This is an update to a post I wrote in December when the Fed first started tying monetary policy to the unemployment rate. December was the first meeting that the Fed said that interest rates would rise no sooner than the unemployment rate was below 6.5%. In addition to the 6.5% mark, today we got a new mark to keep an eye out for since QE will likely end when the unemployment rate hits 7%.
Below is a forecast of when those triggers could be hit based on the current rate of decline in the unemployment rate. Since peaking in 2009, the rate has declined at an average pace of ~6 bps per month. Extrapolating from the current level, this would imply that we would reach 7% in March of 2014 and 6.5% in December 2014. This assumes that the unemployment rate continues to decline at that pace; however, since December of 2012 the rate has fallen by only 20 bps overall, or 4 bps per month (slower than it had been falling previously).
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Dow Component Margins 20 Years Ago vs. Today
Scott Krisiloff, June 19th, 2013 at 7:49 am, Comments: 0
In order to help put some context around the extent to which profit margins have changed over the last 20 years, below is a comparison of the operating (EBIT) margin of the current Dow components in the early 90′s vs. today. The average operating margin of the 30 Dow components (on an equal weighted basis) was 16.9% in 2012. That compares to 15.1% in the early 90′s. 22 out of the 30 companies have higher operating margins today than they did back then.
It’s likely that a significant contributor to margin growth for all of these companies has been the adoption of technology, which allows companies to produce more with less. However, looking at the list it’s clear that some of the biggest margin improvers are companies that have had material changes in their business models like $IBM or have seen major changes in the operating environment like: $CVX or $XOM. $VZ and $T are also companies that have seen major shifts in their businesses both in terms of product (the switch from land lines to mobile) and also in terms of size (from regional to national players), but both have seen their margins fall significantly, although there may be more to the story that I’m missing as a non-telecom analyst. $CSCO is the company that has seen its margins fall the most, from an unreal 40% operating margin in 1993 to a still healthy 22% today.
Some notes on the methodology: 1) I calculated all of these by hand from SEC filings, so there is a reasonable likelihood that there is an error somewhere. But on average any conclusions drawn from the analysis should hold. 2) Remember that 1992 was a recession year, so margins could have been depressed relative to other comparable years in the same era. If I noticed that 1992 was an anomalous year for a particular company I did grab margins from 1993/1991 as noted. 3) Operating margins for banks are calculated from net interest pre provision revenue (after interest expense).
10 Year Treasury Yield Back Above CPI
Scott Krisiloff, June 18th, 2013 at 8:09 am, Comments: 0
CPI, which was reported this morning, has shown some deceleration lately. The core index is 1.68% higher than it was last year, which is a smaller increase than the >2% y/y increases that the index showed for much of 2011 and 2012. The deceleration comes as the interest rates are rising, which means that the yield on the 10 year Treasury note is now higher than the trailing change in CPI. Yesterday’s closing level on the 10 year was 2.16%, 48 bps higher than the year over year change in Core CPI.
Best First Halves in S&P 500 History
Scott Krisiloff, June 17th, 2013 at 9:38 am, Comments: 0
There are two weeks left until the end of the second quarter and so far 2Q13 has been a strong follow up to the first quarter. The $SPX is currently up 4.6% quarter to date and 15.1% year to date, which is good enough for the 9th best first half in the index’s history.
Below is a chart of the other ten best first halves besides 2013. Six out of ten times the index closed the year higher than its level to end the second quarter. The biggest drop-off was in 1987, which was also the second best first half of all time.
Company Notes Digest 6.14.13
Scott Krisiloff, June 14th, 2013 at 4:35 pm, Comments: 0
A digest of some of the top insights that I’ve gathered from this week’s earnings calls. Full notes can be found here.
