The “V” or the “L”

With inflation and interest rates on the rise, I’m becoming increasingly optimistic about the winding down of the current market cycle. Based on my macro views – derived from the bottom-up analysis of my opportunity set – I expect the Federal Reserve to continue raising interest rates (barring a sharp decline in asset prices). As the picture I took last week illustrates, the economy is showing classic signs of late-cycle strains, especially as it relates to wages and labor availability.

How long can rising interest rates and elevated equity valuations live in harmony? It’s a great question, and possibly the most important question for investors attempting to ride the cycle a little longer. Although I don’t have the answer, each basis point increase in risk-free rates applies stress to balance sheets, the economy, and the justification for owning risk assets. However, for now, the Federal Reserve’s gradual approach to raising rates appears to be going relatively smoothly. Similar to past cycles, rising rates may appear inconsequential for months or even years, and then one day investors wake up to discover everything has changed (it is true, they don’t ring a bell!).

As has been the case in previous cycles, once the unexpected occurs and asset prices decline, central banks will likely end their attempt to normalize and reverse course. After the last market cycle ended, the Federal Reserve slashed the fed funds rate from 5.25% in July 2007 to near 0% in December 2008. Other emergency responses, such as quantitative easing, were also implemented.

As the Federal Reserve slashed interest rates and purchased trillions of dollars of assets, financial markets responded in a “V” shape fashion – rebounding sharply and relatively quickly. While the financial pain resulting from the last cycle’s decline was severe, the Federal Reserve’s put option was effective in limiting the bear market’s duration.

Although I’ve been critical of the Federal Reserve from time to time, I’ve also benefited from their policies. Over the past twenty years, the extraordinary booms and busts caused by easy money have also created opportunity. For instance, after being conservatively positioned leading up to the end of the last cycle, the market’s sharp decline in 2008 and 2009 allowed me to rotate out of cash and into attractively priced small cap stocks. Due to the Federal Reserve’s decision to lower rates and purchase assets, many of the stocks I acquired in 2008-2009 rose sharply shortly after purchase. In hindsight, I was very fortunate – the cycle’s trough could have been considerably worse and lasted much longer.

While the last bear market was shortened by extremely accommodative monetary policy, there are no guarantees future bear markets will act similarly. For instance, what if during the next bear market 0% interest rates and central bank asset purchases are less effective or even counterproductive? While such a scenario seems implausible today, considering current trends in inflation and fiscal deficits, a less cooperative bond and currency market may be something investors should consider, if not expect.

Assuming central bank policies lose some or all of their effectiveness during the next bear market, I believe it’s possible the end of the current cycle could look more like an “L”, instead of a “V”. Given current valuations and trends in equity markets, investors do not appear overly concerned about the Federal Reserve’s ability to revive asset prices during the next market decline. And why should they? Over the past twenty years, many investors, including the “buy and holders”, have been conditioned and rewarded for assuming all bear markets and recessions will recover quickly and in a V-shape manner.

While investors have been conditioned to expect the next bear market to be short-lived, I’m positioning and preparing for either the “V” or the “L”. To properly prepare, I believe it’s important to understand the differences between today’s cycle and past cycles and how these differences could influence absolute returns in a variety of bear market scenarios.

In my opinion, and based on my opportunity set, one of the most glaring differences between the current market cycle versus past cycles is corporate balance sheets. During the last bear market (2008-2009), there were significantly more businesses on my possible buy list with strong balance sheets. Many of the stocks I purchased had zero debt and limited liabilities. Today, many of those same businesses have increased their financial risk by taking on debt, often to fund stock buybacks and acquisitions.

The energy industry is an interesting example. Energy was an area I was finding tremendous value during the financial crisis. During the first half of 2008, many energy companies were selling at significant premiums to the replacement cost of their assets. Later in 2008, as oil crashed from $147/barrel to $33/barrel, large premiums quickly turned to deep discounts. As such, I became an enthusiastic buyer. In fact, the energy weight in the absolute return portfolio I was managing increased from practically nothing in early 2008 to approximately 20% in March 2009.

The energy companies I purchased during this period shared an important characteristic – they all had strong balance sheets. Patterson-UTI Energy (PTEN), a market leading onshore drilling and pressure pumping business, is a good example. In 2008, Patterson had a very strong balance sheet with no debt and $81 million in cash. During the crash, I was confident their liquidity and lack of meaningful liabilities would allow the business to survive a prolonged recession and energy bust.

Patterson’s balance sheet looks much different today. Mainly due to acquisitions, Patterson’s net debt has risen considerably since its debt free days of 2008. During the next cycle bust, the decision to buy Patterson will not be as easy, especially for absolute return investors attempting to avoid combining operating risk and financial risk.

In my opinion, the strength of corporate balance sheets will be a very important variable to monitor during the next market and economic decline. Assuming the end of the cycle resembles an “L” rather than a “V”, companies with strong balance sheets will likely have a tremendous competitive advantage over their more leveraged peers. Who wants to do business with a company nearing bankruptcy? And for investors, fifty cent dollars in bear markets are nice, but if your investment doesn’t have the balance sheet to survive a prolonged recession, attractive valuations and healthy margins of safety can quickly become irrelevant.

In order to successfully navigate through the next bear market and recession, investors may find it valuable categorizing potential buy ideas by balance sheet strength. In fact, I’ve recently put together a list of “A” balance sheets, or companies I believe will survive an extended market decline and recession.

