Changing Horses in Mid-Stream?
Not a quarter goes by that I do not check in on the Duke University/Fuqua School of Business CFO Optimism Survey. As I’ve suggested in these pages many a time over the years, “the CFO always knows”. Infallible? No, but one heck of a lot better than listening to the hot air spewed by the Street in virtual non-stop fashion. Just so happens that in the latest survey macro CFO optimism picked up a bit. Nice to see it and the direction of the current results helps corroborate the recent pick up we are seeing in higher frequency economic stats as of late. To be honest, my personal view of the recent pickup in econ stats is akin to what Francois Trahan has been suggesting as of late. In a world of zero bound (zero interest rate levels), it’s the short-term change in inflationary/price pressures that act as the Fed Funds rate equivalent, if you will. And sure enough the CRB index peaked close to eight months back plus we’ve witnessed a collapse in many a prices paid subcomponent of the manufacturing surveys (ISM, Philly Fed, etc.). The lagged effect of lower input prices acts as a temporary boost to the economy, but only temporary set against the larger macros of deleveraging, negative growth in real disposable personal income, the Euro issues, etc.
Anyway, I want to home in on a few subcomponents of the CFO survey this quarter in the hopes that our CFO friends are imparting some useful information helpful in forward investment decision making. One piece of cautionary news and one piece of news perhaps indicative of opportunity. Let’s get the potentially bad stuff out of the way and end on a happier note as we start the New Year. Have a look at the following chart.
Above we’re looking at the history of CFO responses to how they see growth in both prices of their own products and their own company earnings over time. Noticeable is the fact that expectations for growth in pricing of their own company products over the last few quarters has dropped markedly. Although the history of the data here is very short, this type of consecutive multi-month plunge is not common. And accompanying this drop in pricing expectations is a clear moderation in expectations for earnings growth. At least personally, what this suggests to me is that we need to watch corporate profit margins like a hawk in the year ahead. Although this data circumstance in no way guarantees a profits recession ahead, it’s very much the same set up we saw moving into early 2008. And this thinking is punctuated by the fact that as of now, corporate profits as a percentage of GDP rest at an all time high. Please remember that profit margins are truly one of the most mean reverting series known to man.
In their own language, I personally believe the CFOs are concerned about margins and are expressing such in this data. After all, it’s tough to reconcile one of the greatest cyclical corporate profits recoveries with one of the weakest macro economic recoveries on record, is it not? In 2011 we watched valuation contraction in many a sector and individual issue while nominal corporate earnings held up nicely. Will 2012 be the year of margin contraction and is that what the valuation contraction of 2011 was “telling us”? Stay tuned.
One last data point I hope is important. First, as I perused the 2012 forecasts and outlooks from many a Street firm, I was stunned by the level of “herding” this year. As you probably know, recommendation after recommendation is focusing on safety, dividends, large cap defensive issues, dividend growth, etc. Of course the irony is that this is what has exactly worked…over the prior 12-18 months. And so this will be the case directly ahead? We’ll see. But as usual, the markets act to disappoint the greatest number of investors possible when it comes to prognostications.
Wildly enough, in the recent survey the CFOs are telling us that they are looking to de-emphasize dividend growth in the period ahead and instead focus a bit more on share buybacks. Is this saying CFOs and their management brethren see their own valuations as being very attractive? In the large cap space I think this is exactly the case. Again, the history of the data is very short as you look at the combo chart below. Over this short history we’re looking at a record response level from the CFOs in terms of anticipated share buybacks. Take notice.
Look, there’s more than plenty of macro doom and gloom to go around. Plenty. I personally expect Europe to be ground zero for financial market volatility once again in 2012. If we see a hard default or two in Europe this year, I will not be surprised at all. But given this, we need to keep in mind the valuation compression we’ve seen in many a sector not just last year, but really over the last decade-plus. Are the CFOs seeing the same thing? While the Street prognosticators are looking squarely in the rear view mirror and suggesting buying yield that has ALREADY performed very well, is it now time to focus on larger cap traditional growth where valuations are the focal point as opposed to nominal yields? Think about it, because it seems that’s exactly what the CFOs are doing at present.
All the best for the New Year!
About Brian Pretti CFA
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