopping for a deal on a minivan was surprisingly refreshing. While they aren’t giving them away, there are some “relative” values out there if you’re willing to be patient and disciplined. Unemployment also helped, especially in sharpening my negotiating skills! In any event, after a week of wheeling and dealing, our transportation issues have been solved, with the minivan dream rolling on.

A less unexpected, but still difficult event occurred last week when our dog, Pete, passed away. Pete was diagnosed with lung cancer a year and a half ago. We expected to lose him shortly after his diagnosis, but Pete was determined to stay with us longer. We were very fortunate to have Pete as a family member and friend – the kindest dog I’ve ever known.

We met Pete at our local animal shelter 13 years ago. How could anyone consider putting this dog down? Unfortunately, many dogs like Pete are unable to find homes and are put to rest during the prime of their lives. According to the Humane Society, “2.4 million healthy, adoptable cats and dogs – about one every 13 seconds – are put down in U.S. shelters each year.”

If you’re looking for a dependable investment analyst who is a good listener and never asks for a raise, I strongly recommend adopting a dog. Some of my best ideas and portfolio management decisions were made after long walks with Pete and his best friend Jimmy (our other dog). We believe Pete was 14 or 15 years old. He will be missed dearly.

Last, and certainly not least, a very good friend was diagnosed with cancer and began chemotherapy a few weeks ago. His cancer is treatable, but after visiting him in the hospital, I learned his path to recovery will not be easy and will take tremendous courage. Understandably, his sudden and unexpected illness has altered his view on his past and future. Life-changing events like these often cause us to put things into their proper perspective and reconsider our priorities.

It wasn’t long ago when I reassessed my life’s priorities. When I recommended returning client capital over a year ago, I took a hard look at my past and what I wanted out of my future. For most of my adult life, I dedicated a considerable amount of time and effort to my career. While I don’t regret my professional path and continue to have tremendous passion for investing, as recent events have reemphasized, there is more to life than discovering high-quality small cap stocks selling at 70 cent dollars.

I often joke about how grateful I am for global central banks and their asset inflation. But it really isn’t a joke. Without their trillions in asset purchases and a decade of negative real interest rates, I’m confident I’d still be behind my desk, consumed by the markets and my career. Although I plan to work again (I managed a mutual fund, not a hedge fund 🙂 ), I intend to remain committed to my newfound appreciation for a healthy and productive work-life balance.

If you’re sitting behind a Bloomberg and your eyes are tired from watching the green and red lights flicker, it may be constructive to reflect on how you’re allocating your time and what matters most to you. In my opinion, there hasn’t been a better time to take a temporary break from the markets. Given current valuations and opportunity sets, what will you really be missing? While it’s important to be prepared, maintaining balance can go a long way in successfully completing the current market cycle with your capital, family, and sanity all intact!

In any event, after taking a few weeks away from the markets, I’m back up to speed and should be posting again soon. In the meantime, I recommend reading General Mills’ (GIS) most recent earnings conference call. It’s a good summary of many of the themes I’ve been discussing over the past several months; especially as it relates to rising corporate costs.

As I was reading General Mills’ call, the following headline crossed Bloomberg, “Powell: No Sense In Data That Inflation About To Accelerate”. I’ll never fully understand why so many economists, investors, and policy makers rely on the “data” to form their macro views. Viewing the economy from the bottom-up, or through the eyes of business, makes so much more sense to me.

Nevertheless, until “New Trends with Few Friends” makes its way into the data, I suppose the Fed’s plan of going gradual — as long as nothing breaks — will continue. Until something does break (sharp decline in asset prices), I continue to believe rising corporate costs and inflationary pressures will persist. While few see it in the data currently, I would not consider inflation first, deflation later (higher rates causing a bust) an unexpected macroeconomic event. In fact, at this stage of the cycle, shouldn’t it be expected?

Policy Distractions and Pricing Actions

I was multitasking Tuesday. While listening to Chairman Powell discuss his expectations for price stability in the medium term, I was reading a press release from H.B. Fuller (a leading provider of adhesive solutions) that communicated the company’s intention to raise prices 5% to 12%. Apparently corporate America hasn’t gotten the memo explaining inflation is expected to remain stable.

When developing my opinion on inflation, I prefer skipping the middleman (Wall Street economists and central bankers) and going directly to the source – businesses operating in real-time and in the real economy.

H.B. Fuller (FUL) is a good example of a company currently experiencing rising costs and implementing price increases. They are not alone. In fact, I thought H.B. Fuller’s explanation of its price increase was a good summary of the current cost and pricing environment for many of the companies on my possible buy list.

