Higher margins are a mixed blessing

Good morning. After a string of downbeat economic data releases, yesterday brought good news: the ISM Services survey for May came in well above expectations, and well into expansion territory. This is important, given that services make up the better part of the US economy. There was, however, a grey lining in the silver cloud. The employment section of the survey continues signal contraction (though a bit less so than in April). As we argued yesterday, if what you are worried about is a recession, employment, rather than activity, is what you really need to watch. Email me if your company is letting people go: robert.armstrong@ft.com.

Margins and competition

We have been discussing the high valuation of US stocks at some length lately. One closely related topic has not yet come up: profit margins. But in the FT on Tuesday, Adam Parker of Trivariate Research makes the connection. His conclusion:

The US equity market is going to trade at higher multiples for a long time because margins are going to be higher in the future than in the past

This might seem like an odd claim. Intuitively, the way higher margins support stock prices is by increasing profits, not the valuation of those profits (if you prefer: higher margins lead to higher earnings, not higher price/earnings ratios). But Parker has noticed a correlation between higher margins, specifically gross margins, and valuations:

The key thing to watch is gross margins, the profitability of a company measured by what is left after deducting the cost of goods sold from revenues . . . The higher the level of gross margins, the higher the enterprise-value-to-sales multiple investors pay for the business.

The enterprise value to sales ratio is a slightly obscure metric. It means the valuation of the whole company (both its equity and debt capital) relative to its sales, whereas the more standard price/earnings ratio looks at equity value only, relative to profits. But for present purposes we can look through this. The relevant questions are why margins should be sustainably higher, and why companies with higher margins should have higher valuations (on whatever metric).

Parker noted gross margins from US companies generally have been on an upward slope for decades, and he is right (though it is interesting to note that this is not true of operating or net margins, which are cyclically high right now but not on a clear long-term upward trend). He gives a very plausible explanation for why this might be: the composition of the corporate economy has changed. There are now proportionately more companies that sell things whose value is intellectual rather than material. More software companies, drug companies, and branded goods companies; less commodity, industrial and manufacturing companies. Companies that sell intellectual property have lower capital costs, lower inventory costs, and lower cost of goods sold, and so their gross margins are higher.

But should the profits of such companies be valued more highly in the market? Parker does not explicitly suggest a reason why this should be, but there is a good argument available. Companies that sell intellectual property tend to have deeper competitive moats than those in traditional “heavy industries”. Intellectual property laws, trade secrets, and strong brands mean these companies can keep their prices high for a long time without losing market share, whereas in the heavier, more commodified industries, profits are quickly competed down to the cost of capital. Sustained higher prices means the ability to reinvest retained capital at a higher rate of return, and means future profits will be more stable and longer-lasting, so the value of the company relative to current profits should be higher.

This theory makes some sense. But you could restate it as “valuations are higher now because the economy is less competitive and companies capture more the benefits, at the expense of consumers.” That is a bit depressing for people like me — that is to say, for capitalists.

Equity volatility is still strangely low

Back in December, Unhedged discussed the oddly low volatility in the equity market. Six months later, the trend is holding:

The ratio of the Move index of market-implied short-term Treasury volatility to the Vix index of implied short-term S&P 500 volatility remains at about its highest levels in 30 years. Relative to bond volatility, equity volatility is stuck at very low levels.

As we said in December, it is not altogether surprising that equity volatility itself is low. What is strange is that bond market vol has not driven equity vol higher. The IMF’s Global Financial Stability report from April concurred that there is something spooky about this. The global economic policy uncertainty index gauges geoeconomic anxiety by tracking disagreement among economists, tax provisions set to expire, and media mentions of economic policy. This index had tracked risk asset volatility closely for the past few years — but not now. The IMF’s chart: 

Some of the structural forces we named in December are still at play, including the popularity of ETFs that sell equity options to increase yields. Increased option selling lowers option prices, which mechanically depresses implied volatility and the Vix. In addition, low correlation among stocks means gains cancel out losses at the index level, further damping volatility. The CBOE implied correlation index, which measures implied correlation between the top 50 stocks in the S&P 500, is at a historic low:

A theory we have not previously considered comes from Russell Rhoads, head of research at EQDerivatives and professor at Indiana University. He sees “hedging exhaustion” in the market:

We came into this year with a lot of potential landmines. None of them have blown up on us quite yet. Investors [were] placing insurance on their bets through puts on the [S&P 500] or the VIX . . . But there has not been an implosion. So if [an investor is] doing that, paying something and not seeing benefit, they become less aggressive as far as guarding against a drop in their portfolio . . . That is one of the things weighing on VIX: market participants not being as hedged as before.

When you buy insurance and the storm never comes, you start to think the insurance a waste of money. So you drop it. Is your house then safer?

The Vix has been suppressed by ETF option-selling, low correlation and, if Rhoads is right, by investor complacency itself. By all means, trade it; but for heaven’s sake don’t use it as a risk measure.

One good read

Go buy yourself a nice jacket.

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