Don’t fall for the “Late cycle” narrative

“Late cycle” is one of the most frequently used terms in financial media for describing the current state of equity markets, the overall economy and the imminent likelihood of recession. While “late cycle” is a term that invokes credibility and financial acumen of those who use it, it also reflects some behavioral biases that can lead to poor investment decisions. Behavioral biases are concepts that seek to explain why investors make decisions that don’t always follow the most likely economically advantageous path and are also part of a branch of economics known as Behavioral Finance.

In this case, “late cycle” represents a familiar and credible term that has an established place in financial jargon from work done by the National Bureau of Economic Research who also officially determines when recessions begin, end and thus measures the length of business cycles. According to NBER data, since World War II, the average business cycle has lasted about 6 years. It’s this 6-year assumption that permeates through financial analysis and has taken on significant meaning with investors primarily from its prevalent use in financial media. Because the 6-year time frame rests so well in investor’s minds, it’s easy for it to be given a greater probability of success than it deserves and can sway investment views towards an irrational outcome. In behavioral finance terms, this is called conservatism bias and it’s a situation in which investors hold on to prior beliefs and fail to change those beliefs when new information has been presented. This bias can also result in investors tending to overestimate unlikely events while underestimating the likely ones. So, while the “late cycle” assumption gets more attention and seems to make a plausible argument as to why a recession (the unlikely event) is imminent, it’s actually a continued expansion (the likely event) that is justified by the current economic data.

Before getting to the economic data that supports a continued expansion, we can look at the NBER data itself and take issue with the 6-year cycle assumption. The period that the assumption is based on is a time in which the economy also made a significant transition from a manufacturing and exports base to a services and consumption base. This transition has allowed for expansions to be more sustainable as internally driven consumption is less susceptible to exogenous economic shocks and makes for longer cycles. That said, if we group the existing NBER cycles to reflect this transition, a transition which is also supported by the dramatic growth in services employment, we can see how the average business cycle is significantly lengthened.

NBER 5.29.17


Man vs PBS 5.29.17

Adjusting for the transition to a services based economy, business cycle length has more than doubled and is set to get even longer as the economy becomes more services and consumption based. The key takeaway here and the best way to manage behavioral biases is to stay focused on the actual data. It’s the data that determines when a recession happens, not the calendar.

Moving on to the current economic data that supports a continued expansion, we have employment and business activity at the forefront. While economists throughout the street debate whether we are at full employment or not (my view is that we are), the fact remains that unemployment remains historically low. Weekly unemployment claims, which are an excellent proxy for the abundance or lack of cyclical work, are down at levels not seen since the 1970’s. When businesses that are most susceptible to economic slowdowns begin to experience a drop in business and let employees go, it is seen almost immediately in unemployment claims data. This is because unemployment benefits are a lifeline for people who work in these cyclical industries and are claimed as needed. An important aspect of claims data is that it is hard data which is based on the actual number of people needing assistance unlike the survey based data that drives most other labor market metrics and are susceptible to statistical errors. That said, as shown in the chart below, there has been no significant prolonged uptick in unemployment claims this cycle.

claims 5.30.17

In an effort to try and project where unemployment claims might be headed, we can look at them in the context of job opportunities that are available as presented in the Job Openings and Labor Turnover Survey (JOLTS). JOLTS is also known to be one of Fed Chair Yellen’s favorite labor market metrics so it certainly warrants attention. By plotting job openings against claims data, we can see how the two series have fed off each other in past cycles and how record high job opening amounts are allowing claims to keep grinding lower.

Jolt claims 5.29.17


When we truly are late in the cycle and business is softening, I would expect to see a collapse in the spread between the two series as has happened in previous recessions. As the chart shows, there is quite a bit of territory to cover before the two series reverse.

At this point in the expansion, when labor market health is not a concern, business activity takes on added importance. It’s healthy business activity that supports employment and in turn the expansion, so it’s something that needs to be monitored closely. For a services based economy like the U.S., the Institute for Supply Management (ISM) provides the best metrics of services industries in its Non-Manufacturing ISM® Report On Business® survey (NMI). ISM has been collecting services data since 1997 and has a robust data set to use for gauging the strength of services business activity.

NMI averages 5.31.17


As can be seen in the table, 2017 activity is outperforming its lifetime average and a comparable expansionary / bull market period in 3 of the 4 NMI components with the laggard being supplier delivery times. Supplier delivery times is also a questionable component at this point because of the advances in shipping logistics that has sped up supply-chain processes but is nevertheless still a component of the NMI.

