The market is up — narrowly

Good morning. Sleepy day yesterday. The Vix reached its lowest level since January 2022. Even the Move index of bond market volatility, which had been going nuts in recent weeks, is falling back to earth. While we have a breather, some thoughts on where markets, companies and consumers stand. Write to us: [email protected] and [email protected]. 

Markets: breadth and circuses

One legacy of the banking mini-crisis of the past month or so is a significantly narrower market. The S&P 500 index has performed just fine since the eighth of March, rising about 4 per cent. This to the surprise of many market participants and pundits, who see the economy slowing and abundant risk of other financial flare-ups. But the index is capitalisation-weighted, and therefore misses the fact that the average stock in the index is down 1 per cent. A few big stocks are doing most of the work. Here is a chart of the performance of the cap-weighted index relative to its equal-weighted sibling, reaching back to the start of the pandemic:

Here is the performance of the top 10 S&P 500 stocks by market cap since March 8:

All but Tesla have outperformed, and the big techs have outperformed by a lot. Notably, several big-cap defensive names (Johnson & Johnson, Procter & Gamble, Walmart) have also done well in the past 5 weeks.

In an atmosphere of quite poor sentiment about risk assets, many will point to all this and say stocks are set to fall. But we are a little sceptical of the argument that a thinner market is an indication of price declines to come. Historically, thinness is a very noisy signal.

Focusing on the big tech rally, though, we do see some reason for concern. The recent rise of the Faangs, et al, looks like a knee-jerk reaction to the fall in rates and rate expectations that followed the banking mess (the 10-year yield has fallen from 4-ish per cent to 3.6-ish). As we have often said, the low-rates-good-for-big-tech trade is just so 2021. Life is not that simple any more.

Companies: another way to look at margins 

Following the recent Unhedged on profit margins, I received an interesting and important response from Andrew Smithers, author of the recent The Economics of the Stock Market.

Smithers makes the simple point that it only makes sense to talk about corporate profit margins being too high or too low if profit levels revert to a stable mean. And interpreted in one straightforward way, they do. This is corporate profits as a proportion of total economic output. It makes sense, broadly, that competition would force profit into a stable equilibrium relative to output, and data from the US national accounts does seem to suggest that this ratio varies around a stable mean. Note how the trend and the average match in Smithers’ chart of profit/output for non-financial companies:

On the other hand, there is not (as far as I know of) a good economic account of why profit as a percentage of sales — the more usual sense of “margins” — should revert to a stable mean. A shift in the types of businesses that predominate in an economy might mean lower sales margins, even as businesses’ return on investment and business owners’ share of total output hovers around its long-term equilibrium. Smithers points out that the ratio of sales to output does not revert to a stable mean over time.

In any case, looking at margins in terms of the profit/output ratio, profits before interest and tax look very high. Smithers quantifies just how high:

“It thus seems likely,” Smithers writes, “that non-financial profit margins will fall [and] financial profit margins will fall even more”. The timing of this decline may be impossible to predict, though. As the chart above shows, margins were very high on and off for 30 years in the period after the second world war.

Smithers also points out that I mischaracterised his view by saying that low investment may be responsible for high margins. He does not think this; his view instead is that the poor structure of management incentives since the 1990s have caused companies to prioritise profit per share over investment. This has impaired growth, but does not seem to have affected the profit share of output.

Consumers: what we’ve learned from the bank reports

We have seen one or two somewhat breathless news stories about bad-debt write-offs and provisions at the big banks this quarter, so we had a quick look at the numbers. What we see is that while credit statistics are emerging from the medically induced coma of the pandemic, credit quality remains very good. We saw zero evidence of impending recession in the big bank results for the first quarter — just a slowing to a normal pace.

Loan loss provisions are pretty subjective, so it’s better to look at actual delinquency rates and writedowns for unsecured card loans, which are the bleeding edge of bank credit. Here are the 30-day card delinquency rates for Bank of America, JPMorgan and Wells Fargo (Citi has an annoying comparability issue with its historical data so we left it out) the past five first quarters:

The pattern is clear: delinquency rates are rising, but are still below normal, pre-pandemic 2019 levels. Charge-offs look almost identical (banks generally charge off-card loans after 120 days):

The consumer is still doing fine. This was also evident in what the banks reported about debit and credit card spending growth. It’s slowing, but is still growing faster than inflation. Bank of America provided this chart:

The other banks had a broadly similar story to tell. Here is JPMorgan’s Jamie Dimon:

The consumer has money. They pay down credit card debt. Confidence isn’t high, but the fact that they have money, they’re spending their money, they have $2tn still in the savings and checking accounts. Businesses are in good shape. Home prices are up. Credit is extraordinarily good . . . that’s going to continue in the second quarter, third quarter. And after that, it’s hard to predict.

We think Dimon has the picture about right. There are lots of reasons to worry about recession in the next few years, but if consumer spending and borrowing habits are any indication, we’re not in one yet, and we’re not about to be, either.

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