The Bull’s Case for 2019

Is the bull back? Did he ever leave, or was he just ignored while investors focused on various sources of volatility such as trade wars, rising interest rates and Italian banks? Whatever the case, investors lost sight of all the positive market drivers that have been in place and still support the bull narrative headed into 2019. While prudence demands looking at all risks, it’s focusing on actual earnings and economic data which is the key to navigating stormy markets. Even though spiking Italian bond yields and the possibility of a Euro collapse can be distracting, the fact that the S&P is currently trading at 17.2x 2018 blended operating earnings and just 15.5x 2019 estimates is what should be investors’ focus looking into next year. Given that the Q3 earnings theme was about a strong dollar driven sales headwind being offset by robust business demand, we can see top and bottom line growth gearing up for solid gains as FX risk can be managed in the short term but also reverses itself over the long term. The important point here is that solid business demand is not just reflected in healthy earnings and guidance but also in business activity metrics. The highly regarded ISM Manufacturing and Services surveys have shown a strong expansion all year with October’s data no exception. In fact, ISM research shows that October manufacturing and services data translate to 4.5% and 4.1% respectively annualized GDP growth versus the 3.5% Q3 growth just reported. Then we have the NFIB Small Business Optimism Index which is right near its all-time highs. Small businesses have responded very well to tax reform and deregulation by increasing their hiring and CapEx spend. Even as the “late cycle” narrative has just morphed into an “end of cycle” story, business activity and guidance show that we are still in an expansionary period.

Forming a virtuous cycle with healthy business activity is the strong labor market we currently have. Driving today’s labor market are historically low unemployment claims, record high job openings and a quits rate showing strong employee leverage in attaining better opportunities. It’s all these attributes that support strong consumer confidence and continued consumption.

claims 11.7.18Weekly unemployment claims are a great metric for labor market health thanks to its near real-time frequency and hard data basis. Because claims are often a financial lifeline for cyclical workers and are filed as soon as a job ends, we can look to this series to see any softening of the labor market. Thus far, there are no signs of that. Furthermore, if we look at claims data in the context of job openings (JOLTS), we see that claims can still grind lower and break below the 200K level.

Jolts 11.7.18

The JOLTS data series, one of former Fed chairwoman Yellen’s favorite metrics, does a great job in capturing the liquidity of the labor market. Greater liquidity in this context is defined by the high level of openings and voluntary turnover (quits) we are seeing.

quits 11.7.18

Overall, the data is showing that the labor market can tighten further, wages can still rise, and the economic expansion can continue.

With a solid economic backdrop in place, we can now focus on the actionable part of the situation which is market valuation. While determining any valuation is arguably more art than it is science, investors can still use a historical multiples analysis to get an idea of fair valuation. So, the question becomes what is a comparable period to this market and why?

With technological advancements being the fundamental driver of this economic expansion, it’s easy to draw a comparison to the market / expansion of 1996 – 2000 when the internet came to life, with the major difference today being that companies are actually making money! That said, today’s advancements like fracking, open source software (OSS), smart phones, cloud computing and artificial intelligence have had an even greater impact on today’s economy than what drove the original tech bubble of 2000. Aside from actual earnings, the subtle and powerful differences that make the current expansion so much stronger, sustainable and yet misunderstood are the changes which technology has had on inflation and productivity.

While consumers have enjoyed lower energy prices thanks to fracking and the U.S. going from being the world’s largest consumer of oil to the largest producer, it’s been advancements in information technology that have had the most profound effects. Lower costs of various consumer goods and services thanks to advances in technology and manufacturing processes can be easily seen in retail sales data while the much more permeating effects of technology like OSS remain difficult to measure. OSS is software whose inner workings are made public and can be enhanced by the public with many applications being available for free. OSS is being used for the development of E-commerce platforms, big data projects and many other applications across multiple sectors.  Big data includes the development of artificial intelligence and something near and dear to the investing world, algorithmic trading. Investment banks have groups who use OSS applications like Python to develop trading and various analytical applications. Python, which is free to download and use, is one of the most powerful and easy to use programming languages in existence. Banks are essentially able to create incredibly complex trading algorithms and data management tools which can be used across multiple asset classes for trading and research at a minimal cost. Thus, in the case of investment banks and other corporate users developing applications with Python and other OSS, productivity has been dramatically enhanced at minimum cost. As per the BLS, productivity is measured as the units of output produced per units of input, with input defined as the cost of goods and services used in that input. Which begs the question, what happens to productivity when an input cost is zero? Is it undefined? Granted, there are always some costs associated with something like OSS, but the point here is that with the nearly unlimited potential and scalability of something like OSS, the productivity achieved today is exponentially greater than anything of the past and has been generated at a fraction of the cost. It’s because of technological advances like fracking and OSS that we have not had run-away inflation in many goods and services and why traditional productivity metrics have failed to capture the phenomenon of advancements like OSS. The net effect of these technological advances are structural changes to inflation and productivity which have caused a unique situation of having a strong and sustained economic expansion with subdued inflation and increased productivity. This occurrence has allowed the Fed to not have to act as aggressively as they previously would have at this point in the cycle. So, it really is different this time.

