SUSTAINABILITY OF HIGH MARGINS (CHECKLIST)

A significant part of the current bear thesis rests on the shoulders of supposedly "unsustainable profit margins". You have to seek truth in the opposite opinion (my view is that SPY should be around 1,000 rather than where it is at the moment) and I find that arguments in favor of high margins are quite hard to challenge. I decided to make a checklist and revisit it periodically to see if "argument" still sounds realistic. So, is it different this time?

==> US exported lower returning businesses (e.g. manufacturing) to other countries and kept the best pieces locally (pharmaceuticals, tech) (Mason Hawkins of Southeastern Asset Management - Link) = inflation of labor abroad is sending manufacturing jobs back (probably in yet irrelevant quantities);

==> accounting (minority stakes report just profits and no sales) (same source as above) = sounds logical;

==> effective tax rates are lower (probably partially explained by the above points) (David Bianco of Deutsche Bank - Link) = budgets are unbalanced, tax rates may go up, including foreign tax rates;

==> foreign sales and profits are higher (same source as above) = I do not know how he constructed the chart but as I understand, he is saying that the world is different outside of US; it could be simply a function of dollar depreciation;

==> interest rates are lower (same source as above) = this is clearly mean reverting.

This Link dated April 2012 gives a good illustration of how people tend to extrapolate.

I presented my views in the beginning but I want to stress that I am not pretend to anyhow time the market. I am just more cautious these days but an example of PCS shows that the crowd sometimes moves pretty fast in any environment.

I would be grateful for additional points to the checklist.

READING RECOMMENDATIONS (ii)

I wanted to document a few good reads.

First, I reread a few times a few weeks old John Mauldin’s Outside the Box with Dr. Lacy Hunt of Hoisington Investment Management. If you are going to read a single piece on macro this year this one qualifies quite well. It is a very powerful reminder on where we currently stand – protracted deleveraging; and on the trend direction of treasury rates – down. Consumers are spending their savings and are taking more debt – this does not spell well on growth prospects. There are plenty of graphs and non-noise insights.

Second, I recommend always reading Jeremy Grantham’s quarterly missives. His latest one resonates well with my thinking about individual investor’s edge – it is simply absent, at least in terms of thinking of a professional investment manager.

A few interesting thoughts from the letter: 

“You don’t have to be a PhD mathematician to work out that if the average Chinese and Indian were to catch up with (the theoretically moving target of) the average American, then our planet’s goose is cooked, along with most other things.” 

“…: there have been several recent decades in which the BTU equivalent price of natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term.” 

Jeremy Grantham made an interesting twist on S&P fair market value. He is saying that top quality quarter of S&P is fairly priced (5.5% real annual returns for next 7 years), while the poor quality 75% is moderately overpriced and will deliver negative returns over the next 7 years. At current price GMO projects 1% real annual return for S&P 500 for the next 7 years.

I believe that he still thinks that FMV of S&P should be close to 950 – 1,000. Therefore, S&P at 1,370 clearly warrants a fully hedged position. I think that IWO (Russell 2000 Growth) could be the most convenient hedge – it is volatile and @ 93 has only 0.65% yield (if you have no time to identify the most mispriced poor quality stocks).

Interestingly, J. Grantham and L. Hunt views differ on long duration treasury rates. The first believes that long duration bonds is almost the most risky investment at the moment. The second projects that 30Y Bond will go down to 2% (now ~3.1%). Maybe they do not contradict each other because interest rates may go down first before jumping up.