Tag: macro

What Does The Manufacturing PMI Tell Us About Forward Stock Returns?

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When you think about all the articles being written about shortages and fears of inflation, it seems like the US economy is doing very well. You can’t really have those things without consumer demand. Indeed, some are calling for GDP growth of 8% in 2021 and a big increase in inflation.

I’m a little cautious on the GDP growth in 2021 causing sustained inflation (mainly because its high growth lapping a year that was beaten down) (as I previously wrote about). Let’s not confuse a one-time increase in prices with inflation…

But I also get pretty cautious when everything I read is all the same – “a boom is here.”

One piece of data that gets thrown around is ISM Manufacturing PMIs. The latest reading was 64.7%! It’s well above pre-COVID levels.

As they say on their website:

A Manufacturing PMI® above 43.1 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the March Manufacturing PMI® indicates the overall economy grew in March for the 10th consecutive month following contraction in April 2020. “The past relationship between the Manufacturing PMI® and the overall economy indicates that the Manufacturing PMI® for March (64.7 percent) corresponds to a 6.2-percent increase in real gross domestic product (GDP) on an annualized basis,” says Fiore.

Now, a PMI is a “purchasers managers index” and is basically a survey from a wide array of companies in manufacturing in the US. It basically is asking, “are you growing or shrinking?” across a wide array of topics.

Investopedia says, “when the index is rising, investors anticipate a bullish stock market in reaction to higher corporate profits.”

Actually – it can really be used as a CONTRA indicator.

I went back through the data to 1960 and checked the 6-month, 12 month and 18-month S&P500 returns after the manufacturing PMI was at certain levels. It’s not perfect, but its something.

I’ll just put the data out there – would you rather swing hard with the index around 65? Or below 43? There aren’t many cases when it goes above 70, but that generally does not have a good track record.

Look, I try not to market time. I’m typically nearly-fully invested. But I also understand there’s a time to own some names (e.g. cyclicals) and time to eh… maybe cool it and wait for a better day.

Contrarian Corner: Inflation is a Consensus Bet. Look at Deflation $TLT

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I’m thinking of starting a new segment called, “Contrarian Corner.” In these posts, I will try to point out the other side of a company perception, trade, or view that I see as pervasive in the market.

When everyone crowds to one side of the boat, there are typically better opportunities to sit on the other side.

Right now, it seems “inflation is coming” is a pretty consistent view. (Somehow, the people shouting inflation think they are contrarian?) Every report, article, or tweet is talking about it…. I really try to avoid macro talk, but this is too good to pass up.

My favorite example of this is pointing to lumber prices as an indicator of runaway inflation.  This totally ignores prior supply / demand dynamics that led to this surge. To me, its picking a data point to support a view.

I follow lumber prices, so I know why they are up. Canadian lumber is high-cost supply. The crash in prices in 2018 meant many mills to the north were unprofitable and were curtailed. Add in forest fires and impact from the Pine Beetle and supply was constrained. Lastly, Canada implemented caribou protection which curtailed logging activity. Lumber prices were still very low so even mills in the US shut. Now that housing has come back strong, this caught supply off guard and prices surged.

Is that inflation? Or is that a short-term supply demand imbalance? Prices are now at a level where everyone can make money if they can get supply back online. Would you make a bet with me that lumber prices will be higher than where they are right now in 3 years?

There are other examples of this. I’ve discussed oil (prices are up and rig count is at multi-year lows) as well as housing (underinvested post-GFC), and used car prices. Each of these are specific  supply / demand issues or the bullwhip effect.

Is that persistent inflation? Is a one time rise in prices due to a demand shock (COVID lockdown), that resulted in a supply shock, inflation?

The reason why *persistent* inflation matters is because that is what is going to move long-term interest rates.

So Why Deflation vs. Inflation?

First, its that the government’s use of debt to stimulate is suffering from declining marginal returns. Second, its that M2 is NOT what drives inflation. Its also velocity, which continues to decline.

As the National Bureau of Economic Research stated in a 2010 study (my emphasis added):

The median growth of the 20 advanced nations in this study fell by half as their debt levels moved from less than 30 percent of GDP to 90 percent or more. The drop-off was particularly significant at the 90 percent threshold: between 60 and 90 percent of GDP, median growth was still 2.8 percent; above 90 percent it was 1.9 percent. The drop in average growth between countries with debt ratios of 60-90 percent of GDP, and those above 90 percent of GDP, was even greater: 3.4 percent to 1.7 percent

What happens when you go from 100% to 120%? Japan is approaching 200% debt to GDP and we all know the impacts there (their central bank also straight up buys equity ETFs)

Essentially, the marginal benefit we  get from adding a new dollar of debt is going down. And has been for quite some time.

Yes, the coronavirus stimulus was big. But a lot of it also went to plug a big hole in the economy.