How we view the Fed and inflation are critical in determining whether there will be earnings multiple expansion or contraction going forward. Given that rising rates are an accepted reason for multiple contraction, that can certainly help explain the slight S&P multiple contraction so far this year while actual 2018 S&P operating earnings have risen 27% from 2017. Being that it’s correct to argue that higher rates can contract multiples through a greater discounting of future earnings, it also opens the door to looking at the overall rate sensitivity of equity which is known as equity duration.

Equity duration was presented in work from Leibowitz, Sorenson, et al back in the 1980’s as part of portfolio / risk management work and is still used today. That said, one principal of duration is that as more capital is returned to the investor, the less sensitive an investment will be to changes in interest rates. For example, bonds that have a higher coupon rate will have a lower duration while the opposite can be seen in zero coupon bonds which have significant sensitivity to rate changes. In equities, return of capital comes primarily through dividends and stock buybacks. As we all know, since the financial crisis, stock buybacks have become a staple of corporate actions. Since the crisis, Yardeni Research estimates that S&P 500 shares outstanding have fallen by roughly 8% since their highs in 2010 while the dollar amount of dividends has more than doubled for the same period! With the significant increase in buybacks and dividends, an argument can be made that equity duration has been lowered, thus making equity prices more resilient to a rise in rates. Looking at the rise in rates we’ve had and that we’ve only seen a slight contraction in multiples while equity prices have still managed to hit all-time highs, the idea of a lower duration market is supported.

All this said, what markets and investors are dealing with today is an unprecedented combination of economic growth and technological advances that have changed the traditional business cycle and its metrics. Even without technology, the transition of the economy from a manufacturing / export base to that of a services / consumption one has had the effect of lengthening business cycles as the economy has become more self-sustaining. Now that we have made such significant technological advances, the business cycle, interest rates and their long-term behaviors need to be reassessed.

Taking a potentially less aggressive Fed along with the current economic environment, markets are set up for earnings and multiple growth going forward. A less aggressive Fed will take strength out of the dollar and put developed and emerging markets at ease. We can already see a more dovish Fed taking shape in recent remarks from Fed Chair Powell. Powell has acknowledged the strength of the economy, its great potential and, more importantly, his desire to support the expansion. Investors should take solace in the fact that we have a Fed chief who is taking a very pragmatic approach to monetary policy and will not just dogmatically raise rates as the traditional Fed playbook would dictate. A dovish Fed and a lower duration equity market is a great setup for 2019.

With current S&P operating earnings estimates for 2019 and a 20x multiple which is still 3x less than the average 23x multiple enjoyed throughout 1996-2000, the S&P 500 would trade  at 3,515 or about a 30% gain from today. While this may seem overly bullish given all the “end of cycle” rhetoric going around, it’s not if investors simply listen to what the Fed chair has to say and what the actual data is showing.  Earnings multiple and economic expansion are on deck for 2019 and will get investors’ attention while the “end of cycle” narrative goes into the recycling.


At the time of this posting, the author has the following positions: None

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG

Shakedown City

As we head into what is typically the slowest part of the investment year, we have markets dealing with an unprecedented situation: the US – China trade war. While much of Wall Street is on vacation in August and trading volumes seem to dry up in the summer heat, markets and investors are now being held captive by escalating tariffs and rhetoric out of Washington and Beijing. Combining thin markets, lightning fast algo-driven trading and material information being released as quickly and randomly as a tweet can be tweeted, a perfect storm of market forces has been created. To weather this trade war storm and perhaps even use it to our advantage, one needs to understand how China’s trade policies developed and how they are managed. Fortunately, with just a brief history lesson and a look back at a surreal incident between a small American manufacturer and its Beijing hosts, we can get an excellent preview of how this trade war is likely to unfold.