The past 12 months have seen continued increases in feedstock costs, logistics costs and labor costs. Inflationary pressures in global markets have occurred due to trucking shortages, Hurricanes Harvey and Irma in the United States, regulatory and environmental actions by the Chinese government, and robust demand. These increases will affect products in the company’s hygiene, packaging, durable assembly, construction, paper converting, and engineering adhesives segments.

Based on my bottom-up research, evidence of a tightening labor market, cost pressures, and pricing actions continue to build. Assuming corporate costs rise further and the Federal Reserve’s preferred measurement of inflation exceeds 2%, how will policy makers respond?

According to a recent Bloomberg article, instead of defending their target, the Federal Reserve may simply move it. Bloomberg explains, “Federal Reserve Chairman Jerome Powell and his colleagues may be willing to accept inflation rising as high as 2.5 percent as they seek to extend the almost nine-year economic expansion.”

If the Fed is willing to move its inflation target, why should investors assume it won’t move again? If inflation exceeds 2.5%, will policy makers move their target to 3%? And why not 4% or 5%? A slippery monetary slope indeed.

The bigger risk, in my opinion, isn’t if the Fed changes its inflation target or raises rates three or four times in 2018, it’s investors discover – as I have through my bottom-up work – that our central bank is falling behind the curve. In effect, as inflation moves through the pipeline, perceptions and investor psychology could suddenly change, causing the bond market to question the Federal Reserve’s ability and determination to confront rising prices.

While I believe an “inflation recognition” scenario is possible, investors do not appear very concerned. In fact, I recently watched an investment professional on financial television explain why inflation was good for stocks. And I thought the equity ownership justifications of TINA (there is no alternative to stocks) and FOMO (fear of missing out) were creative! What is next, trade wars are good for stocks too? 🙂

As the Federal Reserve debates inflation targets, companies aren’t waiting around for help with rising costs. Many are acting now. As H.B. Fuller’s actions illustrate, corporate pricing decisions are based on what businesses are experiencing, not an arbitrary and possibly fluid central bank inflation target.

It’s a tricky time to be an investor in stocks and bonds. In my opinion, to justify current equity valuations and experience further gains, stock investors need perpetually low interest rates and a stable bond market. While ideal, is such an environment possible considering rising equity prices would be stimulative, leading to additional inflationary pressure and higher interest rates? On the other hand, bond investors (ex junk) would likely benefit from stock market instability, sharply lower stock prices, and the economic drag it would bring.

Although stocks or bonds may rise in the near-term, if inflation targets and trends become unhinged, I believe many of the assumptions used to justify owning stocks and bonds would be challenged. In such an environment, the days of indiscriminate asset class inflation (everyone wins) would likely come to an end – a victory for capitalism and free markets.

Have a great weekend!

What’s Happenin’ Q4 2017

There is a growing debate about interest rates and why they’re rising. Is it inflation, expanding fiscal deficits, quantitative tightening, reduced foreign demand, lethargic policy response, late-cycle fiscal stimulus, or a weakening dollar? After reviewing Q4 2017 operating results, it seems simple to me. The economy is expanding, labor markets are tight, and signs of inflation are building. In my opinion, interest rates are acting as they should at this stage of the economic cycle.

When I put on my “bottom-up economist” hat, I’m viewing the economy through the eyes of business, not government data. While my macro views (especially on inflation and wages) have differed from government data for several months, recent CPI and PPI reports were more in-line with my observations. Furthermore, the latest job report confirmed the rising trend in wages I documented for most of 2017. Lastly, the government’s Q4 2017 GDP report showed an increase in inflation and an economy continuing to grow in a 2-3% range. In summary, my bottom-up opinion and government data appear to be converging.

Assuming government data continues to follow the path of my observations and conclusions, I expect to see further confirmation of a tight labor market and building inflationary pressure. In effect, I believe the reports on rising inflation and wages are most likely a start of a trend, not a one month anomaly.

While I continue to believe my opportunity set remains very expensive, the operating results for most of the businesses I follow and analyze was generally positive in Q4 2017. Barring a shock to the economy or sharp decline in asset prices (possibly one and the same), I’m not expecting a meaningful shift in economic activity in the near-term — business outlooks and backlogs are healthy, on average. That said, several variables that influence corporate profits are in transition, increasing profit margin uncertainty.

