Stocks fell last week amid profit taking as earnings season got underway in earnest. But the selling was orderly. Flat bond trading didn’t give the bears any ammunition to extend the selling.
This week and next will provide the bulk of the remaining earnings. So far, results have far exceeded expectations. However, that hasn’t translated into a further surge in stock prices. That supports the notion that even though analysts underestimated the power of the recovery, investors did not. While earnings beat forecasts, apparently that was a foregone conclusion and already built into stock prices.
What analysts missed is the concept of operating leverage. If you run a plant that makes widgets, and you expect to make a million widgets per month, you set out an expense plan that matches your forecast. That includes your raw material and labor needs. But what happens when customers want 1.1 million widgets? You dig into inventory to meet the sudden surge in demand. And you ask your workers to either work a little harder or do some overtime. In the short run, that may leave you with some frazzled workers, but it also leads to higher profits as output per man hour increases. Long term, this isn’t a solution. Should demand persist, you will have to add more workers. You might even need more plant space. Certainly, you will need to replenish inventories. But your bottom line will yield an upside surprise. The same is true on the downside. If customers order only 900,000 widgets, you will still need to make your workers work the same.
In the short run, this leverage derived from sales rising faster than costs yields a big upside earnings surprise. Perhaps with careful planning, over time you can keep some of the margin gain. But not all of it.
For cyclical companies this happens often. That is a major reason why a cyclical company like Caterpillar or Delta Airlines stock sells at a low P/E when earnings are at a peak, and a high P/E when earnings are at a trough. There are always ups and downs to the economy which lead to peaks and valleys of demand. Delta can’t just go out and buy more planes to solve a short-term surge. Rather, when demand is high, it will raise prices and sell every seat. Six months ago you could have bought a transcontinental ticket for a couple hundred dollars or less. Come Christmas, assuming most travelers are back, prices could be at new highs. But we all know from experience, neither state will last forever.
For several months, equity investors have been euphoric about the speed of our recovery. It has happened faster than most expected. Future expectations continue to be adjusted higher. As long as that continues, stock prices will keep rising. Remember, it is all about expectations versus reality. The actual number is far less important. Show me a company that persistently beats expectations, and I will show you a winning stock.
But analysts and investors constantly look ahead. When companies consistently beat forecasts, what do they do? They raise their own forecasts. Analysts who want to be the most recognized sometimes raise them a little more than others. Obviously, this raises expectations further. At some point, however, this shell game ends. No company can beat expectations forever, especially if analysts get too far out over their skis and raise numbers too far, too fast. In addition, at some point the law of large numbers comes into play. Emerging companies might be able to double in size quickly. But they can’t double forever. 2,4,8,16,32,64,128. How many companies can grow 128 times in 7 years? Success attracts competition. For quite a while, Tesla has been the only substantive maker of electric cars in the U.S., that will come to an end soon. That doesn’t mean Tesla will stop growing, but it will certainly give up market share. It already is no longer the leader in Europe or China even as it still grows in both markets.
Today is the best of times for equity investors. Earnings are surging. Interest rates are low. In fact, they are so low, thanks to Fed intervention, that real returns on investment grade bonds are negative. Meanwhile, the Fed keeps pumping $120 billion every month into markets, feeding the enthusiasm while the Federal government serially passes multi-trillion-dollar spending packages.
While we know this can’t continue, there are no signs it is about to end. Despite the great growth numbers, the inflation data remains benign. Earnings are likely to surge again for at least a couple more quarters. Economic growth will be above historic norms at least through most of 2022. As Alfred E. Neuman famously said, “What, me worry?”
But good investors always watch the radar. We see home prices surging. That is starting to leak over to rents. Restaurants are paying more for needed workers. Ultimately, these trends will have to show up in inflation. Car dealer lots are empty. Hard to sell cars with no inventory. Yet chip shortages have plants idle. Those shortages will last for at least the next several months. New home sales are surging but existing home sales are down. Why? Again, lack of inventory.
When the pandemic hit, companies reacted quickly. You go broke for one reason; you run out of cash. Therefore, companies that knew they would have to hunker down for a long stretch did everything they could to conserve and raise cash. They depleted inventory. They sold new bonds and stock. Car rental companies sold much of their existing fleet. Why sit with cars gathering dust? Last summer and early fall, there were signs that maybe things were about to get better. But they didn’t. Covid-19 surged in the fall. It was too early to open up. Too early to rehire. Too early to rebuild inventory.
By January, the fall surge was ending, and there was no new surge. Instead, vaccines arrived. People’s mindsets changed; they were ready to get out. They wanted to buy houses and cars, and they did. Until there wasn’t any inventory left.
You still can’t go see a Broadway show, but you will soon. Maybe you will be able to fly to Europe this summer after all. But it is going to take time for supply and demand to even out. They will, but not before some disjointedness.
That brings me back to the idea of expectations. Right now, we are witnessing the best of times. The temptation is to extend today’s good times forward without revision. But once supply and demand get rebalanced, once we all catch up and get back to normal, growth will start to move back to trendline. The past decade says that is 2-3% at best, not the 6-10% we are seeing today. Can inflation stay near 2% with all the resurgence? That is a big question for which no one has an answer. The experience of the last 30 years says it can. But the last 30 years didn’t see the surge in money supply and government spending that we are seeing today. The risk is to the downside, in that rising inflation is bad for both stock and bond prices.
The good times aren’t going to end tomorrow. Enjoy them. As earning season continues, you will see lots of smiles and optimism. Yet you see what happens at the speculative fringes of the market when enthusiasm gets way out of hand. SPAC prices are rapidly coming down to earth. Even Bitcoin took a breather last week. GameStop isn’t $400 anymore and the Reddit/Robin Hood investment crowd isn’t a young pack of millionaires anymore. Eventually reality rules.
So, enjoy the ride but realize today’s ideal mix of news won’t last forever. There isn’t any recession in sight. The bull market isn’t over, but stocks aren’t going to rise 3% per month forever either. Use your common sense. Adjust as needed. Rational always wins over irrational in the long run.
Today, Channing Tatum is 41. Melania Trump is 51. Carol Burnett turns 88.
James M. Meyer, CFA 610-260-2220