Behind the Curve Illustrated

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

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

Packaging Corporation (PKG):

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

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

Kennametal (KMT):

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

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

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

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

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

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

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

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

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

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

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

Have a great weekend!

Transcript source: Seeking Alpha

The Consumer “Last to Know” Price Index

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

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

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

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

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

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

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

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

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

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

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

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

Real Vision Interview

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

Interview Snapshot

Real Vision TV (14 day trial near bottom)

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

Drive-By Jobs Report

As investors eagerly await tomorrow’s jobs report, I’ve been busy going through quarterly earnings reports and conference calls to form my macro opinion — independent of government data. While my review is far from complete, as it relates to the job market, I’m again observing growing signs of a tight labor market and wage pressure. Regardless of the jobs report tomorrow, my opinion of the labor market will remain reliant on what businesses are reporting, not the government.

In addition to reviewing the operating results of hundreds of small cap businesses, I noticed a few other signs (literally) of a tight labor market this morning. As I was stuck in traffic, I took a few pictures. This three mile stretch on A1A was filled with “For Sale and For Lease” signs in 2009. Today, those signs have been replaced with “Help Wanted” signs.

Have a wonderful jobs report Friday! I won’t be tuning in. Instead I’ll be going through earnings reports and learning more about the economy in real time. I should have a summary, along with supporting data, in a couple weeks.


Q&A and Responses to Reader Comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1.) Regulatory/legal pressure

2.) Worker quality

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

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

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

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

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

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

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

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

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

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!

New Trends with Few Friends

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.