This is the weekly newsletter post.
2012 as a year of compression
Last month, I wrote that 2012 would be an inflection point toward S&P500 margin compression. This was a short article but it followed a lot of commentary in 2011 in which I spoke about the record level of margins at US companies. My conclusion last month was:
The question is whether this is baked into earnings. It depends on revenue growth of course. If margins fall, this can still be made up for by top line growth. But, the high fliers have prodigious earnings growth estimates baked into their numbers and I believe these high beta stocks will underperform. Lower beta stocks with less earnings volatility, lower growth estimates and higher dividends would outperform in this environment.
My belief that margin compression will occur this year is one reason to play this rally by rotating out of high-beta, high-risk and cyclical sectors and into consumer staples and lower-beta, lower risk stocks. This is the kind of rotation one would do near the end of a business cycle as the highest economic growth ebbs and economic growth slows. I would also add banks into this group of underweight sectors because zero rates also have compressed margins there. See my October post "A year later everyone is catching on about Fed policy and net interest margins".
The macro case for why this matters
Just a little background first. Back in June 2010, I mentioned the record high profit margins in the US and their mean-reverting nature. And I asked What do present large profit margins mean for stocks? My conclusions were threefold:
- US economic policy is geared toward the business sector. The sectoral balances of national accounting show the economy’s financial sectors must balance to zero. Therefore, a massive government deficit is balanced by an equivalent surplus in the trade and private sectors. But, depending upon public policy, that surplus can fall to businesses, households or exporters. The surge in corporate profitability as a priori proof that the US economic policy of zero rates, bailouts and stimulus is geared toward business through the maintenance of excess consumption. If we had an industrial policy more geared to promoting household deleveraging, the household sector would be doing the saving instead of the business sector. Above all, expect corporate profits to decline as government deficits decline.
- The US economy is very sensitive to interest rates because of the dependence on the financial sector. Because the financial sector accounts for a huge percentage of US profitability, corporate margins are highly sensitive to interest rates. The margin whiplash you see from about 1996 onward demonstrates this. Moreover, with rates at near zero percent, during the next recession we will see how Quantitative Easing and Permanent Zero are toxic To bank net interest margins and general corporate profitability as the yield curve flattens.
- High margins mean-revert as do P/E ratios. P/E margins are actually still above their long-term average (especially if one uses CAPE, a cyclically adjusted P/E ratio also known as the Shiller P/E ratio which uses a 10-year inflation-adjusted price earnings ratio average). So based on high profit margins which also mean revert, you have two technical factors which will be negative for shares in the next downturn.
Since 2010, I have been looking at second half economic slowdowns as potential recessionary events. We saw the slowdowns in 2010 and 2011 and in both cases, growth slowed and stocks pulled back as a result. But the policy response in the US has been expansionary and we have avoided recession. My formal prediction is for recession by 2013 and so I expect the margin compression to precede this, making 2012 the year when the compression happens.
Timing may not be perfect but I would say we need to look for a narrowing of market leadership and this is one reason I mention Apple. More on that later, but note that Niels Jensen, who is more bullish than I am makes this cautionary note on using P/E’s for individual stocks like Apple (which has a P/E in line with the market):
We believe that equity valuations should only be used to determine when investors enter and exit the stock market. Equity valuations should not be used for trading or for determining which equities to buy as, in our opinion, there is no correlation between valuation and relative performance.
I agree with this and am keeping the thoughts here at a macro and sector rotation level.
What James Montier says
Let me use this as a segue into some other commentary elsewhere. I caught two comments from market watchers making similar comments so I thought I would run them by you. First is James Montier of GMO with What Goes Up Must Come Down (registration required).
At GMO, we are ?rm believers in mean reversion, and as such record elevation in pro?t margins causes us much consternation. Of course, we are constantly on the lookout for sound arguments as to why we might be wrong in our assumption of margin reversion. After all, believers in mean reversion are always short a structural break, and such a break clearly matters. For instance, Exhibit 2 shows that in simple trailing P/E terms the U.S. market isn’t actually expensive. However, the P/E is only one part of a valuation – it also depends upon the state of earnings. It is the margin component that is dragging our return forecast down. If we are incorrect on our assumption of mean reversion in pro?t margins, then our forecast radically alters. For instance, if instead of falling to 6% over the next 7 years margins stayed at today’s levels, our forecast would be closer to 4.5% p.a.
Clearly the ?rst two elements of Exhibit 2 are all about cyclical adjustment: we are assuming that the market goes to a “normal” P/E based on “normal” E. Therefore, it is no surprise that we see the same point from a different perspective when we look at a comparison of the simple trailing P/E using the Graham and Dodd P/E (Exhibit 3). The latter tries to smooth out the business cycle’s impact upon earnings by using a 10-year moving average of earnings. Hence, differences between the two measures are a statement of how far earnings are from their “trend.” The simple trailing P/E is around 15x and the Graham and Dodd P/E is around 24x, again highlighting the divergence of pro?ts from their long-run normal levels.
