<July 12, 2023>
From a career standpoint, graduating college in 1993 wasn’t ideal. The job market remained impaired from the 1990-1991 recession, with unemployment slightly over 7%. Competition for entry level positions paying $18,000 to $25,000 a year was intense. And forget about the money, most graduates just wanted experience and their first step on the corporate ladder.
I was one of those eager job seekers in 1993. With a job history of scooping ice cream and repairing brakes, I didn’t have a lot of experience to bring to interviews. I quickly discovered it wasn’t easy to convince a company to incur an expense without commensurate revenue! This was especially true in a weak economy with thousands of candidates fighting over limited positions.
I remember a conversation I had with a good friend during this difficult period. He was also desperately seeking employment and was going through the interview grind. His name was Scott.
“So how is your search going?” I asked
“Nothing yet, but I’ve had a lot of interviews,” Scott replied.
“Me too. Between us, some interviews haven’t gone well. I’m having trouble convincing employers how my experience can be applied to the corporate world,” I lamented.
“I hear you! I’m having trouble too. If you’re interested, I have an interview trick that really helps,” he said.
“What is it? I’ll take anything!”
“Before my interview, I place a red superball in my inside suit pocket. If the interview isn’t going well and it looks hopeless, I pull out the superball and throw it against the wall and yell, ‘Watch the red superball! Look at it go. Watch it bounce. Go red superball, go!’”
“You can’t be serious,” I said.
“I know it sounds crazy, but it works. And you don’t have to throw the ball—just having it in your pocket and knowing you have a backup plan helps,” Scott explained.
I recently reached out to Scott to reminisce about our conversation. We had a good laugh. He ended up landing a good job after what I’m sure was a very entertaining interview! Whether or not he threw the red superball, I’m not sure, but I’m certain he had it in his pocket ready to go.
Looking at today’s financial markets, I can’t help but think about the red superball. With so many important macroeconomic, monetary, and business trends bouncing around, the future is extremely uncertain. We’ve listed some of the variables and trends we believe are important and could end up going in many different directions.
Inflation
The rate of inflation has been trending lower. With lower energy prices, improvements in worker availability, and fading stimulus demand, most companies have reduced the rate of price increases. That said, inflation remains positive, and accumulated inflation continues to be a significant and underappreciated issue. A dollar received at the beginning of 2021 is now only worth $0.86 (ouch!) with accumulated inflation continuing to build. Adding to inflation’s complexity, asset inflation no longer appears contained, as a growing number of businesses cater to the wealthy and set prices accordingly.
While many investors and policy makers expect the inflation rate to continue to subside in the coming months, we believe there are many paths to inflation remaining too high and possibly rebounding later this year. Catalysts for persistent inflation include: a rebound in energy prices, the end of inventory destocking, shortages of skilled and productive workers, unchecked fiscal deficits, the premature end of quantitative tightening, the resumption of quantitative easing, yield curve control, asset inflation spillover, compromised inflation targets, deglobalization, a decline in the dollar, and the continuation of businesses choosing profits over activity (Make Less Make More). In our opinion, the future path of inflation is very uncertain.
Energy
The decline in energy prices has been an important contributor to the reduction in headline inflation. We believe the price of energy in the near term is very uncertain. At $70 oil and $2.70 natural gas, energy prices are high enough to provide healthy profits for the industry but too low to encourage aggressive drilling and oversupply. Even with oil exceeding $100 and natural gas $9 in 2022, the industry remained disciplined, focusing on profits over production growth. Although the rig count has increased from its COVID lows, most exploration and production companies continue to drill within cash flow, and the rig count remains below 2019 levels. With supply in check, demand remains less certain with a sputtering global economy and the disappointing reopening of China’s economy. In our opinion, $70 oil and $2.70 natural gas is too comfortable for almost everyone, and we don’t expect it to last. We can’t predict the future, but we’re confident the energy industry will remain highly cyclical and prices volatile.
Consumer
As long as asset prices remain inflated, the higher-end consumer continues to spend, partially offsetting noticeable weakness in the middle and lower-end consumer. That said, in aggregate, the consumer is slowing and showing signs of stress (The Worm Turns). Real personal consumption has stalled as consumers struggle to maintain their standard of living. Accumulated inflation continues to weigh on purchasing decisions, with discretionary spending under considerable pressure. As a result, a growing number of consumer companies are reporting weakening operating results and outlooks. Although elevated stock and home prices may mask broader weakness in the near-term, we believe many of the drivers of spending, including debt growth and asset inflation, are unstable. In our opinion, the sustainability and direction of consumer spending is very uncertain.
Housing
Housing has stabilized in recent months; however, affordability remains a serious problem. Homebuilders have reduced incentives and price cuts in favor of profit margins. Existing home prices have benefited from limited supply and low unemployment. Many homeowners feel trapped by their low-rate mortgages and soaring renovation costs. Inflated home equity balances and rising stock prices have contributed to housing’s resilience. It’s no coincidence, in our opinion, that housing stabilized at the same time the Nasdaq 100 soared 38.8% during the first half of 2023! For homebuilders boasting about persistent demand in the face of higher interest rates, we suggest they reconsider the drivers of the industry. Interest rates appear less of a factor this cycle. With a greater reliance on asset inflation and the policies that foster it, we expect the direction of the housing market to remain uncertain and increasingly correlated to a very expensive stock market.
Bonds
The bond market is extremely challenging to predict, in our opinion. On the one hand, the inflation rate is declining, but it remains above the Fed’s target and could rebound later this year. Elevated fiscal deficits will also flood the bond market with additional supply of Treasuries, putting further upward pressure on yields. Meanwhile, at any moment, the bond market could rally in anticipation of the Fed reacting to the next crisis, bout of financial instability, or bullish inflation report. To complicate matters further, the market’s response to the next round of rate cuts and quantitative easing is unknowable. In our opinion, the Fed’s powerful tools have been overused and will eventually be viewed as harmful by bond investors. We are grateful we don’t forecast interest rates for a living! The future of the bond market remains very uncertain.
