This Is Inflation at Work
Walmart delivers an unscheduled update... Consumer habits are shrinking profit margins... This is inflation at work... You can't sacrifice dinner... The yield curve keeps warning us about a recession... So do junk bonds...
Well, that was quick...
I (Corey McLaughlin) wrote in yesterday's Digest about how this was a big week for corporate earnings...
About 170 of the S&P 500 Index companies report their second-quarter financials this week. In addition to learning specifics about the businesses themselves, we're looking for clues about what's going on in the economy from these reports.
And around the same time we published last night's letter, we got a related and revealing (but unscheduled) earnings-season update...
Walmart (WMT), the nation's largest retailer – which doesn't formally report earnings until next month – forewarned that it's slashing its profit outlook for the second quarter and the rest of the year. Doug McMillon, Walmart's CEO, said inflation is the reason...
The increasing levels of food and fuel inflation are affecting how customers spend.
Higher prices for essentials like groceries and gas are "affecting customers' ability to spend on general merchandise," the company said... This is similar to what we heard from Walmart and fellow retailer Target (TGT) earlier in the year about what they were starting to see from customers. It has continued.
According to Walmart, customers are focusing on cheaper, must-have items like food... which have lower margins for retailers.
This behavior change, combined with a backlog of inventory tied to supply-chain issues and skyrocketing shipping costs, has led Walmart to sell overstocked, higher-margin items like clothing at significant markdowns.
Overall, this shift means less profit... which means less growth and less money for hiring and investment... which means higher prices to start growing profits again, which means... well, you probably get the idea.
This is inflation at work...
Folks are still shopping at Walmart. The company expects U.S. sales to grow 6% for the second quarter.
But the company now warns that its profits could fall by as much as 14% for the quarter and 12% for the year.
Shares of the mammoth retailer plunged as much as 10% in after-hours trading yesterday. And since Walmart is a bellwether for the retail sector in general, the company's guidance update took related stocks down with it.
Shares of Amazon (AMZN), which reports on Thursday, fell more than 5% today. Shares of Target shed roughly 4%... as did the sectorwide SPDR S&P Retail Fund (XRT), whose heaviest weightings are in shares of pet-supply store Chewy (CHWY) and online marketplace Etsy (ETSY).
This is what we've been talking about...
As our colleagues Mike DiBiase and C. Scott Garliss have written specifically here, Wall Street earnings forecasts have been far too rosy in general – ignoring all the evidence of a rocky economy and the consequences of inflation.
Coming into this earnings season, analysts expected the S&P 500's earnings per share to increase 15% this year from 2021... then another 9% in 2023 and 2024. In the meantime, economic growth has been slowing.
To us, that meant plenty of room for disappointment in the markets.
It's the way these things work... Wall Street is often the last to know, or at least the last to react to what's really happening on Main Street. As Mike wrote in the June 30 Digest...
Clearly, the market hasn't priced in a recession yet, much less stagflation [slower growth paired with high inflation].
I believe we'll start to see companies guiding down their earnings as we get into the heart of the next quarterly earnings season, which begins in July.
To be fair, this earnings season hasn't been a total overshoot by Wall Street...
Some companies have been reporting higher profits than expected, like fast-food chain McDonald's (MCD). The company beat consensus analyst expectations for U.S. and international same-store sales growth, checking in at 3.7% and 9.7% respectively in the second quarter.
That's because McDonald's is a company with pricing power, the business antidote to inflation...
For example, McDonald's has raised prices on its value menu... and quietly taken some items, like soda, off its Dollar Menu at some locations. And these moves aren't going to keep customers away from the iconic fast-food chain.
This is the type of business that holds up in any economic times... high-quality companies that sell in-demand and even addictive products, perhaps with additional tailwinds to boot. These are the companies we've recommended owning as part of a well-balanced portfolio.
Remember, consumer spending drives most of the U.S. economy... And people need and want to eat no matter what, even if it costs a bit more. You can sacrifice other things like new clothes if money is tight, but not dinner.
