The U.S. is closed Monday for the Memorial Day holiday. That will give us an extra day to read up on all of the hot debates in the economy and the markets.
Market-watchers will continue to obsess over low volatility and high profit margins, both topics we will discuss shortly.
Economists, on the other hand, will focus on housing data this week. Friday’s new-home sales report was very encouraging. Societe Generale’s Kit Juckes expects more good news will keep coming. “These data will help ease some of the concerns expressed by Fed Chair Yellen before Congress on 7 May that “readings on housing activity – a sector that has been in recovery since 2011 – have remained disappointing so far this year and will bear watching”,” noted Juckes. “These concerns were also expressed in the 29-30 April FOMC minutes.”
Here’s your Monday Scouting Report:
A Terrifying Lack Of Fear: The stock market continues to hit new highs with very little volatility and few notable sell-offs. The CBOE Volatility Index, or VIX, closed on Friday at 11.3, its lowest level since March 2013. And this has people freaked out that complacency will has made us more vulnerable and sensitive to bad news.
Societe Generale’s Andrew Lapthorne notes we’ve seen an unusually low number of 1% down-days and we’ve gone an extraordinarily long period without a 10% correction. “The point of all these figures is to illustrate a potentially risky build up of investor complacency,” said Lapthorne. “The longer equities (and other risk assets) go without a typical period of losses, then the more these assets may be seen as one-way upward plays. Encouraging for new investors who may not have the capacity to absorb normal equity volatility and losses. Downplaying risk serves no one in the long term and we think policy makers should be more vocal about the potential downside.”
Regarding the VIX, Citi’s Tobias Levkovich thinks we should consider history before freaking out about complacency. “Looking back at volatility data reveals that there are much higher probabilities for market gains when the VIX is sitting between 10 and 15 than when it is in the 20-25 range,” said Levkovich during a luncheon earlier this month. Since 1990, a VIX at current levels saw positive returns over 3-month periods 75% of the time, 6-month periods 86% of the time, and 12-month periods 88% of the time.
- U.S. markets will be closed for Memorial Day.
- Durable Goods (Tues): Economists estimate orders fell 0.7% in April following March’s 2.6% jump. Nondefense capital goods orders excluding aircraft — a proxy for business investment — is estimated to have declined by 0.3%. “Boeing orders shifted lower in April following a very strong March,” noted Credit Suisse economists. “This should drive headline orders into negative territory. We expect a 0.5% gain in ex-trans, slower than March’s 2.1%, but still consistent with an improvement in 3-month momentum (see Exhibit 2). The investment components — core capital goods orders and shipments — should get plenty of focus, as equipment capex was a sour spot for the economy in Q1.”
- S&P/Case-Shiller Home Price Index (Tues): Economists estimate prices climbed 0.7% month-over-month in March or 11.8% year-over-year. “Looking ahead, we expect home price appreciation to slow as valuations continued to get stretched,” said BofA Merrill Lynch economists.
- Markit US Services PMI (Tues): This services index registered at 55.0 in April. “May manufacturing measures maintained momentum,” said UBS’s Kevin Cummins.
- Consumer Confidence (Tues): Economists estimate the Conference Board’s index of sentiment climbed to 83.0 in May from 82.3 in April. “The preliminary reading of the University of Michigan consumer sentiment declined in early May,” noted Nomura economists. “However, higher equity prices and lower initial jobless claims this month suggest that consumers might be more optimistic in May.”
- Richmond Fed Manufacturing Activity (Tues): Economists estimate this regional activity index slipped to 4 in May from 7 in April.
- Dallas Fed Manufacturing Index (Tues): Economists estimate this regional activity index declined to 9.0 in May from 11.7 in April.
- GDP (Thurs): Economists estimate Q1 GDP growth was revised down to -0.6% from an earlier estimate of 0.1%. Here’s Goldman Sachs’ Jan Hatzius: “The first-quarter disappointment has resonated among economists and market participants for two reasons. First, it brings to mind the 2011 precedent, and more broadly the repeated downside surprises on growth in recent years. Second, it comes in the wake of the debate around “secular stagnation” that was kicked off by the speech by Lawrence Summers at the November 2013 IMF research conference. If the US economy cannot accelerate to a clearly above-trend pace even after the end of the private and public sector retrenchment at a time when monetary policy and financial conditions still look very supportive, then it is certainly appropriate to ask whether the forces holding the economy back are deeper and more structural in nature. In that sense, it is really ‘showtime for the recovery’ … ”
- Initial Jobless Claims (Thurs): Economists estimate claims fell to 320,000 from 326,000 last week. “Still, first filings over the last three months have averaged 320,000, providing little information about the direction of the labour market,” said Citi’s Peter D’Antonio. “In contrast, the story for beneficiaries has been unambiguously better. We forecast another drop in this figure, which would keep the insured rate at 2.0% for a fourth week. Since the beginning of the year, continuing claims have fallen by more than 200,000 and recent readings point to further improvement in the labour market ahead.”
