On My Radar: Peak Profit Margins – And What They Tell UsSteve Blumenthal
“Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle.” – Wesley C. Mitchell and Arthur F. Burns
Last week we ran the gamut covering a number of diverse valuation metrics. You can find that post here. Bottom line: The market remains richly priced. We should expect low equity market returns over the next several years. Retail investors are expecting 10% returns per year, but high market valuations are pointing towards 2%. Warren Buffett once wrote, “We like pessimism, but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” A meaningful market correction will reset the opportunity. Let’s teach ourselves and our clients to appreciate equity market pessimism.
In that direction, I meant to share the following chart on average profit margins with you last week, but that letter was getting long. You and I are hearing a lot about the high level of corporate profit margins. Put that good news in the “optimism that is the enemy of the rational buyer” category. We are on the lookout for “we like pessimism.” I know that is counterintuitive and opposite of everything you hear cheered about in the press. Frankly, I believe it is why the average investor buys and sells at the wrong time. So let’s take a look at a perfect example of this today.
Peak average profit margins are displayed in the following chart. Notice the red “We are here” arrow. The red line tracks average profit margins (earnings/sales) over time. The positive news is average profit margins in the S&P Industrial Average sit at a record high. But is that a good news from an investment point of view (think initial starting conditions and subsequent returns) or is it the “enemy” of future returns? Take a look at the level of the red line at the bull market peak in 1966. The top section of the chart (the blue line) plots the S&P Industrial Average. Focus on the path of the blue line from 1966-1982. Subsequent returns from ’66 to ’82 were approximately 1% per year before inflation and, boy, was inflation a problem in the 1970s. When I began my career at Merrill Lynch in 1984, nobody wanted to own stocks.
Look at the chart again and notice the levels in 2001 and again in 2007 (red “Market tops” arrows). Compare that to the level of profit margins in 2002 and 2009 (green “Market bottoms” arrows). Were they not outstanding entry points? As Buffett said, “We like pessimism, but because we like the prices it produces.” I know this is counterintuitive, but large corrections followed those two “peak profit margins” and great buying opportunities followed those prior very poor profit margin periods. That’s the message I’m sharing today. More defense until pessimism returns. Let’s keep a close eye on profit margins. I’ll update as time moves forward.
Bottom line: Keep your risk radar up and, importantly, get ready to seize opportunity when profit margins dip to levels seen near the green “Market bottoms” arrows. Keep Buffett’s message front of mind. No one will be singing a happy song. It will be a scary time. The selling will drive prices lower. At that time, few investors will be buyers. That is the opportunity we are looking for. My old soccer coach used to yell at me when I messed up, “Stevie, it’s a game of opposites.” Seems like the investment game is similar in that way. Don’t bite on the record profit margin news. I’m pretty sure it’s a head fake.
I’ve shared the next chart with you several times. It shows the length of every economic expansion since 1858. The Fed was formed in 1913. So, to me, the averages are a little skewed. All expansions end. The economy will always cycle. The point is we are three months from tying the longest expansion cycle in history. The economy is definitely late cycle.
We are here:
Today I share a few ideas about what you can do. I favor diversifying to a handful of trading strategies that seek to profit but also risk manage the downside. I want to get to the opportunity with capital in good shape so I can take advantage of the coming opportunity. I recommend hiring a few seasoned ETF strategists (like CMG) and other active managers. If you are a do-it-yourself investor, I share a few ideas in the “Economic Cycles and Sector Performance” section. For example, do you remember how value stocks were so unloved in 1999? They went on to do very well through the last two recessions. You’ll find a bit of a roadmap based on the economic cycle that may be helpful.
I’m currently in Jackson Hole, Wyoming and am finishing writing this piece early this morning. Son Matt competed in a Freestyle Ski event yesterday. Think jumps, inverted 360s and rails. I stand slope-side and pray. The kids came from schools all over the country and they were amazing. Matt had a solid showing and boy was it fun to watch. I’m checking in excited, fortunate and happy.
Grab a coffee and find your favorite chair. You’ll also find a link to my very first podcast. Daughter Brie and my good friend Jan van Eck have been politely pressing me to start podcasting! Well, game on. John Mauldin, Steve Cucchiaro and I talk about the global markets, the Fed, what we are seeing and how we are positioning. CNBC’s Bob Pisani called Cucchiaro the most successful ETF strategist of all time. Please know we are biased — Steve is one of the four ETF strategists in the CMG Mauldin Smart Core Strategy. It was a fun conversation.