Whether or not high-quality businesses go on sale will likely depend on the severity and broadness of the next bear market. Given the current breadth of overvaluation this cycle (including high-quality stocks), I’m optimistic investors seeking liquidity will eventually be forced to sell the good along with the bad. If so, I will be ready.

As I prepare for the end of the current market cycle, I want to be properly positioned for either the “V” or the “L”. While a sharp recovery in asset prices appears to be the most popular and preferred shape of the next bear market, history shows every cycle is different. With trends in inflation and fiscal deficits on the rise, the market’s response to the next round of ultra-easy monetary policy is becoming increasingly unpredictable, in my opinion. In fact, assuming the next bear market will behave like the last could be as costly of an assumption as believing the current bull market will never end.

Tick Tock Where Does the 2-Year Stop?

It’s been an interesting two weeks of macro inflation headlines. On September 7, the Bureau of Labor Statistics (BLS) reported average hourly earnings increased 2.9%, or the largest year over year increase since 2009. Meanwhile, the Fed’s Beige Book was released last week, highlighting the difficulty companies are having finding sufficient labor. The report stated, “Labor markets continued to be characterized as tight throughout the country, with most Districts reporting widespread shortages.”

The picture below (provided by a reader) is one of the many help wanted signs sprouting up across the country. Based on company reports and commentaries, entry level positions continue to be difficult to fill and are often paying well above minimum wage. These are similar to the wages Jesse Felder and I discussed in his podcast on inflation. In effect, we weren’t crazy after all — $12 to $15 an hour appears to be the new minimum wage in many regions.   

With the latest reports on labor confirming wages are indeed rising, I was beginning to believe the market’s “Inflation Recognition Moment” was finally approaching. However, just as I was getting my hopes up, last week’s PPI and CPI reports came in below expectations (PPI -0.1% and CPI +0.2%).

Shortly after the PPI was released, a reader asked, “Shouldn’t the inflation you’ve been writing about show up in the PPI?” I responded, “After I saw the PPI declined -0.1% I emailed my former analyst and asked him to name one producer experiencing lower costs. He couldn’t think of one. And I couldn’t either!”

In effect, the corporate cost trends I’ve been documenting over the past year do not appear to be reversing. That said, I remain open-minded to changes in inflationary trends, especially if the dollar rises sharply (similar to 2014) or asset prices collapse. However, based on my bottom-up analysis, real world inflation in wages and operating expenses continues to be a common theme for many businesses.

Since I began noticing rising corporate costs in 2017, the 2-year Treasury yield has increased considerably. I continue to be amazed by the 2-year’s determination to march higher, not to mention its steep slope. It’s one of the most exciting, underreported, and important trends in the financial markets, in my opinion. 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.

During the past two market cycles, the 2-year Treasury yield topped near 5-6%. Can short-term rates reach similar levels this cycle? While I believe current trends in the labor market and inflation support mid-single digit interest rates, the U.S. government’s fiscal position is much weaker this cycle. In 1999, the United States was generating a fiscal surplus vs. a deficit of $895 billion during the first 11 months of fiscal 2018. And in 2007, federal debt was significantly lower ($9 trillion vs. $21 trillion today or 62% vs. 107% debt to GDP). Based on current debt levels and fiscal deficits, can the U.S. afford a doubling of its interest expense?

And what about asset valuations? It will be very difficult to justify 3% normalized earnings yields on equities assuming 2-year Treasuries are providing 5-6% yields – not to mention the trillions of dollars of other investment decisions made while interest rates were pegged near 0%.

Of course, many investors believe the 2-year Treasury will never reach previous cycle yields of 5-6%. In addition to there being too much debt, the Federal Reserve has become increasingly sensitive to financial instability and the consequences of deflating asset bubbles. Maybe so, but someone needs to tell the 2-year and rising inflationary trends – they don’t appear to be listening.

In my opinion, the maximum 2-year interest rate the market can withstand will ultimately determine when the current cycle ends. If asset prices can hold together until 5-6% yields are reached, the cycle could last another two or three years (assuming the continuation of gradual rate increases). Or maybe the peak 2-year rate this cycle is near current levels. I really don’t know, but I continue to watch the 2-year closely as it marches higher without interruption or concern. In essence, I view the 2-year yield chart as my market cycle countdown clock. After being stuck for so many years (2009-2016), it’s nice to see the clock is ticking again!

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To summarize and highlight many of the inflationary pressures the companies in corporate America are experiencing, we recently released a new report on The Bottom-Up Economist. For those who haven’t subscribed, you can find the report on the following link (BUE September Report).

Thanks for checking out our new website and all of the feedback – it’s been very helpful. If you have any questions or would like to submit a request for future reports, please contact us at BUE@thebottomupeconomist.com.

Would You Rather with Warren Buffett

While working as a fund manager, I often watched Bloomberg TV at night to see where the futures were trading and if I missed any news after leaving the office. Out of habit and curiosity, I continue this routine today. On a recent and relatively uneventful evening, a portfolio manager was interviewed and asked about her opinion on the stock market. Her hedged response caught my attention. Specifically, the portfolio manager said she was “structurally constructive and tactically cautious”. Is this bullish or bearish? I couldn’t tell, but I wrote it down for the next time I’m asked an uncomfortable question.