Mickey D's shares were up nearly 3% today.
Moving on, we have an update on the yield curve...
It keeps on warning "trouble ahead"...
While most folks are enamored with the stock market (and rightly so), as I've said before, the bond market can also tell you a lot about expectations for the economy in the short and long terms.
I'm talking specifically about the prices of Treasury bills, notes, and bonds – which, for brevity's sake, we'll refer to collectively as bonds – and their yields. Government-backed U.S. Treasurys are a $22 trillion market... For comparison, the S&P 500 has a market cap of $32 trillion.
Typically, longer-duration bonds pay higher interest than shorter-dated Treasurys.
This makes sense... When you lock your money up for a longer period of time, you'd want a higher interest rate in compensation. But this "yield curve" behavior goes upside down sometimes – and when it does, it has been a reliable indicator of trouble ahead for the economy.
That's what we're seeing today...
For example, the spread in yields between the 10-year and 2-year Treasurys is inverted, meaning 2-years are paying higher interest rates than 10-year Treasurys. This month, this spread dipped to negative 0.22% – a number not seen since November 2000 during the dot-com bust.
Today the 10-year/2-year spread is negative 0.19%, matching the "peak" inversion in November 2006 ahead of the great financial crisis...
I'm not trying to scare the pants off anyone with this one statistic, but I bring it up to show you the bond market is clearly telling us to be cautious about any economic outlook today.
It also suggests these things take time to play out. As I wrote in the April 1 Digest...
Almost every time the yield curve has inverted – dating back to the 1950s – a recession has followed. By almost every time, I mean 11 out of 12 times, with only one false positive...
But here's another very important point if you're wondering about the timing of all of this.
In these instances since 1955, the recession has occurred within six to 24 months after the initial "inversion"...
Not tomorrow. Not next week. Not even next month... But, on average, about 19 months later.
As we know, too, the stock market and economy don't necessarily move in concert with one another... They can, but they don't have to. To this point, many pros use the stock market as an economic indicator itself.
Stock market valuations are forward-looking. (That's why Walmart shares plummeted today on a lower growth outlook.) Economic data is backward-looking. (That's why economists don't define a "recession" until long after it has begun.)
As we've mentioned before, stocks have typically risen 21% for about 18 months, on average, after yield curve inversions. That's likely because the bond market is quicker to price in trouble ahead than the stock market.
The COVID crash is the latest example... The yield curve inverted six months before March 2020. The economy was already in a position to slow down, and the longest bull market in history was bound to end. The pandemic was the trigger.
The ensuing government response – namely trillions in stimulus – followed by supply-chain issues and now war have led to today's levels of inflation.
The key phrase in this discussion is one that folks tend to gloss over: 'on average'...
What I mean to say is that "on average" doesn't always happen...
An average represents a collection of past results, not a guarantee about the future – especially if the current context has changed significantly from the past.
Remember, we're going through the highest inflation in decades. Many folks with money in the market, or those who manage it, have little or no experience with high inflation to draw on.
They're working with their own "recency bias"... that is, thinking the market will act the way it has for the past few decades. Buy the dip and get on with life has worked for the most part.
They learned those lessons in a low-interest-rate, low-inflation world. But we have no expectation that the recent past will repeat. As our colleague Dan Ferris wrote in the June 24 Digest, consider thinking about now as the end of the world as we've known it...
We're facing a new problem...
Interest rates are rising, the stock market's overall valuation has fallen (and yet is still very expensive by the most reliable metrics), and the economy is shrinking in inflation-adjusted terms.
It's easy to get stuck in the thought pattern or follow the assumption that it'll all revert to the way it was for two decades... but it's probably wrong to rely on that solution, too.
The longer I keep watching what's happening, the more I think today could be like the one other time in the past five decades when stocks peaked before the yield curve inverted. As I wrote in the March 8 Digest...
