Confluence of Inflation and Margins
Holiday season is underway and you can’t turn on the TV or open a newspaper/magazine without being blasted with holiday sales promotions. This is the time of year where retailers are playing catch-up and to drive home the revenue to boost the full year profits. The good news for retailers is the drop in gas prices, which puts more money into consumers pockets to spend. Some numbers I have seen are in the $200 range per month in savings from the fall in gas prices. However, is it all that rosy for the holidays?
Confluence of Inflation and Margins
Inflation / Deflation / Disinflation
While some economists, even a couple of Fed members, have raised fears of “Deflation” from the strong dollar, the truth is “Deflation” is not even a remote possibility. It is true that we can experience deflation pressure in segmented market or commodities – not the entire economy – which has always been the case. The reality is that disinflation (the decline of inflation) is the only worse case possibility and that is even a low probability. But what about the CPI, showing a fall from 2% to 1.7%? A big part of that “headline” number has come from the decline in gas prices, coupled with the dollar rally.
Courtesy of shadowstats
It is important to remember the recent dollar strength (rise in the dollar against foreign currencies creating seemingly disinflation) is not by design by the Federal Reserve. The Fed’s policy is actually trying to create inflation and trying to weaken the dollar (devalue), to boost exports, narrow the trade gap, in an effort (they believe) will create more manufacturing jobs domestically. The dollar strength (disinflation) has come solely from the actions by the Bank of Japan (BOJ) and the European Central Bank (ECB) launching their own versions of QE.
The big impact to the CPI and what some are stressing about the risk of deflation is coming solely from the gas price declines. Remember the headline CPI includes food and energy, with gas/energy being one of the biggest contributing factors. The fall in gas prices has been a culmination of strong dollar and also OPEC’s overtly supply increase and price cuts. While certainly great news for consumers (more money to spend) as well as retailers (hoping to profit from the new found money not going into the gas tank), the real inflation levels (stripped of energy/gas) remains elevated – especially food prices.
The reality is that the headline CPI is being depressed by the gas/oil prices, so I don’t think we can buy too much into the deflation concerns or that it will boost consumer spending beyond the gas savings. The core inflation rate, food, and costs have remained elevated.
The formula that rules all business is Revenue – Costs = Profits or Loss. While we can only project and estimate revenue, businesses can directly control costs. This determines margins and how businesses control margins.
Margins traditionally can only expand in one of the following ways:
1. Revenue increases as costs are cut = rapidly increased margins
2. Revenue increases as costs remain static = increase margins.
3. Revenue is static as costs are cut = increased margins.
4. Revenue contracts as costs are cut even more = increased margins.
In both 1 & 2, the business is seeing revenues grow and that is the MOST important factor for any business, as it shows that business is actually growing. The problem is when we see options 3 or 4 with either stagnant revenue or contracting revenue; this means there is a serious problem with the business.
Courtesy of wikipedia
Fooled by Earnings:
Earnings can certainly fool us if we only pay attention to the earnings per share, because unless we ask HOW the profit is generated (how margins have increased usually) then we actually don’t know the health of the company.
Courtesy of wikipedia
During the crisis (2008-2010) companies were cutting costs fast and hard just to stay ahead of the decline in revenue. They were trying to stay out of the RED (the loss column). When the market seemed to hit a bottom and we seemed to be moving into a recovery phase, we saw many companies continue to cut costs and run lean. We saw a rapid move into emerging markets to seek growth, while also trimming costs.
Some additional gaming (for lack of a better word) that companies had done is share buy-backs, which reduces the float of shares that help boost earnings. Remember earnings are reported on a PER SHARE basis, so it is possible to reduce the number of shares on a decreasing revenue/profit and see an increase in the earnings per share.
Company has $2 billion in revenue and $500 million in profit. It has 50 million shares outstanding. The company reports earnings per share are $10 per share.
A year later the company buys back 20 million shares, reducing the outstanding shares to 30 million. The company has $1.8 billion in revenue (10% decline) and $400 million in profit (20% decline). The company reports an INCREASE to $13.3 per share a 30% increase
As you can see if you are not paying attention to the top-line revenue, profits, and share buy backs and ONLY paying attention to earnings per share – you are not REALLY getting the full story.
The per share basis is always subjective based on stock splits, reverse stock splits, share buy-backs, spin-offs, etc. One needs to pay close attention to the changes in the company and always look at the total numbers. This is why I pay closer attention to top-line revenue and top-line sales – because that is the best measure of company’s growth.
Courtesy of wikipedia
With the holidays fast approaching and the air waves bombarded with advertisements, we should start paying attention to the big retailers (both on-line and brick-n-mortar) and compare them domestically vs. internationally.
