Everyday Not So Low Wages

As I was waiting in line at Starbucks yesterday, The Wall Street Journal’s front page headline caught my attention.

Interesting, I thought. Maybe the bond market is finally noticing what I’ve been documenting over the past two quarters — corporate costs (especially labor) are on the rise. And then this morning I woke up to another inflationary data point, “Walmart to raise starting hourly wage to $11, expand parental leave benefits, and issue bonuses of $1,000”. Most pundits are contributing the increase in compensation to the new tax law. This may be true, but based on my bottom-up observations, the move may also be a result of a tightening labor market.

Last quarter I wrote the following as it related to Q3 earnings, “Wage pressures were mentioned frequently, while raw material costs were also noticeably higher for many industrial companies. To be clear, I don’t believe inflation is spiking higher, but the trend has definitely shifted. Specifically, the trend in inflation appears to have moved from fears of deflation (2015-2016), to slow to moderate inflation.”

As earnings season begins, I will continue to monitor trends in costs and labor closely. However, based on recent operating results, I suspect these trends will remain intact and will become more noticeable in certain industries with growing capacity constraints. Construction is a good example.

KB Home (KBH) and Lennar (LEN) both reported earnings yesterday and had similar commentary related to costs and labor. Both companies are raising prices as a result of higher prices and strong demand. KB Home notes, “In the fourth quarter, our overall average selling price of homes delivered increased 8% to $416,500.” Lennar mentioned a similar increase in price stating, “Revenues from home sales increased 14% in the fourth quarter driven by a 5% increase in wholly owned deliveries and an 8% increase in average selling price to $387,000.”

KB Home also discussed costs stating, “…higher margins in recently opened communities, will offset expected increases in trade labor, building materials and land cost.” Lennar’s comments on labor were a little more descriptive, mentioning there was a “labor shortage”.  Specifically Lennar stated, “The low unemployment rate and the labor shortage has been translating into wage growth…”

Material prices were up as well. An analyst on Lennar’s call commented, “Costs up 8% in addition to labor being up 6%, surprised me a little bit.” Management explained, “The bulk of that cost increase is really lumber increases that had taken place earlier in the year but were flowing through our cost of sales. So lumber, both labor and materials associated with framing, were up — were — made up 32% of that 8% increase year-over-year.”

Similar to most companies involved in construction, KB Home and Lennar each reported strong operating results. Based on these and other recent earnings reports, my expectations for Q4 earnings and growth remains unchanged. Specifically, last quarter I wrote, “Looking forward, outlooks and commentary suggest the economic and profit cycle will continue into Q4 2017. Barring a sharp decline in asset prices (financial markets and economy appear to be one and the same currently), I’m expecting approximately 3% growth in Q4. Overall, I believe Q4 will be similar to slightly better than Q3, with easier comps in consumer and slightly tougher comps in certain industrials and energy. Business outlooks appear more confident this quarter versus Q3.”

As earnings season begins, I’m looking forward to learning more soon. That said, I’m expecting operating trends I noticed last quarter to continue. If so, it could be another quarter that threatens the widely-held belief interest rates will remain lower for longer. While investors focus on another “melt-up” in equity prices, I’m more interested in the bond market and its growing awareness that something has changed. While I believe this change started a few quarters ago, better late than never!


Valuation Variable Equality

Several weeks ago I received an interesting email from my friend and fellow absolute return investor Frank Martin related to the new tax law.

Frank’s email: “According to pundits the impact on S&P 500 EPS estimated to be $10, taking 2018 to $151, a forward PE of 17.4. Given where we are in the cycle, one could easily conclude that the tax cuts are more than priced in. What is a bit of a surprise to me is that nobody seems to be talking about companies involved in hot competitive rivalries using the windfall to cut prices and yet maintain margins or thereabouts. With every new technological innovation it is the consumer, and not the companies themselves, who are the biggest beneficiaries. Might not the same thing be said about the proposed corporate tax cuts?”

My response: “I agree. Higher margins from tax cuts don’t live in a vacuum. Suppliers, customers, employees, and other stakeholders will all want a cut. But I don’t have any special insight on the timing of margin reversion or who gets largest share. My view on tax cuts funded by deficits/debt, not spending cuts, is geez…at this stage of the cycle?!?!?! 2yr USTN keeps rising…1.81% today. I like it! I continue to be fascinated by the growing correlation between the short-end of the curve and asset inflation. Tax plan/more stimulus could amplify.

I was reminded of our email exchange last week while reading Cintas’s (CTAS)  quarterly conference call. On the call an analyst asked, “This has always been a competitive industry, you’ve acknowledged that regularly. What is the risk that some of the tax reform savings that the industry will earn gets competed away, think about an after-tax return as their margin or whatever is their focus? Is that — do you see that as a risk?”

Management responded, “I think it’s too early to tell. Certainly, that could throw a little bit of a wrinkle into the way our products and services are priced in the marketplace. We’re going to have to keep our eyes on that and see how it plays out. But I think it’s a little early, but certainly we’re going to keep our eyes on it.”

Cintas’s answer isn’t surprising. In fact, I expect “it’s too early to tell” will be a popular answer to questions related to the new tax law. Considering Cintas was one of the first companies to report since the law was passed, their call was filled with questions and answers related to its potential impact. I’m expecting Q4 conference calls to contain similar discussions.

In fact, if you want a sneak peak into what many companies will most likely be communicating as it relates to the new tax law, I think Cintas did a good job of covering the main talking points. I’ve listed the highlights below.

In general, the tax law is expected to be a net positive.