The crux of the trade war is the US holding China accountable for its intellectual property theft and other aggressive business practices which are clearly considered standard operating procedures throughout public and private organizations in China. These operating procedures are part of a much larger protectionist dynamic of Chinese culture that stems from China having suffered through what is known as the “Century of Humiliation.” The Century refers to the years of 1839 to 1949 when the British and Japanese empires plundered China with Japan specifically carrying out numerous atrocities during World War II. Given these terrible occurrences and the deep social scars they left in Chinese society, it’s understandable why China has taken aggressive approaches to economic development as it re-established itself in the global economy. However, now that China sits atop the world economic order, these practices need to end because they are coming at the expense of its partners.

One area where China’s protectionist policies are well defined and stand out from global standards are in its labor laws. The OECD, a highly regarded and objective international organization, produces an indicator which reviews a country’s hiring / firing policies, their associated costs and then ranks them on a scale from 1 to 3.5, with 3.5 being the most restrictive. As you can see, China’s labor protection policies are essentially the strictest in the world because they are outdone only by Venezuela! To put this in perspective, France (a known labor-friendly country) is roughly twice as restrictive as the US while China is three times that of the US.

OECD Labor Protection



It’s these labor policies and the sense of entitlement they have created that gives us an excellent view into how an escalated trade war could play out. In 2013 an American business executive, Chip Starnes, was literally held hostage for six days by his employees over a labor dispute. Mr. Starnes company, Specialty Medical Supplies, was going through a restructuring and was going to terminate some positions and re-locate others. After severance packages were given to 30 (yes, just 30) terminated employees and others were told they would be relocated, the relocated employees began demanding severance pay as well. It was then that the issue escalated into Starnes being barricaded in company facilities by groups of employees who blocked all the exits. While no physical harm was done, although sleep deprivation tactics were used, Starnes was always allowed to communicate with his family, the US Embassy and his lawyers. Throughout the ordeal, and most troubling, is that local authorities sided with the employees and allowed the situation to continue until a new agreement was signed. As outrageous as this situation would be in any developed country, it’s a perfect example of how the “shakedown” mentality exists in China and is pervasive from high-level government trade policies all the way down through locally run businesses.

Thanks to Starnes shocking ordeal, it’s safe to assume that the civil unrest and reactions to a major corporate restructuring from the likes of Nike, Wal-Mart or GM, who employ 161K, 99K and 58K respectively in China, would be apoplectic compared to what happened with just the handful of employees in the Specialty Medical Supplies case. Then we have a more recent case of civil unrest from a trade war casualty, even though it was censored in Chinese media, but news still got through on Twitter, was when a temporary shutdown of ZTE (a known supplier of technology to China’s weapons industry, not just a telecom firm) idled 75K workers. Numerous tweets were seen that detailed workers’ feelings of frustration with the government’s inability to keep the business running. So, it’s not surprising that a deal with the Trump administration was quickly reached to get ZTE back open.

Along with IP theft being a known issue which Beijing doesn’t like to discuss, is also their fear of civil unrest. In a country of nearly 1.4 billion people who are being controlled by President Xi and his Politburo, civil unrest can’t be allowed to happen. China has made giant strides in its development over the last several decades which was made possible through authoritarian and effective leadership. However, this leadership is only possible through a satisfied and passive body of people who are willing to accept strict leadership in return for economic gains. Like the Kingdom of Saudi Arabia where the citizenry is appeased through massive social entitlements, China’s leadership needs to keep the masses happy, or they could lose their grip on power.

Looking at the potential massive civil unrest that could be unleashed from a full-scale trade war, it seems more likely that Beijing will do whatever is necessary to keep businesses open and jobs where they are. So, while there will be more rhetoric out of China as the Trump administration pushes for fair trade and fair business practices, an amicable solution is the most likely outcome. While some will argue that China can retaliate with similar actions that could cause unemployment here, the American economy with its services base and dynamic nature will be much better able to handle such retaliatory responses. There will be no hostage taking in America when corporate restructurings happen, and people will find a way to persevere as we always have.

With all this said, if we take the trade war narrative out of the equation and allow investors to focus on the excellent earnings season we’re having and the fact that the S&P is now trading at just 17.9x 2018 (versus 25x seen in the 1997-2000 bull market) blended operating earnings, we see that there are a lot of good things going for this market. Now, with a Fed saying that they are close to a neutral rate, long term rates settling in with structurally lower inflation dynamics (see third paragraph) and a healthy economic backdrop, we have a market primed for earnings growth and multiple expansion…In which case, the only things shaking will be the bears.


At the time of this posting, the author has the following positions: None

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG



Serving up the second half..

