The US bond market is saying that the Federal Reserve will cut interest rates by roughly a quarter of a percent in the course of the 12 months, and the yield on inflation-protected Treasury bonds has tracked expectations about the Fed.
That’s hardly a sign of a strong economy. Factset, meanwhile, projects a year-on-year decline in first quarter corporate profits. Economic data have been mixed, and some key numbers (such as the Markit purchasing manager indices) have been alarmingly low. Why, then, are most of the major equity indices at or close to all-time peaks?
A good deal of the market is hurting, in fact. 249 US stocks were at 52-weeks lows on Wednesday, versus 439 at new highs. The gains have been very concentrated.
Three-quarters of the US stock market’s gains this year came from five stocks – Amazon, Facebook, Apple, Google, and Microsoft. These are monopolies which the market considers bulletproof. They aren’t, and I wouldn’t buy them at present prices for reasons I’ve explained before (see “Seventeen Reasons to Hate the US Stock Market,” December 17, 2018).
But there are some things worth buying. I called attention to US banks earlier this week. The combination of value (cheapness) and quality (reliability of earnings) looks like the winning combination for the moment.
The above chart shows the operating margin (gross earnings as a percent of sales) relative to the long-term average for a number of sectors. Note that banks show the highest operating margin relative to the average while consumer staples show the lowest. In fact, consumer staples (the Proctor & Gambles, Cokes and Pepsis) went off something of a cliff late in 2017.
The trouble with the consumer giants is that they have coasted on customer loyalty for generations, assuming that consumers would buy the same dishwasher detergent and hand soap that their parents did. That can’t be taken for granted, not when Amazon offers generic products in pop-up adds every time you try to purchase a box of laundry detergent.
The banks, by contrast, finally have figured out that they are a low-margin business whose profit margin depends on cutting costs, which they are doing with a will. Their lousy return on equity of around 12% looks threadbare next to the 18% return on equity for the big consumer staples names, except that the banks are trading at just 10 or 11 times earnings. They offer cheap and reliable returns and decent dividends.
Operating margin is the best starting point for corporate performance. Return on equity, a more commonly used measure, involves a bit of sleight of hand.
The banks still look good, but so do the consumer staples companies. Why do the soap-makers look great in terms of return on equity, but terrible in terms of operating margin? There is a one-word answer to that question, and it is, “leverage.”
The consumer staples companies increased their leverage (measured by net debt divided by earnings before interest, taxes, depreciation and amortization) from 1.5x in 2011 to 2.2x in 2018. The health care sector did the same. Utilities, who generally are heavily geared, actually reduced their leverage during 2018 and 2019, by contrast.
Equity buybacks and M&A turned the sow’s ear of operating margins for the consumer staples sector into the silk purse of return on equity. For investors seeking income, the sector seems attractive, with a dividend yield of about 2.9%. What appears rock-solid may be riskier than most investors think, as consumer preferences change and the Amazon effect erodes brand loyalty. That is why the consumer staples giants aren’t widows-and-orphans stocks anymore.
That may explain why the banks are up 21% this year vs. less than 12% for consumer staples. The two sectors offer the same dividend yield (about 2.9%), but the banks appear less risky.