Precious metals
We like precious metals. While many of the variables we’ve discussed remain uncertain, we believe the return of an easy Fed and quantitative easing is highly likely. In our opinion, the need to finance growing fiscal deficits and federal debt will require the Fed and its price insensitive bid. As such, we believe precious metals will eventually respond favorably. However, in the near-term, we’re less certain of the direction of gold and silver prices. With the Fed talking tough and maintaining the Fed funds rate near the rate of inflation, precious metals have had trouble gaining upside momentum. We’re willing to endure near-term uncertainty for the longer-term protection we believe gold and silver will provide holders of cash equivalents denominated in U.S. dollars.
Fed Credibility
The economy and financial markets have withstood U.S. Treasury yields of 4-5% better than we anticipated. In our opinion, the Federal Reserve deserves some credit for hiking rates and attempting to make up for past policy mistakes. Past mistakes include: believing inflation was transitory, maintaining quantitative easing in 2021-2022 even as inflation spiked above the Fed’s target, pivoting in 2019 in response to market instability while unemployment was near record lows, and expanding the Federal Reserve’s balance sheet by $8 trillion since 2009.
The Fed currently appears to be attempting to rebuild its credibility. As long as stock prices are rising and financial markets are stable, the Fed is better able to raise rates and talk tough. In our opinion, the real test for the Fed will come when financial instability returns, asset prices decline, and the rate of inflation remains above 2%. We’ll be watching the Federal Reserve’s balance sheet closely, as we believe it’s the most accurate measurement of Fed credibility. When the Fed’s balance sheet rises, their credibility falls and vice versa. Based on abrupt changes to policy and its balance sheet over the past several years, we believe the direction of Fed credibility remains highly uncertain.
Stocks
With short-term U.S. Treasuries yielding over 5% and normalized earnings yields of stocks near 3% (Shiller P/E 31x), we’re puzzled by the desire to chase equities higher. We are finding very few absolute values within our small cap opportunity set. Earnings growth, on average, has slowed and in some cases is declining. The current environment for stocks continues to remind us of 2007 when investors also appeared undeterred by developing cracks in the economy and earnings. Based on normalized earnings of many of the businesses we analyze, we believe most stocks are overvalued and have significant downside risk. As investors shrug off slowing earnings growth, sticky accumulated inflation, competitive risk-free rates, and expensive valuations, we believe the future returns of equities are very uncertain, and in our opinion, remain inadequate relative to risk assumed.
Hot & Fresh Dinner Rolls
After a recent softball tournament, my daughter’s team decided to eat at Texas Roadhouse (TXRH). It was my first visit. Once seated, the waitress brought us drinks and a basket of dinner rolls. The rolls were hot, fresh, and paired with sweet butter unique to Texas Roadhouse. I put the butter on a roll and gave it a try. It was incredible. I commented to another softball dad, “These things are ridiculous!” He replied, “Yeah, it’s Russia—they’re playing the long game.” After my fourth roll, I realized why Texas Roadhouse’s stock trades at 27x earnings! In the face of growing consumer stress and declining discretionary spending, the company’s same-store comps have been impressive (+12.9% comps in the first quarter of 2023).
We believe Texas Roadhouse’s hot and fresh dinner rolls are highly correlated to economic activity. Simply look at the parking lot of a typical Texas Roadhouse—it’s filled with the cars and trucks of hard-working Americans. Construction workers are represented particularly well. If these workers are forced to give up irresistible dinner rolls, we will know the consumer is in serious trouble and we are finally in recession. While our new favorite economic indicator is currently trending positively, based on the commentary and outlooks of other consumer companies, we believe the trend in hot & fresh dinner roll consumption is at risk and very uncertain!
Look at the economy, look at the markets, and look at the Fed. Watch them bounce and watch them go! Just like the red superball, the paths of many important variables influencing asset prices are currently highly uncertain. In the face of so many unknowns, investors are driving stock prices higher and volatility lower, showcasing their confidence in the future. Our positioning is different and reflects our belief that businesses generate uncertain future cash flows, and those uncertainties should be properly considered in every business valuation. Instead of pricing in certainty and chasing stocks higher, we find ourselves patiently positioned, requiring adequate compensation for the unknown. And while this may cause us to lag the market and our peers in the near-term, if there was ever a time when we don’t want to look like everyone else, we believe that time is now.
Eric Cinnamond
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Definitions:
Consumer Price Index (CPI): An index of prices used to measure the change in the cost of basic goods and services in comparison with a fixed base period.
Real Personal Consumption Expenditures: An inflation-adjusted measurement of consumer spending on goods and services by people of the United States.
Quantitative Easing: A monetary policy in which the central bank increases the money supply in the banking system, as by purchasing bonds.
Quantitative Tightening: A monetary policy in which the central bank decreases the money supply in the banking system, as by selling bonds or letting them mature.
Yield Curve Control: Yield curve control involves targeting a longer-term interest rate by a central bank, then buying or selling as many bonds as necessary to hit that rate target.
Price to Sales: The price-to-sales ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.
Nasdaq 100: The Nasdaq 100 is a capitalization-weighted stock market index comprised of equity securities issued by 100 of the largest non-financial companies listed on the NASDAQ exchange.
Shiller P/E: A valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
S&P Homebuilder Index: Equity index that comprises stocks from the S&P Total Market Index that are classified in the GICS (Global Industry Classification System) Homebuilding sub-industry.
S&P 500: The Standard & Poor's 500 is an American stock market index based on the market capitalizations of 500 large companies.
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