the Fed’s dilemma


From almost my first day in the stock market, domestic macroeconomic policy has been implemented by and large by the Federal Reserve.  Two reasons:  a theoretical argument that fiscal policy is subject to long lead times–that by the time Congress acts to stimulate the economy through increased spending, circumstances will have changed enough to warrant the opposite; and ( my view), until very recently neither Democrats nor Republicans have had coherent or relevant macroeconomic platforms.

If pressed, Wall Streeters would likely say that Washington has historically represented a net drag on the country’s economic performance of, say, 1% yearly, but that it was ok with financial markets if politicians didn’t do anything crazily negative–the Smoot-Hawley tariffs of 1930, for example.

During the Volcker years (1979-87), money policy was severely restrictive because the country was struggling to control runaway inflation spawned by misguided policy decisions of the 1970s (Mr. Nixon pressuring the Fed to keep policy too loose).  Since then, the stock market has operated under the belief that the Fed’s mandate also includes mitigating stock market losses by loosening policy, the so-called Greenspan, Bernanke and Yellen “puts.”

recent past

We’ve learned that monetary policy is not the miracle cure-all that we once thought.  We could have figured this out from Japan’s experience in the 1980s.  But the message came home in spectacular fashion domestically during the financial crisis last decade.  As rates go lower and policy loosens, lots of “extra” money starts sloshing around.   Fixed income managers gravitate toward increasingly arcane and illiquid markets.  In their eagerness to not be left out of the latest fad product, they begin to take on risks they really don’t understand as  well as to forego standard protective covenants.

We could almost hear the sigh of relief from the Fed as the tax bill of 2017, which reduced payments for the ultra-rich and brought the corporate tax rate down to about the world average, passed.  Because the bill was so stimulative, it gave the Fed the chance to raise rates as an offset, meaning it could tamp down the speculative fires.


Enter the Trump tariffs.

Two preliminaries:

–tariffs are taxes.  Strictly speaking, importers, not foreign suppliers (as the president maintains (could it be he actually believes this?)) pay them to customs officials.  But the importer tries to ease his pain by asking for price reductions from suppliers and for selling price increases from customers.  How this all settles out depends on who has market power.  In this case,it looks like virtually all the cost will be borne by domestic parties.  Domestic economic growth will slow.  The relevant stock market question is how much of the pain consumers will bear and how much will be concentrated in a reduction of import business profits.

–I think Mr. Trump is correct that the US subsidy of NATO is excessive.  It represents the situation at the end of WWII, when the US left standing–or at best the time when the USSR began to disintegrate into today’s Russia (whose GDP = Pennsylvania + Ohio, or California/2).  I also think that China, with a population five times ours and an economy 1.25x as big as the US (using PPP), is a more serious economic rival than we have seen in decades.  It doesn’t have the post-WWII sense of obligation to us that we have seen elsewhere.  So we have to rethink our relationship.

Having written that, I don’t see that Mr. Trump has even the vaguest clue about how the country should proceed, given these insights.

To my mind, tariffs + retaliation mean both domestic and foreign companies will be reluctant to locate new operations in the US.  Tariffs on Chinese handicrafts may bring industries of the past back to the US, at the same time they force China to increase emphasis on industries of the future.  I don’t get how either of these moves should be a US strategic goal….

the dilemma

The question for the Fed:  should it enable the president’s spate of shoot-yourself-in-the-foot tariff policies by lowering rates?  …or should it let the economy slide into recession, hoping this will jar Congress into action?


tariffs and the stock market

The Trump administration has just triggered the latest round of tit-for-tat tariffs with China, declaring 10% duties on $200 billion of imports (the rate to be raised to 25% after the holiday shopping season).  China has responded with tariffs on $60 billion of its imports from the US.  Domestic firms affected by the Trump tariffs are already announcing price increases intended to pass on to consumers all of the new government levy.

It isn’t necessarily that simple, though.  The open question is about market power. Theory–and practical experience–show that if a manufacturer/supplier has all the market power, then it can pass along the entire cost increase.  To the degree that the customer has muscles to flex, however, the manufacturer will find it hard to increase prices without a significant loss of sales.  If so (and this is the usual case), the company will be forced to absorb some of the tariff cost, lowering profits.

From an analyst’s point of view, the worst case is the one where a company’s customers are especially price-sensitive and where substitutes are readily available–or where postponing a purchase is a realistic option.


Looking at the US stock market in general, as I see it, investors factored into stock prices in a substantial way last year the corporate tax cut that came into effect in January.  They seem to me to be discounting this development again (very unusual) as strong, tax reduction-fueled earnings are reported this year.  However, the tax cut is going to be “anniversaried” in short order–meaning that reported earnings gains in 2019 are likely going to be far smaller than this year’s.  The Fed will also presumably be continuing to raise short-term interest rates.  Tariffs will be at least another tap on the brakes, perhaps more than that.

