Margins look peaky

Good morning. We’ve written before that if inflation is going to subside peacefully, workers have to enter the workforce. We got bad news on that front yesterday: quits and job openings rose in March. If the Fed still needed a reason for a 50 basis point increase and a swift reduction in the balance sheet, they have it now. Some comments on margins and on sentiment below. Email us: and

Margins must fall

Here is a chart of the year over year change in the producer price index, through the end of the first quarter:

And here’s the employment cost index, an inclusive measure of labour costs:

Off the top of your head, what do those charts mean for corporate profit margins? Well right now, as it turns out, margins don’t care. Here are quarterly operating margins for the S&P 500:

Margins have come off their peak, but are still near all-time highs and are well above pre-pandemic levels. In a sense, these three charts taken together are just a picture of the current inflationary environment. Supply is constrained, limiting competition for many products and taking away an incentive to keep prices low. At the same time, both household and corporate customers are flush with cash from government stimulus, meaning demand is hot. Under these conditions, even big input and labour costs can be easily passed on to consumers.

All of this makes sense. Two questions, though. First, what will the margin chart look like if we do get the much-hoped-for “immaculate disinflation” (that is, inflation subsiding without a recession)? A key element of the Goldilocks scenario is that more supply comes online, both of goods and of labour. The former increases price competition and the latter prevents a wage-price spiral.

If that happens, margins are going to come down: companies that price too aggressively in an environment of ample supply will lose market share, and consumers will discriminate more on the basis of price as the labour market cools.

Suppose now that there is not an immaculate disinflation, and the Fed has to resort to causing a recession to control inflation. You can be sure that margins will come down in that case, too — but by even more.

Either way, margins are coming down. Now, boys and girls, do we all have significantly lower margins in our earnings models? Good.

The second question is more peripheral. How quickly does the environment change from a hot economy where costs can be passed on without friction, to a knife fight for market share? Hat tip to my colleague Sujeet Indap who pointed out a gem of an article written by two partners at Bain, a consultancy. It advises companies that inflationary periods offer good cover for margin-widening price increases:

Limited experience with inflation may be translating into missed opportunities to play offence. Pricing moves, executed thoughtfully and strategically, cannot only help cover cost increases but also expand margins.

The most effective private equity firms are helping portfolio companies develop pricing playbooks that serve a dual purpose: tracking the cost pressures the business is under and preparing the organisation to take pricing actions that better reflect the full value proposition for customers.

Moving proactively with a clear view of what’s coming is the best approach to preserving margins amid a period of rising costs. And for those in a strong position, it may be an important chance to set the bar higher.

These sentences seem to have been developed in a lab — part of an experiment to see how nefarious a management consultant can make itself look (“Times are tough! Screw your customers while the screwing is good!”). That said, I don’t think this is actually nefarious at all. Companies should charge what they can. Profit is the point of the whole exercise.

The interesting question is whether Bain is giving good advice here. Are companies that push prices as hard as the current environment allows, maximising profits in the short run, going to find themselves paying a price in market share down the road? I don’t have the answer to this question, but when I look at that margins chart, I do wonder.

Be greedy when others are scared shirtless

Yesterday’s letter featured this chart of bearish survey sentiment versus future S&P 500 returns:

It’s a simple message: when everyone’s down on stocks, a little perking up is all that’s needed to boost prices. And on the other hand, if everyone is partying, be worried. Admittedly, though, the chart is crude. Is more going on?

First, we turned the noisy sentiment data from the chart above into an index to smooth things out. Specifically, we took the six-month average of what share of investors said they were bearish, and measured how many standard deviations from average the bearish sentiment was. If bad sentiment suggests good stock performance to come, our index should correlate inversely with future S&P 500 returns. But the data showed no meaningful relationship (scatter plot is twice yearly since July 1987):

A thin relationship isn’t shocking. Sometimes, like in 2008, sentiment was bad because market conditions were in fact really, really bad. Still, maybe we just aren’t cutting the data in the right way.

Unhedged’s readership has thought more about this. One reader at a European family office recently broke down bull/bear sentiment into four quartiles, from most bearish to most bullish, looking for how each category corresponds to S&P 500 returns six months down the road. He found that bad sentiment foreshadows higher than usual average returns — but only for the most bearish quartile. Only when investors are at their sourest, in other words, should we expect a sentiment-driven bounceback.

That’s broadly in line with work done by Faek Menla Ali, a finance prof at University of Sussex Business School, who wrote in to share a recent paper. He and two co-authors fashioned sentiment data from the social-investing service StockTwits and looked at the correlation to Dow Jones Industrial Average returns. They conclude:

Predictive effects of sentiment . . . show that sentiment is a strong negative predictor of returns in the lower [return] quantiles only, implying that sentiment mainly affects the valuation of assets in turbulent times.

The punchline: wait until investors are not just scared, but scared as hell, before you get greedy. (Ethan Wu)

One good read

The NFT market is collapsing.