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Included in this week’s On My Radar:
- Economic Cycles and Sector Performance
- Employment and Top Quintile Valuations
- Median Price-to-Sales Chart
- Mauldin, Blumenthal, Cucchiaro Podcast
- Trade Signals – The 10-year Bull Market (Longest in History) May Have Peaked
- Personal Note – Optimism
Economic Cycles and Sector Performance
Do you remember back in 1999 how depressed all the value fund managers were? Everyone was all-in on tech. Everyone! Except managers with a value-based investment strategy. Value was nowhere for a number of years leading up to the March 2000 tech top. When tech (-75%) and the broad indices (-50%) crashed, value did well and continued to shine until 2010. You’ll probably be running into your favorite value manager at the drug store refilling that Prozac prescription. It’s been a downright depressing eight years for those folks.
Recently, we took a look at the data that drives the Ned Davis Research CMG Large Cap Long/Flat model. Essentially, we separately measure the short-term, intermediate-term and long-term trends of 24 different sub-industry sectors. The idea is that markets are leading indicators for the economy and we believe there is signaling in the data. Much like other factor-based strategies that may toggle from value to growth or high beta plays (think higher risk stocks) to low beta plays (lower risk stocks).
Below is a look at the 24 sub-industry sector scores. We measure the short-term, medium-term and long-term trends in each sector. Highest scores are best trending sectors based on price behavior. Now, please note this is not a recommendation to buy or sell any stock, sector, ETF or security, but keep 1999 in the back of your mind. Not all areas are grossly overvalued and I’m hoping to share this information with you in future Trade Signal posts. I’ll keep you posted. I like to see what price is telling us about trends – high scores are the best trending sectors (I highlighted in green all sectors above a score of 80). Note the sectors not doing as well.
Let’s take another look at the economic cycle. I like the next chart and believe the team at ACG Advisors did a good job at summarizing what tends to happen to the markets along the cycle. The red “We are here” arrow is my best guess for where we sit right now. I believe we are moving from “short rates rising” to “short rates peaks” and, with the next Fed move, likely to be “short rates drop,” as the Fed is expected to lower the Fed Funds rate.
Stocks are a leading indicator for the economy. In a picture, it looks like this next chart:
What can you do? Tactically shifting to value plays, consumer staples and health care made a lot of sense in 1999. I came across the next chart and liked how it organized which sectors tend to do best based on where we sit in the cycle. For example, tech and financials tend to do well coming off market bottoms, while consumer non-cyclicals (value-based plays like food, personal products and utilities) tend to do well after markets have peaked. For discussion and educational purposes only. Please speak with your advisor. Again, this discussion is not a recommendation to buy or sell any security.
If you are interested in diving deeper into the subject, this piece from State Street is very good. To give you a feel, next are a few clips from the State Street research piece.
I’m starting with the summary:
Look, ahead of us may remain a market “melt up.” A crisis in Europe could send capital rushing to the U.S. similar to the late 1920s. That money would likely rush into the DJIA and the S&P 500 stocks. We don’t know, nor does anyone else. It’s a guess. But to argue we are not late cycle is naïve in my view. De-risk on rallies and seek sectors that are undervalued. There are a few.
Employment and Top Quintile Valuations
“Regardless of valuation levels, periods of high unemployment were followed by strong S&P 500 Index gains.” – Leuthold Group
I tweeted this out earlier in the week. An interesting take on employment. Put this one too in the “it’s a game of opposites” category.
Loved this post from the Leuthold Group. It’s based on the level of employment in the economy. (Well, maybe “loved” is a little strong). Bottom line: what it is showing us is that when employment is high (unemployment low) and valuations are in the top quintile (most overvalued) expect coming seven-year returns at just 2.9% before inflation is factored in. (BTW, you can follow me on twitter @SBlumenthalCMG).
Median Price-to-Sales Chart
OK, please forgive me, one last valuation chart then let’s call it quits on this topic for a few months. I left out one of my favorites last week – Median Price-to-Sales Ratio. Same message, expect low coming returns. Hey, and a good re-entry level will be when the ratio mean reverts back to or below the dotted green line. I’ll update you in future posts.
The “We are here” points to the performance of the S&P 500 Index when in the way overvalued zone. From March 2000 through October 2002, the S&P lost 50%. Value plays made money. We humans find it emotionally easier to buy what worked and sell what we are going to need. A better understanding of the business cycle, which sectors do best, and when it may help to provide a better roadmap in terms of a game plan: more defense or more offense. Anyway, I do hope you find this conversation helpful.