Because of this, I find it hard to imagine big gains for the S&P 500 next year.  In fact, I’m imagining the market as kind of flattish.  Globally-oriented firms that deal in services rather than goods will be the most insulated from potential harm.  There will also be beneficiaries of Washington’s tariff actions, although the overall effect of the levies will doubtless be negative.  For suppliers to China or users of imported Chinese components, the key issues will be the extent of Chinese exposure and the market power they wield.

PS   Hong Kong-based China stocks have sold off very sharply over the past few months.  I’m beginning to make small buys.




A regular reader asked me the other day to explain why I said I thought the margins of Whole Foods (WFM) are too high.  Here goes:

what they are

Margins are ratios, usually some measure of profits (gross profit, operating profit, pre-tax profit…) divided by sales. (Yes, in cost accounting contribution margin is a plain old dollar amount, not a ratio.  But it’s an exception.  I have no idea why the misleading name.)

when high margins are bad

At first thought, it would seem that the higher the margins, the better off the seller is.  Buy the item for $1, sell it for $2.  That’s good.  Raise your prices and sell it for $5, that’s better.

The financial press encourages this notion with articles that talk up high margins as a good thing.

At some point, however, other people will work out how much you’re making and start doing the same thing.  They’ll typically go for market share by undercutting your prices.  So now you’ve got a competitor who wasn’t there before and you’re facing a price war that will at the very least undercut your brand image.

Creating what analysts call a price umbrella below which competitors can price their products and be protected from you as a rival is one of the worst mistakes a firm can make.

In my experience, it’s infinitely better to build a market more slowly by yourself than to have to try to dislodge a new rival who has spent time–and probably a lot of money–to enter.

One potential exception:  patented intellectual property (think:  Intel or drug companies). Even in this case, however, there’s the danger that once-successful firms become lazy and fail to continue to innovate after initial success.  The sad stories of IBM, or of Digital Equipment, or INTC for that matter, are cautionary tales.

More tomorrow.

P&G (PG) and Gillette


P&G acquired Gillette in 2005 for $57 billion in stock.  The idea, as I understand it, was not only to acquire an attractive business in itself but also to use the Gillette brand name for PG to expand into men’s health and beauty products.  More or less, PG’s a big chunk of PG’s extensive women’s line would be repackaged, reformulated a bit if necessary, and sold under the Gillette label.

Unfortunately for PG, millennial men decided to stop shaving about ten years ago.  The big expansion of new Gillette product categories hasn’t happened.  And PG announced two months ago that it was slashing the price of its higher-end shaving products by up to 20%, effective late last month.

It’s this last that I want to write about today.


The Gillette situation reminds me of what happened with cigarette companies in the 1980s.  I’m no fan of tobacco firms, but what happened to them back then is instructive.

the iron law of microeconomics

The iron law of microeconomics: price is determined by the availability of substitutes.   But what counts as a substitute?  For a non-branded product, it’s anything that’s functionally equivalent and at the same, or lower, price.  The purpose of marketing to create a brand is, however, not only to reach more potential users.  It’s also to imbue the product with intangible attributes that hake it harder for competitors to offer something that counts as a substitute.


In the case of cigarettes, they’re addictive.  It should arguably be easy for firms with powerful marketing and distribution to continually raise prices in real terms.  And that’s what the tobacco companies did consistently–until the early 1980s.

By that time, despite all the advantages of Big Tobacco, it had raised prices so much that branding no longer offered protection.  Suddenly even no-name generics became acceptable substitutes.  This was a terrible strategic error, although one where there was little tangible evidence to serve as advance warning.  As it turns out, in my experience there never is.

The competitive response?  …cut prices for premium brands and launch their own generics.  There certainly have been additional legal and tax issues since, and because I won’t buy tobacco companies I don’t follow the industry closely.  Still, it seems to me that tobacco has yet to recover from its 30+ year ago pricing mistake.

razor blades

The same pattern.

Over the past few years, Gillette’s market share has fallen from 71% to 59%.  Upstart subscription services like the Dollar Shave Club (bought for $1 billion by Unilever nine months ago) and and its smaller clone Harry’s (which I use) have emerged.

Gillette has, I think, done the only things it can to repair the damage from creating a pricing umbrella under which competitors can prosper.  It is reducing prices.  It has already established its own mail order blade service.  On the other hand, Harry’s is now available in Target stores.   Unilever will likely use the Dollar Shave Club platform to distribute other grooming products.  So the potential damage is contained but not eliminated.  Competition may also spread.