I have many questions as it relates to future corporate profits. Will volume growth and price increases be sufficient to offset higher costs, wages, and interest rates? Will a tight labor market help or hurt the economy (some companies noted labor constraints impacted operating results)? How will lower corporate taxes impact labor, demand, and inflation? Will positive business sentiment spill over into decision making? Will freight market constraints subside or intensify? How does a weakening dollar impact inflation and an already hot industrial/export market? Will efforts to lower inventory reduce promotions and increase consumer prices? Will consumer businesses experience a noticeable benefit from rising wages? Will rising interest rates and prices offset the stimulus from wage gains and lower taxes?

I’m looking forward to discovering the answers to these and many other questions. While patient investing can be unexciting at times, the shifting macro environment is making things much more interesting! I will be monitoring Q1 2018 operating results closely to learn more.

Below is a summary of several business trends I noticed during Q4 2017:

  • Rising costs, especially wages, are becoming increasingly noticeable. Frequent discussions on strategy to pass on prices increases. In addition to labor, freight and commodity increases mentioned frequently. The shift from deflationary tone (2015-2016) to inflationary (2017-2018) is becoming more evident with costs and wages accelerating in Q4. Based on results and outlooks, this trend does not appear transitory.
  • New tax law discussed frequently. There remains uncertainty, but overall the consensus is the law will be positive for most companies and the economy. Currently it’s more sentiment than actual data supporting optimism. We’ll need to learn more in Q1-Q2 2018. The tax benefit varies between companies and industries (depending on international exposure and expiring deductions). Most initial EPS estimate increases range from 10-20%. Capital allocation priorities remain unchanged, on average. However, some companies stated they plan on investing immediately in employees/wages.
  • Consumer companies reported mixed operating results, with sales trends improving on average. It’s been over a year since I noticed the consumer slowdown (see post Elevated Consumer Discretionary Risk); therefore, it shouldn’t be surprising that year over year comparisons are easier and improving. Companies have had time to make adjustments, including large reductions in inventory and other costs. While the environment remains somewhat promotional, deep discounting is less widespread with more full-pricing noticeable (lower inventory strategies affecting). That said, there remains store closure pressure which initially hurts comps/increases promotions, but eventually helps. Lower inventories may also be responsible for recent uptick in inflation (last month’s large gain in apparel prices makes sense).
  • Industrial operating environment is healthy. Growth is broad-based with construction and aerospace/defense reporting above average growth (mid to high-single digits). Material costs rising and pricing being passed on. Exports healthy, on average.
  • Domestic energy industry showed further signs of improvement in Q4. Confidence in 2018 is growing with higher energy prices. E&Ps continue to appear to be more disciplined this cycle, with many attempting to drill within cash flow. Credit/capital, on average, remains available and relatively inexpensive. Most commentary suggest North American activity will be robust in 2018, while international has stabilized, with some predicting growth will return. The drag from the energy credit bust in 2015-2016 is officially over. The energy headwind has become a tailwind for many businesses.
  • Auto manufacturing flat to slightly down. Little changes expected with estimates for small decline in auto production in 2018.
  • Agriculture remains weak, but stabilizing.
  • Rising freight costs mentioned on several calls. Transportation capacity utilization is high. Pricing and availability is becoming a greater issue. Difficulty in finding sufficient capacity and labor increasing. Barring a decline in economic activity, expect transportation costs to become a growing issue – was very noticeable this quarter. Companies are attempting to figure out how to pass on rising freight cost and maintaining sufficient transportation availability.
  • Financials continue to do well on average. Bank loan and deposit growth healthy with low losses (as one would expect at this stage of the credit cycle). Insurance catastrophe losses increased in 2017. Premium pricing has firmed from declining to flat/increasing slightly. Despite increases in underwriting losses in 2017, there remains excess capital in the insurance industry. Interest income improving for banks and insurance.
  • Technology results were mixed, but grew on average.
  • Currency expected to shift from minimal variable to a noticeable tailwind in 2018. Several companies noted Q1 2018 should benefit from currency.
  • Housing and construction is strong. Labor availability and cost remains an issue to meeting demand.
  • International results were healthy. Asia strong. Brazil/Latin America stabilizing – more optimistic tone from several companies with sales in Latin America.
  • Weather had mixed impact. Colder than normal (especially vs. last year) weather mentioned by some businesses, but did not influence quarter significantly.
  • Supply reductions from China environmental efforts mentioned on several calls. Price increases could result for several raw materials.

Have a great weekend!

