Inflation Trade: AMZN + WFM

rcwhalen's picture

Here is the latest post from The Institutional Risk Analyst -- Chris

“Markets go up on an escalator, they come down on an elevator. This is the most hideously overvalued market in history.”

 

David Stockman

 

Last week’s action by the Fed was an effort to restore normalcy, but in the context of extraordinary action by the central bank. When you tell markets that the risk free rate is zero, it has profound implications for the cost of debt and equity, and resulting in different asset allocation decisions.  Ending this regime also has profound implications for investors and markets.

 

In the wake of the financial crisis, some investors found comfort in the fact that when risk free interest rates are at or near zero, the discounted future value of equity securities was theoretically infinite.  Markets seem to have validated this view.  But to us the real question is this: If a company or country has excessive and growing amounts of debt outstanding against existing assets, what is the value of the equity?  The short answer is non-zero and declining.  But hold that thought.

 

Reading through Grant’s Interest Rate Observer over the weekend, we were struck by the item on China Evergrande Group (OTC:ERGNF), a real estate development company and industrial conglomerate that has reported negative free cash flow since 2006, but has made it up in volume so to speak.  The stock is up over 200% this year, Grant’s reports.  The real estate conglomerate has its hands into all manner of businesses and seems to typify the China construction craze.

 

Grant’s recalled an earlier observation by a US Texas real estate manager in the 1980s, something to the effect that real estate is not a cash flow business, but rather an asset appreciation business – until you can no longer service the debt.  We can recall hearing similar cautionary comments about the dangers of leverage from Kevork S. Hovnanian years ago, when he spoke about holding on to some of his land investments in South Jersey for decades and with no debt.

 

Today the idea of investment without leverage draws ridicule, partly because unlevered returns in most industry sectors are down in single digits.  The observation from the unknown Texas real estate man three decades ago pretty much sums up the state of the US economy.  This week as The IRA heads for Leen’s Lodge in Grand Lake Stream for some Spring fishing, we see bubbles in the water just about everywhere, but little in the way of revenue growth.

 

Empty retail locations are multiplying across Manhattan.  Earnings in sectors like financials are up on cost cutting and share repurchases, but supported by little else.  Asset prices for all manner of investments have risen by double digit rates or more, but income – that is cash flow – seems wanting. 

 

As in the early 2000s, the Fed has squeezed credit spreads and thereby gunned asset prices, but to little effect in terms of employment or especially income.  While some of our fishing partners believe that tight spreads are always a benefit to the economy, when spreads fail to differentiate relative credit risk, then eventually equity must be restored via a little old fashioned deflation – right?

 

Consider the case of Amazon (NASDAQ:AMZN). Here’s a company with relatively little debt and fewer profits, but high revenue and equity market growth rates.  The company has less than $2 billion in net working capital supporting $140 billion or so in revenue, but trades at 3x sales and 21x book value.  Moody’s has AMZN at “BBB+” based upon improving debt service cover for its $20 billion in long term and lease obligations.

 

One of the fabulous FAANG stocks – this after Facebook (NYSE:FB), Apple (NASDAQ:AAPL), Amazon, Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) -- AMZN last week announced the acquisition of Whole Foods Market (NASDAQ:WFM) for $13.7 billion.  The consideration to be paid, in cash of note, is a rounding error compared with the $472 billion market cap of AMZN. 

 

And like AMZN, WFM is a low or no margin business as well, thus the pairing seems entirely appropriate -- but is also enormously disruptive.  AMZN + WFM adds to the financial black hole created in retailing by AMZN. The combination of AMZN and WFM is seen as bringing the deflationary apocalypse for the retail food sector, one of the more vulnerable parts of the US economy.  Jim Cramer of CNBC says "AMZN is a deflationary force.  Fed needs to think about it." 

 

True, but the more interesting question is how the massive expansion of debt orchestrated by the Fed since 2008 and particularly with QE after 2012 has impacted equity market valuations for stocks such as AMZN, as shown in the chart below.

 

 

By pulling trillions of dollars worth of duration out of the US financial markets via quantitative easing (QE), the Federal Open Market Committee has shifted risk preferences for both debt and equity.  The net result is a series of debt-fueled bubbles in various asset classes, but none larger and more problematic than in large cap US equities. In order to “normalize” the credit markets, the Fed must be willing to let the equity and debt markets adjust in the short-run – by no means a given.  With the toppy state of equity market valuations, the components of FAANG may be in for some significant downside.

