No More Free Lunch

The 1980s to 2021 has been a great time to be a stock and bond investor.  Risk parity seemed like a free lunch of protecting downside while collecting coupons through bonds and getting dividends and capital gains through ever rising stock prices. The best of both worlds.  Downside protection through bonds and upside through stocks.  Both positive yielding.  That free lunch is over. 

Its been an amazing time to be a US stock investor for the past 13 years.  And its mainly because of one thing: profit margins.  The profit margins for S&P 500 companies has gone from a cycle peak of 7.5% in 2000, 9% in 2006, 11% in 2018, and 13% in 2021.  Those are fat profit margins.  

The rise in profit margins from the 1990s to 2021 coincides with a decrease in the cost of debt funding, as investment grade corporate bond yields have steadily gone lower, tracking the fall in 10 year Treasury yields.  

Notice how the recent sharp increase in investment grade bond yields coincides with the sharp drop in profit margins in 2022Q2.  

There are other factors that have contributed to the sharp drop in profit margins recently.  First, the revenue boost from massive fiscal and monetary stimulus has come and gone.  Second, the rise in commodity and housing inflation are net negatives for corporate profit margins, as discretionary spending gets reduced when the cost of necessities increase (food, energy, housing).  Less consumer spending on discretionary items hurt the S&P 500 as a whole.  The main beneficiary of commodity/housing inflation are a small portion of the SPX and are not well-represented in public financial markets (private market real estate investments).  

If you are a believer in secular commodity and housing inflation like I am, you have to believe that stocks will struggle in the coming years.  

I haven't even gotten to the cost of labor.  In a tight labor market where the working age population as a percent of total population is steadily shrinking, the productivity of the overall population decreases, as the growing elderly population are net consumers, and produce very little, while collecting Social Security and consuming subsidized medical services via Medicare.  This is a net drag on productive capacity in the US, while increasing federal outlays.  With fewer workers relative to the total population, you end up getting increases in the cost of services, as wages go up, a supply-demand phenomena exacerbated by huge federal budget deficits.  

Higher wages for the same productivity, or less, considering the growing trend of work from home (reduces productivity), and that hurts profit margins.  And that doesn't even get to globalization and labor arbitrage scraping the bottom of the barrel in China, where the excess labor coming from rural areas is near its end, and higher political cost of outsourcing to China as US-China relations continue to get worse.  

With the oligopolistic pricing power of many of the S&P 500 corporations, can't they just raise prices to maintain their profit margins?  Yes, they can, and that will exacerbate the inflationary pressures in the economy, and just guarantee that inflation stays high and the Fed keeps rates higher than they would otherwise.  In a labor and energy restrained world, inflation is the release valve, to relieve the pressure caused by a supply limited environment.  Also, at some point, raising prices on consumers is counter-productive as they will just either find alternatives or will be constrained from buying due to high energy/housing costs. 

Seeing how the US, UK, and other countries have reacted to high inflation, they've decided to fight fire with fire.  Basically handing out more money to the public either through stimmy checks or by capping prices on electricity bills/reducing gas taxes.  That's a recipe for a secular stagflation where central banks will either have to go back to financial repression and negative real rates to keep the economy going at the cost of high inflation or have positive real rates and kill the economy to keep inflation under control.  Its no longer a free lunch environment where cheap overseas labor and ever increasing oil and gas supplies allowed the Fed to print gobs of money without any inflationary consequences.  Under resource constraints, the Fed has to now weigh tradeoffs between lower inflation/lower growth or higher inflation/higher growth.  No more free lunch.  

Its been a sharp selloff after the FOMC meeting, much quicker than I thought would happen.  It just underlines the weakness in this market, where it gives you very little time to sell rallies and gives you plenty of time to buy weakness.  I remain short and not in a rush to cover.  Sure, the put/call ratios got very high on Friday and you are seeing some dislocations in the FX market.  But considering how weak the bond market is, I would expect the June lows to crack sometime soon and that will probably usher in some panic as we hit new 52 week lows in SPX and finally start flushing out some of those diamond hand retail investors who haven't budged in their equity allocations.  The low DIX reading on Friday (40.3%) after high readings for the past few weeks is the first sign of the retail investor cracking.  Will need to see several more days like that to have me believe that we can put in a tradeable bottom, where I will cover shorts.