Count Jamie Dimon as another believer in housing:
“Housing has turned the corner…Supply and demand are in balance, if not in short supply in a lot of cities” (JP Morgan)
The regulatory environment is getting better:
“you can make a very coherent argument that the political environment will get better not worse…The regulatory environment will probably get better…[in the] second term of Presidency, new regulations come way down.” (JP Morgan)
“you got to remember America still has the best economic system by far in the world, okay. It’s got the best military, the best universities, the best hospitals. It’s got the best businesses large, medium and small. The rest of the world has a lot of very good stuff, still the best here. It’s got the most innovation, the most R&D innovation from the factory floor to a Steve Jobs. It still got a very strong work ethic here. It’s got the lowest corruption and the widest, deepest most transparent financial markets the world has ever seen.” (JP Morgan)
But Europe is still not healed:
“Europe is going to be a little bit roller coaster, because they’ve so many things to do.” (JP Morgan)
Smaller banks are getting healthier, coming back to market:
“on the pricing front, there are pockets that have been pretty stable, and then there are pockets in the community middle market that things have been getting more aggressive as those banks — those smaller banks have rebuilt their capital bases and are coming back in, but we stay competitive” (US Bank)
Banks with lower costs of funding (the big guys) can afford to be more aggressive in pricing loans:
“our rating…offers us tremendous funding advantages…I think we rarely, if ever, lose on pricing. We have an advantage on that. We’re very disciplined in terms of structure, but pricing is not an issue…I mean, we’re clear with all the relationship managers not to lose on price.” (US Bank)
Don’t be looking for any acquisitions from JP Morgan:
“there will be no major acquisitions in our foreseeable future… overseas I would rather grow organically and there’s plenty room organically.” (JP Morgan)
The big guys are going to war over the mortgage business, can Wells maintain its share?:
“We are going to be in the mortgage business. We want to be a winner, it’s too important a product not to do it.” (JP Morgan)
Blackstone is the “largest owner of real estate in the world.” Is that really a good thing?
“Our latest Real Estate fund is up 32% compounded in the last 2 years…And as a result of that, we are getting hugely disproportionate allocations from almost everyone…We’re currently operating at roughly 4x the size of anyone else” (Blackstone)
I’m not really sure I understand how these numbers from Restoration Hardware are even possible:
“we delivered industry leading sales growth with a net revenue increase of 38%…an outstanding 41% comparable store sales increase, which was on top of a 26% comp increase in the year-ago quarter…We also operated fewer stores overall with 70 galleries open at the end of the first quarter versus the 74 we had open last year.” (Restoration Hardware)
Dollar General not seeing people trade back out of discount retailers if economy gets stronger:
“There is no evidence at this time that there’s a change with the trade-down customer or the trade-in customer…[when we did a survey] there was no indication from the higher demographic that if the economy got significantly better, that they were going to trade out of the channel…right now, the fastest-growing customer segment we still have is that customer that’s around $50,000 to $70,000 a year, which is above the income of our core customer.” (Dollar General)
Doctors are getting squeezed (more small businesses getting hammered):
“what we’re seeing is this declining physician take-home compensation. And so we see physicians looking for income stability. That’s got 2 sides to it. The obvious side is the declining physician professional reimbursement…on top of that, the expense base for the physicians has been growing, not just from the standpoint of labor, but the IT initiatives, the electronic health record, has rarely perhaps resulted in core operational efficiencies, but certainly has added overhead and initial costs…You put all those things together and the net result is in the small practices, you end up seeing declines.” (HCA)
The future for physicians may be to be employed by the hospital:
“mom and pop practices that have not been perhaps as deeply operationally managed. They’ve not had the leverage of scale…So in many cases, we’ve been able to…integrate them into larger practices…and create some pretty important efficiencies that might have otherwise, stabilized them.” (HCA)
Industrials, Materials, Energy
Danaher’s acquisition philosophy is worth noting:
“what we bring to capital deployment, and we really kind of comes down to really 3 simple themes for us. One is the strategy first mentality. We don’t think about businesses first. We think about markets that we want to be in and invest in, and then we think about what are the companies within those markets that we want to attempt to acquire…Two is to have a model to run those businesses…three, to bring financial discipline” (Danaher)
Counterintuitively, Sometimes high margin businesses have more fat to trim than low margin businesses:
“I think we learned, as we look at some industrial businesses, that with 30%, 35% gross margins, you went into one of their facilities, they’re often pretty well run. They were thoughtful about the supply chain…[alternatively] we’d find a 50% gross margin business…They didn’t have the best players running the facilities, they didn’t have the best people focused on the supply chain” (Danaher)
Miscellaneous Nuggets of Wisdom
You can’t predict the future but you can prepare for it:
“we’re just trying to grow our businesses and some of these things are like the weather. We have to manage through it. We’re not going to guess the bad weather time.” (JP Morgan)
Investing in Real Estate has its advantages:
“It’s much easier to invest in real estate than it is in the company. Companies are very complex, very dynamic and what you find about real estate that’s very comforting is first of all, buildings don’t talk, right?” (Blackstone)
It’s not easy to start a business:
“I remember, when we just started the firm and almost everybody turned us down for everything. Our first fund, our 17 closest relationships turned us down.” (Blackstone)
But you know you’re successful when…
“As an entrepreneurial business, you know when you’re successful because it’s when people really want to join you who have enormous records of success.” (Blackstone)
The most important thing in business? People, People, People:
“go into other businesses that would be great on their own but would make the existing mix stronger, and you had to do it with people who were 10s on a scale of 10.” (Blackstone)
US Oil Production Relative to Global Consumption
Scott Krisiloff, June 13th, 2013 at 11:26 am, Comments: 0
$BP Came out with its Statistical Review of World Energy report for 2013, which is a great resource for macro data on energy markets. Using the data, below is a chart to help put some perspective around recent increases in US oil output.
