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Good Morning. We have written before that if inflation goes down in peace, workers should enter the labor force. We received bad news on this aspect yesterday: layoffs and vacancies rose in March. If the Fed still needed a reason for a 50 basis point rise and a quick reduction in the balance sheet, they have it now. A few remarks on the margins and the sentiment below. Send us an email: [email protected] and [email protected]
The margins must go down
The following is a chart of year-on-year changes in the producer price index, up to the end of the first quarter:
And here is the labor cost index, an overall index of labor costs:
Over your head, what do these charts mean for companies’ profit margins? Well right now, as it turns out, the fringe does not care. The following are the quarterly operating margins for the S&P 500:
The margins have dropped from their peak, but they are still close to the all-time high and are well above pre-plague levels. In a sense, these three charts together are just a picture of the current inflationary environment. Supply is limited, limiting competition in many products and lowering the incentive to keep prices low. At the same time, both domestic and business customers are flowing in cash from government incentives, i.e. the demand is fiery. Under these conditions, even large input and labor costs can easily be passed on to consumers.
It all makes sense. But two questions. First, what would the margin table look like if we did get the desired “flawless disinflation” (i.e., inflation would fall without a recession)? A key component in the gilding scenario is that there is more online supply, both of goods and of labor. The first increases price competition and the second prevents a wage-price spiral.
If that happens, margins are going to go down: companies that price too aggressively in an environment of wide supply will lose market share, and consumers will fall more based on price as the labor market cools.
Suppose now that there is no impeccable detachment of inflation, and the Fed should resort to causing a recession to control inflation. You can be sure that even in such a case the margin has dropped – but even more.
Either way, the margins are going down. Now, boys and girls, do we all have significantly lower margins in our earnings model? are good.
The second question is more peripheral. How quickly is the environment changing from a hot economy where costs can be transferred without friction, to a knife fight over market share? Hat tip for my colleague Subject Indap Who pointed to the pearl of a Article Written by two partners at Bain, a consulting firm. He advises companies that inflationary periods offer good coverage for marginal price increases:
Limited experience with inflation may translate into missing opportunities to play offense. Pricing moves, made out of thought and strategy, can not only help cover cost increases but also expand the margins.
The most effective private equity firms help portfolio companies develop pricing books that serve a dual purpose: to track the cost pressures of the business and prepare the organization to take pricing actions that better reflect the full value proposition to customers.
Initiated traffic with a clear vision of what is coming is the best approach to maintaining margins in a period of rising costs. And for those who are in a strong position, this may be an important opportunity to set the bar higher.
These phrases seem to have been developed in a lab – part of an experiment to see how vicious a management consultant can make himself look (“Times are tough! Knock your clients out while the thread is good!”). However, I do not think it is actually disgusting at all. Companies need to back up what they can. Gain is the key to the whole exercise.
The interesting question is whether Bain gives good advice here. Will companies that push prices as hard as the current environment allows, maximize profits in the short term, find themselves paying a price for market share down the road? I have no answer to this question, but when I look at this margin chart, I wonder.
Be greedy when others are scared shirtless
Of yesterday Letter Presented this graph of sentiment to Bear Survey sentiment versus future S&P 500 returns:
This is a simple message: when everyone is down in stocks, a slight rise is all it takes to raise prices. And on the other hand, if everyone is celebrating, worry. However, it must be admitted that the chart is rough. Is anything else happening?
First, we turned the noisy sentiment data from the chart above into an index to smooth things over. Specifically, we took the average of six months of some investors who said they were bears, and measured how many standard deviations from the average was the sentiment of the bear. If bad sentiment indicates good stock performance in the future, our index should be an inverse correlation with future S&P 500 returns. But the data showed no significant relationship (the scatter plot is twice a year since July 1987):
A lean relationship is not shocking. Sometimes, like in 2008, the sentiment was bad because the market conditions were actually really, really bad. Still, maybe we just do not cut the data correctly.
The Unhedged readership thought about it more. One reader in a European family office recently dismantled the bull / bear sentiment into four quarters, from the most bear to the most bull, and looked at how each category matched the S&P 500 yields six months down the road. He found that bad sentiment heralded higher-than-average returns – but only for the most bearish quarter. In other words, only when investors are at the peak of their minds, should we expect a sentiment-driven return.
This is consistent with the work done by Pak Manela Ali, a professor of finance at the University of Sussex Business School, written to share recently Newspaper. He and two co-authors created sentiment data from the stock investment service StockTwits and examined the correlation to the returns of the Dow Jones average. They conclude:
Predictive effects of sentiment. . . Show that sentiment is a strong negative predictor of bottom-up returns [return] quantiles only, which implies that sentiment mainly affects the valuation of assets in turbulent times.
Crash line: Wait until investors are not only scared, but so scared, before you become greedy. (Ethan Wu)
One good read
The NFT market is Collapses.
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Margins look peaky | Financial Times Source link Margins look peaky | Financial Times