Whether right or wrong, I’ve always respected investors with strong opinions. And there are certain investors whose opinions I always appreciate and seek. Opinions that you know you can trust and are unbiased. For most value investors, including myself, Warren Buffett comes to mind.

For those who missed it, I recommend watching Warren Buffett’s Bloomberg TV interview from last week. He was interviewed while visiting New York to dine with the winner of his annual lunch auction. The winner paid $3.3 million to have lunch with the Oracle of Omaha. Fortunately, I didn’t need to pay $3.3 million for Mr. Buffett to answer a question I’ve been eager to ask.

Specifically, David Westin of Bloomberg TV asked,

“One of the things you look at is the total value of the stock market compared to GDP. If you look at that graph it’s at a high point, the highest it’s been since the tech crash back in the late 90’s. Does that mean we’re overextended? Is it a better time to be fearful rather than greedy?”

What a great question, I thought. I couldn’t wait for his answer. Let him have it Warren! It’s your favorite valuation metric flashing red – tell everyone how expensive stocks have become! I was very excited to hear his response.

He replied,

“I’m buying stocks.”

Shortly after his response a red breaking news headline appeared on Bloomberg announcing, “Buffett: I’m Buying Stocks”. It wasn’t the answer I was hoping for or agreed with, but how can you argue with Warren Buffett? He’s a value investor many of us admire and strive to emulate. No one starts a client meeting with, “Hi, I’m a value manager and disagree with Warren Buffett. Please send me your money”.

The interview continued with Mr. Buffett discussing his long-term perspective, saying,

“I’m not buying them because I think they’re going up next year. I’m buying them because I think they’ll be worth quite a bit more money 10 years or 20 years from now. I don’t know if they’ll go up or down tomorrow, next week, next month, or next year. I do know they’re good businesses.”

In other words, if you hold high-quality stocks long enough, you should do well. Or at least relative to bonds. Warren Buffett explained,

“You have to measure investments in relation to each other. And your alternative for most people is fixed income and you get 3.02% or something like that for 30 years. So would you rather invest in a company which is earning 15 or 20 percent on their invested capital and compounding or would you rather have a 3% bond which could never earn more than 3%?”

A game of “Would You Rather” with Warren Buffett – how exciting! Unfortunately, Mr. Westin of Bloomberg didn’t play along. Nevertheless, I think it’s an important and timely “Would You Rather” question for investors. Specifically, at today’s prices, would you rather buy high-quality stocks or long-term bonds?

Based on how the question was phrased, the answer seems obvious. Of course I’d rather own an investment compounding 15% to 20% per year than a long-term bond yielding 3%. Who wouldn’t? However, it’s not that simple. More information is needed.

What about price? Even good businesses can be poor investments assuming one overpays. Just look at many of the high-quality stocks in the late 1990’s. Or how about the Nifty Fifty in the 1960’s? To make an informed decision and avoid overpaying, we must know the price we’re paying for these high return on capital businesses.

Based on my analysis of the stocks on my possible buy list, I believe high-quality businesses, on average, are very expensive. WD-40 Corp (WDFC) is an excellent example. Although I consider it a good business with superior returns on total capital and equity (41% ROE), its stock is trading near 43x earnings and 6x revenues. As an absolute return investor, what is more important, the company’s ROE of 41% or its earnings yield of 2.3%? Regardless of WD-40’s above average return on capital, I’m avoiding its stock and consider it expensive.

In addition to price, I believe it’s important to consider the cyclical influences on return on capital. At this stage of the profit cycle there are many companies generating attractive returns. And it’s something we addressed in our most recent The Bottom-Up Economist report – on average, operating results for most businesses are favorable. However, acknowledging profits and returns on capital are healthy is not the same as acknowledging stocks are attractively priced. This is especially true if profits and returns on capital are unsustainable or near peak levels.

For example, Fannie Mae (FNM) was generating attractive returns on equity capital during the housing boom (averaging 15.8% ROE 2004-2006). Many investors believed the company’s retained earnings could be reinvested at double-digit returns on equity indefinitely. At least until the housing bubble popped. In Fannie Mae’s case, historical returns on capital were not an accurate guide of future returns.

To properly answer Mr. Buffett’s “Would You Rather” question, I’d also like to know if the 15% to 20% return on capital is on existing capital or on the reinvestment of new capital. There’s a big difference, especially as it relates to compounding. Currently, I’m aware of many companies generating 15% to 20% on existing capital, but fewer that can generate those type of returns when reinvesting profits. It’s one of the reasons so many companies have turned to buybacks and dividends. With a limited number of high return on capital projects, a large portion of free cash flow this cycle has been returned to shareholders.

Stock buybacks are an interesting topic as it relates to return on capital. As corporations spend hundreds of billions on stock repurchases each year, how have return on capital metrics, such as return on equity (ROE), been impacted? Given the amount of buybacks this cycle, is return on equity a reliable measure of business profitability and future returns on reinvested capital?

A good example is Altria (MO), which has reduced its balance sheet (capital) considerably over the years with significant buybacks. It currently has an extraordinarily high return on equity of 75%. It’s difficult to imagine Altria reinvesting profits into the business and earning 75%. Again, for compounding purposes, it’s important to differentiate between return on existing capital and return on reinvested capital. For many companies, including Altria, these are two very different numbers.

