Reader Comments and a Few Questions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Q: Some corroborating top-down stuff…

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

Q: Article on rising inflation.

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

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

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

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

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

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

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

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

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

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