Not only do we have strength in services, but the manufacturing side of the economy has also picked up in 2017. In fact, manufacturing activity in the U.S. and in Europe has picked up significantly in 2017 as seen in the Markit Manufacturing PMI data which shows that both regions are well in expansionary territory. The most recent May readings had the Eurozone Flash Manufacturing PMI at 58.4, a six year high, while the U.S. came in at 52.5, much improved from May 2016’s reading of 50.5. As the data is showing, the economy is on solid ground and not teetering on the brink of recession as the “late cycle” thesis implies.

All this is not to say that the data which I have cited here can’t be interpreted as reaching an exhausted stage or as topping out which would be a characteristic of a “late cycle” scenario. It clearly can be. However, when we take all the data in the context of the Trump administration and its significant pivot towards business-friendly policies, a foundation has been laid for future economic expansion. Also, the comparison of the current environment to the 1997-2000 period which ended in the bursting of the infamous tech bubble could certainly be interpreted as ominous. Except, this time around, we are not discussing cash burn rates of various companies because firms today are actually making money, and lots of it, in certain cases. Putting all this together, I would say it’s more likely that this “late cycle” narrative ends up being a virtuous cycle for several years to come.





Darden Excels by Keeping It Simple

Originally published on on 4.12.17

A Darden earnings model is available upon request, just send an email to:


Keeping things simple is typically one of the best and most consistent ways to make money in business, and Darden Restaurants (DRI) has figured out how to do just that while still serving up large portions of high-quality earnings.

DRI reported fantastic third-quarter earnings recently that beat on both the top and bottom lines while the company also raised its guidance for 2018 (DRI’s fiscal year ends in May). The company also announced an acquisition of Cheddar’s Scratch Kitchen for $780 million in cash, which is expected to add to earnings per share in 2018 with those additional earnings doubling in 2019. The transaction will be financed with a combination of DRI’s existing cash of $391 million, its existing credit facility and possibly new debt.

Regardless of the sources of financing, thanks to DRI’s low existing debt, the new financing will leave DRI well within management’s desired leverage position. Since the 2014 divestiture of Red Lobster and the recently completed real estate transaction (DRI converted 424 properties to a REIT and received the proceeds) that allowed DRI to pay down a significant amount of debt, the company has become a lean and well-financed portfolio of brands that are leaders in the casual and fine-dining space. In fact, in the third-quarter earnings conference call, CEO Gene Lee emphasized how committed DRI is to simplifying its business through its decentralized platform that allows the brand presidents to stay focused on their respective businesses. The brands can then use Darden’s size and resources as leverage with suppliers and to better manage each brand’s human capital.

While DRI management is focused on delivering great service and value to its customers, I’d like to look at how DRI is delivering value to its shareholders through its excellent financial position and growing revenues.

Main Course

When looking at a business, people often focus on typical return measures like return on equity (ROE), return on assets (ROA) and multiples based ratios like price to earnings, which can all tell you something informative about the business but also have drawbacks in their constructs. For example, P/E ratios tend to be lower for companies with higher debt-to-equity ratios since more debt means less earnings are available to equity holders, but the business could still be well run and creating value.

Then we have ROE and ROA metrics, which include significantly sized non-operating items like pension assets and equity interests in other companies, which don’t help with the day-to-day revenue generation of the core business. Also, net income, the numerator in ROE and ROA, is usually not adjusted for one-off items that aren’t indicative of the underlying business, which causes the ratios to give a misleading view of the core business.

For those reasons, a properly constructed return on invested capital (ROIC) becomes such an important metric. ROIC is designed to focus on the core aspects of the underlying business and the value it generates. Then, ROIC can be measured against a company’s cost of capital to show just how much value a business is really generating.

Without getting too heavily into the accounting involved in calculating ROIC, just understand that the goal is to have a numerator (return) and a denominator (invested capital) that are both derived from the core operations of the business. In the table below, I have calculated the ROIC for DRI and its main competitors. Along with ROIC, there is each company’s weighted average cost of capital (WACC), invested capital (investments needed to run the core business) and the economic profit (a cash flow metric that combines a company’s size with its ability to earn a return above the cost of generating that return).

Darden Restaurants: Return on Invested Capital
ROIC 3.31.17

The table also looks at ROIC without intangibles, which is a way to look at a company without its acquisition history and gives a more accurate picture of the core assets of the business. As you can see, DRI outperforms all but one of its peers in terms of ROIC (2016 w/o), but is clearly the dominant company in terms of actual economic profit generated. The table also presents an excellent exercise in showing how the market treats the differences in the composition of ROIC.