“There will be significant benefits. As a profitable business with the vast majority of our earnings in the United States, we have historically paid a high tax rate. The reduction in the corporate tax rate will boost Cintas’ earnings and increase cash. Also, we expect many of our customers to benefit from tax reform and invest additional amounts of cash to grow their businesses. Healthy and growing customers are good, of course, for our business. Tax reform will enable us to repay debt more quickly and then have additional cash on hand for our priorities, namely, investments, acquisitions, dividends and share repurchases.”

There will be some adjustments to deferred tax assets and liabilities, or as Cintas states, it will also be an accounting event.

“The signing of the legislation by the President will be an accounting event for Cintas. We will need to revalue deferred tax liabilities.”

Some credits and deductions will be eliminated.

“Well, the — when we think about that kind of an ongoing rate of 23% to 26%, there is a big benefit, obviously, from the drop in the corporate rate. However, couple of things that I might point out. There is something called a Section 199 manufacturing credit that is no longer existing, and that had a small impact on us. There is also the Section 162(m) impact, which is the loss of the deduction for any executive comp over $1 million. That certainly will have an impact. But that’s about it. And certainly then there’s the one time toll charge related to the taxing of foreign E&P.”

And of course, “Could you talk about the cash benefit and how it will be allocated?” will be a popular question. Cintas provided what I expect to be a common response.

“I would say that when you think about the cash flow that we’ve generated in the past, our first priority is to invest in our business. And that’s investing in our business, in our employees, whom we call partners, but then also in capital expenditures, etc. That is always our first priority. The second priority is we will continue to look for M&A opportunities when they make sense at the right value. We will likely continue to look at dividend increases and then share buyback. So I would say that our prioritization hasn’t changed much…”

And finally, it’s a new law and will take time for companies to review and make adjustments.

“We do certainly still need to spend some more time with all of the details. But I would say, over the course of the next couple of months, we’ll likely update our guidance to give some more specific thoughts.”

At this stage of the economic and market cycle, I’m not sure additional stimulus is needed (see Cintas’s 7% organic growth in its uniform business). Nevertheless, the new law is here and we’ll have to wait and see how things unfold (not to mention how long lower tax rates stick – see Political Math).

While I expect corporate management commentary will be positive and earnings will increase, the valuations for most of the businesses I follow will remain well above historical norms. For example, based on my calculation, Cintas’s current P/E of 31x will decline to 27x using its new tax rate – not exactly a bargain for a mature high-quality business. And this assumes all of the tax savings falls to the bottom line.

Although it’s relatively easy to estimate the immediate impact of lower corporate taxes on cash flows, how will other valuation variables be affected? Will rising fiscal deficits and economic growth result in higher inflation and interest rates?

For example, let’s assume economic growth increases from 2% to 4%. What would happen to the 10-year Treasury yield in such a scenario? It would not be surprising if its yield increased accordingly from 2% to 4%. In such a scenario the valuation benefit from a higher growth rate would be offset by higher interest rates.

In my opinion, the current market cycle is highly dependent on the belief interest rates will remain lower for longer. As such, I’m very interested to learn how additional stimulus will influence inflation and if recent upward trends will be amplified (especially labor). In effect, will lower taxes, along with relentless asset inflation, provide enough stimulus to finally jolt the bond market and force central bankers to reconsider their current course of dovish gradualism? And if lower taxes aren’t enough, how about a trillion dollar infrastructure plan? Things sure are getting more interesting!

In summary, I’m looking forward to learning how savings from lower tax rates will be distributed and ultimately allocated. I also plan to monitor its impact on inflation and interest rates. Although I expect earnings and cash flows to increase in the near-term, I believe changes to other valuation variables are equally as important and should be carefully considered in any valuation scenario analysis.

After one of the most uneventful and least volatile years in the history of financial markets, I’m optimistic fluctuating valuation variables will create a less predictable and more interesting market environment in 2018. And who knows, maybe one day we’ll discover volatility in valuation variables has spilled over into asset prices. I don’t know about you, but a touch of symmetry in financial markets sounds very refreshing to me!

[As I was about to publish this post, a mortgage broker friend stopped by my office (Starbucks). He informed me he made $1,500 in the stock market yesterday and took his gains from last year to join the most exclusive country club in North Florida. He went on to inform me stocks will never go down with Trump in office. He asked what I was doing. I said I was waiting to buy his stocks at much lower prices. We both laughed. He then recommended bitcoin and left my office with a double shot espresso.]

It’s official — we’ve entered the “serenity now!” phase of the market cycle 🙂

Patience Paying on the Short End

Rates on the short end of the yield curve continue to increase. As 2018 begins, I’m reviewing yields and considering ways to modestly increase returns on patience. Below is a link to U.S. Treasury yields. Treasury bills are now yielding above most online saving accounts and money market funds (3-month 1.4%; 6-month 1.58%; and 12-month 1.80%). The yield on the 12-month Treasury is 98 basis points higher than a year ago.

Treasury Yields


A Table For the Two

Excluding the hiccup in 2015-2016 (energy credit bust), the current economic and profit cycle remains intact. According to conventional wisdom, strong profits and a healthy economy are good for stocks. In fact, besides the belief interest rates will remain lower for longer, it’s one of the most popular talking points used to encourage equity ownership. Instead of finding comfort in extended economic and profit cycles, experience has provided me with an independent perspective.

I have a long history of stock selection (over twenty years), including the purchase and sale of approximately 180 small cap stocks. After reviewing my largest winners and losers, I noticed a common theme. Specifically, at the time of purchase the underlying businesses were either generating peak or trough operating results. For example, many of my biggest losers were purchased when profits were strong and growing. Conversely, my biggest winners were often purchased when profits were weak and deteriorating. In other words, profit reversion was a major contributor to many of my past investment victories and defeats. This raises the question, should the “profits are high” argument frequently used to buy stocks, actually be used as a reason to sell?