Macy’s reported earnings today and it was a mixed bag and the talk on the financial networks has only added to the confusion. The stock is up in the pre-market, but could that change as we dive deeper into the numbers asking “How” and “Why”?
The company reported earnings of 61 cents a share on $6.2 billion in revenue. The earnings beat expectations of 50 cents, but the revenue disappointed as expectations were for $6.34 billion. This is as interesting as it is confusing. The bottom line beat by 22%, but revenue disappointed by almost 3%. The only reasonable conclusion is that the company managed (cut) costs to boost the bottom line.
What is more disappointing in not beating revenue expectations was that retail sales actually FELL 1.4% vs. an expected RISE of 1.9%. Economist expected with the drop in CPI (disinflation) to 1.7% and the drop in gas prices, which we should see a rise in sales, yet that was not the case. It wasn’t that it rose less than expected, it actually DECLINED.
Even the headlines and talking heads, depending on who you are listening are reporting different stories. One reads: “Macy’s earnings beat estimates!” another reads “Macy’s revenue misses Street estimates!” Neither headline is lying; they are just not giving you the full details.
I am frequently asked questions like, “The company beat estimates, how come the stock fell?”, “The company earnings came in lower than expected, and how come the stock is rallying?” Those that ask these questions never look beyond the headline or the earnings per share. The story is never the headline data, it is the how, what, why inside the numbers – take the time to look.
Courtesy of wikipedia
Yesterday was “Single’s Day” in China – their largest shopping holiday. Alibaba sold over $9 billion dollars in one day in China, which dwarfs our own Cyber-Monday (Monday after Thanksgiving) by all online U.S. retailers which generated just over $2 billion.
The point I want to make is that China just has the numbers (population), growing jobs and growing wages. Companies that focus in this market will continue to see top-line sales increase and it is one reason why we have seen a huge shift over the last decade by companies moving into China and the BRIC / emerging markets – it is where consumers, jobs, and wage increases are.
The U.S., Europe, and West are all contracting populations that are aging out with very slow growth. According to the U.S. census one person dies 12 second, one person born every 8 seconds. That ratio gap is closing towards 1:1 with also a growing aging population; this is the same story in Europe and Japan. Add in a very high consumer debt, with limited access to credit and you have very weak consumer growth. That doesn’t even include higher costs (taxes, healthcare, fines, inflation) and it also doesn’t include the “slack in the labor market” (more part-time, fewer full-time, and lack of skilled labor) as stated by the Federal Reserve.
Being objective one can’t help but remain skeptical of strong retail growth in the U.S., Japan, and Europe. It is not mathematically feasible.
Top-line revenue and sales will continue to grow in the emerging markets, BRICS, and China. At the same time the top-line revenue and sales in the WEST (U.S., Japan, and Europe) will remain very weak and possibly see contractions.
Earnings will continue to fool investors and even analyst and the financial media, as they don’t bother or don’t know or don’t have the time to ask the “Why”, “How” and “What”.
Blindly accepting and trusting in headline data is one of our biggest weaknesses. Companies and the Government relies on us NOT asking questions and accepting the topline numbers be it CPI, GDP, U3 or even Earnings Per Share.
This is just simple math coupled with reason and logic. Domestic reliant earnings, if one is willing to pour into the data and numbers – bear out that conclusion.
If you are seeking growth, continue to invest in companies that are reporting REAL top-line growth and have access to growing nations – like Alibaba. While avoiding domestic reliant retailers like JC Pennies, Macy’s and others.
Support & Resistance
The rally has slowed some and we seem to have seen a little resistance up in the 17,600 area. We could see a short-term contraction down to 17,400.
Seems like the tech heavy index is in a consolidation range in the 4150-4200 range. Look for a strong break-out up or down in the short-term. This is going to be a short-term long gamma play.
The slope of the rally is slowing slightly and I think we could be getting into an area and time in reflecting on forward expectations into the holidays. VIX is holding in the high 12s and I think we could see it stay here or move up into the 13-14 range if the SPX stalls.
I will be watching the RUT closely to see if it can gain steam and push through 1180 with volume or if we see a fall back into the 1140 area.
The market seems to be pausing to reflect on holiday sales. Will it be better than expected, good, strong, bad, slow, tepid, or stagnant? Who knows, but if we continue to see reports like Macy’s we could be in for a rather disappointing domestic year, but at the same time we may see robust sales in the BRICs.
We may start facing a very segmented market in which we have strong international companies and we see the domestic companies flounder. This could bring both volatility to the market and also see the general indices struggle as mixed results pushes and pulls on some of the indices.
Whether investors are optimistic in the equity market or not will most likely be seen first in the RUT index.