And finally, to properly answer Mr. Buffett’s Would You Rather question, I’d like to clarify if stocks and long-term bonds are our only options? Is patience also an option? Asked differently, instead of buying stocks generating an uncertain 3% normalized free cash flow yield, would you rather buy a 6-month T-bill yielding a certain 2.29%? I know what I’d rather own.

It’s been a difficult cycle for disciplined value investors. I’ve spoken with many and I can tell you they are tired, very tired. And I understand how many professional investors need a reason to own stocks regardless of price and valuation – fully invested mandates require it. Owning high-quality businesses generating high returns on capital sounds reasonable. And I’m certainly not qualified to disagree with an investment legend like Warren Buffett. But in this case, or this particular game of “Would You Rather”, I’m not buying stocks and will instead buy the long-bond yielding 3%. However, as soon as I buy the bond, I’m selling it and trading it in for a T-bill. 🙂

The Bottom-Up Economist

In my attempt to limit large valuation mistakes, I prefer normalizing cash flows instead of extrapolating recent corporate operating results far into the future.  My preference for normalizing is based on my belief that profit margins and earnings for most businesses are cyclical – influenced by credit and economic cycles. In effect, normalizing helps me avoid valuing businesses on peak or trough cash flows.

To normalize cash flows, it’s important to know where you are in the profit cycle. As such, it’s also important to have an opinion on the economic cycle. As regular readers know, I avoid using government economic data to form my macro views. Instead, I prefer viewing the economy through the eyes of business. Specifically, my economic and profit cycle opinion is developed through the analysis and aggregation of hundreds of company reports and management commentaries.

By focusing on the most recent corporate operating results and management discussions, I believe I’m better able to form a more timely and accurate assessment of the economy versus relying on government data, which is often adjusted and revised multiple times after its initial release. Because the bottom-up data is so fresh and is based on real world operating results and outlooks, I also believe I’m better equipped to discern macro trends before those who rely on government economic data (recent examples include consumer slowdown in 2016 and uptick in inflation in 2017-2018).

Since Q2 2017, I’ve been providing readers with a quarterly summary of the current operating environment of the businesses in my opportunity set (300 small cap stocks). With the help of my former analyst, this quarter’s format has changed and has been placed on a new website.

In an attempt to improve the report, we generated a more detailed and comprehensive summary that incorporates my quarterly review process along with many of the larger cap companies my analyst follows. It’s our attempt to provide an alternative for investors and economists who remain highly dependent on government data to form their macro views and forecasts.

We’re very happy with how the report turned out. We put a lot of work into it and we’re hopeful readers will find it useful. We’ve also completed past quarterly reports since I’ve been providing summaries (beginning Q2 2017). These reports can be found on the website (The Bottom-Up Economist). Given the reports length (19 pages), we include a summary and tear sheet for those who do not have time to read the supporting data and commentary.

I provided a link below to download the report. Your feedback is always welcome and appreciated!

The Bottom-Up Economist Q2 2018 Report

Diverging Inflation Narratives

I was watching Bloomberg TV yesterday and a portfolio manager was asked about his current market outlook. He started by saying earnings growth is strong and inflation is subdued – a ripe environment for higher stock prices. This morning I read the following quote from James Bullard of the St. Louis Federal Reserve, “I just don’t see much inflation pressure”. Meanwhile, hundreds of companies in multiple industries are openly discussing the current inflationary environment, price increases, and a tight labor market. It’s as if Wall Street, the Federal Reserve, and corporate America live in different worlds.

It’s been approximately a year since I began noticing and writing about shifting inflationary trends (from a disinflationary environment in 2015-2016 to an inflationary environment in 2017-2018). While inflation has received more attention over the past few months, many investors and policy makers continue to assume inflation remains low and its recent uptick is temporary. With the dollar rising and certain commodities in decline, I’m open-minded and alert to another reversal in inflation (similar to late 2014); however, to date I am not seeing it. In fact, Q2 2018 operating results and outlooks support my belief that inflationary pressures are not subsiding, but are persisting and even spreading.

Rising average prices (see recent retailer earnings reports) are allowing many companies to pass on higher costs and grow revenues. Investment bankers beware. Companies may discover growing revenues through price increases is easier than taking on debt and acquiring. Price increases carry lower risk and are not capital intensive – better for margins and the balance sheet!

As price increases become more prevalent and acceptable, companies are becoming more comfortable asking for seconds and even thirds. As stated in past posts, inflation psychology is changing. In effect, it’s no longer poor business etiquette to ask for a price increase – it’s rational and understood.

Tariffs are also contributing to inflation and revenue growth. In fact, I’m beginning to wonder if tariffs are a clever way to grow sales and nominal GDP (and real GDP if inflation is underreported). Many management teams recently communicated their intentions to raise prices further assuming additional tariffs are implemented. For business, tariffs are just one more item they can point to justify raising prices.

Based on my bottom-up analysis, I believe the disparity between Wall Street and corporate America’s inflation narrative is growing. Furthermore, unless asset prices decline and the economy slows, I do not expect inflationary trends to reverse in Q3 2018. Company commentary and outlooks suggest the inflationary pipeline remains healthy and full. As such, I expect the Federal Reserve will continue to raise rates and proceed with its quantitative tightening (again, barring a sharp decline in asset prices – then all bets are off). As I wrote in Patience a Possible Win-Win approximately one year ago, I believe patient investors will either be rewarded with lower asset prices or higher interest rates. This continues to be the case, in my opinion.