As financial media hits its audience with a constant one-two punch of theoretical recession indicators in the inverted yield curve and late cycle narratives, it becomes even more important to stay grounded in the tangible economic facts. This is not to say that a recession will never happen and that caution should be thrown to the wind, but that investors’ primary focus should be on the concrete data at hand. It becomes very easy to get wrapped up in financial media’s dooms-day scenarios instead of taking the time to analyze the data which is showing a strong probability of continued economic expansion.

Looking at the flattening yield curve and the prospects of the dreaded inverted yield curve as a recession indicator takes a belief in the ability of an asset class to be omniscient. Pundits will site numerous occasions when an inverted yield curve preceded a recession when it was really a coincident indicator, not a leading one. The fact is all asset classes take their cue from all available information and are managed by individuals seeking to maximize gains or minimize risks. That said, in the past it has been inflationary shocks, political upheaval and other macro-events that presupposed Fed actions. It was these actions combined with existing economic forces at work that may or may not have actually caused a recession.

As often is the case in economic analysis, the work becomes as much art as it is science. The science behind a flattening yield curve is current economic growth and inflation while the art is inflation expectations. Clearly, market participants are currently signaling subdued inflation and expectations. However, in the real world, inflation is alive and well in housing, healthcare, education and other costs, but when it comes to asset pricing, it’s dead. This “death” is most likely a function of various financial institutions’ demand for Treasuries and a structural price change across some goods and services. The Fed’s massive accumulation of treasuries through QE and the realized effect of lowering long-term rates has been compounded by demand for Treasuries from other institutions as well. Whether it’s regulatory-driven increased capital requirements or pensions and insurance companies just managing liabilities, the bid for Treasuries has been strong as evidenced in SIFMA data. So, while strong physical demand for Treasuries has helped keep rates down, there has also been a simultaneous suppression of inflation and its expectations through technological advances. Thanks to fracking (lower energy prices), hand-held computing, open source software and social media, there has been a suppression of prices across many goods and services. The fact that the world’s most powerful and easy to use programming language, Python, and its data analysis tools like pandas are free to use, shows that there is a highly pervasive price suppressing element making its way through the economy. In the past, broad price declines were often driven by reduced demand as opposed to the healthy reasons we have today. The point here is that the yield curve isn’t signaling anything other than the current situation, which is one that is beneficial to consumers, earnings and ultimately equities.

Then we have the late cycle narrative which has been pitched in financial media in earnest for the last three years. The late cycle narrative has its roots in historical NBER data which shows that recessions tend to occur about every six years. The problem here is that as the US economy has transitioned away from a manufacturing / export base to a services / consumption base, the cycle has extended since the economy has become more self-sustaining. If we regroup the existing NBER cycles for the change to a services economy, we can see the lengthening of cycles:

NBER 5.29.17


Since the preconceived notion of the six-year cycle is so embedded in investors’ thought processes, it has become a mental error or bias that causes people to stick with a concept even though new data has been presented which should cause a reassessment of the old concept. In behavioral finance, this is known as conservatism bias and can also cause investors to assign a higher probability to the unlikely event (recession) and a low probability to the likely event (continued expansion).

The best way to counter the imposition of inappropriate economic analysis is to look at the data and what it’s truly showing. Instead of worrying about the potential effects of theories, investors can focus on data like corporate earnings, business activity surveys and employment data which are all pointing towards a sustained expansion.

From what we have seen so far from some major names this earnings season is that business is strong, and the outlook is good. According to Factset, with 17% of the S&P 500 having reported, the blended revenue growth rate is the best since 2011 while earnings growth is the best since 2010. Given the trend of top and bottom line beats so far, the present blended rate should end up being below what is actually reported. A particular standout in earnings which ties in directly to the strength and sustainability of our services based economy is Cintas. Cintas supplies uniforms, cleaning services / supplies and safety products to industries such as hospitality, automotive, food services, healthcare and education. Cintas just reported a fantastic quarter last week which helped propel the stock to new all-time highs and is now up 30% YTD. The earnings out of Cintas are also a great company example of the strength of the services economy as represented in the ISM Non-manufacturing (services) index. The June reading for the composite index came in at a very healthy 59.1 with new orders at 63.2. An interesting fact about the new orders index, which doesn’t bode well for the late cycle theory, is that whenever the index touches 60, it takes an average of 34 months for the composite index to move into contraction (based on ISM data up till the financial crisis since the composite has been in expansion since 2009). Then we have employment data like weekly unemployment claims which have been the most consistent indicator of labor market strength throughout the expansion. Weekly claims have now drifted down to levels not seen since 1969, and they continue to grind lower. When we look at claims data in the context of job openings (JOLTS), we can see there is potential for them to move even lower.