While bull markets have typically continued for well more than a year after the yield curve inverts, there have been two notable exceptions...
In 1980, stocks peaked just two months after the yield curve inverted. And in 1973, the market actually peaked two months prior to the first inversion.
That just so happened to be the last time inflation was as high and rising significantly as it is now... This year, stocks peaked in January. The yield curve inverted for the first time in March, the same two-month gap as that outlier in 1973.
But whether that's simply a coincidence or a real signal doesn't necessarily matter. The point is, Treasury yields have been inverted for the entire month of July, so this is not a one-off, one-day signal.
This is a sustained warning...
It's like someone yelling in your ear for a month that investors are more worried about the short term than the longer term right now. Frankly, we don't blame them.
Now, some people prefer to look at a different yield spread as most meaningful...
They correctly note that the 10-year minus 3-month Treasury spread – which has predicted the last eight recessions – hasn't inverted yet...
But it's getting close... plummeting from 2.27% in May to 0.19% today. That's significant enough already to tell anyone paying attention that something is amiss.
The 'junk' bond sector is signaling the same thing...
"Junk" bonds are labeled as such because of their high yields, which are commensurate with the risk investors take on for owning them.
They're essentially the bond market's opposite of safe U.S. Treasury notes... They're issued by businesses at a higher risk of default. It doesn't mean they are all "bad," but they tend to suffer the most during tough times.
And as our colleague Brett Eversole wrote in today's free DailyWealth newsletter, the gap between junk-bond yields and safer investment-grade bonds – the high-yield bond spread – has skyrocketed in recent months. As Brett shared...
When this spread rises, it means investors are worried. Notice how it jumped from a little more than 3% in April to nearly 6% earlier this month.
That's a multiyear high. And it's a clear warning sign from the bond market. Tough economic times are likely on the way.
And as Brett pointed out, history suggests this spread has more room to widen. It typically peaks during the very worst of economic times, and we likely haven't seen that just yet...
The recent spike looks a lot different when we zoom out on the chart. We see that the latest move is large for the last couple of years. But it's nothing compared to history. Take a look...
The junk-bond spread topped 10% during the COVID-19 panic... And it was well over 20% during the global financial crisis. Heck, it even approached 9% in 2016 as crashing oil prices wreaked havoc on the energy sector.
So what do we make of this recent short-term spike?
We take it as a warning of what's possible from here.
The White House and professional economists can tell us all they want that a recession isn't coming, or that it's not already here, or – in their latest spin – that people should ignore the conventional definition of one. But the bond market is telling us the opposite.
Who do you believe? My bet's on the bond market.
It's OK to Be Wrong
In this week's episode of the Stansberry Investor Hour, Dan brings on a new voice to the show: seasoned value investor Gary Mishuris, the chief investment officer of Silver Ring Value Partners...
Among other things, Gary tells Dan how he used to make rookie investor mistakes – like losing his shirt after putting all his money into a hot stock that tanked. But over the years, he has honed a humble philosophy that has served him well...
Click here to listen to this episode right now. And to catch all of the podcasts and videos from the Stansberry Research team, be sure to visit our Stansberry Investor platform anytime.
New 52-week highs (as of 7/25/22): Booz Allen Hamilton (BAH), Centene (CNC), and Option Care Health (OPCH).
In today's mailbag, some kudos for Ten Stock Trader editor Greg Diamond, whose work we quoted yesterday... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"Hi Greg, I just want to pass on my thanks for the great job you are doing with your technical analysis which is helping me make decisions not just about the trades you recommend but also my broader portfolio. I love the idea that you have a base case scenario for what you think will happen but if it does not work out that way then there is always another course of action for what you see is actually happening. That provides me with confidence to be thinking about what I need to do next rather than looking back thinking about what I might have done differently." – Paid-up subscriber Brendan S.
All the best,
Corey McLaughlin
Baltimore, Maryland
July 26, 2022