US Oil Production generally fell from 1970 through 2008 from 11.3 million barrels per day to a trough of 6.8 million. Over the last 5 years production has grown to 8.9 m per day. That means that in 1970 the US was producing enough oil to match 32% of global consumption compared to just 8% in 2008 and 10% today. Relative to our own domestic consumption, today we produce 48% of our average daily need compared to just 35% in 2008.
iOS vs. The Best Selling Video Game Consoles of All Time
Scott Krisiloff, June 12th, 2013 at 6:58 am, Comments: 0
I’ll be at E3 today feeding the video game addiction of the 14 year old boy stuck inside of me. While it should be exciting to check out $SNE and $MSFT’s new systems (along with the ruins of the former $NTDOY empire), the real gorillas of the video game industry will mostly be absent. That’s because $AAPL and $GOOG wont have a presence at E3 even though their gaming systems in the form of smartphones and tablets have sold multiple times the number of units that the traditional gaming guys have ever hoped to sell. Below is a list of the top selling consoles of all time by number of units with iPhone and iPad included for perspective. iPhone has sold double the units that PS2 did over its lifespan, and iPad has already sold more units than Gameboy, a former juggernaut.
US Government Debt by Maturity
Scott Krisiloff, June 11th, 2013 at 3:12 pm, Comments: 0
As interest rates rise, it’s not a bad idea to reacquaint ourselves with the debt profile of the US government. Below is a chart of how the amount and maturity of Uncle Sam’s debt has changed since 1999. The amount has obviously increased by a lot, and the duration has changed a fair amount too.
Over the last five years Treasury has been extending the maturity of its debt by taking the proportion of short term Bills (maturing in <1 year) to 10% from a peak of 17%. This is certainly positive, but since the public debt has grown so much in the last five years, the decrease in share is not matched by quite as large of a decrease in the gross value of debt, which has fallen from $1.8 T to $1.6T. As a whole, marketable debt is now 68% of the government’s total debt load, which is up significantly from earlier last decade. Treasury has focused on issuing 1-10 year notes for the majority of this increase. Treasury Notes now make up 45% of all debt.
On a side note, the Fed has now let almost all of its short term treasury holdings be redeemed in association with operation twist. In place of Treasury Bills, the Fed now holds 37% of all marketable bonds and 19% of all notes.
I know there’s a pretty large contingent of internet monetary theorists who would argue that the Federal government has a printing press, and so all debt analysis is totally moot. I don’t exactly share that view though, and if there’s anything that the financial crisis should have taught us it’s that short term funding structures are inherently unstable.
Technically speaking the Fed is an independent body and although we “know” Ben Bernanke would step in and satisfy all short term funding needs of the US Government, there are no guarantees when dealing with the psychology of the markets. Still, in the very unlikely scenario that the Fed did have to roll all of Treasury’s short term debt it would mean another $1.6T expansion to the Fed’s balance sheet.
Source: Treasury Direct
Most Economic Sectors Now Re-leveraging
Scott Krisiloff, June 10th, 2013 at 9:54 am, Comments: 0
The Fed released its flow of funds report last week, which is the most comprehensive look at the financial position of the US economy. The report showed that in the first quarter of 2013 gross debt grew for almost every economic sector. Overall domestic non-financial sector debt grew by 4.6%, which pushed the non-financial sector debt to GDP ratio to 253%. Extrapolating from here, we should reach a new all time high in Q2.