Below is a chart of the S&P 500 and corporate profits that includes two profit cycle peaks and troughs. As you can see, investors who bought stocks when profits were weak (2002 and 2009), enjoyed large gains. On the other hand, buying stocks when profits were high (2007), was not nearly as successful and much more stressful.

What about today’s profit cycle (2017)? Considering the current cycle is ongoing, it’s too early to judge. That said, using history as a guide, investors paying peak multiples for peak earnings rarely land sunny-side up once market and profit cycles conclude.

Another lesson I learned over the past three market and profit cycles is the foundation of the cycle matters. I believe it’s important to note the current economic expansion – similar to the past two – has been accompanied by tremendous asset inflation. As we learned in 2000 and 2008, economic and profit cycles supported by asset prices tend to be very fragile and can end abruptly. Once asset dependent cycles conclude, it becomes increasingly clear (at least to me) that corporate profits weren’t inflating prices after all, but asset prices were inflating corporate profits.

Considering how the last two cycles of asset inflation and elevated profits ended, it’s not surprising central banks are proceeding very cautiously in their attempt to normalize monetary policy. Central bankers are choosing their words carefully to avoid upsetting financial markets, stating normalization will be “utterly uninteresting” and similar to “watching paint dry”.

An uneventful normalization is what central bankers want, but will it be what they get? Asked differently, can persistent asset inflation, combined with historically expensive valuations, coexist with rising interest rates and a shrinking Federal Reserve balance sheet? Although no one can know for certain (we’ve never been here before), the yield curve may be providing us with clues.

As most investors know, the yield curve has flattened as short-term rates have increased. While many view the flattening yield curve as a recession indicator, in this particular cycle, I believe it is also an indicator or measurement of confidence in the Fed’s ability to normalize policy. Specifically, the flatter the curve, the less likely the Fed will be able to accomplish its goal of raising rates and reducing its balance sheet.

Based on its current shape, the yield curve appears to be anticipating an event in the economy or financial markets that interrupts the Fed’s plan to normalize. Based on my bottom-up view, and barring a decline in asset prices, I do not expect the U.S. economy to enter a recession in the near future. Instead of recession, I believe the flattening yield curve is questioning the sustainability of current asset prices in the face of higher rates and quantitative tightening. In effect, the flattening yield curve may be predicting financial market instability that would prohibit the Fed from completing its tightening goals.

Until we discover what the yield curve is communicating with certainty, I expect the economy to continue to expand slowly. In this environment (see July’s post Patience a Possible Win-Win), I believe further increases in equity prices will be met with higher short-term interest rates. With stocks reaching new highs and the 2-year Treasury yield recently hitting 1.84%, this is exactly what has happened over the past several months (see charts below).

As an absolute return investor waiting for an improved opportunity set, the current period is becoming increasingly comfortable. Even though stocks continue to rise and valuations remain very expensive, patient investors are at least being rewarded with higher short-term interest rates. Meanwhile, every basis point increase in short-term rates should make risk asset holders that much more uncomfortable.

Risk free short-term rates are beginning to look more and more appealing in absolute and relative terms, especially compared to equities. Has anyone heard from T.I.N.A. (there is no alternative to stocks) lately? Below is a chart of the 2-year Treasury yield and the S&P 500 dividend yield. Yesterday the 2-year yield surpassed the S&P 500’s dividend yield for the first time since 2008. What does this mean for stocks in the near-term? I don’t know exactly, but I like it and hope it continues!

I find the 2-year Treasury to be an interesting option for absolute return investors. If the bond market is correct and the Fed’s effort to normalize is short-lived, the 2-year could be used to capture some of the recent rise in yield while remaining liquid. By riding the short-end of the yield curve, the addition of the 2-year in patient portfolios could increase average yields while assuming a modest amount of duration risk. For what it’s worth, I’ve been buying a 2-year each month in an effort to gradually create a 0-2 year Treasury portfolio without the associated ETF or bond fund fees.

In summary, investing patiently is rarely easy during periods of extended and elevated asset inflation. However, with short-term yields on the rise, the waiting game is getting easier and more comfortable. With the Fed’s normalization process finally in motion, I’m hopeful 2018 will be a year of higher interest income (if the Fed succeeds) or an improved opportunity set (if the Fed fails). I’ll take either, or even better, I’ll take both!


I’d like to wish everyone a Merry Christmas, Happy Holidays, and Happy New Year! With the year-end performance panic in full swing, I plan to step away from the markets and take the next two weeks off to spend time with my family. For those absolute return investors who continue to fight the good fight, it may be a good time to turn off the screens, take a break, and recharge your sanity batteries 🙂  Here’s to a prosperous 2018 filled with volatility and opportunity!

Few Friends for New Trends

For readers who made it through my quarterly management commentary, it should come as no surprise that wage pressure is a growing concern for many businesses. An increase in operating costs, particularly employee related, is a relatively new business trend I noticed earlier in the year. As the trend became clearer in Q2 2017, I began documenting and sharing my observations with readers.

In addition to providing numerous company-specific examples, I continue to collect a growing list of anecdotal evidence from readers and personal experience. For example, after being shocked and awed by our homeowner’s insurance renewal a few days ago, I called our insurance agent to ask for an explanation. The representative blamed higher premiums on the rising cost of home repairs and construction. I informed the agent that she must be mistaken, as the Federal Reserve has been very clear on this subject — inflation is not a problem, and in fact, is inadequate. She laughed and said, “Yeah, yeah, I know, I know, you don’t have to tell me about rising expenses.”