Regardless of your views on inflation, I thought readers may be interested in learning how my macro views on corporate costs and pricing are developed. Instead of relying on government economic data, I prefer viewing the economy from the bottom-up, or through the eyes of business. Today I intended to list many of the inflation examples I noticed in my latest quarterly review, but the list was too long (near 100 examples and over 40 pages). If you’d like to learn more (especially if you “just don’t see much inflation pressure”), please shoot me an email and I’ll send some interesting and possibly enlightening weekend reading.

Thanks to a reader for picture/example of inflation psychology shift!

Hurts So Good

Near the later stages of a market cycle, if I don’t feel stupid and my portfolio doesn’t hurt, I’m probably not positioned appropriately. With short-term interest rates rising considerably over the past year, my patient positioning is beginning to feel a little too comfortable. At this stage of the cycle, I should be suffering more. As such, I recently reintroduced a painful position to my absolute return portfolio – a precious metal miner.

For asset managers who are currently experiencing shiny-happy performance and congratulatory client meetings, a beaten-down miner may be just the thing needed to scratch that contrarian itch. From a personal perspective, I’ve found a good time to make uncomfortable changes to a portfolio is often when performance looks best. And there’s nothing like a precious metal miner to create the right amount of angst and discomfort!

For most of the current market cycle, the only thing more painful than holding cash has been the precious metal miners. I held several miners in 2014-mid 2016. The pain was excruciating. At one point, the miners I owned were down -30%+ after they had already declined 50-60% at the time of purchase! It was the most challenging and controversial position I’ve ever taken. Frankly, I hated it. But value is value. And as many seasoned investors will attest, the best values are rarely presented as beautiful bouquets.

I wouldn’t be human if I didn’t feel reluctant to readminister the pain. To help me cope, I started with a small weight and plan to add to the position slowly as the price declines and discount to value increases. My slow and steady approach to positioning is based on experience. Historically, once I’ve determined commodity stocks are cheap, they typically become much cheaper! Picking the bottom in commodity stocks is extremely difficult – at least for me – so I prefer buying small positions and averaging down.

Another thing I’ve learned about commodity stocks is investors love or hate them – rarely do they remain near their valuation equilibrium. With such wishy-washy investor psychology, one can expect volatility and violent booms and busts. While the commodity prices themselves are partially responsible, I believe popular valuation techniques also contribute to volatility.

Many analysts use cash flow metrics to value commodity businesses, such as EBITDAX. Although cash flow is important, when attempting to value a commodity business with a high degree of confidence, I’ve found future EBITDAX to be too uncertain and volatile.

Early in my career I decided to part ways with EBITDA valuations. Capitalizing depreciation or depletion has never made sense to me, especially for commodity businesses (reserves must be replaced to stay in business). Instead of cash flow, I prefer using a less volatile valuation technique for asset-heavy commodity businesses. Specifically, I use replacement cost. In effect, my goal is to buy a dollar of reserves (oil, natural gas, gold, timber, etc) at a discount to the cost required to replace those reserves.

For example, if it costs $300 to find and develop an ounce of gold and I can buy a proven and developed ounce for $150 in the equity market, I’m interested. Focusing on developed mines with a sufficient history in production and operating costs can also reduce risk. Accumulating reserves by building a new mine often comes with uncertain production, operating costs, and financing. In effect, instead of taking the risk of building a new mine, I’d rather buy the reserves of a developed and operationally efficient mine selling at a discount. And that’s what I’m finding today in the mining sector. Proven and funded mines that are selling below the cost to find and develop their reserves.

To be clear, commodity businesses, such as miners, are very risky and carry tremendous operating risks. As such, I focus on commodity businesses with strong balance sheets that I believe can survive a prolonged period of depressed commodity prices. It doesn’t matter if you can buy an asset-heavy business at a large discount if the company doesn’t have the balance sheet required to survive the cycle. I’ve seen many commodity companies worth much more than their stock price go bankrupt in commodity bear markets. They simply ran out of time and liquidity. Ideally, I prefer commodity stocks and miners with no debt, but they’re almost as rare as the metals themselves!

With extreme pain and discomfort, I’m back in the precious metal miners (or I should say miner). Similar to past experiences with commodity stocks, I’m assuming the miners will continue to fall and I will not be able to time their bottom perfectly. My plan is to gradually add to the position during the decline, but will not exceed my pain threshold (during the last miner bear market the weight in the absolute return portfolio peaked between 10%-15%). In addition to my pain threshold, my weight will likely be limited by the number of small cap miners that pass my balance sheet requirements and other guidelines (mine locations, all-in costs, reserve life, etc.).

While the introduction of miners will likely hurt in the near-term, given my patient positioning, I like the idea of owning asset-heavy businesses selling at a discount. In effect, I view my recent miner purchase as an investment and a hedge. A hedge against the Fed falling behind the curve (before the cycle ends) and a hedge against future central bank asset purchases (after the cycle ends).

Inflation Hits the Headlines

As I discussed in recent posts and podcasts, I began noticing a growing number of companies reporting rising costs and pricing power in Q2 2017. At that time, I wasn’t sure if these trends were temporary or sustainable. In my Q2 2017 quarterly update I wrote,

“Despite reports of tame consumer and producer inflation, many businesses reported cost pressures and pricing action in Q2. I’m not certain if or when these increases make it into the government data, but I listed dozens of examples of cost and price increases in my quarterly management commentary. Although inflation isn’t spiking higher, it was definitely noticeable in Q2 and certainly isn’t dead.”

