thinking about Walmart (WMT)

On August 16th, WMT reported very strong 2Q18 earnings (Chrome keeps warning me the Walmart investor web pages aren’t safe to access, so I’m not adding details).  Wall Street seems to have taken this result as evidence that the company makeover to become a more effective competitor to Amazon is bearing enough fruit that we should be thinking of a “new,” secular growth WMT.

Maybe that’s right.  But I think there’s a simpler, and likely more correct, interpretation.

WMT’s original aim was to provide affordable one-stop shopping to communities with a population of fewer than 250,000.  It has since expanded into supermarkets, warehouse stores and, most recently, online sales. Its store footprint is very faint in the affluent Northeast and in southern California, however.  And its core audience is not wealthy, standing somewhere below Target and above the dollar stores in terms of customer income.

This demographic has been hurt the worst by the one-two punch of recession and rapid technological change since 2000.   My read of the stellar WMT figures is that they show less WMT’s change in structure than that the company’s customers are just now–nine years after the worst of the financial collapse–feeling secure enough to begin spending less cautiously.

 

This interpretation has three consequences:  although Walmart is an extraordinary company, WMT may not be the growth vehicle that 2Q18 might suggest.  Other formats, like the dollar stores or even TGT, that cater to a similar demographic may be more interesting.  Finally, the idea that recovery is just now reaching the common man both justifies the Fed’s decade-long loose money policy–and suggests that at this point there’s little reason for it not to continue to raise short-term interest rates.

a US market milestone, of sorts

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.

 

 

 

corporate taxes, consumer spending and the stock market

It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so.  The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.

However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration.  Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes.  The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks.  And even that bump is likely to be relatively mild.

In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects.  Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.

 

What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season.  We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade.  It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time.  I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.

calling for higher inflation

Last week a group of prominent economists wrote an open letter to the Federal Reserve arguing that the current Fed target of 2% annual inflation is too low.

Their basic view is:

–circumstances have changed a lot in the US since 2% became the economists’ consensus for the right level of inflation a quarter-century ago, so it isn’t necessarily the right number anymore, and

–the lack of oomph in the US economy is a result of maintaining an inflation target that’s too low.  So let’s try 3% instead.

Having a 3% inflation target instead of 2% isn’t a new idea.  I heard it for the first time about 20 years ago, from an economist at the then Swiss Bank Corp.  Her argument was that getting from 3% to 2% inflation would require an enormous amount of effort without any obvious payoff.  The whole idea of inflation targeting is to eliminate the possibility of the kind of runaway inflation–and associated crazy economic choices–of the kind the US had begun to experience in the late 1970s.  Whether actual inflation is 3% or 2% matters little, just as long as the current level is not the launching pad for a progression of 4%, 6% 9%…

Another way of looking at this would be to say that the nominal figures matter much more than academic economists realize, and that 4% nominal GDP growth (2% trend economic growth + 2% inflation) feels too much like stagnation.  Therefore, it undermines the entrepreneurial tendencies of ordinary people.

 

How to create 3% inflation?  …slower interest rate increases and/or increased government stimulus (meaning tax cuts and infrastructure spending).

 

The letter certainly won’t affect the Fed’s thinking about a rate rise in June.  But it seems to me that the debate on this issue can only intensify.

By the way, I think 3% inflation would be good for stocks, neutral/bad for fixed income.

 

Employment Situation, March 2017

The Bureau of Labor Statistics released its monthly Employment Situation report earlier this morning.

With an addition of +98,000 jobs, the figures were a little more than half the rate of gain or recent months.  Revisions to data from the prior two months clipped another -38,000 positions from the total.

Although the report isn’t great reading for stock market bulls, we’ve seen over the past eight years of economic recovery that bad months occasionally occur, even in the midst of a sharply upsloping trend.  In addition, although the monthly figures are seasonally adjusted, the weather during 1Q17 has been so unusual in the populated regions of the US–unusually mild in January-February, ugly in March–that the first two months probably look better than they should and March worse.