I also noticed more anecdotal evidence of rising wages last week. After our three-year-old dishwasher decided to break down a day before Thanksgiving (I thought quality was improving Mr. Hedonic Adjustment!), I went to the local hardware store to search for a part. While walking into the store, I was greeted by a sign advertising $15/hour positions. That’s pretty good, I thought! But the need for labor didn’t end there.

As I drove home contemplating working for a local hardware store, I drove by a Walgreens with its sign advertising “flu shots” and “hiring”. Shortly thereafter, I found myself stuck behind a school bus with a “drivers wanted” sign taped to its back window. If this wasn’t enough to convince me to write another post on the tight labor market and rising wages, a commercial advertising employment opportunities (included signing bonus!) at a waste management company came on the radio.

In summary, thanks to our broken dishwasher, I was introduced to four job leads all within fifteen minutes. I can’t wait for the refrigerator to break!

And finally, I ended my week with an interesting conversation with an owner of a large lawn service company. He was lamenting on how difficult it was finding workers. In fact, he said his company doesn’t want or need new business, but desperately needs employees. I told him I’d be happy to help as I enjoy mowing the lawn, but wouldn’t be available during allergy season! Given his capacity constraints, I also mentioned raising prices may make more sense than chasing a dwindling pool of available workers. He seemed to like this idea better than putting me on one of his crews!

While signs of rising wages and costs are becoming more apparent, inflation doesn’t appear to be a very popular topic for most investors — including the bulls and the bears. While the bulls love rising asset prices, they’re not particularly fond of inflation spilling over into the real world. In my opinion, rising inflation would be devastating for the bulls, as it would undermine one of their key assumptions used to justify current asset prices. Specifically, the assumption interest rates will remain abnormally low indefinitely.

Bears, on the other hand, aren’t especially open-minded to rising costs and wages either, as it conflicts with certain bearish views on the economy. Many bears believe the economy is weak, saddled with debt, and incapable of generating wage and cost pressures. While I agree the tremendous amount of debt accumulated over the years will have serious consequences, I do not believe the economy is currently weak or incapable of generating higher prices.

And then there’s the policy makers. Despite their own Beige Book stating otherwise, most Federal Reserve members continue to believe wage growth and inflation is too low. In fact, while watching Bloomberg TV last week the following headline appeared, “Yellen Says It’s Dangerous to Allow Inflation to Drift Lower”. Out of curiosity I read the article (link) and discovered Janet Yellen is in fact concerned “raising rates too quickly risked stranding inflation below the U.S. central bank’s 2% target and there’d been ‘some hint’ that expectations for future price increases may be drifting lower.”

While I don’t know the precise rate of inflation, based on the last two quarters of corporate operating results, I’m very confident trends in cost and price are not “drifting lower”. My view on inflation is focused more on trend than a specific rate. Is inflation running at 1%, 2%, 3%, or 4%? I don’t know exactly, but the trend, in my opinion, is very clear – it’s higher. How long and how far this trend goes remains to be seen. However, to say inflation is currently drifting lower conflicts with what many businesses are reporting and openly discussing.

Although many investors and policy makers remain in a deflationary mindset, several investors I know and respect recently contacted me to provide support of my bottom-up views. In effect, they reassured me while my views were in the minority, I was not crazy or alone.

A former fund manager who continues to monitor the markets closely sent me the following chart on the number of times “wage pressure” was mentioned on conference calls. I’m not certain of the sample size, but the trend certainly confirms what I’ve been noticing over the past two quarters.

Another knowledgeable investor sent me an article from The Economist titled, “Blue-Collar Wages Are Surging. Can it last?” As the title implies, the article discusses the generous wage gains blue-collar workers are currently enjoying, further supporting my belief wage pressures are building in many areas of the economy.

In the current job market, finding an MBA to enthusiastically recommend stock buybacks and acquisitions isn’t difficult — they’re a dime a dozen. However, try hiring a skilled worker to wire your house, drive your goods cross country, or nurse your patients back to health. It’s much more challenging.

A shortage of skilled labor would help explain why certain blue-collar wages are growing at a healthy 3-5% rate (per The Economist article). Interestingly, The Economist’s blue-collar estimate is similar to the Atlanta Fed’s 3-4% estimate of median wage growth (link). I found the rate and trend of the Atlanta Fed’s wage growth tracker (chart below) to be informative and similar to my bottom-up view.

In my opinion, current trends in wages should be concerning for investors extrapolating the past to support future asset price assumptions. For example, how would investors respond to an employment report confirming mid-single-digit wage inflation? Where would the 10-year Treasury and stock market trade with wages expanding 3% to 5% a year? I’m not certain, but I believe some very confident and important inflation, interest rate, and valuation assumptions would need to be adjusted.

This isn’t the first time my bottom-up macro views have conflicted with the top-down consensus. Furthermore, business trends have and can reverse, especially in an economy overly dependent on asset inflation (all bets are off assuming a sharp decline in financial markets). That said, based on my current observations and analysis, I believe the deflationary scare popularized throughout the current market cycle is coming to an end.

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.

What’s Happenin’ Q3 2017

During periods of inflated asset prices, patience is an essential tool for absolute return investors. In addition to avoiding eventual losses associated with overpaying, patience allows absolute return investors to act decisively when valuations revert and opportunities return. While patience may be required during certain periods of the market cycle, inactivity in the portfolio should not be confused with inactivity in the investment process. In other words, patient positioning is not a ticket to the beach or golf course! This is especially true for flexible and opportunistic strategies.

To my surprise, over my career I’ve found I’m often busiest when cash levels are highest and discounts to value are in short supply. During periods of patient positioning, I spend considerable time remaining current on my possible buy list and searching for new buy ideas. Furthermore, it’s a great time to update business valuations and improve the quality of opportunity sets. Instead of resting during periods of excessive overvaluation, absolute return investors should be preparing for the eventual transition from patient to aggressive positioning.