By the end of 2017, it was becoming clear to me that the uptick in corporate costs and pricing was not temporary and was in fact a new trend. In my Q4 2017 quarterly update I wrote,

“Rising costs, especially wages, are becoming increasingly noticeable. Frequent discussions on strategy to pass on price 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.”

Evidence of rising inflation continued to build in Q1 2018. I wrote several posts discussing these trends, including a post that included a long list of company-specific examples (Inflation Subsiding or Accelerating). I also participated in an hour-long podcast with Jesse Felder, specifically devoted to inflation (podcast link). More recently, as I plow through Q2 2018 earnings reports and conference calls, I continue to notice and document numerous examples of rising corporate costs and price increases.

In summary, the bottom-up data I’ve accumulated over the past several quarters supports my belief that the disinflationary environment (most noticeable in 2015-2016) has passed and has been replaced with rising rates of inflation. And while the shift in narrative from deflation to inflation has been slow to develop, it appears others, including the media, are beginning to take note and are currently reporting on the change in trend. In fact, last week I noticed several articles highlighting inflation.

The first article, “Kraft Heinz Tops Estimates with Higher Pricing, Shares Surge” discusses packaged food companies and how they’ve been forced to raise prices to offset rising costs. While there is often a lag, recent price increases appear to be sticking for many businesses, restoring profit margins and earnings growth. As a result, investors are celebrating and rewarding companies with the ability to pass on price increases. While pricing power is certainly a positive business attribute, I can’t help but wonder if the broader implications of price increases – as it relates to interest rates, balance sheets, and required rates of return – are being ignored (good topic for future post).

Another article published last week, “Inflation, Gas Prices, Tariffs, Squeeze Consumers”, documents rising corporate costs and how inflation is influencing consumer behavior. The article provides several examples of recent corporate price increases and inflationary pressure, stating,

“Procter & Gamble…said Tuesday that Pampers prices will increase by an average of 4 percent in North America, while the Bounty, Charmin and Puffs brands could see 5 percent increases. Gas prices have already surged more than 24 percent in the past year. Rent and other housing costs were up 3.4 percent in June compared to a year earlier, and auto insurance has jumped more than 7 percent.”

And while I don’t rely on government data to form my macro opinion, for those who do, the article states,

“The consumer price index, the government’s primary measure of inflation, rose 2.9 percent in June from a year earlier, the fastest increase in six years.”

In effect, the government’s inflation data and my bottom-up assessment are in agreement – inflation has arrived.

And finally, the title of the Bloomberg article, “How U.S. Companies are Coping with Inflation and Scarce Labor” caught my attention yesterday. While I thought the title was a good summary of my recent posts on inflation, I was less enthusiastic about the article’s assertion regarding the sustainability of current trends. Specifically, the article states inflation “may prove to be temporary.” While this could prove to be true, I currently see little evidence suggesting inflationary pressures are subsiding. That said, the article did provide a quote from Clorox’s CEO supporting its view. Specifically, Clorox’s CEO stated he “expects increases in transportation costs to ease to a mid to high-single-digit pace from high double-digit.”

While I agree high double-digit increases in transportation costs should moderate (mainly due to comparisons), high-single-digit increases remain above average and inflationary. Unless the Federal Reserve can print 50,000 truck drivers in the near-future, (also known as QT – Quantitative Truckers 🙂 ), I’m not expecting elevated transportation costs to subside in the near-future.

As I sort through Q2 2018 operating results and conference calls, I’m growing increasingly confident in my belief that there has been a shift in inflation psychology. There appears to be a growing understanding between businesses that price increases are necessary. In effect, pricing requests have become more acceptable and in many cases expected. And as businesses discover price increases are sticking and becoming more acceptable, it’s logical to assume managements will be more comfortable requesting further increases. In fact, I’ve noticed several instances of companies announcing multiple price increases over the past year (pricing decisions are typically limited to once a year). And finally, with tariff concerns increasing, several executives stated they are prepared for further increases in costs and pricing. Based on management commentary, I suspect a growing number of corporations will use tariffs to justify additional price increases.

In summary, the rising trend in corporate costs and pricing I began noticing and documenting in 2017 continues today. How long current trends persist remains uncertain, but to claim the uptick in inflation is temporary seems premature. In fact, based on recent corporate operating results and outlooks, I believe inflationary pressures will remain elevated in Q3 2018. Given the tightness in many areas of the economy and labor market, I expect pricing pressure to persist until asset inflation or demand subsides. In the meantime, I will remain alert for signs that market participants are beginning to recognize inflation and its growing threat to elevated asset prices.

As last week’s articles on inflation illustrate, the inflation narrative appears to be in transition and is gradually becoming more aligned with my bottom-up analysis and views. I’m beginning to wonder if the market’s inflation recognition moment I’ve been expecting is a process, not an event. If so, I believe the process has begun and its momentum is building.

Cliff Hangers

With earnings season in full swing, I was unable to write a post last week. While it remains very early, so far Q2 2018 looks similar to Q1 2018, but with a more favorable weather comparison and tariff concerns sprinkled on top. I plan to get through the remaining quarterly reports and calls over the next two weeks.