We had stimulus checks. That put money directly in the pocket of consumers, but it didn’t create a new income stream for them. Wages didn’t go up and in my view and so the spending will be a 1x boost in some select sectors. Unless all the debt we just used goes to create a new income streams, all we’re doing is exchanging current consumption for future consumption.

Velocity of money is going down.

I’m going to let Dr. Lacy Hunt explain the next bit. For context, he’s a manager on Hoisington bond fund and has been right on bonds for about 40 years (i.e. he’s been long duration). I highly recommend his investor letters. All of these are quotes from his Q1’2020 letter, with my emphasis added:

  • When the Fed buys government or agency securities from the banks, holdings of government debt declines and the banks’ holdings of deposits or reserves at the Fed go up.
  • The bank balance sheet is unchanged except that the banks are selling government paper of longer maturity and they receive an overnight asset at the Fed. Those deposits do not circulate freely within the economy. (Diligent Dollar Note: QE is not just printing money)
  • If the Fed’s purchase of the debt is from non-bank entities, there will be a transitory rise in M2. Further M2 expansion from that new level will depend on the banking industry. The banks high level of reserves at the Fed will result in no further increase in money unless they and their customers make the collective decision for new bank loans to be originated and the loans are used to expand economic output
  • This is what happened in 2010-11. M2 surged transitorily to a nearly 12% rate of growth along with an increase in loans. The money and loans were used to shore up financial conditions rather than channeled into the purchase of new goods and services. As such, the velocity of money fell dramatically, and the Fed’s purchases of securities did not lead to increased economic growth and inflation. After financial conditions were stabilized, the depository institutions held large amounts of excess reserves.

I feel like the first two bullets need re-emphasizing, because a lot of people associate QE with money printing. Joe Weisenthal put it (again, my emphasis added):

When the Fed buys a Treasury, what it’s really doing is replacing one kind of government liability (maybe a 10-year Treasury) with another kind of government liability (an overnight reserve held at the Fed). If you’re a bank that sold a Treasury to the Fed, you’ve given a long-term asset that yields something for a short-term asset that yields something else. No new money has entered the system. The government doesn’t have any less debt. All that’s happened is that the consolidated government balance sheet (the Treasury and Fed combined) has shortened the term structure of its liabilities. After the Fed buys a Treasury there’s less long-term debt outstanding and more short-term debt outstanding. That’s it.

Bottom line: in order to actually get a boost to GDP and inflation, you need the velocity of money to go up.

All these headlines of GDP growth in 2021 tend to be missing the point. If we have 8% growth in GDP following a year where GDP was down 3.5%, then you just have 2% growth on a 2-year basis. That’s not that great considering all the debt taken on. And then you actually need the banks to lend out the capital, but that depends on risk they see in the market, returns, and whether people need the capital for investment.

Add in worsening demographics (and I think its possible we are sitting where Japan and Europe are sitting 5 years from now.

I think what will happen is inflation expectations will continue to rise short-term as the economy re-opens and we have some supply constraints that gives further pseudo-inflation scares, but long-term the writing will be on the wall.

So bottom line: Do I think reflation will happen? Yes. We will be lapping a serious decline in our economy and there are supply constraints. Do I think those supply constraints will be overcome? Yes. And therefore, I think we will continue on the longer-term deflation trend.

What World Changing Things Will Come From This Episode of Irrational Exuberance?

Reading Time: 4 minutes

I think pockets of this market are clearly showing signs of irrational exuberance. The valuations of companies with no revenue, or even products yet, is alarming. I don’t know much about Nikola, but despite a credible short report and the CEO stepping down, they have no product but a $7.6BN equity valuation. I talk about View windows later in this post because even though they have a product, they have $30MM in revenue and a $2.2BN valuation. It is laughable.

Buffett had a good point in one of his shareholder meetings in the 2000’s. He noted that some of these companies wouldn’t even be able to raise debt, but their stock valuations are huge. I see that today – that’s View, in my view.

The point of the post isn’t to argue about these names, it’s not even an argument about “market timing” because I don’t believe you can do that effectively. There are also still some cheap names out there. But I do want to lay some groundwork that there is excess.

But the main point I am wondering what infrastructure is being laid down today that we will benefit from in the future? For example, the tech bubble destroyed returns for any investor in any of the most exciting names. However, the exuberance also led to a lot of fiber cable being laid that we now benefit from today.

You could say there was a huge transfer of wealth. Investors got completely hosed, likely lost most of their money, but the infrastructure led to consumer surplus way down the road.  If you don’t want to hear me discuss the exuberance first, then skip to the end of this post.

We have a SPAC mania. SPAC’s are literally called “blank check companies.” I am giving you a check to just go out and do something — and demand has never been higher. That seems somewhat lost on people. I guess people also don’t realize this is a red hot contra-indicator. When SPACs are booming, that’s a clear sign there’s too much money chasing too few things and probably not a great time to be investing (i.e. “I don’t know what to do with this money… but YOU do… take my money!”).