Whilst we at GMO fret over evidence of the strained nature of pro?t margins, the ever bullish Wall Street analysts expect pro?t margins to continue to rise! Witness Exhibit 4. In our search for evidence of a structural break, this simple-minded extrapolation gives us some comfort because the Wall Street consensus has a pretty good record of being completely and utterly wrong.
Montier then provides a chart which brings the point home.
My view is that this chart represents the best reason to limit risk and to even expect a re-test of the 666 March 2009 low on the S&P500 in the next recession as P/E ratios and corporate margins go in reverse.
What Richard Bernstein says
The US corporate profits story, however, is showing the first chink in the armor. The proportion of US companies reporting negative earnings surprises has jumped significantly so far in the current reporting period. With over half of the S&P 500 companies reported, 30% of the companies have reported negative earnings surprises. If reports continued in the same pattern for the remainder of the reporting season, the current reporting period would be the worst since 2008.
It seems increasingly clear that the profits cycle is slowing enough so that one should again consider the probability, albeit still reasonably low, of a profits recession. We are not suggesting that a profits recession is imminent. Rather, we are simply saying that the profits data appears for the first time in this cycle to be weakening enough to warrant consideration of such an outcome.
In short, Bernstein is pointing to the same phenomenon James Montier and I are and saying the negative earnings surprises suggest the margin compression has already begun. He calls this a profits recession, meaning that we could just be in a typical mid-cycle dip but it could be the makings of a deeper profits downturn.
What about Apple?
Here is my basic thesis from on Apple. Apple is a monster company, the largest cap company in the world. And this is for good reason as Apple is executing perfectly on its strategy and throwing off so much cash that it now has over $100 billion that it could invest or distribute. The fact that Apple has finally done what I have been encouraging it to do for a while, provide a dividend, is a sign that the company has realised that it doesn’t have investment opportunities for this cash pile. That doesn’t have to be a problem though as long as it continues to execute on its business model.
That is where the problem is. Apple has very good margins due to its premium pricing. However, Apple is now faced with a choice of whether to go downmarket to protect share and network effects and suffer margin erosion as Android has now taken over as the top dog in the mobile space. The iPad fills a premium niche that was partially filled by the iPhone/iPod as a mobile computing device. So it has more than offset the share erosion in iPhones because of this. Still, it’s more than a worry. It is what’s coming this year I believe.
I predicted this is where we would be two years ago and I think now is when the margin compression will actually occur. At that time, I wrote:
Does that make Apple a short? Barron’s says no but the pressure is definitely on. If the iPhone 4 does well, Apple’s share will continue apace because market darlings don’t fall unless there are negative surprises. And even if we get a negative surprise, I imagine we need to see a few before it really pressures the shares.
I stick to that thought and so it will be a negative surprise combined with margin/growth compression that will be the harbinger of less robust times for Apple.
How Apple fits into the margin theme
What is clear to me is that we have high margins combined with still historically normal or above normal price/earnings ratios. These margins are mean reverting and I believe the next recession will see a doubly difficult compression as both P/E and margins come in.
Apple fits into this perfectly. It is not a bubble stock in the way Cisco or Microsoft were in 1999 or 2000. However, it is the market leader in the S&P500 the way those stocks were. And the technology sector is also experiencing the buoyancy and IPOs that we saw during that time. Again, the froth is much less pronounced but the trend is the same.
Apple’s market share have been pressured by Android and the company has turned to patent wars to deter its competitors. This won’t nearly be enough. Android will continue to gain share, not just in mobile phones but increasingly in tablets. And so I expect Apple’s margins to compress as well. I should note that while everyone has told us that the Amazon Kindle Fire would not pressure Apple because it was an inferior mid-level piece of technology, it is clear that the aggressive pricing of the Kindle Fire and it’s huge sales volume has had the pricing pressure effect I anticipated. The Wall Street Journal points out that Apple’s new iPad costs at least $316 to build.
It is only a matter of time here and I believe now is when we will see earnings growth slow at Apple. But Apple could already be indicative of narrowing market leadership as the negative earnings surprises have mounted. I believe this cyclical bull market looks tired. My recommendation: rotate out of high beta, high risk and cyclical sectors into a more defensive investing posture.
That’s it for this week.
P.S. – Some of my previous posts on Apple have provocative titles but I don’t think Apple is “screwing it up” at all. They are executing incredibly well. They are the largest cap stock for a reason. But their business model has a flaw in that it relies excessively on product ties, network effects and switching costs in a world of more open platforms. I think this is Apple’s Achilles Heel.
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