Once the excitement of earnings season comes to an end, it will be interesting to see where the market turns its attention. Although I don’t have a strong opinion on Wall Street’s next narrative, the recent rise in interest rates would be on top of my list. In fact, I can’t keep my eyes off the 2-year Treasury yield as it continues to rise like a FANG stock (or at least before last week)!

To illustrate, below are two charts (both two years). One is a chart of the 2-Year U.S. Treasury yield and the other is a chart of QQQ. Which one is a portfolio of popular growth stocks and which one is the yield of a boring short-term USTN? They’re very similar, aren’t they?

  

If you guessed chart 1 was QQQ and chart 2 was the 2-year USTN yield, you are correct. Now which one is more exciting and enticing? I’d go with chart #2, or the 2-year Treasury yield!

  

Given where we are in the profit, credit, and economic cycle, I continue to believe the 2-year Treasury yield and equity markets will remain correlated. However, I also believe there is an eventual breaking point in these charts – they cannot rise together indefinitely. At what rate will the 2-year yield reach before asset prices crack? I wish I knew, but I find the equity market’s lack of concern fascinating. It reminds me of the game Cliff Hangers on the Price is Right. The mountain climber marches higher and higher until the contestant makes a large valuation mistake, resulting in the climber falling off the cliff (Cliff Hangers video).

I plan to continue watching the sharp rise in short-term yields with amazement and an opportunistic mindset. Although the timing remains uncertain, I remain prepared for the mountain climber’s (risk assets) fall.

I hope everyone is having a wonderful earnings season! I have a growing backlog of topics I want to discuss and will hopefully be posting again in a couple weeks.

Cyclically Non-Adjusted Earnings

Last week I played tennis with a mortgage broker I’ve known for over twenty years. In addition to being a good friend and tennis player, he often provides me with a timely and accurate assessment of the Florida housing market. Since we hadn’t talked in several months, I was eager to hear what he had to say.

As I drove up to the tennis court, I watched my friend step out of a shiny new $100,000+ luxury vehicle. I knew immediately an update of the Florida housing market wasn’t necessary! I greeted him by saying, “If this isn’t a sign of the top, I don’t know what is!” We both laughed. He proceeded to show me all the different features and gadgets on his new ride. It was impressive.

While not as shiny and new as my friend’s luxury car, the current profit cycle has also been impressive. Approaching its 10-year anniversary, today’s profit cycle has shown considerable persistence and strength since its 2009 beginnings. As the current expansion marches on, I’ve been thinking more and more about business cycles and how I incorporate cyclicality into my valuation process.

Historically, I’ve used a normalized cash flow assumption when calculating the value of most businesses. My preference for normalizing is based on my belief profit margins and earnings for most businesses are cyclical, albeit to differing degrees. In effect, normalizing enables me to avoid valuing businesses on peak or trough cash flows, in addition to the large valuation errors that can accompany extrapolation.

Normalizing was essential in helping me navigate through the tech and housing bubbles. It allowed me to avoid becoming too optimistic during the booms and too pessimistic during the busts. The results of normalizing during the current cycle have been less conclusive. While normalizing was beneficial during the earlier years of the current cycle, it has appeared unnecessary and even counterproductive in later years.

The extended duration of the current profit cycle – currently twice as long as the average cycle – has challenged the value and usefulness of normalizing. This cycle’s length is also affecting normalized valuation metrics, such as the Shiller PE. As a reminder, the Shiller PE uses a 10-year earnings average in its attempt to smooth or cyclically adjust earnings. As discussed in the post “Normalizing Earnings and Real Rates,” assuming the U.S. economy does not enter a recession in the near future, the Shiller PE’s 10-year earnings average will soon consist of all economic boom and no bust. As the depressed earnings of 2008 and 2009 roll out of its calculation, average earnings will increase and the Shiller PE will likely appear less expensive.

The 10-year anniversary of the current profit cycle raises an important question. How useful is a cyclically adjusted PE (CAPE) that only includes a period of profit expansion? While I don’t know Robert Shiller personally, I suspect when he developed his CAPE, he didn’t envision a 10-year profit cycle without a recession. I know I didn’t!

The longevity of the current profit cycle is also influencing how investors perceive the cyclical nature of operating businesses and the economy. Based on equity valuations, investors appear to be dismissing the risks associated with recession and profit reversion. In effect, the longer the current cycle persists, the greater the temptation to abandon normalizing and embrace extrapolation.

There are many examples of extrapolation in today’s market and business environment. From an individual perspective, look no further than my friend’s new luxury vehicle (after asking his permission to write about our conversation, he reminded me that he also recently bought “another” house!). Would he have made such an extravagant purchase if he believed a decline in Florida real estate was forthcoming? Probably not. Instead of normalizing over an entire cycle, I suspect he extrapolated current business trends well into the future. While I’m not certain if there has ever been a real estate boom in Florida without a bust, I suppose it’s possible. That said, if it were me, I would have normalized and went with the Toyota. 🙂

In addition to individuals, there are many examples of investors assuming extrapolation risk. The most obvious is the use of recent earnings results and forecasts to calculate the value of equities. One of the most popular methods of equity valuation is to simply apply an earnings multiple to next year’s earnings estimate, with many estimates assuming current trends will persist without interruption. In effect, earnings predictions are based on the past several quarters of operating results (extrapolation), not full-cycle margin dispersion and scenario analysis (normalizing).

