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.

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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.