Takeaway: Tops are processes & “late-cycle” is not some discrete peak on a Macro sine curve. Move while the music plays but don't be willfully blind.
A CENTURY OF CYCLES: In our 2Q15 Macro Themes presentation we profiled the historical economic cycles of the last century, catalogued a selection of late-cycle indicators and contextualized the current expansion within the historical experience.
Canonical Macro cycles, left to themselves (i.e. with central banks following a largely passive policy reaction function), follow a pattern that largely resembles the circular, counter-clockwise flow captured in the inflation-output loop depicted in the chart below.
Conventional monetary policy is designed to function within the context of this naturally evolving cycle. The broader goal of current policy efforts is to both jump-start and (perhaps discordantly) smooth such a cycle in the face of persistent cyclical challenges and sectoral/secular shiftings.
“PATIENCE” - TOPS ARE PROCESSES: The halcyonic days of the late-cycle invariably birth discussion about whether it is, in fact, different this time, whether the economic cycle actually matters to stocks over protracted, investible periods of time and whether great central-bank catalyzed volatility moderations can matriculate into perma-profiteering opportunities.
The “It’s different” tag-line holds credence to the extent it refers to using the temporal pattern of typical business cycle oscillations as the appropriate anolog for the current expansion. Indeed, a defining characteristic of financial/balance sheet crises is the muted and crawling pace of the subsequent recovery. ‘Lower in Amplitude and Longer in Period’ is the periodic function speak we’ve used to describe the likely macro path over the last 2 years.
As it stands, we’re now 73-months into the current expansion – which compares to a mean of ~60 over both the last century and post-war era. What’s worth re-remembering is the fact that, on average, it takes between 6.5 and 8 years to reach pre-crisis levels of income following a financial crisis. In the current cycle - real per capita income in the U.S. reached pre-crisis levels at the end of 2013, so just about 6 years from the onset of the recession.
So, even with unprecedented intervention and global policy coordination we still fell basically right on the average. This time, in fact, was not particularly different.
PROFITS PAST-PEAK? As Keith referenced in an institutional highlight yesterday - during the 2000 and 2007 economic (and profit cycle) slow-downs, Wall St ramped M&A/IPO/Buyback activity to levels never seen before. I.e. the ramp in “everything is different” was happening to offset the cyclical slowdowns.
Corporate Profits peak mid-to-late cycle and the last few quarters of data suggest we’re probably past peak in the current cycle. Past peak profitability in combination with companies facing prospective acceleration in wage inflation, a continued dearth in aggregate global demand and the ongoing secular retreat in the worlds core consumption demographic of 35-54 year olds is not a factor cocktail supportive of a step function rise in capex.
VALUATION IS NOT A CATALYST…BUT IT IS A DECENT HARBINGER:
Valuation is not a catalyst and investor’s maintain varying proclivities for particular multiples and conceptual valuation frameworks. There is good debate to be had regarding the superiority or shortcoming of different multiples but there is a more general point to be made about current levels of valuation.
Looking across the selection of metrics below, broadly, current valuations are richer than pretty much at any point except the nose bleed tech bubble highs. Lower neutral policy rates and perma central bank interventionism may indeed be supportive of higher mean valuations but that only modestly dilutes the conclusion. When valuations are in the top decile of LT historical averages, subsequent returns over medium and longer-term periods are just not that compelling.
Solving for what drives prices higher as profits flag is trivial. But if you’re going to be paying near-peak multiples on peak margins as margins appear to be past peak and the expansion enters its twilight, you should at least be aware that that’s what you are doing.
Tops are processes and “late-cycle” is not some discrete peak on a Macro sine curve. We’re continuing to move tactically while the music plays but we won’t be willfully blind to the #LateCycle reality of it all.
Christian B. Drake
On Fox Business' Mornings with Maria today, Hedgeye CEO Keith McCullough discussed the U.S. economy, stagnant wage growth and how to rekindle economic growth with Laffer Associates Chairman and economist Art Laffer, host Maria Bartiromo and FBN's Sandra Smith.
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Today we are announcing the removal of NDLS from our SHORT LIST, at this point we believe the stock has been beat to the floor. We originally added it to our Investing Ideas list as a short on 2/18/15, and as you see in the chart below it was a great time to get in short. Since our call the stock price has traded down 44.2% falling from $26.56 to $14.81. The valuation of this company is very much in line with where we think it is worth and we do not believe there is much more room to go lower, EV/ NTM EBITDA is down 33.8% from our call to 9.24x.
Our original reasons for shorting the stock still hold true, but for the most part are now priced into the valuation:
- Cost of sales inflation: management is only estimating 2% food inflation, but durum wheat prices are under pressure and food cost estimates could head higher as we move into the back half of the year
- Geographic concentration: the company has a notable number of stores in the DC metro area, which is an extremely competitive market
- Rising labor costs: 52% of company operated restaurants are in markets that are facing minimum wage increases in 2015 or 2016 (or both), the majority of which are coming this year
- The Affordable Care Act: will add about 30-50 bps of pressure on margins in 2H15
Please note the changes made to our Restaurants Investing Ideas List below. In addition to our update on NDLS, MCD has been elevated to our LONG LIST (previously reported), WEN dropped to our LONG BENCH (previously reported) and BOJA added to our SHORT BENCH (new).
During this brief excerpt from today's edition of The Macro Show, Hedgeye Financials Sector Head Josh Steiner goes deep into the weeds on the single biggest risk facing U.S. equities right now.
Hedgeye's Internet & Media Team hosted an update call to our SHORT Yelp (YELP) Best Idea. YELP's business model is unsustainable and is already breaking down. Further, a new major red flag has emerged, which we believe is what prompted YELP to shop itself. However, we don’t believe YELP will find a buyer.
We updated our bearish thesis and explained why we see an additional 35%+ downside from here.
KEY TOPICS INCLUDED
- Extreme Attrition Rate: Overwhelming majority of customers are churning off annually.
- Insufficient TAM: YP.com is not the low-hanging fruit, it's a pipe dream.
- New Major Red Flag: The story is going to turn much sooner, and get much uglier, than we initially expected
- Is There a Buyer? Assessing the M&A landscape in terms of both ability and willingness of potential suitors
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