We can see DineEquity (DIN) has a very high ROIC without intangibles, but a declining ROIC with intangibles. This is a result of DIN’s declining operating profits combined with the accounting treatment of its Applebee’s franchise. In short, DIN has complex accounting issues that are being compounded by declining sales, which is why it trades around a trailing 10 P/E versus DRI, which trades around 21 (including the quarter just reported). DRI’s wise “keeping it simple” approach shows in its growing ROIC (especially relative to its peers) and supports its best-of-breed position in the restaurant industry.

This is not to say ROIC is the ultimate metric to be used for company valuations, but when it’s calculated properly and used along with other metrics, it provides excellent insight into how a company is running its business and how the market rewards its overall performance.


The argument against Darden and the restaurant industry in general has been the usual bear case that the consumer is struggling and that people in general are choosing to stay at home more. Given DRI’s excellent earnings and the strong consumer confidence data we have gotten, it’s safe to say consumer health is not an issue. However, there are trends in the marketplace that do show a consumer preference for the stay-at-home experience, which has also been a major theme highlighted by Jim Cramer on Mad Money.

In response to this stay-at-home trend, CEO Lee specifically stated on the third-quarter call that Darden is aware of consumers wanting to drive less and that the company is making an effort to bring the dining experience closer to its customers. Darden can establish this through better-located properties along with enhanced takeout and delivery options, so it does have choices.

The bottom line here is that Darden is adapting to customer trends, as can be seen in its above-industry sales growth. I suspect that as the economy continues to do well, Darden will be eating its competitors’ lunches while investors continue to dine on its excellent earnings.

Darden Restaurants…Get long America!

In celebration of Darden’s great earnings today and the stock being up 5% , I thought I’d repost this…Originally written in April…To reiterate things..I am still very much bullish the economy and the market. Yesterdays ISM manufacturing data supports the rebound from the August slowdown. 10/4/2016


This article was submitted for the Sohn Conference investment idea contest on April 22,2016. It was not selected as a finalist. The first half contains some of my earlier services work while the second half focuses on Darden Restaurants (DRI). I will be putting out more work on DRI and other names in the future. To be clear, this was written prior to the strong ISM NMI (services) data released on May 4,2016. #Sohn2016



Before looking at DRI, I feel it’s important to analyze the current economic backdrop and how it plays into the success of DRI. My thesis for DRI being undervalued is based on the belief that the long term strength of the consumer and the economy in general has been underestimated by the investment community. This underestimation is a function of many investor’s conservatism bias towards recognizing and accepting the strength of a services based economy. In short, conservatism bias is a term used in behavioral finance which describes why people cling to prior views and fail to update those views when presented with new information. This failure is mostly driven by the mental discomfort, or cognitive dissonance, that comes with processing new information that conflicts with an existing belief. Then compounding this bias, we have financial media constantly associating services based employment with that of “burger flippers” or low skilled and low paid positions. This association, quite frankly, is not only derogatory to a whole group of people that work very hard, but it’s also untrue. Most people don’t realize that the services jobs spectrum includes computer hardware designers, programmers, electrical and mechanical engineers, medical professionals, scientists, accountants, lawyers, architects, advertising agents, commercial drivers, CEOs, custodial arts professionals and even those very special folks that toil in financial markets. Not only are services jobs primarily high-skilled positions, they also have high earnings. Using data from the most recent nonfarm payrolls report, the table below shows how many people are employed in various goods producing and services sectors, and how much in earnings they generate.

total earnings 4.16.16


Much to the chagrin of those in financial media, you can see that four of the top five earning industries are all in the services sector and do not include the leisure and hospitality industry.

The U.S. economy used to be a manufacturing and exporting powerhouse, which is what many people still think the economy is about today. In reality, the economy has been transitioning from a manufacturing/export base to a services/consumption base since the mid 1900’s. This transition has had significant effects not only on the composition of the workforce, but also on business cycle length. Because a services/consumption based economy is highly self-sustaining and less susceptible to exogenous shocks, the length of the average business cycle has increased. In the table below, I have adjusted NBER business cycles to include the transition from a manufacturing/exports based economy to a services/consumption based one.

Biz Cycles 3.26.16.jpg

The current expansion is in its 83rd month, and I would argue we have more than a year to go.

In addition to having a longer business cycle, the services based economy also has a labor force that is more resilient to recessions and is able to recover more quickly from them as the charts below demonstrate. In the charts, I have drawn a comparison betweenManufacturing, Professional and business services (PBS) and Total private employment. All three data series are titled and defined by The Bureau of Labor Statistics which is the source of all data used in the charts. I chose PBS because it best represents a broad range of service industries. The charts include every recession that has occurred since 1945 as defined by the NBER. 1945 is the earliest starting point for which data was available for all three series.