The lesson from the story:  the cost of preventing competitors from entering a market is always far less than the expense of minimizing the damage once a rival has emerged.  That’s often only evident in hindsight.  Part of the problem is that once a competitor has spent money to create a toehold, it will act to protect the investment it has already made.  So its cost of exit becomes an additional barrier to its withdrawal from the market.




lessons from the Eastman Kodak bankruptcy

A bankruptcy is never fun.  But studying what happens as a company approaches a financial crisis is an important and useful exercise in securities analysis.  Eastman Kodak’s Chapter 11 filing illustrates many general characteristics, as well as one or two novel twists.  Here’s what I see:

a close-in look

–bankruptcy fears feed on themselves.  One day a senior analyst at my first job told me about a research report he wrote on a small magazine publishing company.  He pointed out gently deteriorating subscriber trends and opined that–unless they were reversed within a year or eighteen months–the company could be out of business.  He called the publisher two months later and found out the company was closing its doors for good.  Why?  The CEO told my colleague that advertisers had read his report, concluded it made no sense doing business with a dying firm and stopped placing ads.  Cash flows dried up, the company began to bleed red ink and was forced to cease publication.

Maybe my former colleague’s report was that influential, maybe not.  But something did happen to accelerate the magazine company’s decline–a loss of market confidence.

On paper, a firm might appear to have plenty of time to fix current financial problems, but the situation can change dramatically and very quickly if business partners decide to defend themselves against a possible Chapter 11 filing.

What can happen?

working capital issues 

End users will likely worry that bankruptcy will mean the end to a product line, or at least a cessation of operating supplies, repair parts and service.  Warranties, too.  So they’ll hesitate to buy.  Anticipating a falloff in demand, wholesalers and retailers may no longer want to carry the products.  And they certainly won’t be in any rush to pay the manufacturers for units they have in stock–no matter what terms they’ve agreed to.

Suppliers, knowing that trade creditors have little clout in bankruptcy proceedings, may ask for payment in advance before they’ll ship raw materials.

In theory, these supplier and customer actions should show up on the balance sheet in expanding receivables and shrinking payables, or maybe a buildup in finished goods inventory.  In practice, however, my experience is that they’re almost impossible to detect.

drawing down a bank credit line.  Contrary to what people commonly believe, a bank’s commitment to offer long-term finance can be very fragile thing.  For money already borrowed, restrictive clauses (covenants) in the loan agreements can easily mandate that if the borrower’s financial condition falls below specified levels, bad stuff will happen–say, the entire principal becomes due immediately, or the borrower has to devote all of its cash flow to repayment.

The same thing applies to unborrowed money, except that the line can be reduced or cancelled outright if the bank sees deterioration in the financials a company periodically submits as a condition of keeping the credit line open.  When Kodak suddenly borrowed its entire $160 million credit line (see my post), it signaled to Wall Street that it was worried about this possibility.

–fraudulent conveyance.  This is a new one for me.  Kodak had been supporting its turnaround efforts in recent years despite by selling patents.  According to newspaper reports, lawyers for potential buyers warned of a legal risk were Kodak to enter Chapter 11 soon after a purchase.  In that event, lawyers for the creditors could sue to reclaim the patents, arguing the sales price was too low (the fraudulent conveyance).  If this tactic were successful, the pre-bankruptcy buyer would have to give up the patents.   But it wouldn’t get its money back.  It would become an unsecured creditor of Kodak–at the end of the line of those hoping to be paid by the bankruptcy court.  If bankruptcy is imminent, why take the risk?

–foot-dragging in litigation.  Kodak has also been suing tech companies for violating its intellectual property rights.  After its Chapter 11 filing, Kodak complained that the other parties had been dragging out settlement talks, ostensibly in hopes of getting better terms from the bankruptcy court.   Maybe so, but what’s so surprising about that?

–resigning directors.  Shortly before Kodak’s bankruptcy filing, three independent (that is, not company employees) directors resigned.  This isn’t an everyday occurrence.  It’s almost never a good sign.  In this case, it signaled to me that Kodak had made a very important decision that these directors not only disagreed with but wanted to forcefully distance themselves from.

stepping back a bit

From the Kodak case, I think an analyst can develop a useful checklist of possible bankruptcy symptoms.  I have one further, Kodak-specific comment though:

why printers?

I’ve followed printer companies in the US and Asia off and on for the better part of twenty years.  My take is that printers, both corporate and personal, are a very mature, brutally competitive, commodity business, whose heyday was three decades ago.  Corporate customers play one supplier off against another to get discount services.  Retail customers buy machines for well below the cost of making them, while the printer companies hope to eventually earn a profit through ink sales (I understand this may not exactly be the Kodak model, but that in itself is another potential worry).

In my view, this is an industry to get out of, not get into.  My questions about Kodak’s strategic direction would make me less willing to back the company, not more–and I suspect I’m not alone in this view.  That alone would make business partners quicker to adopt defensive measures than they ordinarily would.