Macro comments

Even though I dont think you should put your money strictly on macro views without a bottom up analysis of an asset, it is essential to understand the marco picture to assess what scenarios may adversly effect your poisitons and what global events may create value in certain industries or geographies.

There is alot of systemic risk in the global economy given the number of black swans we have seen in the past several months. Currently the market is trading at just over 15x trailing EPS, which in and of itself is not a useful statistic. US corporate profit margins are over 13%, near their highest level in 30 years, and well above the 8.4% average. These margins were brought about by the massive deflation we saw during the great recession. Labour was slashed, the prices of raw goods were decimated, and corporations ceased large capex that would have brought about increased depreciation expense. Capitalism dictates that high margin businesses bring about competition, leading to lower margins in the future. Profit margins are one of the most mean reverting statistics in finance.

How about the other factors affecting margins? Recent events in Libya, QE2, and supply disruptions in Japan have all increased the cost of both raw and processed goods. Both CPI and PPI components are showing well above core comfort levels for policy makers, and with high unemployment the Fed is still unlikely to rein in its liquidity barrage. PPI alone was up 35-40% in the last 6 months. Labour is the only component that has stayed in a deflated state. Combine the continued weakness in the labour market with the "tax" of high oil prices and you have a recipe for weak aggregate household demand. David Rosenberg and others have demonstrated that such large increases in oil prices have always lead to slower economic growth. The reason is simple; oil creates a tax on commercial users and households, while producers such as OPEC tend to save their new-found surplus wealth knowing that price increases may be temporary.

These factors ultimately lead to margin compression, so if there is going to be positive returns on stocks there must be robust sales growth to offset margins and multiples must remain above their long term averages (as they are now) or even expand. John Mauldin points out that if margins revert to historical norms, the PE ratio would be close to 24 at today's prices. The extension for QE2 may be the impetus for multiple expansion given the near perfect correlation between the Fed's balance sheet and asset prices. A long bet on equities means you believe that sales growth will be strong enough to offset margin reversion and multiples will stay at elevated levels, likely through a liquidity induced QE3 program. Sales growth could very well surprise on corporate spending given record cash hoards and ramping capex post recession.

A more likely scenario is that QE2 expires and the effects are observed. Margins compress due to oil price and supply disruptions emanating from Japan, while aggregate household demand feels the pinch of deflated wages and higher commodity prices. The remaining black swans out there are one of the PIIGS biting the bullet and the credit tightening that would ensue, or further oil disruptions stemming from the middle east. The world sure is a scary place, and its often the best time to invest when chaos and confusion rein. However, that is only the case if you are paying the right price for a specific asset, so if I were viewing the market as an asset I would not be going head long into it now.

Warren Buffet has been quoted recently saying that stocks are a screaming buy for those with a 10 year time horizon and deals exist. I certainly agree that specific assets are worth investing in when times get tough. Look at INTC, MSFT, or ORCL. These companies generate boat loads of cash and have considerable brand recognition and competitive advantages. Buffet's recent purchase of Lubrizol still gave him a 10% FCF yield in a company with massive market share. No one in the US wants to start a specialty chemical company anymore, even if they could! I think that the bulls, especially the smart ones like Mr. Buffet, should not make such broad blanket statements like rush out and buy stocks on margin, especially given the short term headwinds. Pick the names you like and the prices you want, and use the upcoming volatility as a buying opportunity.