The first chart shows the average number of jobs lost on a monthly basis as a percentage of its total industry. For example, in the recession of 2001, manufacturing lost an average of .81% of its workforce on a monthly basis while PBS lost just .43%. Then in the Great Recession, they lost .83% and .47% respectively.

recession 3.27.16


As you can see, PBS has been more resilient to downturns than manufacturing.

The second chart shows the monthly average number of jobs recovered (or decline in job loss) in the first six months after a recession has ended.

postrecession 3.27.16


The takeaway from these charts is that PBS has outperformed manufacturing in terms of losing fewer jobs during a recession and then recovering them more quickly after a recession. This outperformance is a function of the self-sustaining nature of services labor and suggests that a longer than average expansionary cycle is possible. It is these changes in the nature of the economy and the labor force that I believe will keep this expansion alive and take equities along with it. It’s a bull market!

Now that I’ve covered my reasons for believing why the economy will continue to provide a bullish atmosphere for equities in general, let’s take a look at DRI. Darden Restaurants is the largest full service restaurant chain in America with 1,534 domestic locations and just 39 restaurants internationally. DRI finds itself in a great position to capture consumer discretionary dollars because of its excellent brand reputation and the wide spectrum of consumers that it appeals to. Unlike typical retailers that target a specific demographic, DRI has restaurants that appeal to all income levels and provides a range of atmospheres. The table below demonstrates the brand diversification that is offered to customers:

dri menu 4.19.16



DRI restaurants themselves are often situated in the main social structure of the locality they serve. These prime locations are what allows DRI to capture maximum consumer dollars during cycle upswings, but also allows DRI to capture dollars in a downturn by being part of the focal point of the community. The fact is, even in bad times, people still find a way to go out to eat and DRI will be there.

The greatest challenges that DRI faces come from managing its food and labor costs. While food costs can be extremely volatile, DRI is able to manage its suppliers by leveraging its significant scale. DRI has become a Walmart of the restaurant industry in its ability to manage costs through its dominant position over suppliers. As for labor, costs have risen as the economy has strengthened. To address this, in 2014 / 2015, DRI reviewed its operating structure and reduced its workforce for which it did incur termination expenses but has made the organization more long-term efficient. This leads us to the first aspect of “disruptive” technology that DRI may be able to take advantage of. Technology is currently being developed that could revolutionize labor intensive kitchen processes such as food preparation, basic cooking and cleaning. Spyce Kitchens, for example, is a company formed by MIT students which has made an entirely robotic kitchen service. Once this kind of technology is fully proven and brought up to scale, it could be an absolute windfall for DRI. Labor is roughly 30% of COGS, so just a 20% drop in labor costs would give a 50% increase to operating income. A reduction in labor costs will also allow DRI to redirect capital towards dining experience enhancing projects, thus making them that much more appealing to consumers in the long-term.

In terms of its finances, DRI is an investment grade credit with a fairly transparent balance sheet. Its long term debt is rated BBB- by S&P and Ba1 by Moody’s. While this is just barely IG, I would expect upgrades in the future as DRI has significantly reduced its leverage and continues to generate strong free cash flow. During the second and third quarters of fiscal 2016, DRI retired $1.01 billion of loans and notes, leaving just $450 million outstanding of long-term debt with overall leverage at just .5x on TTM EBITDA. The debt retirement was funded by the sale-leaseback of 64 restaurant properties and its corporate headquarters. After the sale-leasebacks, DRI still has significant real estate assets that can be used for future financing needs. The one issue on the B/S that there is, is the $1.44 billion in goodwill and trademarks that could be a problem should they incur an aggressive write down. That said, given that DRI has significant assets and minimal debt, tapping capital markets for future financing should not be an issue. This brings me to the second “disruptive” aspect of DRI which is that it operates in a nearly “disruptor” proof business. Given that the dining out experience is essentially irreplaceable and a timeless one, DRI future cash flows can be counted on. Obviously DRI’s business is still subject to normal competition, at least the risk of being “disrupted” can be almost entirely eliminated. In today’s technology driven and “disruptable” environment, the safety that DRI offers is sure to command a premium in its valuation.

While the food services industry has a history of being volatile and highly susceptible to the business cycle, I feel that DRI has built a business that will be able to rise above these risks and come out ahead. In conclusion, I think the economy is in good shape and has reached a critical mass where the expansion can keep going until we inevitably run into some kind of turbulence. That said, a great way to take advantage of this expansion is to get long DRI and in general, get long America!