 

Part of the reason that the FOMC remains so clearly hesitant about reducing the size of its balance sheet is the well-informed suspicion that the Street will be unable to absorb the increase in volatility that will accompany true market normalization.

 

Since much of the market in US Treasury debt and agency mortgage paper such as GNMAs is controlled by foreign central banks, the free float is small.  Dealer inventories are minimal, thanks to the Volcker Rule.  The end of portfolio reinvestment and even modest sales will increase both longer yields and market volatility.

 

For those of us who have been critical of Fed policy since the end of QE1 in 2012, the return of more normal levels of volatility would be a positive sign that the central bank finally is willing to allow markets to once again price risk.  But the downside is that the fiscal situation in the US and overseas could see yields on government debt rise dramatically once investors fully appreciate that the days of QE are ended.

 

Having redefined “normal” based upon the extraordinary environment maintained by the FOMC since 2012, the Yellen Fed is now faced with its greatest test, namely allowing the financial markets to engage in price discovery without overt government support.  We’ve been talking for years about the financial implications of the Fed’s portfolio and how trillions in duration negatively influences yields and spreads, but credit also impacts equities.

 

At the same time, mounting levels of public and private debt call into question whether investors can really invest in equities for the longer term without an assumption of more or less continuous QE.  Where would stocks like AMZN and WFM be trading in the absence of QE?  Just as a zero percent risk free rate suggests an infinite valuation for equities, the end to official market manipulation by the Fed suggests an equal adjustment in market valuations as we walk back from extraordinary to normal.

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null's picture

Good article.
Question was obviously rhetorical ...

Fahq Yuhaad's picture

Where does this Whalen guy earn money? The website is just blah blah articles.

Gordon_Gekko's picture

"Where would stocks like AMZN and WFM be trading in the absence of QE?"

ZERO.

ASimpleTrader's picture

Something most people don't know about Amazon, ( I interviewed with them once upon a time and had some family sowkr for AMZN for a number of years)  they pay roughly 1/3 of their peoples salary in company stock. Takes two years to vest before you can sell any of it. First two years you get s speical bonus to offsett the 1/3 less of company stock you can't touch. This dumps a TON of AMZN stock out into the 'wild' as people get is in lieu of some pay effectively, then in 2 years they start cashing out some of the stock to make up the loss of $$ an equivilent job would pay somewhere else. Amazon saves some real money by effectively paying everyone 1/3 less than they are normally worth. As long as the AMZN stock price keeps going up then thie scheme works. 

Microsoft did similar back in the day, and after something like 15 years they stopped calling themselves a 'growth stock' and started offering dividends? I don't remember the details. So AMZN doesn't effectively have to sell stock, they just give it away as salary which then gets sold on the market by people needing the cash to make up their salary base.

 

 

aliens is here's picture

Where is DOJ's anti-trust division on Amazon buying WF, aren't they suppose to prevent big companies from owning too much?

ASimpleTrader's picture

No, not really. Whole Foods isn't quite the retail market that Amazon plays in, Amazon Fresh notwithstanding which is more of a Amazon partnerships.

 

Too-Big-to-Bail's picture

Shouldn't be allowed to buy Whole Foods only Partial Foods

steve2241's picture

Expect a new "Loyalty Program" at Whole Foods:  Anyone able to present documentation showing government assistance of any kind will receive 15% off all their purchases.  Onward!

Never One Roach's picture

I'm ready for the "correction' or reversion to the norm.

Juggernaut x2's picture

This is all totally sustainable/ sarc

asteroids's picture

The FED and the FANG's are alike. They can print fiat or stawk. They have printed trillions. In the normal course of affairs J.Q. Public takes his dollars and trades them for debt or stawk and gets fleeced, hence resetting the matrix. Well, that can't happen this time. The FED tightening, will eventually cause stawks and treasuries to implode. Just a matter of time.

Juggernaut x2's picture

Now John Q Public takes his income and turns around and gives 60% of it back to the govt in some form of tax or fee- the other 40% goes to food and shelter and insurance- everybody is broke hence daily stock volume traded is about 1/3 of what it was in 2005.

Moe Hamhead's picture

Did I miss something, or does he never answer his own question?

Edward Morbius's picture

He answered it in the last sentence. "Lower than today's price" is essentially his conclusion. Not real brilliant, but... probably true.