Being prepared takes considerable time and effort, but the rewards can be tremendous. Knowing an opportunity set well allows absolute return investors to act decisively and confidently when the bids disappear and the market cycle ends. During periods of market dislocations, market participants frequently panic, causing extraordinary volatility and uncertainty. During such chaotic periods, concentrating and following through on discipline becomes increasingly difficult. Knowing exactly what you’d like to own beforehand (and at what price) can be very beneficial once the market cycle concludes. Investors without a thoughtful and detailed strategy may find it difficult to act decisively and with reason. Instead of acting opportunistically, unprepared investors may freeze and miss the bounty the end of the cycle often brings.

During the current period of patient investing, I’m spending my days staying on top of my possible buy list and preparing for future investment opportunities. It’s a very labor intensive process. In fact, I just completed one of the busiest earnings seasons in recent memory. Over the past three weeks I reviewed and analyzed the quarterly reports and conference calls of the majority of stocks on my 300-name possible buy list.

Based on my review, operating results for most businesses in Q3 2017 were very similar to Q2 2017, with organic growth remaining in the low single-digits. Given the time and effort I allocated to this earnings season, I was slightly disappointed with my conclusion. Nevertheless, the process and information I gathered was very valuable and has increased my confidence in my business valuations and cycle positioning. While the financial markets and business operating environment are relatively uneventful and frankly, uninteresting, I’m prepared and ready to reallocate capital at a moment’s notice.

Below is a summary of several business trends I noticed during Q3.

  1. Consumer companies, on average, reported soft to mixed operating results. Most volumes and comparisons remain low single-digit positive to negative. It’s been a year since I noticed the consumer slowdown (see Elevated Consumer Discretionary Risk); therefore, it shouldn’t be surprising that year over year comparisons are getting easier. Several companies reporting mid-single digit negative comps are now reporting low single digit negative to flat comps. Several companies blamed warm weather and hurricanes for weak results, but impact temporary. Although results remain sluggish for most, the operating environment and outlooks improved slightly for several companies. Easy comps, persistent asset inflation, and wage growth may be contributing. I plan to research new consumer ideas now that earnings season has concluded. I’m especially interested in beaten down retailers (see Retail Survivor) with strong balance sheets.
  2. Similar to Q2, I again noticed growing signs of cost pressures and pricing action in Q3. Wage pressures were mentioned frequently, while raw material costs were also noticeably higher for many industrial companies. To be clear, I don’t believe inflation is spiking higher, but the trend has definitely shifted, in my opinion. Specifically, the trend in inflation appears to have moved from fears of deflation (2015-2016), to slow to moderate inflation. I believe costs and pricing is something to pay very close attention to as it relates to profit margins and systematic risk (equity and bond markets have clearly not priced in the risk of inflation, in my opinion).
  3. Industrial businesses had another good quarter. Companies tied to construction and aerospace/defense reported healthy results. Exports healthy, on average. The rebound in energy spending also contributed to improved results, but year over year growth has slowed (rig count rebound stalling).
  4. Investment in domestic energy infrastructure was satisfactory in Q3, but growth is moderating (more from difficult comps than slowdown in industry). Credit has returned and terms are favorable (especially considering the bust was only 1-2 years ago). Energy production is growing again, but cap ex growth more disciplined versus 2014 peak. Assuming $50 oil and $3 gas holds, I suspect 2018 capital expenditures will be similar to cash flows – growing moderately from 2017 levels. We’ll know more when most 2018 budgets are released with Q4 2017 results. Hedging programs are active for 2018, therefore, many E&Ps have already locked in a large portion of 2018 prices which should provide some visibility/stability for cap ex next year. Labor and material costs clearly increasing for industry. Lastly, offshore remains weak, but some mentioned the sector may be in the process of bottoming.
  5. Auto manufacturing slightly down to stable. There doesn’t appear to be strong conviction on future trends. Hurricanes may have stemmed the slight decline temporarily.
  6. Agriculture remains weak, but stabilizing.
  7. Transportation capacity utilization and pricing appears to be improving modestly. Higher transportation costs mentioned on several calls.
  8. Financials are doing well on average. For now, loan losses are manageable. I continue to believe there is a growing risk insurance companies are underwriting too aggressively to maintain premium growth. And of course their investment portfolios are tied to the bond and equity markets to different degrees. As such, I have a low degree of valuation confidence when using book value for insurance/financials.
  9. Technology results were mixed depending on end customer. I tend to avoid using technology results to help me form my opinion on aggregate profits and economic activity. Technology operating results are often not a good indicator given choppiness of their forecasts and results – their cycles can be very short and abrupt. Results and outlooks can change weekly.
  10. Currency was not a major factor in Q3.
  11. Hurricane impact was mixed, but not meaningful and temporary for most. Some short-term sales and raw material cost/availability impact.

Looking forward, outlooks and commentary suggest the economic and profit cycle will continue into Q4 2017. Barring a sharp decline in asset prices (financial markets and economy appear to be one and the same currently), I’m expecting approximately 3% growth in Q4. Overall, I believe Q4 will be similar to slightly better than Q3, with easier comps in consumer and slightly tougher comps in certain industrials and energy. Business outlooks appear more confident this quarter versus Q3. Again, this assumes asset prices remain inflated, which appears to be the path market participants are committed to heading into year-end (performance panic season).

As always, if you’d like to read the management commentary and quarterly highlights that helped form my macro and profit cycle opinion, please request via email. Given its size (60 pages) it was again too lengthy to post.

Happy Thanksgiving!