(See below for ratios)

Ratios 4.21.61


A time for caution and enthusiasm

**first published on 7.25.16**


The S&P 500 closed Friday at 2175.03, a new, all-time high close. Even though it was a low-volume summer day, there is still much to learn from it — and all of last week’s market action.

With a market that keeps pushing to new highs without a decent pullback, there is as much cause for concern as there is for enthusiasm. As bullish as I am about the market — and the U.S. economy in general — I would be remiss in my duties as an analyst to not sound a note of caution here. As the saying goes, no one ever went broke taking profits.

With that said, I still believe that markets will trade higher from here, but there will be a period of consolidation. This consolidation will be a healthy respite that allows the major indices to form a technical base for the next move higher. The market has had a great run since the February lows, and the pieces are in place for another run higher, but it won’t be a straight line up.

Last week’s market action was encouraging — in part because we finished at an all-time high, but more because of how equities reacted to external factors. Even with the macro uncertainties of the Turkey coup and a near 5% drop in oil for the week, equities managed to trade off of the positive earnings and economic news we received in the U.S.

So far this earnings season, we have had great reports from significant names across a wide range of industries. One company that reported excellent earnings last week, which did not receive enough attention was Cintas Corporation (CTAS) . Cintas is a service provider to the services and manufacturing industries. Its primary business unit provides uniform rentals and facilities services to automotive, health care, education, food services and gaming businesses, amongst others. Facility services include the cleaning and upkeep of properties, air ventilation maintenance and providing towels and safety mats for shops and restaurants.

Cintas just reported fourth-quarter earnings, which completed a record year in terms of revenue and earnings per share and also raised its guidance for next year. Fiscal 2016 sales were up 9.6% from 2015 while net income was up 15.1%. With 2017 revenue expected to grow at least 5% and a current market cap of $11.2 billion, we are looking at a large-cap name with solid growth prospects. The key takeaway from Cintas’ strong performance is that it is a direct reflection of the health of the U.S. business environment.

On the economics front last week, we had the most-comprehensive housing market data point there is: existing home sales (EHS). As the National Association of Realtors note, EHS account for roughly 90% of total home sales, and are currently on their best annual pace since February 2007.

This is significant, because of the drastic difference in lending standards between pre- and post-housing-crisis lending. Before the housing crisis, lending standards were very lax and sometimes almost nonexistent for some borrowers. These irresponsible lending standards led to a sharp increase in home sales — and ultimately the collapse of the housing market.

Today’s lending standards are very stringent, which makes the high level of home sales that much more impressive. Now we actually have a housing market that is based on qualified borrowers, and is thus sustainable. Our housing market is running on both a high quality and quantity of transactions. Strong EHS data is also another reflection of the health of the U.S. economy — and further justification for this bull market to keep going.

Now we head into one of the most important weeks for earnings data. We are getting reports from tech and retail heavyweights like Apple (AAPL) , Facebook (FB) , Alphabet(GOOGL) and Amazon (AMZN) , among a whole slew of industrial and health care names.

For Apple, market consensus seems to be expecting bad news stemming from slowing device sales. We could certainly see that, but I’m expecting to see a pickup in their services-based revenue, which help makeup the “Apple ecosystem,” to offset that decline. In general, the market is pretty much priced for perfection, so any slight miss from some big names will probably give us the consolidation period we are looking for. There is also plenty of economic data to look forward to this week, with the FOMC meeting, ending on Wednesday, getting the most attention.

While a rate hike is warranted when looking at how the economy stands, it’s a rather unlikely possibility. With that said, let’s see what Mr. Market brings us this week.

Consumers at it again..

“Man is a perpetually wanting animal” is a quote from the seminal work A Theory of Human Motivation by the famous behavioral psychologist A.H. Maslow in which he succinctly captures and predicts consumer behavior. It is this perpetual wanting which also defies many economists’ fears of a deflationary scenario where consumers hold off purchases in hopes of lower prices. The fact is, if people have the ability to consume, we will. This allows us to see consumption as mostly a function of ability (employment) because the motivation to consume is already there. Using Friday’s healthy retail sales print as a starting point, we can see that consumption has increased as the economy and labor market have strengthened even as some goods prices have declined. For example, in the last cycle, real retail sales grew 9.8% from trough to peak. Whereas in the current cycle, real retail sales are up 20.5% and still climbing from the trough. Factoring in the significant price declines in commodity prices and some consumer items like electronic goods, the large rise in sales shows that overall consumption is meaningfully higher.

biz cycle 7.17.16

Even using an apple to apple comparison and keeping the cycles at the same length or using the same 2001 trough would yield a 17-19% gain for the current cycle. So you can see how robust this cycle really is. Supporting this increase in consumption has been a tighter labor market as evidenced by declining weekly claims data throughout both periods. Claims are currently sitting at an all-time low when you factor in the growth of the labor force.

claims 7.17.16

Looking at the above claims chart, it’s very difficult to say that we are in recession or even nearing one as many in financial media seem to think we are. We would need to see claims levels rise nearly 60% to the 400,000 area for the recession alarms to go off. The good news is that we can watch this on a weekly basis and adjust our thinking accordingly.