Behind the Curve Illustrated

After being forgotten for most of the market cycle, inflation is quickly becoming a popular topic and growing risk for investors. Recent CPI and PPI reports raised concerns further. It’s uncertain if government reports will continue to show an acceleration in prices; however, I’m increasingly confident of what businesses are experiencing. Based on my bottom-up analysis, inflation is in the pipeline and the upward trend remains uninterrupted.

I’ve reviewed several conference calls this morning – all reporting cost pressures and intentions to pass on price increases. I thought the Packaging Corporation of America (PKG) and Kennametal (KMT) calls were particularly interesting and to the point. For those who believe the increase in inflation is just a “one-month wonder”, it may be worthwhile to perform an assumption check by viewing the economy through the lens of a business operator. A good place to start, in my opinion, is with this quarter’s earnings reports and conference calls.

Packaging Corporation (PKG):

Q: Just following up on George’s question on the cost inflation you are seeing in 1Q, the reference is to higher labor and benefit costs. Is that just the normal annual wage increases that you would expect? Or are you seeing any kind of incremental wage pressure with a tighter labor market that you might not have normally expected?

A: It’s the normal inflationary effect that you see every year with our wage increases benefits and fringes but also, we are in a tight labor market. And as you would expect, we are going to manage that tight labor market. We have for the first time that I can recall, we have a robust economy that presents an opportunity for us to grow significantly with the customer base. In order to do that, again, you have a labor factor that we haven’t seen in this country for probably 20 years.

Kennametal (KMT):

Q: …I’m curious specifically on how you’re doing on the price side because I know you had some increases a few months back and I think you mentioned that you’re planning more and maybe just flush that out a little bit?

A: Now in any given quarter, there might be a slight lag, but certainly over the mid-term we think that on average we’ll be able to offset the cost increases for material with the price increases.

And then, of course no customers are really excited about getting a price increase, but I think many of them expect it because there’s increased level of activity.

Many customers have not had a price increase for four or five years and yet they have continued to enjoy the productivity benefits from the new products that we’ve brought online and enhancements to the existing products.

While I don’t know the exact rate of inflation, I’m growing confident in a few things. First, wage pressure and price increases are relatively new economic variables for many businesses this cycle (I began noticing in 2017). Kennametal’s comment “customers have not had a price increase for four or five years” illustrates this well.

Second, the job market is very tight for skilled and entry-level labor. Packaging Corp’s comments on the labor market are similar to those of many companies in need of skilled employees.

Third, I’m not expecting the trend in inflation to reverse in the near future, as I believe cost and wage pressures remain in the pipeline (inflation lag is noticeable).

And finally, inflation etiquette and psychology is changing. As Kennametal’s comments imply, asking for a price increase is no longer taboo, but in some cases expected.

In my opinion, barring an economic shock or sharp decline in asset prices, the new trend in costs, wages, and prices is not going away after one jobs or inflation report.

If inflation continues to come in higher than expected, how will policy makers respond? Will three or four rate hikes in 2018 be sufficient? We’ll find out, but for now the Fed’s gradual and transparent approach does not appear very effective in altering the behavior of business or the financial markets.

Assuming current trends persist, I expect the Federal Reserve will eventually be faced with the difficult decision of either fighting inflation or protecting asset prices. Based on Chairman Powell’s recent comments regarding “financial stability”, along with the slow and measured pace of the current tightening cycle, it appears their decision may have already been made.

Have a great weekend!

Transcript source: Seeking Alpha

The Consumer “Last to Know” Price Index

In November’s post “Few Friends for New Trends” I wrote, “Will incoming wage data and shifting trends in inflation eventually force bond and equity investors to reconsider their valuation assumptions and long-held beliefs? Current bottom-up analysis suggests it’s possible, but only time will tell if new trends in cost and price will persist or be acknowledged.”

Throughout most of 2017, my bottom-up macro opinion differed from the consensus. Specifically, through the eyes of the businesses on my possible buy list, I was noticing rising corporate costs and wages. Meanwhile, many investors – often guided by government economic data – believed wage and cost pressures remained subdued.

The consensus view on wages and inflation abruptly changed on February 2, 2018 when the Bureau of Labor Statistics (BLS) reported average hourly earnings increased 2.9%. While I do not use government data to form my macroeconomic opinions, most investors and economists do. As such, considerable attention was given to the “higher than expected” increase in wage growth. The yield on the 10yr Treasury increased to 2.85% while the Dow fell over 600 points. Suddenly, the popular view of interest rates and inflation remaining lower for longer was being challenged.