The last SPAC boom was 2006-2007… was that a great time to be investing in hindsight?

We now dwarf that period. Sure, IPO’ing isn’t easy. But that doesn’t explain all of this.

I would call it desperation to “catch the next thing.” Even though SPACs have totally misaligned incentives, are paying extreme prices for “businesses” they still pop on the announcement, effectively making the deal even more expensive. With the market this wide open, do you really think the seller got the worse end of the deal in the SPAC transaction that it requires trading up?

I recently tweeted the following explanation:

We’ve all seen the huge bid ups in electric vehicle or battery SPACs.

As an aside, one of my favorite SPACs (and by favorite, I mean laughable), is View – which is being brought public by a Cantor Fitzgerald SPAC (ticker CFII). View makes “smart windows” for commercial buildings. By “smart” they mean that you can change the window tint and that helps save energy, allows people to work near windows without heat discomfort, and reduces glare. Despite being around since 2007, View only has $30MM in revenue… The valuation? Right now around $2.2BN… Given the commercial property market right now, its hard for me to imagine upgrading to these windows or choosing them outright…

I immediately thought, “so… they compete with blinds?” and yes they address that upfront. I mean, c’mon, this is kind of hilarious story. Glass is “magical material.”

Let’s look back at other speculative areas and the benefits that actually came from them:

  • The 1840s: Railway Mania. Railroads had emerged and were completely changing the transportation of goods and people. You could now bring freight across the country at a fraction of the cost. It was a clear pattern bubble in the stock market though, but all this capital flooding into the sector helped build more and more railroads.
  • The 1920s: Right before the Great Depression, there was a major stock market mania. I believe it took ~20 years (as we exited WWII and had an economic boom) for investors to break even. Why was there so much speculation? The world had seen the dawn of the automobile, aircraft, radio, and the electric power grid. It was an exciting time. It’s likely that some of this speculation lined the pockets of these manufacturers to create newer and better products.
  • Tech Bubble / Fiber Cable: “the demand seemed so obvious that scores of new telecom carriers sprung up and by 2001 had hung, buried and bored $90 billion worth of fiber-optic cable across the U.S. Optimists predicted Internet traffic would grow 10-fold every year.” That didn’t really pan out and there was a huge fiber glut. But demand for internet traffic caught up and if it wasn’t for all that cheap bubble money, who knows if our gains from the internet would have been as rapid.

So what will lead to consumer surplus in the future?

  • Is it the electric vehicle? With all the capital flowing into the sector, it seems like a self fulfilling prophecy (not that investors will make money in the next 10 years, just that the cars will proliferate at a fast pace).
  • Is it software that increases our productivity? SAAS valuations are pretty high. And I’ve seen many of them issuing equity. This too may be self-fulfilling in that we get better and better software in our lives.
  • Is it further E-Commerce? We’ve seen Amazon take over the US and with COVID 19, every company is investing in e-commerce. Will this get better and better for the consumer?
  • Is it democratization of finance? Big banks have huge barriers to entry… their competitive advantage is cost of capital. But capital is cheap right now, soooo

Tax reform’s impact on stocks – the question NOT being asked

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A lot has been written about the Tax Plan passed at the tail end of 2017. I recently wrote a post on, while I think the plan is very beneficial to US equities, some considerations we should have on the rest of our portfolio.

And not to be a debbie downer, but I am here again to discuss some questions that are not being asked here. If you’re buying individual stocks today, I think the main underlying question for investing in that company comes down to one thing: Does this company have a strong competitive advantage?

In highly competitive industries, typically those that compete solely on price or sell commodities and have little differentiation, these tax benefits may soon be competed away.

Consider a distributor, which typically sells many goods and the only value it adds is perhaps customer service. Grainger has been an example of a distributor that has faced headwinds from price competition as customers look to Amazon for cheaper products. Take a look at GWW’s stock chart over 2017 to gain an understanding of this impact (stock was down 3-4% when the S&P was up 20%).

GWW’s stock really started to recover at the end of the year, one from earnings being better than feared on low expectations, but also due to its tax rate which should decline from 38%.

Given GWW’s heightened competition, due you think those savings will be used for buybacks or high return projects, or do you think they’ll be used to compete and maintain market share? Let’s say you think that’s fine if they use it to maintain share, as they’ll be in a better position. Well, do you think Amazon and other competitors won’t also respond?

Also consider the recent hikes in minimum wage from companies and $1,000 bonuses. They are doing that to attract and retain talent, which is simply another form of competition.

Hopefully you can see what I am getting at. Low competitive moat industries likely will compete the savings away. While the tax rate will be low, returns on capital may end up being the same.