(MENAFN- ValueWalk) As Q3 earnings season approaches, there is a drought of company-specific news and events to analyze. Regardless of the lack of fundamental data points, investors appear committed to positioning themselves for another end of the year entitlement rally. I continue to have no opinion on the market's near-term direction, but a year-end performance panic wouldn't surprise me. During the current market cycle the S & P 500 has increased seven of the past eight Q4's, averaging slightly over a 6% gain. This cycle's only negative Q4 was in 2012 with the S & P 500 declining -1%.
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While equity investors enjoy daily record highs in the popular benchmarks, I continue to patiently wait in low yielding cash and cash equivalents (granted, yields are thankfully moving higher). As an investor uninterested in owning equities, it's a rather uneventful and boring period of the market cycle. While I acknowledge stocks could go higher, I remain committed to a process and discipline that requires an adequate absolute return relative to risk assumed.
Considering the lack of information coming from companies and the markets, I thought today would be a good time to share some questions I recently received from readers and my responses. I selected questions I receive frequently, are useful in helping understand my absolute return process, and address the current environment. As always, feel free to email me with any questions and comments.
Q: See anything or any sector that is somewhat interesting?
A: Since energy has rebounded, I'm not finding much. Actually almost bored to tears. Considered buying S & P 500 call options to cause the market to crash! Seriously…extremely boring market.
Everyone KNOWS markets are going to rally into year-end. And they certainly could…year-end performance panic has happened seven out of the past eight Q4s during this market cycle. Only down Q4 was 2012 with -1% decline. You have to wonder if this concerns central bankers – the environment they helped create. While a stock market that never goes down may be what they want, the complete lack of volatility and pureness in asset prices must be concerning.
Q: In regards to your most recent blog on inflation, other than government data, have you come across data points that suggest inflation isn't going to increase? Also, suppose you knew inflation would increase with 100% certainty, how would that change the way you invest? What companies would you gravitate towards? What securities would you gravitate towards?
A: Yes, there have been some areas where price is not increasing or even decreasing. Often these areas are found where there is too much capital/over supply (energy bust 2014-2015 good example). Food was also a good example, until KR reported this quarter that trend has reversed. While there will always be cycles within certain industries causing inflation to fluctuate, I'm currently noticing more signs of rising costs than declining. I suspect this will continue in Q3, especially with higher energy prices vs. Q2. We'll see…still need more data points to come to a conclusion.
I currently have a very patient position (liquid and waiting) and I'm not making investment decisions based on my inflation views (volatility in cost and price should be included in your required rate of return and normalized cash flow assumption). My main issue remains valuations. Small cap valuations are high regardless of my view on inflation.
That said, I think it's important when valuing individual businesses to understand how margins are or have been impacted by inflation or deflation. For example, many companies dependent on natural gas have benefited from abundant supply. A chemical company would be a good example. Or how about PZZA and cheese prices? In effect, when normalizing margins I believe it's important to normalize input costs as well. I believe extrapolating low input costs (including labor) indefinitely carries risks and assumes margins will remain elevated indefinitely.
Hope this helps. Looking forward to Q3 earnings season and more information.
Q: How did you form your investment philosophy? Did you try other forms like GARP or relative valuation before? How do you think about position sizing? And selling?
A: Great questions. The process question can be found by reading through my blog as I touch on it in several posts. I particularly recommend the post 'What's Important to You'. I plan to do a post on my sell discipline soon…that would be a 1000+ word email, so I'll let you know when I post. Position size has to do with risk/return and quality (degree of operating and financial risk)…that's a good post topic as well I'd like to address. Really enjoyed the article on cheese you sent…7% margins seem reasonable for a monopoly! MSFT's much higher!!!
Q: If you are right and there is an unexpected bout of cost-push or other consumer price inflation in our near-term future, I think the game is over. After all, what options does the Fed have if inflation becomes the problem, not disinflation? I can't think of the Fed being in a more difficult position: stagflation.
A: We'll see what Q3 earnings season says about inflation. I'm not sold on the inflation accelerating idea yet, but definitely noticing more signs. I need more data to conclude. Also, for what it's worth, so far I'm not seeing a noticeable earnings catalyst on the upside or downside in Q3. I think the greatest threat to stocks near-term won't be earnings, but that stocks simply quit going up for no specific reason (old age and fatigue). And on the potential for more upside we have the good ol' year-end performance panic by the 'pros'.
Will be interesting next several months. I think as long as stocks go higher, rates continue to increase…a nice game of chicken could be forming between the stock and bond market! 2yr yielding approx 1.5%…I view gradually increasing rates as a raise so in an indirect way I'm benefiting from expensive equities getting more expensive. Asset prices and the economy are one trade, it seems. As long as asset prices remain inflated, I think the Fed will have to keep raising rates…especially if my theory on rising costs receives more supporting data in Q3.
Q: Do you know of good, niche conferences for small caps or small and mid-caps?
A: I do not go to conferences. I did earlier in my career, but as my possible buy list has grown I've found calling companies to be the only way I can keep up vs. visiting companies or conferences. That said, if an industry were to get extremely depressed, I'd be interested in attending. Great way to see a lot of companies in one industry at once.
Q: If you think about it, that's the mechanism that would catch the majority of people off sides, just enough growth to give confidence that the market has more room to run and suck everyone back in before an unexpected pop in inflation and
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