Jolts 7.20.18


So, with a solid understanding of how things stand and why the inverted yield curve and late cycle narratives are more noise than substance, we can look at where markets are headed. The S&P 500 is currently trading at 17.2x 2018 blended forward operating earnings and 21.1x TTM. We ended 2017 at 18.4x forward and 22.7x TTM so the market has gotten less expensive. Comparing today’s valuation to previous bull market expansions like what we had during 1997-2000 when realized multiples averaged 24.9x, we can see that there is justification for multiple expansion. However, it would be irresponsible to just assume that multiples must expand and that the compression we have seen so far this year isn’t going to continue. Given the pro-business policy stance of the Trump administration, a pragmatic Fed and assuming a benevolent outcome to trade issues, it seems more likely than not that multiples will experience some expansion. Even if multiples stay flat from here and using current earnings estimates, the S&P would trade up to 3,318 or a 24% gain on the year. That would certainly serve up some smiles for investors who stuck with the data and not the noise.


At the time of this posting, the author has the following positions: None

Marco Mazzoco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG





The new era at the Fed

With the first FOMC meeting and press conference led by Chairman Powell out of the way now, investors were given an excellent look at the beginning of a new era at the Fed. Powell, coming from a business and legal background, takes the reins after twelve years of career academics having had the Fed’s top spot. The difference in background and approach was evident in how Powell responded to questions from the press. When specifically questioned about various inflation and employment relationships, Powell used terms like “unobservable” and “disparate” to describe the underlying data and how the views on those subjects are at the Fed. These were candid answers that come from a person not being overly biased by any one particular economic theory as most traditional economists are. Then near the end of the Q&A, to hear the new Fed chair openly disagree with the predictive powers of an inverted yield curve by addressing the underlying economic factors involved instead of just granting omniscient status to such an established bond market signal was nothing short of fantastic. Powell showed flexibility and an openness of thought that was quite refreshing. However, he didn’t stray so far from the script as to cause any wild market swings. Powell effectively achieved what all his predecessors have strived for since Greenspan’s “irrational exuberance” speech, which was to not rock the boat too much. Powell made it clear that the Fed was going to be focused on its two mandates and that he wasn’t interested in any political games. While it seems to be an exercise in futility to say political games won’t be an issue in this environment, Powell still gets the benefit of the doubt for now.

Powell’s responses in the Q&A should be of great comfort to investors. Yesterday, we heard from a Fed chair who is looking to be pragmatic, not dogmatic. Powell is the perfect fed-speak version of #Trump pro-business policies.

So, the question is, now what? The big debate in markets and a major focus of the Fed, is how will inflation play out? As Powell referred to in his “flat” Phillips curve explanation, inflation is lagging the strength in employment. The reason for this lag is of great debate in economic circles and is most attributable to advances in technology in my opinion. Thanks to technology, we find ourselves in a period marked by low inflation and sustainable levels of healthy growth. This is where the art of analysis Trumps science because we are dealing with intangibles and unobservable metrics that must be handled with open mindedness. Like the concept of “dark matter” in physics which scientists use to explain how galaxies maintain their shape when there isn’t enough observable mass to explain it, we know technology has impacted productivity and inflation, just not by how much. We know that thanks to fracking there has been a structural change to oil markets which has filtered through to nearly all products and processes in the form of lower prices with simultaneously higher demand. Then thanks to smart-phones, the on-line renaissance, and the “experiential” economy, the entire retail industry and traditional consumption have changed dramatically to the benefit of consumers through lower prices and increased demand. The moral of the story here is that inflation is different this time. The great news is that we have a Fed chair who is willing to accept this difference and isn’t going to throw markets into a tailspin trying to fit the situation into a box that it doesn’t belong.

2018 Outlook

“If the question is when markets will recover, a first-pass answer is never,” is a post-election quote from Nobel prize winning economist Paul Krugman after Donald Trump won the 2016 election. Since then, the S&P 500 is up 23% with 19% of that coming last year. I cite that quote because it’s an excellent example of how personal biases, ignorance of actual data and a negative view of markets were being promoted in financial media heading into 2017. In fact, last year is an excellent example of how many market participants gave in to preconceived notions about market outcomes and then were caught completely offsides from the actual results. And now, with the S&P sitting just a breath away from its all-time highs, investors are faced with difficult decisions on how to manage their gains and how to invest new money. It’s at critical junctures like this where investing becomes as much an exercise of mental fortitude as it is a test of economic knowledge. This is why it’s so important to assess, not just overall market valuation and future growth rates, but also the psychological reasons that cause investing at this stage to be so uncomfortable.