The only really eyebrow-raising aspect of this report, in my view, is that despite the unemployment rate being at a very low 4.5%, there is still no sign of acceleration in wages.  This implies no urgency for the Fed to raise interest rates aggressively.

reversing quantitative easing

US stocks were up by about 1% yesterday when the minutes of the last Fed meeting came out.  As Fed watchers saw the topic of paring down the Fed’s $4 trillion+ holdings of government bonds was mentioned, stocks (but not bonds) began to give back their gains and ultimately finished the day lower.

What’s this about?

  1.  The Fed typically uses the Federal Funds rate for overnight loan to loosen or tighten money policy.  In doing so, it depends on the banking system to broadcast increases or declines in interest rates into the market for longer-term debt.  The problem since 2008 is that the banks had destroyed their own creditworthiness through years of unsavory and unsuccessful speculative financial markets trading.  So they were ineffective in performing this crucial rate-determining role.  Congress and the administration were–and still remain–lost in their inside-the-Beltway alternative universe, so there was no hope of help for the failing economy from that source.  The Fed’s solution was to begin “unconventional” operations, by buying huge amounts of longer-dated government debt in order to push down long-term interest rates itself.  It now holds something like $4.3 trillion worth of Treasury and government agency debt.
  2. The Fed has long since stopped making new net purchases of longer-dated bonds.  But as its existing bonds mature, it has continued to roll over the money it gets from them into new bond purchases.  The next step for the Fed in normalizing the long-term debt market will be to stop this rollover.  The consensus is that this change will happen later this year or early next.
  3. What’s “new” from yesterday is that the Fed put this thought down in writing, without specifying any details.

My take:  while the Fed announcement may have been the trigger for an intra-day selloff in stocks, the Fed minutes are not a big deal.  There is an investment issue as to how the Fed will proceed, but that will ultimately be influenced by how capable Mr. Trump will be to get Washington working again.

The President’s early performance has had two consequences:  US investors are beginning to think about shifting money to Europe.  Despite Brexit, that region is beginning to experience its own economic growth.  As well, it is having deep second thoughts about electing Trump-like figures in their own countries (we’ll learn more in the first round of the French elections on April 23rd), thereby increasing their attractiveness as an investment destination.

the Fed’s inflation target: 2% or 3%?

There seems to me to be increasing questioning recently among professional economists about whether the Fed’s official inflation target of 2% is a good thing or whether the target should be changed to, say, 3%.

The 2% number has been a canon of academic thought in macroeconomics for a long time.  But the practical issue has become whether 2% inflation and zero are meaningfully different.  Critics of 2% point out that governments around the world haven’t been able to stabilize inflation at that level.  Rather, inflation seems to want to dive either to zero or into the minus column once it gets down that low, with all the macro problems that entails.  It’s also proving exceptionally hard to get the needle moving in the upward direction from t sub-2% starting point.  My sense is that the 3% view is gaining significant momentum because of current central bank struggles.

This is not the totally wonkish topic it sounds like at first.  A 2% inflation target or 3% actually makes a lot of difference for us as stock market investors:

–If the target is 3%, Fed interest rate hikes will happen more slowly than Wall Street is now expecting.

–At the same time, the end point for normalization of rates–having cash instruments provide at least protection from inflation–is 100 basis points higher, which would be another minus for bonds (other than inflation-adjusted ones) during the normalization process.

–Over long periods of time, stocks have tended to deliver annual returns of inflation + 6%.  If inflation is 2%, nominal returns are 8% yearly; at 3% inflation, returns are 9%.  In the first case, your money doubles in 9 years, in the second, 8 years.  This doesn’t sound like much, either, although over three decades the higher rate of compounding produces a third more nominal dollars.

Yes, the real returns are the same.

But the point is that the pain of holding fixed income instruments that have negative real yields is greater with even modestly higher inflation than with lower.  So in a 3% inflation world, investors will likely be more prone to favor equities over bonds than in a 2% one.

–Inflation is a rise in prices in general.  In a 3% world, there’s more room for differentiation between winners and losers.  That’s good for you and me as stock pickers.