The true driving force behind employment and thus consumption is obviously business activity. For a services based economy like the U.S., the Ism® Non-Manufacturing Survey (NMI) is the best gauge we have. The most recent report for June came in at a solid 56.5 up 3.6 points from its last reading. Within the NMI, the business activity index was up to a high 59.5 while the new orders component was even better at 59.9. These are both very healthy levels and should help to bring up the employment index going forward as well.

ism 7.17.16

Looking at the NMI in context of claims and retail sales data, it’s safe to say that we have an economy that is steadily moving along. Adding in the better-than-expected results for Industrial Production and Capacity Utilization which we got last week, we can see the previously lagging manufacturing sector starting to catch up. While manufacturing represents a small part of the economy, it will still be welcomed assistance for the consumer and services sectors.

As we head into the week, we have a lot of earnings reports and economic data points to look forward to. Monday morning, we have Bank of America and IBM reporting earnings. Both have had their woes but also may have turned a corner. So far JP Morgan and Citigroup have posted strong quarters so BAC shouldn’t be too far behind. There will be plenty more technology, industrial and consumer names reporting to fill out the rest of the week. On the economic front, we have several housing market data points and some manufacturing data as well. Unfortunately, we have a new macro situation in the form of the Turkey coup which will add extra volatility in the days to come. However, as of this writing Sunday night, the futures have just opened and the S&P’s are up 6 points from the close, which pretty much says the real turkeys are the folks that were selling everything at 4:45pm on Friday when the Turkey news broke. Well, let’s see what this week brings!

Live and learn

“Live and learn” is one of those succinct yet incredibly meaningful sayings that we often hear but don’t pay enough attention to. This past week in markets was certainly one of those times that we all could learn a lot from. In fact, if last Friday after the Brexit referendum vote, someone had told me that the S&P 500 would close over 2100 the following Friday, I would have questioned their sanity in a rather colorful way. As it turns out, it’s my sanity that should have been in question as the S&P went on a strong rally starting Tuesday all the way to the close on Friday to finish at 2102. While we didn’t have any official Brexit news from the EU or the U.K. to justify the rally, we did get a vote of confidence of sorts from the FX and equity markets. The GBP was able to regain its footing and stay flat against the dollar while the Euro managed to gain a little ground. This stability seemed to come from investors taking a more sanguine look at potential Brexit outcomes and their implications. This improved view allowed equities to rally across Europe and in the U.S. with some markets posting their best weekly gains in years. I would attribute some of this improved outlook to the points I touched on in last week’s writing and what other Wall Street analysts pointed out this week about the trade relationships between the U.K. and the rest of the EU (mainly Germany). These relationships are so significant that it behooves all parties to come to a cordial agreement. In terms of the actual Brexit campaign, there have been some changes as well. Since the referendum vote, the remain and pro-EU voices across the U.K. and Europe have become more vocal and made their presence more known. Attesting to this was a march in London this weekend which garnered lots of media attention in support of staying in the EU. If nothing else, the referendum has certainly sent a clear message to EU leadership that changes must be made to strengthen the union for the long term. While Brexit may eventually happen, I have a feeling that it will be a watered down version that allows all sides to save face and will end up being a positive for markets in general.