Getting Old Is Not For Sissies

Considering I don’t own equities, it may come as a surprise that I believe the operating environment for most businesses is satisfactory. As I wrote last quarter, “Based on the operating results of my opportunity set, I continue to believe the U.S. economy is growing in the low single-digits.” I went on to note that I believe on a nominal basis, the mid-3% growth reported in Q1 and Q2 appear reasonable. Lastly, I stated real GDP of slightly below 2% was in-line with my bottom-up observations and analysis.

Although I don’t use government data to form my macro opinions, last week’s GDP report was similar to my “slightly below 2%” economic growth estimate. While Q3 GDP grew at 3%, after removing the impact from inventories and trade, final sales to domestic purchasers increased 1.8%.

Based on my initial review of third quarter corporate earnings, Q3 is shaping up to be similar to Q2, with low single-digit growth continuing. It’s not especially strong growth, but the economic expansion and profit cycle continues nonetheless.

Given my view on the economy and profit cycle, I’m not expecting stocks to decline near-term due to poor earnings. Nevertheless, in my opinion, the risk associated with equity overvaluation remains significant.

I continue to believe my opportunity set is the most expensive it’s ever been, with prices well above levels that can be justified using realistic assumptions. I do not know when or exactly how the current market cycle ends, but when it does, I expect my opportunity set to change considerably. Hence, my absolute return discipline and strategy remains the same – wait and wait some more. Zzzzzzz, I know — the boredom is excruciating.

While I’m not anticipating a near-term earnings catalyst to end the current market cycle, in the “they don’t ring a bell” department, catalysts are not always necessary. I remember the end of the tech bubble well. I came into work one day and everything changed — there was no warning. For no particular reason, internet stocks simply stopped going up, rolled over, and crashed. Few investors saw it coming and most were in shock. Many newly created millionaires (often through stock options) lost it all almost instantly.

Similar to March 2000, I believe one of the least appreciated risks facing investors today is one morning they’ll come into work and discover a stock market that no longer goes up. Despite the best efforts of dip buyers, financial television enthusiasts, and central bank talking heads, the stock market gets tired, rolls over, and dies of old age. And because this market lacks valuation support, stocks can decline considerably before genuine margins of safety reappear and protect investors on the downside.

Of course conventional wisdom suggests central banks will come to the rescue at the first sign of declining stock prices. However, what if central banks achieve their inflation goals, as I believe they already have, and find themselves behind the curve?

In recent posts and quarterly management commentary, I provide many examples illustrating the Federal Reserve’s inflationary “success”. Assuming the end of the current market cycle coincides with a period of accelerating inflation, will the bond and currency markets permit another round of open-ended QE? Maybe, maybe not, but the belief that central banks will always be capable of bailing out investors with an unlimited bid is flawed, in my opinion.

Based on my observations over the past two quarters, the trend in inflation (especially wages) is clearly higher. Even last week’s GDP report showed inflation is accelerating. For clues on inflation, or the QE assassinator, I plan to continue monitoring trends in company-specific costs, wages, and pricing. I’ll be watching the bond market closely as well. While equity investors appear unconcerned, the short-end of the curve appears to be sniffing out what I’ve been observing and documenting.

Going forward, I expect rising equity prices will be accompanied by rising inflation and interest rates – classic ailments of an aging market and economic cycle. In effect, I believe we’re entering the stage of the cycle when the equity and bond markets transition from being friends to adversaries. If I’m correct, relying on extraordinarily low interest rates to justify equity allocations may become increasingly precarious and uncomfortable.

Based on recent increases in equity prices, I question if the changing relationship between stocks and bonds is being adequately considered by investors. In fact, as I was watching Bloomberg TV yesterday, a CEO of a large asset management firm recommended buying stocks. He stated that while interest rates have increased, they remain low historically. Maybe so, but what is the trend in rates and inflation? And if his prediction of higher equity prices becomes true, what does that mean for the economy, inflation, and an already extremely tight labor market?

It sure is a fascinating market cycle. I’m very interested to see how it ends. While a market dying from old age and without warning wouldn’t surprise me, I suspect rising inflation, an uncooperative bond market, and an impotent Federal Reserve would surprise many. This isn’t a prediction, but one of the many possibilities to consider as the clock on today’s aging market cycle ticks.


Until the cycle ends, I plan to continue documenting the growing number of inflationary signals I’m noticing. Feel free to email me examples. Below are some headlines I noticed this week. I also included a few management comments from my possible buy list names. I believe this is an important change in trend versus a year or two ago when inflationary trends were less certain and visible.

“Employment cost index advanced 0.7% after a 0.5% gain in the prior three months. Total compensation rose 2.5% over the past twelve months.”

“U.S. August S&P CoreLogic Home Prices rise 5.9%”

“Oil Extends Two-Year High as Investors Eye OPEC Extension”

“Rent is Eating Up a Record Share of Americans’ Disposable Income”

“Hot Labor Market Seen in Dallas Fed Manufacturing Markets”

“U.S. Companies Add Most Workers in Seven Months”

“Why the Biggest Metals Rally of the Year May Have More to Run”

“NJ Transit is Missing $2.4 Million in Fares From Worker Shortage”

“We have plans in place to respond to the approximate 8% per ton increase in manufacturing costs…increases were driven by increased labor, employee benefits and depreciation costs…” Oil-Dri conference call.

“So the whole impediment…is labor and I think you may have witnessed this in the new home construction site where the demand is very strong and basically labor constraints in general are inhibiting the natural growth that could take place.” Pool Corporation conference call.

“And all over the country, you hear how challenging it is with unemployment being so low to — you’re competing for talent. And so you’re having to pay in almost every position more than you did even a couple of years ago, and every year has gotten tougher as unemployment has continued to trickle down.” Texas Roadhouse conference call.

