From Squeeze to Crush (Part One of Two)
There are a number of factors which are central to any traditional equity valuation methodology. One of these is profit margin, or expectations thereof. Expectations of rising profit margins are naturally positive for valuations, other factors equal. But then the opposite is also true. And ultimately, no matter how many units you sell, if your input costs are equal to or greater than your output costs, you are going to lose money and, if this situation becomes chronic, go bankrupt.
The US auto industry is a good example of this in practice. Prior to being in significant part nationalized in 2009, the US auto industry has faced near-zero or even negative margins in car production over most of the past decade even as headline revenue rose. For a number of years, this situation was somewhat obfuscated by large and growing financing activities and fleet sales to downstream car rental businesses, but astute observers knew what was going on and the question for many was when, not if, the industry would be substantially restructured, and how. Naturally, few auto analysts expected the legally murky, arguably unconstitutional government-led restructuring that was forced on secured creditors by executive order. Today, with the notable exception of Ford and a few boutique producers, the US auto industry is basically a government jobs program which happens to manufacture cars.
As such, while the overall revenue outlook for a firm is important, so is that for profit margins. That said, it is normally somewhat easier to gauge the revenue outlook, in particular for mature companies in mature industries, as this requires that one forecast only one-side of an equation.
Equity analysts naturally have sophisticated models which can take a given view for GDP growth or other macroeconomic variables and translate this into anticipated revenue growth for an industry or specific company. Chances are that, if the GDP forecast is reasonably accurate, so should that be for revenue. More difficult is to forecast both the revenue side and the cost of production side, as is required to forecast profit margins.
Now we would not accuse equity analysts of being lazy, but in our experience, financial analysts of all stripes, be they “growth-” or “value-focused”, “top-down” or “bottom-up”, bullish or bearish, are all inclined to concentrate on those variables they think they can forecast well, and hold constant, or regard as randomly distributed, those variables which they consider difficult or impossible to model with reasonable accuracy. It should not surprise anyone that, when it comes to global commodity prices, equity analysts don’t generally feel highly confident making forecasts. In some cases, to be sure, they are obliged to do so, such as oil or mining industry analysts. But nearly all equity analysts will have more confidence in their ability to forecast revenues or profits as a function of commodity prices rather than the prices themselves.
What this means is that, in practice, when you get large swings in commodity prices, up or down, you can get massive swings in profit margins throughout the business sector but–and this is the important point–equity analysts will be notoriously slow to react. In the current instance, with global commodity prices soaring, the implication is that profit margins may be coming under pressure but, unless these levels are sustained for some time, equity analysts may not take much notice.
In the meantime, however, investors need to act accordingly. In this analysis, we will take a look at two prominent indicators of US corporate profit margins which show that they are already being substantially squeezed, despite weak final domestic demand–GDP minus inventories and net exports–especially when adjusted for the state of the business cycle. If one then assumes, as we do, that recent advances in global commodity prices are indeed likely to be sustained, then the profit squeeze already in evidence is likely to turn into a profit crush in 2011. In this context, the recent, relentless rise in US and global stock markets looks increasingly out of line with fundamentals.
Let’s take a look at a broad measure of commodity prices. Perhaps the most widely cited reference for the US economy is the venerable CRB (Congressional Research Bureau) Commodity Index. Currently at 333, this is up some 18% y/y. That said, essentially all of this rise has come through in the past four months. Now some will point out here that commodity prices are currently nowhere near the extremes they reached in the first half of 2008, prior to the subsequent financial crisis and recession. But as far as changing profit margin expectations are concerned, it is primarily the change rather than the level of commodity prices that really matters. To place things in perspective, by mid-2008 the CRB index was up about 25% y/y, more or less in line with more recent developments. This is worrying.
Much more worrying is when one looks behind the data to see how much of the recent rise in commodity prices is due to a weaker dollar–the global pricing benchmark–and how much is, shall we say “real” commodity price inflation. Here we note that the dollar was declining sharply in 2007 and H1 2008, down some 12% in broad, trade-weighted terms. Over the past year, however, the dollar’s value has changed by little. This implies a greater overall margin squeeze on both US and global businesses.
Now consider: If you are operating a business and your input and output costs are rising in more or less equal measure due to a combination of dollar weakness on the one hand but healthy real final demand for your products on the other then your profit margins can remain intact. But when commodity prices are rising in dollar terms and your revenues are not–say due to weak real final demand–then you are going to suffer both a margin squeeze and reduced profitability. In theory, at least, we should see some evidence of this margin pressure showing up in corporate surveys and data. Indeed we do.