With the obligatory Brexit analysis out of the way, we can take a look at some good and rather interesting data we got about the U.S. economy this week and the big week coming up. As much in the rear view mirror as it is, the first quarter GDP final revision we got on Tuesday deserves a mention. Q1 GDP was revised up to a final 1.1% from its originally reported .5% on primarily stronger exports. This is significant because improving exports, which were nearly flat in 2015, would be a great addition to our current GDP that is being driven almost entirely by consumption. Building on Q1 GDP data is the export component of the national Manufacturing ISM® Report On Business® which ticked up a point to a healthy 53.5 as well as being its fourth month in a row of expansion. As it stands now, the overall ISM index which came in at 53.2, its highest since February 2015, would equate to a 3.2% GDP if annualized. Within the ISM index, all the components were in expansionary territory except for inventories which did still rise for the month but remained in contraction. Also of note in the report were the gains in new orders to a very healthy level of 57 and employment which pushed back into expansionary territory to 50.4. That said, I would not try and extrapolate gains in ISM employment to gains in the upcoming nonfarm payroll (NFP) report. We’ve seen enough NFP reports to have learned that it marches to its own drummer. The fact still remains that the U.S. is a services based economy, but the growth in exports are a welcome tailwind for the economy. Should export growth persist, this will certainly add to the top line of S&P industrials / exporters and result in significant earnings growth and greater shareholder wealth thanks to all the stock buybacks done over the last couple years. I think the CFO’s who implemented all these buybacks will be the last ones laughing after having been ridiculed for “manufacturing” earnings throughout this cycle.

Along with the solid ISM report came the Chicago PMI, which is a 60/40 services to manufacturing weighted index, at 56.8 from its previous contractionary level of 49.3. Even though the report is regional, it still gives good insight into a major business hub of the Midwest. The report showed strong growth in new orders and order backlogs with employment being the only component in contraction. Taking the June PMI report in context with the previous couple months of less robust reports, this could be a case of payback along with some outright improvement. We’ll have to wait till next month for confirmation. Still, when looking at this and the ISM report, the economy is in good shape as we head into the second half of the year. It’s important to keep in mind that we are well into this expansionary cycle and that steady levels of activity and employment are what we are looking for.

Heading into next week, we have two significant data points. First up is the services version of the ISM manufacturing report, the Non-Manufacturing ISM® Report On Business® or NMI. The NMI is the best gauge of the services sector available and warrants close attention. Last month’s report came in at 52.9, down from 55.7 which was a bit worrisome. Given what we have seen on the manufacturing side of things and the persistently low unemployment claims data, I am expecting a bounce back in the report. Next up, on Friday we have the almighty nonfarm payroll report. This report has truly become an enigma as of late with its completely unpredictable results. However, as statistically flawed the report may be, it still holds sway over the markets and the Fed. Personally, I’ll be more interested to see what the weekly unemployment claims data have to show on Thursday. So, having lived through and learned from the markets’ behavior last week, we are well prepared to deal with upcoming volatility. The fact is the game hasn’t changed, but it’s our mindset that does need to change. Therefore, stay focused on the actual data and try not to fall into the hysteria that financial media is so good at creating. Otherwise, we haven’t learned a thing.

Brexit, the markets & what to expect

“Brexit will never happen” is what a prominent fund manager told me while we exchanged bullish market views a couple weeks ago at a social gathering. I was a bit surprised at how emphatic the person was about Brexit, but it was understandable. I responded with my favorite behavioral finance quip about investors’ tendency to be overly fearful and risk averse at times when in fact probability favored a rising market. We both chuckled and seemed to have it all figured out. Well, as we all watched events unfold Thursday and into Friday, Brexit did happen and the market did go down. Much to my chagrin, I was faced with the difficult thought of having to reassess my bullish position. But, as investors, this is a painful but necessary exercise if we hope to survive inevitable bear markets. So, the question is, what does Brexit mean? The answer is, no one knows. Could it be the end of the European Union and the beginning of years of financial and political chaos in Europe which would undoubtedly wreak havoc with global markets? Or is it the event that forces the EU to reorganize itself and take serious measures to ensure fairness among its members? Again, the truth is that we simply don’t know yet. What we do know is that financial markets responded swiftly on Friday by knocking down the equity markets of all parties involved and dropping the value of the British Pound a staggering 8% versus the dollar. So while the U.K. has decided to head into the unknown in search of better arrangements and perhaps to find its former self, financial markets have already made some of its future known. And that future is not bright.

It is the financial realities that markets have delivered already that I believe will force the U.K. and EU to come to some sort of amicable agreement. Until the situation fully plays out, all we can do is to take a look at how market reactions may affect the principal participants’ (U.K. and Germany) motives. For the U.K., which is a consumption based economy like the U.S., a depreciating currency is like a tax on its citizens as imports become more expensive. Then, from the Bank of England’s perspective, a rapidly depreciating GBP could theoretically create hyperinflation, a situation in which the BoE would have to aggressively hike rates to thwart capital outflows and inflation. So Friday’s dramatic FX losses against its major trading partners will certainly have everyone’s attention. In terms of trade so far this year, Germany and the U.S. were the U.K.’s top trading partners to which the U.K. is running a 6.4 billion GBP deficit. A deficit that will get more expensive the further the pound drops. Now from Germany’s perspective, in 2015, the U.K. was their third largest export destination behind the U.S. and France. So we can see how it would behoove Germany, the de facto leader of the EU, to keep communications open and friendly with the U.K.

