The Real Issue Is Inventory Buildup

 | Feb 13, 2014 | 4:30 PM EST  | Comments
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The actual moment when I believe this market went from "irrational exuberance" to actual delusion occurred at 11:57 a.m. today. At this time, I clicked on a CNBC.com article entitled "U.S. stocks rise as disappointing data seen weather driven."

I worked as a sell-side analyst for 10 years, and I realized quickly that it is far easier to generate client happiness and votes with long ideas than with short ones. The majority of managers are long-only, and this leads to cheerleading among money managers, and then by association, the financial media. But every person has a tipping point, and mine came with that article.

Can we stop blaming the weather for everything? It's just a ridiculous excuse, and it makes sense only if we were comparing the current weather with a year-ago period when the entire U.S. (or entire planet, depending on data being analyzed) were covered by some sort of weather-protective dome.

The weather on the East Coast is indeed horrible, and as someone who can't get back to either his place in the Triangle region of North Carolina or his apartment in New York City, I couldn't empathize more with those who are suffering storm-related trauma. But it is winter in the Northern Hemisphere, isn't it?

In a data point largely ignored today, the Commerce Department reported that business inventories rose 0.5% in December, compared with a 0.1% rise in business sales. The inventories-to-sales ratio rose to 1.3, the high end of the recent range of 1.25 to 1.30. Companies were building stocks to supply a consumer whom I frankly don't believe is that healthy, especially at the low end (go back and re-read Wal-Mart's (WMT) earnings report if you don't believe me).

So when inventories are running at the high end of a comfort range, the big worry is a demand shock that will cause inventories to build even further. And of course, now we are having one. Oh my God, I just blamed the weather!

Anyway, when inventories are too high, prices will have to be cut, and that affects margins. Remember, as I noted in my Jan. 28 piece, the earnings estimates for the S&P 500 are predicated on significant margin expansion, and the 2015 estimates even more so.

That's just not going to happen if prices for goods already produced are to be cut. Obviously, cost-cutting affects only future sales revenue, not dollars generated from goods already held in inventory (those production costs have already been incurred). We're looking at endemic margin pressure here, and in an environment where margins have to rise to make S&P earnings estimates come true, that makes me worry about the market as a whole.

Auto companies have been the most flagrant offenders, and as someone who spent a decade following that industry, I can tell you that recent 100-plus-days' supply inventory readings from Ford Motor (F) and General Motors (GM) are an absolute flashing red light. The Big Two will have to cut production to avoid choking their dealers, and in that industry, production equals earnings.

But I am looking for a broad-based (not just autos) inventory correction in the U.S. economy, and that will hit GDP. Inventory growth added 42 basis points to the fourth-quarter GDP growth of 3.2%, but that factor can just as easily be negative as positive.

The bull case on the U.S. equity markets has been based on an acceleration in GDP, which, by association, juices corporate profits, and I just don't see that happening.

Procter & Gamble (PG), Wal-Mart, General Motors and so many consumer-focused companies have issued downbeat profit guidance in the last two weeks. And the capper was Cisco Systems (CSCO) last night. Make no mistake, Cisco CEO John Chambers called the emerging markets a "blip" that occurred over the last month on Cisco's September conference call. But Chambers' cautious outlook last night seemed to stem from much more broad-based issues than those that are affecting emerging markets, and if the enterprise slows down, corporate earnings estimates are in even more jeopardy.

So Portfolio Guru is still bearish on the overall markets, and I continue to seek high-yielding alternatives to common stocks for my clients. 

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