As the financial markets remained unsettled last week, it appears investor concern regarding rising interest rates and inflation may be stickier than most “buying opportunity” pundits suggest. The media is also paying closer attention to inflation. In the article, “Bond-Stock Clash Has Just Begun as Inflation Looms” Bloomberg writes, “The tug-of-war between stocks and bonds is at the heart of the shakeout rolling financial markets. This week’s U.S. inflation report could hold the key to the next phase.”

While I agree with Bloomberg’s comments regarding the tug of war between stocks and bonds, I disagree with this week’s inflation report being “the key to the next phase”. In addition to the numerous adjustments made to the Consumer Price Index (CPI) that reduce its objectivity, I don’t consider consumer prices as a reliable indicator of future inflation trends.

After reviewing Q4 2017 operating results, it appears the upward trend in corporate costs and wages remains intact. However, this is a generalization. Rising costs are not spread evenly between business and industry – some are experiencing more (transportation and construction) while others less (absolute return value managers 🙂 ). Furthermore, rising costs are typically absorbed or passed on unevenly and at different intervals. For instance, many cost increases are not passed on to the consumers immediately – there is often a lag.

The inflation lag can be seen in certain quarterly operating results and conference calls. For example, The Kroger Co. (KR) discussed the inflation lag in their most recent call stating, “Our inflation at cost is still above our inflation at retail…but they are beginning to converge and both of them are now in positive territory. They were both over zero, so we did have cost inflation as well as retail price inflation that got passed on, but we didn’t pass all of it on.”

In addition to the lag between cost and price, the degree of price increases or adjustments varies. Based on my observations, industrial and transportation companies appear to be passing on rising costs more easily and completely than most. Conversely, while some consumer companies are also experiencing higher costs, they are proceeding with price increases more cautiously. Consumer sectors with overcapacity, such as certain areas of retailers, remain. However, this trend could change as inventories decline and more consumer companies fail and consolidate (Sports Authority bankruptcy is a good example– initially it hurt the industry due to aggressive inventory mark-downs, but ultimately it helped the surviving competitors).

The ability to pass on price increases also depends on the goods or services being offered. For example, the price of a new home is increasing much faster than a tube of toothpaste. In my opinion, this phenomenon is partially due to the influence of credit. In addition to stimulating demand, easy credit and low interest rates can increase the ability of consumers to purchase large ticket items, even as prices are inflating.

For example, if the average price of a new home increases 8% (as LEN and KBH reported), a consumer amortizing the increase over 30 years may not flinch, especially if an “innovative” adjustable rate mortgage is used. We’ve seen this in the auto industry as well, with the rising price of an average vehicle increasing while monthly payments remain unchanged (thanks to longer term loans). Education is another good example. With ample credit availability, students are able to finance the rising cost of tuition over many years. Aggressive vendor financing and stock buybacks (asset inflation) funded with debt also make stomaching rising prices easier. To summarize, if financing with easy credit is an option, there is a greater chance price increases will stick and even accelerate.

In conclusion, although I continue to notice signs of rising corporate costs and wages, it’s difficult to determine if this week’s CPI report will be impacted and to what degree. Due to the inflation lag, I do not believe the CPI report is a particularly useful guide in determining current inflationary trends. Instead, I believe information on producer costs and wages may provide investors with a more accurate and timely measurement. In other words, at this stage of the cycle, inflation in the pipeline may be a more important variable to consider than inflation that has been passed through to date.

It remains a very interesting part of the market cycle. Investor psychology and perceptions are changing. The trends in cost and wages that began to appear last year are only beginning to be acknowledged by investors. Barring a sharp decline in asset prices, I expect rising corporate cost trends to persist. As such, I continue to believe the cozy relationship between interest rates and equities is over. In other words, the portion of the market cycle that rewards all asset classes simultaneously appears to be coming to an end. In my opinion, one CPI report, positive or negative, will not change this.

Real Vision Interview

I’m unable to write a thoughtful post this week as I’m wrapped up in earnings season. That said, I recently did an interview with Real Vision TV that I thought some of you may enjoy. Below is a sample clip. To watch the entire interview and to learn about many other investors/strategies, you can sign up for a 14-day free trial. I’d like to thank Real Vision for their interest in absolute return investing — I really enjoyed our conversation.

Interview Snapshot

Real Vision TV (14 day trial near bottom)

On another topic, I hope everyone is enjoying the recent bout of volatility in the financial markets. It’s been so long, I had to pinch myself yesterday when the Dow was down 1500 points. While I remain uncertain when the current market cycle ends, I’m becoming increasingly comfortable in my positioning and look forward to further volatility and future opportunity.