Transition remains the name of the game this week. Major averages, led by mega caps, touched new highs, but are basically flopping around with increased intraday volatility while the average stock continues to weaken. Earnings are coming in hot, as expected. I want to touch on 3 major pieces of this puzzle today, namely inflation, margins/profitability and market breadth as we prepare for a lower growth rate in the coming quarters with declining stimulus.
CPI and PPI reports showed inflation well above consensus estimates this week. Producer costs showed the highest annual increase since data started being collected back in 2010. Over half of this increase stemmed from stronger services inflation as reopening efforts prove successful and consumers opened up their savings accounts for spending. Goods prices also kept on leaping higher, but as we’ve already discussed, once supply chains are fixed, these will self-correct. Services inflation, driven by higher labor costs, is more of a wild card. Many expect employee pay to calm down once Government handouts end, children go back to school, and businesses require workers to come back to the office where they should be more productive. In fact, data coming out of Georgia and Texas, where extended employment benefits ended early, are showing workers coming back in droves now. If, as we expect, this slows wage gains, then interest rates can remain calm. Even with record inflation data, interest rates have been amazingly tame, sticking to the low end of the trading range.
In “normal” markets, higher inflation reports would cause long-term yields to rise, substantially so. Transitions are tough! We continue to expect elevated inflation, albeit on a declining rate of change, over the coming months. Services inflation is stickier than seen in most commodities. Wage inflation isn’t going to slow much until labor force participation rates rise. This will happen, but it will take time, causing more concern amongst day traders and those not focused on the longer term, all of which increases daily market swings.
This peak in inflation is coinciding with peak growth for top-line revenues. More importantly, what happens to margins from here will determine how much bottom line earnings can continue to expand. History can help us craft a picture. Check out the past 2 recovery periods coming out of a recession in 2000 and 2008.
Source: J.P. Morgan Asset Management
It may be a little tough to see, but the dark shaded areas are margin expansion which contribute to bottom line EPS growth. During the depths of 2000, 2008 and 2020, margins contracted by 31%, 40% and 22% respectively. Early year rebounds drove margins 19% and 47% respectively. So far this year, EPS growth rebounded with margins expanding by 56%. The critical part to understand is that margins, although peaking from a percentage standpoint, kept on rising in previous recoveries. Even if revenue growth slows, companies have shown an ability to flow more profit to investors.
Let’s take that as a high probability of continuing. Then throw in what actually happened in 2020. This Covid crisis accelerated automation efforts across industries which will keep on rewarding companies that invested in capex. Capex will lead to a sustained acceleration in productivity, a critical factor in calculating GDP when population growth is minimal. We’re already seeing a shift in leaner and more efficient operations from retail/restaurants with self-checkout; warehouses have more robots than humans; healthcare finally getting better software along with telemedicine; and leisure/hospitality has gone digital with cell phone check-ins and keyless entry. These all lower the cost of doing business and helps profitability.
Now that labor supply is tight and workers demand more compensation to come back, companies continue investing in labor saving technology. The ROI (return on investment) calculation keeps improving in favor of automation/robots over humans with rising wages. Many believe more than half of the jobs still empty from the pandemic, or 4 million, have or will be replaced by automation and technology efforts. No wages, no employees calling out, no down time, no healthcare costs…etc. Erasing these all add up to higher margins, helping drive earnings per share over the coming years. All is not lost though. History shows that displaced workers learn new skills. This time they will come in the form of software coders, robot repairers, green energy or new jobs we can’t even think of today. Again, this transition will take time, confounding bulls and bears alike during our evolution.
The last piece of the transition puzzle I want to touch on is breadth and valuation. Many investors are concerned about recent narrow leadership and elevated P/E’s. Since May, market indices have ratcheted higher, driven by mega cap stocks. The average stock is not making new highs while FANGMAN is. Market breadth is certainly negative and not healthy. This bears monitoring over the coming weeks, especially during earnings season. It is easy to make money in stocks when coming off a recessionary bottom. Now it is time to separate winners and losers.
As far as valuations go, we have more historic precedent to look at. The last time our markets were driven by so few names reminds many of Y2K and the dotcom bubble. Back then, the top 10 stocks were 27% of the S&P 500. Today that number is 29%. Score one for those concerned about breadth. However, digging a little deeper into actual earnings, yields a different conclusion. Back in 2000, those 10 stocks only accounted for 15% of S&P 500 earnings. Today, our top 10 stocks now account for over 30% of earnings. We are miles away from the bubble-type environment that existed two decades ago on this measure.
Source: J.P. Morgan Asset Management
Further earnings collapsed in 2001. Today, we expect many of the mega caps to keep churning out 10% – 15% EPS profit for several years. As noted earlier, significant capex investment occurred last year. This will only help boost revenues for those technology behemoths today and going forward in the form of recurring revenues. Stocks are expensive, but nowhere near a bubble.
The Fed has our backs, but winning companies need to keep taking market share and expanding margins in order for their stocks to continue their advance. Easier said than done, but this transition will come in fits and starts, allowing investors time to find new opportunities.
SNL alumni Will Ferrell celebrates his 54th birthday today, while Detroit Lions Hall of Famer Barry Sander turns 53.
James Vogt, 610-260-2214