Starting in 2016 and through 2017, the “late cycle” narrative was being used by many pundits throughout financial media to describe an economy and market that were at the end of their prosperous times. The “late cycle” concept is rooted in NBER data which shows that on average since World War II, recessions occur about every six years. This 6-year average completely ignores the changes that have taken place in the American economy which I discussed previously and explained why cycles have lengthened as the economy has become services / consumption based. While the calendar recession timeline is an easy explanation, it’s a very weak analysis that has now become ingrained in investors’ thought processes. The reality is that recessions are started by some type of shock to the economy like a real estate crash, stock market crash or an inflationary spike as was seen after the oil embargo of 1973. The point here is that it’s incorrect to allow the calendar to dictate the timing of recessions and even worse to base investment strategies around it. From a behavioral finance perspective, when a concept like 6-year recession timing takes precedence over the actual economic data being presented, this is called conservatism bias. Conservatism biases lead investors to overestimate unlikely events (recessions) and to underestimate the likely events (continued economic expansion). This bias also causes investors to ignore new data like rising corporate profits, strong business activity data and a newly elected pro-business administration for the mental ease and comfort of assuming a recession is due.

We can see this bias showing itself in the 2017 predictions by this panel of experts in Barron’s:

barrons 1.1.18


We see that even with economic data showing growth into 2017 and a new administration promising pro-business policy changes, the average predicted return was 6.3% which then falls to just 5.4% if we back out the one bullish strategist from Prudential.

multiples 12.31.17



Analyzing the predictions of the panel shows that all but one of them were expecting multiples to contract which is a typical sign of late cycle / early recession market behavior. All the panelists above had the same data to work off of, but only one took the view of a bull market return. It’s also interesting to note that one of the lowest estimates was from Goldman Sachs and they revised their target upward in midyear to 2400 but were still citing “late-cycle dynamics” as a reason for slowing sales and earnings going forward. And now, with Q3 earnings season behind us, we see that a majority of firms have actually raised sales and earnings estimates for Q4 and 2018. According to Factset, 2018 is projected to have the best earnings growth since 2011. This earnings growth is a direct result of accelerating global economic growth and is not indicative of “late cycle” market behavior.

Looking at the economic data at the end of 2016, we see that it was showing growth. National ISM surveys and regional Federal Reserve Bank manufacturing data were all showing activity picking up headed into 2017.

ISM 12.31.17

Table: ISM data

All Feds 12.30.17


(All chart data is the headline activity index taken from its respective Federal Reserve Bank research database.)

Then there was labor market data which was also showing significant strength in terms of a record high level of job openings and a persistently low level of unemployment claims data.

claims 12.21.17

(data from DOL and BLS)


Essentially, at the end of 2016, the economic data was pointing towards further expansion, but most financial pundits were talking about the “late cycle” narrative simply because of the length of the expansion. Looking at the economic data and the pro-business rhetoric coming from Washington, an unbiased analysis showed that the stage had been set for 2017 to be a strong year for stocks, and it turned out to be exactly that. All one had to do to take advantage was to keep an open mind and stay focused on the data which is why my target for 2017 was 2700. Published on Twitter :

2017 prediction 1.1.18

So, what’s in store for 2018? I’m looking for a sustained economic expansion throughout the year. I’m expecting ISM surveys to fluctuate around the mid 50’s and for unemployment claims to drift down to and through the 200,000 level as the labor market continues to tighten. We have a very unique situation in the US economy for 2018 as it’s already on a strong and sustainable path while the government is preparing significant stimulus in the form of a massive infrastructure rebuilding plan. Given the already tight labor market and rising commodity prices, there is a good possibility of getting a pick-up in inflation which could bring out a more aggressive Fed. Even with a more hawkish Fed, I still see equities performing well as economic growth and strong corporate earnings will be the dominating factors.

In terms of market valuation, I like to compare this market to the bull run of 1997 – 2000, a.k.a the original tech bubble. However, what separates today from then is that companies are actually making money. In 1997 – 2000 the S&P traded with an average 25 multiple on low quality and in some cases non-existent earnings.

PE multiple 1.1.18

Today, we have high quality and growing earnings. Coupling current earnings estimates with tax reform benefits and the pro-business agenda of the Trump administration, I see the S&P climbing to 3,350 in 2018. And with that, I wish everyone a happy New Year!!


The market keeps getting what it needs…

“You can’t always get what you want..But if you try sometimes you just might find..You get what you need” are famous lyrics from the Rolling Stones that weren’t meant to be about markets, but they sure fit well after what was seen this past week. Markets came into October at lofty levels and primed for a fall after having worked through hurricanes Harvey, Irma and Maria and that manmade disaster Kim Jong Un. Even with all these terrible events and threats, equities managed to continue their march higher because the economic data never wavered. While pundits throughout financial media warned of impending crashes and doom, markets stayed focused on the data and finished last week with the S&P and Nasdaq at all-time highs.

