What high stock prices do

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. Costco reported yesterday, and comparable sales in its US business were up 7 per cent. That is impressive, but not as impressive as a trip to the Brooklyn Costco on a busy Saturday — overcrowded, polyglot, aggressive and good fun, like the city itself. Email us with your favourite bulk buy, financial or otherwise: robert.armstrong@ft.com and aiden.reiter@ft.com.  

It’s an unforgiving market now

We have rattled on at some length in this space about high stock prices, mostly in the abstract: how high are prices relative to history? How are high prices dispersed through different sectors and countries? And so on. But it is worth looking at the effect of high prices — what they do. We have two good examples this week, in the earnings reports of two huge software companies, Oracle (market cap $500bn) and Adobe ($240bn). 

Oracle reported 9 per cent revenue growth in its second fiscal quarter, but all eyes were on its business selling cloud-based computing infrastructure and software. This business grew 24 per cent in the quarter, and the company set a target of 25-27 per cent growth for the next quarter. This was, as one analyst put it, “merely in line” with Wall Street expectations. The stock fell 8 per cent on the report. 

At Adobe, the segment of the business that stands for next-generation, Cloud-ish and AI-ish growth is bundled under “digital media annualized recurring revenue”. The company forecast that DARR would grow 11 per cent in the fiscal year that just began. Again, in line with what analysts had pencilled in. And again, not enough: the stock fell 14 per cent yesterday.

The point about these results is that they were good and consistent with what the companies had reported in recent quarters. Though both of these companies are already generating AI revenues, unlike some of the Magnificent 7, this bought them no favours from the market. As the market rises the margin for error declines for everyone. What is the message? Not that the market as a whole will go into reverse; no one knows when that might happen. But the ride will be bumpier, and the gap between the winners and losers will increase. If your portfolio isn’t set up to handle that, it’s time for a more conservative allocation. 

Credit spreads

A lot of attention has been paid to high equity valuations. Rightly so. Less attention has been paid to credit, specifically high yield. The spread between junk yields and Treasuries is near a record low. In other words, just as with stocks, people are clamouring for the stuff, prices be damned.

To get a sense of just how expensive credit is, as compared to stocks, Unhedged thought it would be interesting to chart high-yield spreads next to Robert Shiller’s Cape excess ratio, which is also a spread over Treasuries: it is the cyclically adjusted earnings yield on the S&P 500, minus the yield on 10-year Treasuries.

The main observation here is that both are very expensive. Some other observations:

• The current gap between the two is not massive and seems to be normal for a bull market; 2015-17 and 2004-08 make good comparisons. But we all remember what happened in 2008.

• Investors tend to demand higher spreads for junk bonds than for equities. There were only two periods where that relationship inverted, or the two measures were at least at par. From 2012 to 2014, oil bonds proliferated on the back of the commodities supercycle and spreads were driven down to par with stocks’ earnings yields. That ended in the oil bust of 2014. And, as Lotfi Karoui at Goldman Sachs reminded us, immediately after the outbreak of Covid, the government announced a credit support facility, which caused investors to pile into credit and push spreads briefly to par with a hot S&P 500.

• Market crises usually send the two up together. But credit, due to its binary nature, goes up a lot more.

(Reiter)

Department stores revisited

Yesterday’s piece on department stores contained a bad error. I wrote that US department store sales totalled $11bn a year; that is the monthly number, not the annual. 

More importantly, the piece missed an important nuance. While sales for the industry have been falling steadily for years, the publicly traded department stores — Macy’s, Dillard’s, Nordstrom and Kohl’s — have managed to keep revenues relatively flat. In the past decade, as a group, their revenues have fallen by half a percentage point a year on average. 

Part of this is survivorship bias. We know these are best-in-class chains for the simple reason that they still exist, unlike JCPenney or Kmart, and have not been restructured through bankruptcy, like Neiman Marcus. But this is not the whole story. The numbers I used for industry sales from the Census Bureau did not include online sales, as an alert reader pointed out to me. At Nordstrom, Kohl’s and Macy’s, online sales account for about a third of the total; Dillard’s doesn’t disclose digital penetration.

But moving online has not solved the industry’s problems. Profitability tells the story: at Macy’s, Nordstrom and Kohl’s, operating margin has been cut in half, to 5 per cent, over the past decade. Competing with online retailers is one thing; winning is quite another. Only Dillard’s has bucked the margin trend (could it be because it has not emphasised online sales?), but even there, margins have compressed in the past two years. 

One good read

“Which of you shall we say doth love us most, that we our largest bounty may extend?”

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