A less obvious, but interesting example of investor extrapolation, appeared when the corporate tax rate declined from 35% to 21%. The response to the lower tax rate was overwhelmingly positive as earnings estimates and equity prices rose considerably. Instead of normalizing historical tax rates (according to Trading Economics the average corporate tax rate from 1909 through 2018 was 33%), investors appear to be extrapolating the lower rate well into the future. This is despite the fact that tax rates have historically fluctuated with shifts in fiscal policy and political leadership – a near certain future event.

Business leaders also appear to be extrapolating recent profit trends as many companies aggressively pursue acquisitions, buy back stock, and issue debt. Corporate decisions based on extrapolation are often responsible for the eventual industry or economic bust. The energy industry is a good example. When oil was trading over $100 a barrel, energy companies extrapolated boom-time operating results and expanded aggressively – the future appeared certain. Instead of certainty, the energy industry experienced supply increases, price declines, and bankruptcies.

As analysts and portfolio managers, it is not our job to know the future with certainty, but to properly incorporate uncertainty in our valuations and investment processes. While current equity valuations imply a high degree of certainty in future profits, abundant examples of extrapolation and boom-time decision making support my belief that human behavior and profit cycles remain cyclical. As such, I believe normalizing, not extrapolating, remains the preferred method of business valuation. The future will be different from today – guaranteed. So why not value businesses accordingly?

The Inflation Recognition Moment

Before I dive into the topic of the day, I’d like to briefly discuss my recent spite trade (Growth, Value, and Spite). Specifically, I closed out my Russell 2000 put position last week after making enough to pay the electric bill 🙂 . It’s another example of why I’m not a successful short seller or put option speculator. Even when I get lucky on the timing, I tend to close the position too early, making it difficult to achieve an adequate return relative to risk assumed.

Instead of short selling and timing when stocks will fall, I prefer patience and investing after prices decline and opportunities reappear. This is not meant to disparage the art of short selling. It simply means as an investor, and over many years, I’ve gotten to know my strengths and weaknesses well. Historically I’ve achieved my absolute return goals by owning attractively priced small cap stocks and holding them until my calculated valuations are reached. It’s not as exciting as short selling, but it’s a process I’m confident and comfortable implementing — it’s what has worked for me.

With my put option speculation behind me, I’d like to focus on the labor market and tomorrow’s jobs report. I’m going to take an unusual position on this all-important economic data point by stating I believe the report is irrelevant. In my opinion, the bottom-up evidence is convincing – the labor market is very tight and wages are increasing. In fact, I feel the bottom-up evidence has become so convincing, I do not foresee anything from tomorrow’s report that will alter my views. And similar to the last time I remember labor being this tight (1999), I’m not expecting a meaningful change until asset prices decline and we enter a recession. In effect, I believe we’ve reached full employment this cycle and will remain here until the next cycle begins.

As we proceed through this cycle’s phase of full employment, I plan to continue to monitor the labor market through my bottom-up lens, with particular interest on wage gains and labor availability. In addition to monitoring the labor market through the analysis of my opportunity set, I’ll continue to accumulate anecdotal evidence and other real world examples. Some of my favorite labor market examples and updates come from reader emails.

Below is an email from an experienced investor who understands the economy and financial markets well. His recent experience while staying at a hotel emphasizes a topic that is becoming increasingly important for many businesses (especially for those attempting to grow) – labor availability.

He writes, “There were two stories that I felt I had to share. First involves our hotel. Despite having made reservations 6 months in advance, none of our rooms were ready upon arrival. We waited into the night when some families just offered to take their rooms as is so they could get some rest. The poor staff was nice enough about it but they simply didn’t have the bodies to clean rooms. Some creative manager had a brilliant idea at checkout though. They offered rewards points to guests who would clean their own rooms upon leaving!”

If reward points in exchange for customers cleaning their hotel rooms isn’t a sign of a tight labor market, I’m not sure what is! His other encounter with insufficient labor came while visiting a local pizza shop. Again, it’s not just about wages, it’s about labor availability.

“On that same trip, we went to a local pizza place for dinner one night. One of the parents was talking about how his folks had owned a pizza place when he was a kid. One of the servers overheard the conversation and offered us all the beer we could drink if this guy would jump over the counter and help make pizzas. After the rest of the place had cleared out the server/manager explained that she was on the verge of losing all of her employees as everyone was massively over-worked and they simply couldn’t find help.”

Another reader sent an article about a convenience store chain in Texas called Buc-ee’s. The company hangs a board advertising its positions and wages in its stores (see picture in article: link). It’s a good article illustrating how companies are aggressively competing for labor and being forced to pay wages well above state minimums. For example, the minimum wage at Buc-ee’s starts at $14 an hour versus Texas’s minimum wage of $7.25 an hour.

As Q2 earnings season approaches, I will be monitoring business labor and wage trends closely. Based on Q1 operating results and earnings reports released in June, I believe the labor market remains tight. While tomorrow’s jobs report will not alter my views, I’m well aware many investors will be paying very close attention. And I suppose even I’ll tune in to learn if tomorrow’s report will be the catalyst that causes investors to finally acknowledge wages and inflationary pressures are rising. I call it the inflation recognition moment. What exactly causes it remains a mystery, but barring a sharp decline in asset prices, I’m expecting and prepared for its arrival.