“$13 for two cups of frozen yogurt! Are you kidding me?” Guy in front of me at Yobe.


My wife just emailed me the picture below. At first I thought she was sending it in support of my last article on inflation, but then I realized she was actually encouraging me to get a job!

I remember some long hours in the office when I was an analyst/portfolio manager. My boss would joke that he’d be happy to slide TV dinners under my door if I didn’t want to leave.

It’s interesting. As analysts and managers, sometimes we sit in our offices reading for hours and hours attempting to figure out our investment and economic worlds. Meanwhile, the answers are often not in the piles of data and research stacked on our desks, but right outside waiting for us to simply look up and acknowledge.

For example, during the housing bubble, all you needed to do in Florida was go for a short walk or drive and count the number of new condo buildings and neighborhoods being constructed. The unsustainable excesses in credit were right outside for all to see. It was not only obvious in hindsight, but in real time.

I believe the same can be said for the labor market today. As stated in my previous post, and based on my bottom-up research, I’m noticing growing signs of a tight labor market and rising wages. If government data isn’t picking this up — making it difficult for many investors and economists to identify — maybe it’s time to step out of the office (or immaculate Federal Reserve building) and go for a walk to observe.

While central banks may still have control of the bond and stock markets, the labor market appears to be functioning freely, with supply and demand pushing wages higher. As such, in my opinion, new labor laws requiring an increase in the minimum wage are unnecessary.

Locally, it’s clear the market price for entry-level employees is well over Florida’s $8.10 an hour requirement. Chick-fil-A isn’t alone. There are many companies being forced to pay higher wages to fill positions. Remember, just a few weeks ago Target (TGT) increased its minimum pay to $11 an hour. I suspect this move wasn’t out of generosity, but out of necessity.

So go for a walk or drive and see for yourself. Talk to mangers and business owners attempting to fill positions with qualified employees. When you return to the office and review macro statistics suggesting wage inflation remains subdued, ask yourself if the numbers agree with your observations and conversations.

Drivers of Higher Rates: Good and Bad Inflation

[Apologies to subscribers: Friday’s post was sent prematurely and did not have a link. Hopefully the link and edited version is sent successfully Saturday.]

The 5-year Treasury yield hit 2% this morning. It’s not much, but the short to middle of the curve is starting to look a little more interesting (relatively). As I wrote in “Patience – A Possible Win Win”, I believe “…as long as financial conditions remain stable and equity prices inflated, the Fed will most likely continue raising rates. In effect, until something in the financial markets ‘breaks’, the Fed’s tightening path appears to be on a set course.”

In other words, as the asset inflation fires rage in risk markets, the Fed has cover to raise rates. And who knows, they may actually feel responsible enough for their asset inflation inferno, and its potential risk to the economy, to at least begin building some fire lines.

While I believe rising asset prices have contributed to the recent increase in interest rates, I’m also continuing to detect signs of less investor-friendly forms of inflation. As I documented in past posts with examples, costs and wages are rising for many of the businesses I follow. While I prefer viewing inflation from a bottom-up perspective, my observations have recently been confirmed by unlikely top-down sources — the media and the Federal Reserve.

Below are a few headlines I noticed this week while watching Bloomberg TV and reading the financial news.

“Consumer Price Index Jumps 0.5% in September”

“Canada Annual Inflation Rises in September on Gasoline, Food costs”

“UK Inflation Hits 3% in September”

“Commodities Rally a Welcome Tailwind for Asia Open”

“China’s Factory Inflation Rebounded”

“New Zealand Inflation Quickens More Than Economists Forecast”

Even the Federal Reserve is beginning to take note of rising costs, or specifically, the tightening labor market (thanks to a reader and very knowledgeable investor for pointing this out).

Similar to the information I accumulate each quarter from small cap businesses, the Fed’s Beige Book gathers and summarizes economic information by interviewing “business contacts, economists, market experts, and other sources.” Below are the Fed’s comments on labor, which conform with many of the company-specific results and commentary I’ve recently discussed.

“Labor markets were widely described as tight. Many Districts noted that employers were having difficulty finding qualified workers, particularly in construction, transportation, skilled manufacturing, and some health care and service positions. These shortages were also restraining business growth.”

“Despite widespread labor tightness, the majority of Districts reported only modest to moderate wage pressures. However, some Districts reported stronger wage pressures in certain sectors, including transportation and construction. Growing use of sign-on bonuses, overtime, and other nonwage efforts to attract and retain workers were also reported.” [my emphasis]

Interesting, isn’t it? Consumer prices are up 2.2% year over year (over 2% goal), unemployment is near 4% (under full employment), and the Fed’s own Beige Book is reporting tightness in the labor markets, with shortages and the growing use of signing bonuses. Meanwhile, after a nine year bull market in risk assets and an economy displaying classic late-cycle signals, Fed policy remains in an emergency and very accommodating stance (negative real short-term rates and a severely bloated balance sheet). From a policy perspective, is it 2009 or 2017? Hard to say.

As I noted in a previous post, “Exactly when the current market cycle ends remains unclear, but in my opinion, the cozy relationship between short-term interest rates and equities is over. Going forward, higher stock prices will most likely lead to higher short-term rates.” And this is exactly what has happened. However, when I initially wrote this, I was focused mainly on asset inflation.

Going forward (barring a decline in asset prices), I suspect there will be a growing number of headlines related to other forms of inflation. In my opinion, given the widely-held belief that interest rates will stay low indefinitely, broadening inflation, from the perceived good to the bad, is something investors should monitor closely.