As the realities of the vote start to reveal themselves, it seems there are many in Britain who are experiencing, if you will, a kind of voters’ remorse. For example, Cornwall, a county in the south of England whose economy is based primarily on fishing and agriculture, received roughly 60 million GBP yearly in financial aid from the EU. Prior to the vote, the Leave campaign promised that funding would still be in place post a leave vote one way or another. Now that the vote has happened, Cornwall finds itself looking at a possible interruption of these funds as the transition takes place. It’s all fun and games until the bill comes. All this said, Brexit remains an extremely fluid situation as the idea of a new referendum is already being passed around and gaining momentum. Given the economic realities of what has happened so far, I would expect a softening of rhetoric from the Leave campaign and for the remaining political leaders in the U.K. to work with the EU in making as smooth a transition (if any) as possible to the benefit all parties. Translation: Now that real damage has been done on all sides, cooler heads should prevail and market volatility should subside.

Now moving to situations on this side of the pond, let’s look at a significant data point we got in the midst of all the Brexit hysteria last week, which was weekly unemployment benefits claims. Last Thursday’s initial claims print came in at a very low 259,000 with continuing claims getting close to their cycle low at 2.142 million. While labor market health has been under some scrutiny since last month’s “weak” nonfarm payroll (NFP) print of 38,000, I’m taking issue with both the scrutiny and the “weak” description. Since the labor market has essentially reached full employment and the economy is in a slow but steady growth mode, it is incorrect to expect 200,000 monthly job growth into perpetuity.  An excellent assessment of the “weak” payroll report and the labor market is given here by Stephen Williamson of the St. Louis Federal Reserve Bank. In short, Williamson says the labor market is doing just fine.

What I would like to focus on here is how well the weekly claims data does in capturing the cyclical nature and health of the labor market. Unlike NFP data which is based on statistical sampling, weekly claims data is based on the actual total numbers of people seeking unemployment benefits. While NFP data still does a great job in describing the composition of the labor force, claims data is the most accurate and timely gauge for judging true labor market health. The reason for preferring weekly claims data is that when cyclical industries hit slowdowns and lay people off, those layoffs show up almost immediately in the initial claims data. For people in cyclical and / or high turnover industries like construction, leisure & hospitality, unemployment benefits act as a lifeline until new work can be found. The Bureau of Labor Statistics also put out a report which shows that within initial claims data you have not just cyclically unemployed persons, but also workers who may be intentionally filing claims once they meet minimum work requirements. Depending on how much of the latter group is true, the labor market could be even tighter than the data suggests.

To illustrate how strong today’s labor market is, I have taken the initial claims data series and adjusted it for the size of the labor force. While the labor force has grown over time, the percentage of claimants to the total labor force has been fairly consistent through prior periods of higher labor force growth as is seen in the first two ovals. As we move forward to today, labor force growth has been fairly flat while the claimant number has dropped. This is indicative of a healthy / tight labor market.

IC LF 6.26.16

The key takeaway here is that regardless of nonfarm payroll growth, we know that cyclical industries are keeping people employed and that employment is the backbone to a healthy job market and, in turn, a healthy economy.

A market update would not be complete without a look at some recent services sector data, which we also got last week. On Tuesday, the Federal Reserve Bank of Philadelphia released its Nonmanufacturing Business Outlook Survey for June which is the services version of its highly regarded manufacturing report. Unfortunately, most people missed the release because it was not on the economic calendars of any of the major news sources. This is truly a shame because the report is one of the few metrics provided on the services sector by a regional Fed bank and deserves to be followed. As I’ve written before, services data just doesn’t get the coverage it deserves in financial media. That said, the report showed solid gains in employment and modest growth in sales and new orders, which is in line with our steady economy.

The above is all well and good, but the real issue is where are we headed now? Unfortunately, like back in February when we were tied to oil, we are now tied to Brexit. Given the news over the weekend, it seems that the Leave campaign has bitten off more than it can chew and is scrambling to control an unexpected victory. Already there is enough of a backlash from the Remain campaign that it may be able to thwart an actual Brexit. I think the fact that so many people in England, Northern Ireland and Scotland want to be a part of the EU and believe in a united Europe that it bodes well for the survival of the EU. Ultimately, I believe agreements will be reached and the bull market will continue. Otherwise, I would certainly hate to run into my fund manager friend again and have to share some humble pie.