- Pending Home Sales (Thurs): Economists estimate pending sales climbed 1.0% in April. “We look for pending home sales, which track signed contracts on single-family homes, condos, and co-ops, to rise 2.0% m/m in April to 96.2,” said Barclays’ economists. “Factors in our forecast are MBA applications for purchase, which rose 4.7% on the month, and buyer traffic in the NAHB home index, which rose to 32 in April from 31 in March. Improvement in both inputs is likely driven by better weather, and suggests upward momentum.”
- Personal Income And Spending (Fri): Economists estimate income climbed 0.3% and spending increased by 0.2% in April. “Personal spending surged 0.9% [in March], partially due to the implementation of the Affordable Care Act (ACA), which fuelled health-related spending as enrollees piled into the exchanges,” noted Wells Fargo’s John Silvia. “The weather-related rebound and higher spending on healthcare likely are not sustainable.”
- Chicago Purchasing Managers Index (Fri): Economists estimate this regional PMI fell to 60.0 in May from 63.0 in April. “April showed sharp increases in the employment, new orders, and production sub-components, and the Philadelphia Fed and Empire State indices also showed gains in May,” said Barclays’ economists. “Taken together, these factors suggest that the April rise was backed by solid underlying fundamentals and should favour a strong print in May.”
- Univ. of Michigan Confidence (Fri): Economists estimate the final print of this sentiment index climbed to 82.8 in May from 81.8. “An improving labour market should contribute to improved financial conditions and expectations for consumers,” said BofA Merrill Lynch economists. “Businesses have pointed to increased sales and expectations for continued improvement in business conditions. Unfortunately, weak wage growth, increasing food and gas prices, and a declining saving rate may drag on consumers’ assessments of their respective financial situations. The slow-to-recover housing market is likely still weighing on consumers as well.”
Folks like Deutsche Bank’s David Bianco have argued that profit margins have made a structural move higher. Meanwhile, bears like GMO’s James Montier and John Hussman have argued that margins are doomed to revert to a mean.
In an unexpected twist, the profit margin bulls are now saying we’ve been missing the point. Rather than quibbling over profits as a per cent of sales, we should be considering profits relative to capital (e.g. return on equity, return on assets). After all, this is the primary metric a business considers before making an investment.
“Profits of GDP and net margins are incomplete profit metrics,” said Bianco in a research note on Friday. “Profits should be measured relative to capital employed and both NIPA based ROA and S&P financial statement based ROE measures are consistent with history.””
Jesse Livermore, the pseudonymous author of the brilliant Philosophical Economics blog, explains in a post on Sunday.
The mistake we’re making here is to assume that corporations “compete” for profit margins. They don’t. Profit margins have no value at all. What has value is a return. The decision to expand into the market of a competitor and seek additional return is not a decision driven by the expected profit margin, the expected return relative to the anticipated quantity of sales. Rather, it’s a decision driven instead by the expected ROE, the expected return relative to the amount of capital that will have to be invested, put at risk, in order to earn it.
Suppose that you run a business. There is another business across town similar to your own whose market you could penetrate into. If operations in that market would come at a high profit margin, but a low return on equity — i.e., a low return relative to the amount of capital you would have to invest in order to expand into it — would the venture be worth it? It obviously wouldn’t be worth it, regardless of how high the profit margin happened to be. Conversely, suppose that the return on equity — the return on the amount of capital that you would have to invest in order to expand into the new market — would be high, but the profit margin would be low. Would the venture be worth it? Absolutely. The profit margin would be irrelevant — you wouldn’t care whether it was high or low. What would attract you is the high ROE, the fact that your return would be large relative to the amount of capital you would have to deploy, put at risk, in order to earn it.
This is not to say that the return on capital metrics are high. They’re just not as out of whack as the profit margins we usually hear about.
“Domestic corporations clearly aren’t generating as much profit on their invested capital as a superficial glance at the profit margin would suggest, which sheds doubt on the claim that ‘competitive arbitrage’ is going to dramatically drive down profitability in the coming years,” said Livermore.
For more insight about the middle market, visit mid-marketpulse.com.
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