It’s particularly noteworthy that credit market debt owed by the financial sector grew slightly, the first time that it has grown since the 4th quarter of 2008. The only segment still showing signs of deleveraging is the home mortgage segment, which continued to contract by 2.3% and has contracted for 19 of the last 20 quarters. However, other consumer credit showed strong growth, up 5.7%.
Source: Fed Z.1
June 2013 Investor Letter
Scott Krisiloff, June 6th, 2013 at 1:56 pm, Comments: 0
Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog. If you are interested in receiving this letter monthly by email, sign up here.
When I was growing up my Grandma had a cabin in a community called Pine Mountain, which is in the Los Padres National Forest about 100 miles North of Los Angeles. Like many national reserves, when you drove into the boundaries of the forest you would be greeted by a sign with Smokey the Bear that would warn you about the current propensity for fire danger. The sign had five degrees of danger: low, moderate, high, very high and extreme. And depending on that day’s conditions a ranger would change the sign to let visitors know the current risk.
In nature, the main contributor to fire risk is the quantity of fuel. This is primarily determined by the amount of rain received in the previous season and also how long it has been since the last fire. If an area goes a long time without a fire, dry brush builds over multiple years and increases the potential severity of a future burn.
In securities markets, danger also increases with long periods of calm. If investments are vegetation, the most fertile time to “seed” new purchases is when the last wildfire has cleared away the old brush. At that time the potential for forward returns is at its juiciest because valuations have fallen to levels that reward risk takers. However, as a bull market progresses investors suck up potential returns like hot weather drying out a healthy plant. Beyond a certain point investors squeeze out all of an investment’s “nutrients” and like the desert sun continue to parch the land until all that’s left is fuel for the next fire. At that point, a small spark can ignite a severe blaze.
At 1650 on the S&P 500, there’s enough dry brush lying around the market that it’s time to change our danger sign to read “very high.”
Back in January, I wrote that 1650 was the peak level that I could justify for the S&P 500. When I used fundamental analysis to price in the most optimistic reasonable scenarios for a sample of the S&P 500’s constituents, this was the level that I reached—maximum realistic value.
In January I also noted that I wouldn’t be surprised to see the market rise much higher than this point though. That’s because it’s typical for the markets to pass well beyond realistic value into the realm of illogical value as an economic cycle ages. Like with natural fire danger, a market fire isn’t necessarily imminent just because the danger is high. Even the driest brush can pile up for many seasons if there is no catalyst of a spark. In investing, valuation is not itself a catalyst either, which means that unless a spark hits the markets, it’s likely for our brush to get drier before it burns.
For me, 1650 represents the limit at which market prices tip from following aggressive logic to following little logic. Past here 1850 is probably the next point at which I would change our fire danger sign to “extreme.” At that number it’s unlikely that there would be much of anything left with the potential to meet our return objectives.
Although I think it’s a reasonable likelihood that we could see 1850, I certainly don’t think it’s prudent to expect that we will, and so I continue to sell holdings as individual companies reach our valuation limits. We came into the year with 18 core holdings across our portfolios, and today we are left with 12. I expect that number to continue to fall, but on the other hand there is always the possibility that a summer shower could come along and provide some brief refreshment.
Of course, nobody knows what will provide the spark for the next fire or when it will occur, but I can write with absolute certainty that at some point one will come along. When it does, the fire will likely push stocks through fair valuation to the downside, at which point it will be time for us to re-plant our crops for the next cycle. In the last cycle this process took about 18 months to complete, which was actually longer than average. Still, based on these expectations, if a fire starts to break out it could be a long time before we are committing significant amounts of capital back into the market.
Whenever and however the next fire occurs, it may be violent and unnerving, but it will also be important to remain optimistic. After all, fire is a healthy part of a natural ecosystem; clearing away old brush is what allows new growth.
Opinions voiced in the letter should not be viewed as a recommendation of any specific investment. Past performance is not a guarantee or reliable indicator of future results. Investing is subject to risk including loss of principal. Investors should consider the suitability of any investment strategy within the context of their personal portfolio.
Scott Krisiloff, CFA is Chief Investment Officer of Avondale Asset Management, a Los Angeles based investment firm, which manages investment accounts for individuals and institutions More.