With just over half of the S&P 500 having reported as of Friday, the market is indeed getting just what it needs, and that’s earnings. Strong results have come in across multiple sectors with industrials and technology leading the way. Major international firms ranging from CAT, MMM, UTX, MSFT, INTC and JPM are not only putting up great earnings but are also raising their guidance. Such confidence and visibility from market leaders like these only comes with a strong global economic backdrop. Thanks to global economic strength, the U.S. economy finds itself in an excellent position. The U.S. has the benefit of having 80% of our labor force working in consumption oriented services industries while the S&P 500 extracts roughly half of its earnings from manufacturing and export focused sectors like energy, materials and industrials. So as the global economy continues to strengthen, U.S. workers will reap the benefits from increased labor demand and wages while corporations earn significant profits domestically and internationally. In other words, exactly what the market needs.

While many analysts and strategists have been caught off guard by the strength of markets and the economy, the regional Fed data available has been showing the strength for quite some time now. The reason it’s been missed is because it’s “soft” data derived from surveys that many analysts are quick to discount as not valuable since some have short histories or just flat out aren’t paid attention to. Regardless, regional Fed data, as discussed in this space often, has been presenting evidence in support of the bullish narrative all along. The data has shown how activity has not only accelerated over the past couple years but has also gone virtually uninterrupted from the hurricanes and, most importantly, is showing strength as firms look ahead.

Leading the regional data is the highly regarded Philadelphia Fed which has been putting out its manufacturing survey since 1968 and is also considered an excellent proxy for national activity. The future (6 months out is the standard for all Fed data presented) expectations chart shown below shows just how historically strong the data is and how long it’s been at these levels. The chart also shows that we would need to see a significant trend change in the data before a recession becomes likely.

(All charts show diffusion indices which represent the percentage of positive responses minus negative ones)

Philly Fed Future Expectations 10.28.17


Then we have the Kansas City Fed manufacturing survey whose data goes back to 2001 and covers Kansas, Colorado, Nebraska, Oklahoma, Wyoming and the northern half of New Mexico. The future expectations index here just hit its series high.

KC Fed FE 10.28.17


The Kansas City and Dallas survey discussed next are quite telling, as one would expect, about the relationship between energy prices and business activity in those neighboring regions. The chart shows how expectations took a dramatic tumble at the same time oil prices did but have since rebounded just as oil has. Given the stability we’ve seen in oil prices and OPEC’s stated commitment to keeping production in line with demand, a repeat of the 2016 collapse in oil prices is highly unlikely. That said, we can see why future expectations look so positive for the area.

In a true testament of resiliency, we have the Texas Manufacturing Outlook Survey put out by the Dallas Fed, whose expectations stayed strong throughout the hurricanes. This survey has the shortest history of the group just going back to 2004 and covers the state of Texas. The data, which was collected well after Harvey, October 17-25, shows just how unfazed and upbeat manufacturers are.

Dallas Fed 10.29.17

Part of the strength of future expectations in the Dallas District is from the explosive growth in oil exports. Port capacity and the export supporting infrastructure is already being stressed at current levels and will soon need to be upgraded. These upgrades along with maintaining normal domestic production will all help to strengthen business activity in the region and dramatically increase CapEx spending.

Moving on to the Richmond Fed’s Fifth District Survey of Manufacturing Activity which covers Virginia, Maryland and The Carolina’s and dates back to 1993, we see a similar story of strength in future expectations. The Richmond survey doesn’t have a future component for its general index, so the new orders component has been substituted. Again, we see a data series moving towards its highs that would still need a lengthy reversal period before approaching recession levels.

Richmond Fed 10.28.17


Rounding out the group, we have the New York Fed’s Empire State Manufacturing Survey which goes back to 2001. The data here reflects the same trend we’ve seen in all the other regions, which is that manufacturers are upbeat about the future.

NY Fed 10.28.17

It can be seen in the above charts that the strong forward guidance being presented this earnings season so far is corroborated by strong domestic expectations.

Given the strong business expectations at a regional level and what we are hearing from the heads of major international firms, it looks like it’s full speed ahead as we head into the end of the year. As of Friday’s close, the S&P was trading at 21.6x blended Q3 trailing twelve month operating earnings. Based on current Q4 earnings estimates (as provided by S&P) and today’s multiple, the S&P would be trading at 2,722 in early 2018. Given the strengthening of the global economy, we could certainly see multiples expand from here as investor sentiment picks up. During the 1997-2000 bull market run, the S&P 500 traded at an average of 25x operating earnings. Considering that the technology boom of today is being driven by actual earnings and not just clicks, this market just might also get what it wants.