And speaking of conversation, the link to my first podcast is in the next section. Please let me know what you think…
Mauldin on Investing
John Mauldin, Steve Cucchiaro and I recorded a podcast where we discussed the global economy and investment markets. Steve founded 3EDGE Asset Management and is one of the most successful ETF strategist in the business. In 1994, Steve founded Windward Investment Management and grew it from $75 million to nearly $20 billion in 2014. His firm was acquired by Charles Schwab in 2006. After helping Schwab integrate the business, Steve retired in 2014. But, a former Olympian and highly competitive person by nature, he couldn’t stay away. He put most of his former team back together to manage their money and now other institutions. We are thrilled 3EDGE is one of the strategists in the CMG Mauldin Smart Core Strategy. Following is the link to the podcast. We hope you find it insightful and I believe you’ll enjoy the lightness and depth of the conversation. Make sure you listen until the very end. John was cute. He thought the recording was stopped and exclaimed, “Well, I think that went really well.” I think it did and hope you gain a few insights into what we see in the period immediately ahead.
Trade Signals – The 10-year Bull Market (Longest in History) May Have Peaked
March 13, 2019
S&P 500 Index — 2,799
Notable this week:
No major changes or updates.
Most notable is that March 9, 2019 marked the 10th anniversary of the current bull market – now the longest bull market move on record. Trend indicators continue to improve (you’ll find them below). The bond market remains in a buy signal. Investor sentiment is back in the “neutral” zone. Do take a quick look at the investor sentiment charts – the data will give you a feel for how they work.
I ran across the next chart and explanation in a recent John Murphy blog. John is a famous technical analyst and I like to keep an eye on his work. From his recent post:
LONG-TERM MOMENTUM IS ALSO WEAKENING… The monthly bars in Chart 2 show the uptrend in the S&P 500 that started exactly ten years ago. And that uptrend is still intact. The sharp selloff that took place during the fourth quarter of 2018 stayed above the rising trend-line drawn under its 2009, 2011, 2016 lows. That’s the good news. What may not be so good are signs that long-term momentum indicators are starting to weaken. The two lines in the upper box in Chart 2 plot the monthly Percent Price Oscillator (PPO). [The PPO measures percentage changes between two moving averages]. The PPO lines turned negative during the second half of last year when the faster red line fell below the slower blue line. And they remain negative. [The red histogram bars plotting the difference between the two PPO lines also remain in negative territory below their zero line (red circle)]. Secondly, and maybe more importantly, the 2018 peak in PPO is lower than the earlier peak formed at the end of 2014. That’s the first time that’s happened since the bull market began. In technical terms, that creates a potential “negative divergence” between the PPO lines and the S&P 500 which hit a new high last September. That raises the possibility that the ten-year bull market may have peaked in the fourth quarter and is now going through a major topping process. If the bull market in stocks is nearing an end, that could start the clock ticking on the nearly ten-year expansion in the U.S. economy. That might not prevent it from setting a new record for longevity this July, but it might diminish its chances for celebrating an eleventh anniversary in the summer of 2020.
The S&P 500 is again trying to break above the 2,816 level that was the December 2018 high.
Click here for this week’s Trade Signals.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note – Optimism
Susan turned me on to Jon Gordon. They went to Cornell around the same time. Both were jocks and she loves Jon’s optimism and now so do I. Jon posts frequently on Instagram. I’m not sure if you use Instagram, but it is a fun app. I use it to follow my kids’ posts, other family members and close friends. And I also follow Jon Gordon and a few others.
Jon is an author and motivational speaker and an infectiously positive human being. I find I need an inspiration injection from time to time… The other day I came across a few posts I liked and thought I’d share them with you.
“Lead with passion. Fuel up with optimism. Have faith. Power up with love. Maintain hope. Refuse to give up. Ignore the critics.”
Ignore the critics… That one fits well with what all my kids know in our home to be “Rule Number 3: Don’t take things personally…” It’s hard to do sometimes, but sometimes thick skin is needed. Or maybe Churchill put it best in this next quote:
“When you’re 20, you care about what everyone thinks. When you’re 40, you stop caring about what everyone thinks. When you’re 60, you realize no one was ever thinking about you in the first place.”
Anyway, I really liked the next post from Jon (I sure hope my kids are reading this week’s OMR ;-)). The following top 19 are awesome… Number 20 is for you!
A hat tip to Jon Gordon.
I head to Salt Lake City to present next Thursday at the Barron’s Advisor Summit. If you are attending the event, please reach out and say hello. Mauldin and I are speaking at a large advisor/client event in Austin, Texas on April 3 and again in Dallas for a dinner presentation on April 4. The Mauldin Strategic Investment Conference follows May 13-16 in Dallas. I hope to see you there.
Tonight a toast to optimism! Lift up someone you love… hug your kids, call an old friend, thank an old coach and drink some yummy red wine. The best is now and more is yet to come!
Wishing you a wonderful weekend!
Stephen B. Blumenthal
Executive Chairman & CIO