One widely-followed measure of corporate profit margins is that provided by the monthly Philadelphia Fed Index, which publishes a prices-paid (input) index and a prices-received (output) index. Since mid-2009, the prices paid index has risen from -30 to nearly +50, the highest level since mid-2008, indicating that there has been a massive swing from falling to rising input prices. On the other hand, over the same period, the prices received index has risen from -40 to +10. While this shows that output prices are now rising, it also indicates that input prices are rising much faster, implying that a margin squeeze is already underway. Moreover, this squeeze appears to be larger than that which occurred around mid-2008, as the gap between the priced paid and prices received index, currently at 40, is ten points greater. And keep in mind that the results of the most recent survey were collected over one month ago, prior to the substantial further spike in a broad range of commodity prices in December.
Another potentially useful indicator of profit margins, although one that is a bit lagging rather than coincident, is the US producer price index, especially when viewed in terms of the stage of processing. The headline PPI, that for “finished” or wholesale goods, is currently at 4.0% y/y. This is somewhat above the rate of the headline CPI, at 1.5% y/y, implying shrinking margins. However, looking at the so-called “intermediate” and “crude” stages of processing, we find that producer prices are now rising at more elevated rates of 6.5% and 15.5%, respectively. Barring a huge rise in the CPI in the coming months, this implies that a crush on profit margins looms in 2011.
There is also some anecdotal evidence that US profit margins are under increasing pressure. Major US retailers did not engage in nearly as much product discounting this past holiday season as they did in previous seasons. Amidst relatively weak growth in real final domestic demand, this can only be explained as a reaction to rising input prices and sharply narrowing profit margins.
Should a profit-expectation-driven correction in valuations occur, it could be rather large and sudden. This is not only because the existing squeeze on margins could become a crush but also because available market positioning data suggest that the equity bulls are increasingly speculating with leverage–borrowed funds–whereas the bears are in hibernation, so to speak.
This can be seen in the surge in margin interest–leveraged equity holdings–on the major US stock exchanges which, at over 2% of market capitalization, has risen to a level which, in the past, has preceded large market corrections. Indeed, the current level has only been observed twice before (with the possible exception of 1929, for which we don’t have compatible data): In fall 1987 and spring 2000, immediately prior to two of the largest equity market crashes in US history!
Other measures of potentially dangerous speculation abound, including the growing dominance of high-frequency trading (HFT) and unusually high correlations between the stocks of different companies and industries. Other factors equal, speculative rather than value-driven investing tends to be higher frequency, so the explosive growth of HFT over the past two years is cause for concern. And high correlations are worrying because they imply that investors are chasing returns rather than intelligently discriminating between the shares of companies that offer good value and those that don’t.
As such, it is entirely possible that, should a stock market correction soon occur, it might be entirely technical in nature rather than driven by something more fundamental, such as growing acceptance that profit margins are being not only squeezed but crushed. But as our own investment process is fundamental in nature, we are inclined to see the greatest significance in that area and merely note up the various technical factors as risks which, in this case, only reinforce our core conviction.
Needless to say, we are not alone. There are a number of prominent, so-called “contrarian” market analysts out there who are making points similar to those above. Indeed, following the series of bubbles and blowups in stocks, housing and risk assets generally over the past 15 years or so, the contrarians have almost certainly grown in number. This is all the more reason, perhaps, for why the US Fed feels that it must fight to reflate asset markets ever more aggressively. Low rates alone won’t do. Even a gently rising rate of CPI inflation won’t do. Even $600bn of US Treasury purchases–the stated amount under the present, second stage of the quantitative easing program (QE2)–won’t do. No, the Fed have told speculators in no uncertain terms that they are going to keep right on printing money until the core rate of CPI is north of 2%.
Well, how’s that for a prod to the bulls? The problem is, by responding to artificial and unsustainable Fed incentives, investors are largely if not entirely ignoring what is happening to profit margins. Sure, core CPI might rise to over 2% before long. It might rise to over 5%. Or 10%. We don’t know. After all, the Fed might lose control of price inflation at some point. They certainly have before. But what we do know, and what we are entirely comfortable positioning our investments for, is that even in the event that artificial, Fed-engineered asset reflation succeeds, corporate profit margins are, by effect of soaring global commodity prices, going to get squeezed or even crushed, implying that, to the extent stock prices rise, real, inflation-adjusted valuations should compress dramatically. In this environment, do you really want to be overweight stocks, which are claims on (shrinking) real future corporate profits, or do you want to be overweight the soaring input prices directly, in the form of commodities? We prefer the latter.
There are other negative factors out there for stocks, such as the increasingly hostile tax and regulatory environment in the US and elsewhere. We are not going to address these here. They, too, are risks that we see lurking in the background although there is no easy way to quantify them.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]