Sorry for the short post this week. As many of you can relate, I’m currently very busy plowing through earnings season. I’ll publish my own Beige Book in a couple weeks, summarizing the operating environment and economy through the eyes of business.

Have a great weekend…and I hope you’re enjoying these higher interest rates!

Fiduciary Hot Potato

The year-end rally appears unstoppable. As has been the case for much of the current market cycle, elevated valuations have been an ineffective deterrent for investors willing to pay higher and higher prices. After such a long and seemingly endless period of rising stock prices, wanting and expecting more comes easier than settling for less.

When overindulging in anything enjoyable, few people want to listen to the virtues of settling for less. No one likes to hear, “Hey buddy, you might want to put down that triple cheese burger, cigarette, beer, or grossly overvalued small cap stock.” I can relate. When I’m knocking down a large bowl of my favorite private label ice cream, the last thing I want to be lectured on is discipline and prudence!

After almost nine years of all gain and little pain in the financial markets, the topic and practice of risk aversion isn’t very popular. Nevertheless, considering the potential losses current valuations imply, I continue to believe risk is a very important message to communicate and consider. Fortunately, I’m not alone.

A fellow absolute return investor, Frank Martin, also continues to consider and write about risk. Last week he focused on tail risk. In his article, “The Tail Risks Optimizer’s Dilemma: Taleb Vs Spitznagel”, Frank writes about the leading experts on tail risk and their attempt to position for black swan events.

While I found his comparison of Taleb and Spitznagel very interesting, Frank’s discussion regarding the difficulty of applying their strategies caught my attention. His comments reminded me of the challenges encountered by many absolute return investors.

Frank writes, “In reality, most people are simply not hardwired to endure pain before gain, especially when the duration of the suffering and the magnitude of reward are uncertain. Moreover, most investors find it difficult to remain patient and circumspect as the gravy train to apparent riches pulls out from the station. The loneliness of watching the caboose get smaller as it fades into the distance is more than most can handle. Benjamin Graham quantified those who can stand such isolation at 1 out of 100.”

Frank goes on to discuss a very important topic that I believe is underreported and underappreciated by many investors. Specifically, business risk and its influence on investing and decision making. As many of you know, Jeremy Grantham is well known for his comments on career risk, or how portfolio managers’ fear of “being wrong on their own” influences decision making. But what about business risk?

Business risk differs from career risk as it’s sourced from the asset management firm, not the portfolio manager. Just as a portfolio manager can invest too differently and risk his or her career, if an asset management firm thinks and positions itself too independently, it can risk losing assets and revenues.

Frank explains, “The human aversion to pain and desire to join others aboard the train affects clients and investment firms alike. Managers, however, are assumed to be more aware of systemic risks than their clients, or else there would be no reason to employ them. Investment institutions are often risking their own economic survival if they try to optimize their clients’ portfolios for adversity and get off the train before their peers. The optimal scenario would constitute institutions that are unconditionally client-centric and clients who understand and appreciate that value proposition. In a battle between human nature and nirvana, the state of the world would suggest that the former will invariably dominate. Consequently, many firms fail to properly prepare clients and their portfolios are left to suffer the vicissitudes of the market.” [my emphasis]

I love that paragraph. It touches on a very important and relevant topic for the asset management industry. Specifically, the possible conflict between business risk and “properly preparing clients and their portfolios”.

Imagine for a moment you’re a board member of an asset management firm. You have a duty to the owners to maximize the value of their business. Asset managers are not charities – they have some of the same desires and objectives as most businesses, such as growing assets, revenues, and profits.

Now imagine you’re in a board meeting. As you sit in the meeting, a discussion of current market conditions, asset valuations, and risk begins. A board member throws up a chart of historical equity valuations, clearly illustrating current prices suggest significant losses to client capital are possible, and if history is an accurate guide, probable.

What do you do? Recommend reducing risk, increasing cash, or returning client capital? This option would most likely cause assets to leave the firm and revenues to fall. Or do you stay invested and point to investment mandates requiring the firm to stay fully committed to risk assets? This option would most likely increase the odds of retaining assets and allow the firm to benefit from further increases in asset prices.

The conflict between business risk and doing what is right for the client (also known as fiduciary duty) is complicated further by investment mandates. Investment mandates often require asset managers to invest in a certain manner, regardless of price, valuation, and risk. I’ve often wondered if strict investment mandates and fiduciary duty can coexist.

For example, during periods of broadly inflated asset prices and elevated risk, can an asset manager with a fully invested mandate act as a fiduciary? In other words, can certain investment mandates nullify an asset manager’s fiduciary duty? If so, do advisers and consultants that request mandates also assume a greater fiduciary responsibility? In summary, where does fiduciary duty reside, where should it reside, and how do investment mandates interfere with its implementation and allocation?

These are very important questions for most relative return managers and their clients. Absolute return managers, on the other hand, typically have more flexible investment mandates that are less likely to conflict with their fiduciary obligations. However, higher flexibility and fiduciary responsibility do not come without a price. To comply with their fiduciary duty, absolute return managers may be required to assume above average levels of career and business risk, especially during periods of excessive asset inflation and overvaluation. As an unemployed absolute return manager, I can certainly relate! 🙂

To conclude, business risk, fiduciary duty, and investment mandates are interconnected and have complex relationships. I believe it’s important to recognize these relationships and understand how they influence investment decisions and the allocation of fiduciary responsibility. Fortunately, given where we are in the market cycle, it is not too late to add flexibility to investment mandates and increase the level of business risk asset management firms are willing to assume. Such modifications, in my opinion, would better enable asset managers to perform their fiduciary roles and as Frank Martin wrote, “properly prepare clients and their portfolios”.

Have a great weekend!