The bull case for a strong finish to 2017

As we get further into fall, a period that people consider particularly worrisome for markets as ghosts of the crash of ‘87, the Asian financial crisis of ‘97 and Lehman Brothers come back to haunt investors’ memories, it becomes very easy to lose sight of the factors that brought markets this far. That loss of clarity is then compounded by natural disasters like hurricanes Harvey and Irma and man-made ones like Kim Jong Un and terrorism. Yet, even with all these negative situations, stocks have continued to climb their proverbial wall of worry as the S&P 500 just finished at a weekly all-time high of 2502. So as markets sit at highs and pundits continue to pitch fear and the “late cycle” narrative, the data tells a different story.

The first item up for discussion, and something which is a pillar of all economic expansions and bull markets, is employment. While many different metrics exist for gauging the health of the labor market, the initial claims series is the most useful one with its hard data basis and near real time frequency. Unemployment claims data is an excellent gauge of changes in highly cyclical industries as claims are often a lifeline for many workers when a job ends. Looking at the long-term history of claims and assuming that the economy has reached most economist’s nirvana of “full employment” at various times since 1980, it’s safe to say that the labor market is indeed healthy.

claims LT 9.16.17

Then looking at what claims could do as we move forward, we can look at the data in the context of job openings to see a relationship that looks set to drive claims data even lower.

Jolts 9.24.17

Having job openings at an all-time high certainly bodes well for future labor market health.

So with a solid employment situation in place, the focus shifts to business activity. Healthy and sustainable business activity is the key to keeping employment high and the economic expansion in place. That said, just last week we got several key data points that showed business activity progressing quite well.

On Thursday, we got the highly regarded Philadelphia Fed manufacturing survey which saw nearly all of its components move up in September. The Philly Fed survey, along with its other regional members, provide a valuable and informed view of local economic situations around the country. September’s survey, which includes responses up to the 18th, saw a marked rise in new orders, shipments, and prices paid/received. The new orders component, which hit 29.5 in September versus its 2017 and lifetime averages of 25.9 and 9.4 respectively, is showing significant strength.

FRBPHI NO 9.23.17

With new orders in a solid position, there would need to be a significant and prolonged downturn before even entertaining the notion of a recession.

Complimenting the Philly Fed data was the NY Fed’s Empire State Manufacturing survey which also showed healthy activity for September. The survey, which includes most data collected up till the 10th, saw both its general business and new orders components come in near cycle highs.

FRBNY NO 9.23.17

The report also saw upticks in its employment and prices components which helped drive those series towards cycle highs as well. We’ll get a look at more regional data this week when the Dallas, Richmond and Kansas City Feds all publish their reports.

On Friday, we got a look at manufacturing and services data in the Markit Flash reports for the Eurozone and the U.S. In the European data, we really couldn’t have gotten a more bullish report. The manufacturing PMI came in at 58.2, near a seven year high while the services component came in at 55.6 up slightly from August. Highlighting the overall strength of the Markit data were gains in its new orders and employment components. The report also cited significant employment gains and increased business confidence for the area. All in all, the report shows a level of activity such that the European economic situation should no longer be described as a recovery, but more so as being recovered.

In the U.S. report, data also showed healthy levels of activity in manufacturing and services with the services side resuming its leading role. The services sector saw healthy gains in new orders and employment while manufacturing was a bit subdued in comparison. Corroborating the rising prices seen in the regional Fed data, the Markit report cited the composite (both manufacturing and services) having its highest cost levels since June 2015 with manufacturing input prices hitting their highest levels since December 2012. Given the significant gains seen in manufacturing activity since late 2016, it’s understandable to see a slight deceleration now. The main takeaway here is that growth and a healthy level of business activity are occurring in the most important and largest sector of the economy, services.

All of the above data have contributed to companies being able to generate the strong economic activity and earnings to get markets to these levels. All these positive economic events are now helping to drive Q3 earnings and sales estimates higher as FactSet puts forth in their September Insight report. Looking at the market at a historical valuation guidance, we can see that on an earnings multiple basis, we are not in uncharted territory.

S&P PE 9.24.17

In fact, if we were to see current S&P Q3 and Q4 earnings estimates realized at today’s multiple, the S&P would finish the year at 2743, making for a very happy ending to this year’s market story.



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


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