CWS Market Review – September 14, 2021
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The August Inflation Report
The August inflation report came out this morning, and the evidence tells us that inflation is cooling off. If this trend continues, then the Federal Reserve will have been vindicated and inflation was, indeed, transitory.
Let me caution you that we’re not out of the inflation woods just yet, but the numbers we got this morning are encouraging.
In the report, the Bureau of Labor Statistics said that consumer prices rose by 0.27% last month. That was below expectations. While that’s not ideal, it’s a lot better than the numbers we saw in the five prior months. In July, inflation rose by 0.47% and the month before that, it was up by 0.90%. These were some of the highest numbers we’ve seen in decades.
If we look at core inflation, which strips out volatile food and energy prices, then inflation was up just 0.10% last month. Compare that to June when core prices rose by 0.88% or to April when core inflation reached 0.92%. That was its highest rate in 40 years.
Over the trailing 12 months, the numbers are still unpleasant as they include the ugly April-to-July period. Over the last year, headline inflation was up 5.20% while core inflation increased by 3.98%. Expect these to gradually drift lower.
This has been a good reminder for investors that when in doubt, pay attention to the bond market. James Carville, President Clinton’s advisor, famously said that if he were to be reincarnated, he would want to come back as the bond market because “you can intimidate everybody.”
While we’ve seen scary headlines and some alarming data about inflation, the bond market has been indifferent. The yield on the 10-year Treasury peaked at 1.76% in February. It’s been trending down most of the time since. In fact, the scarier the headlines, the more the bond market has ignored it.
What does the inflation report mean for investors? Overall, this is good news for a few reasons. I still think it’s likely that the Federal Reserve will start to pare back its massive bond buying before the end of the year, but any rate hike is still a long way off. (By the way, the Fed meets again next week.)
I like to look at the futures market to see what traders think. Unlike economists, they have skin in the game. Even by July 2022, the futures market thinks there’s a 10% chance that the Fed will have raised rates by then. In other words, that’s 10 more months of 0% interest rates.
Stock Returns and Real Yields
I’ve been particularly impressed by the very, VERY low yield on the 10-year TIPs. By this, I mean the yield on the “Treasury Inflation-Protected” bonds. It’s now at -1.05%. That’s the yield adjusted for inflation, also known as the real yield.
Tracking how the stock market performs relative to the real yield is very revealing. I suspect that this may become a more common topic in the future because the issue gets to the heart of stock valuation.
If someone says that the stock market is cheap or expensive, naturally you need to ask, compared to what? For judging stocks, the 10-year Treasury yield is a good starting place. The problem with looking at Treasury yields is that inflation can greatly impact them. That’s where the TIPs come in because these bond yields are adjusted for inflation.
Treasuries are, of course, less risky than stocks. So if real yields are going for 3% or 4%, it may make sense to ditch your stocks and hang out in bonds. Conversely, if real yields are low, or even negative, it’s like an open invitation to buy stocks.
What does the data have to say? I went to the St. Louis Fed’s economic database (an invaluable resource). I downloaded all the daily closings for the 10-year TIPs yield which goes back to 1983. I also downloaded all the daily total returns for the Wilshire 5000 stock index. That’s the broadest measure of the stock market.
I found that if you take all the days collectively when the 10-year TIPs has yielded 1.67% or higher, then you see that the stock market had a negative return. Stocks were a net money loser.
But when the TIPs yield has been 0.00% or lower, then the stock market has delivered an average return of more than 38% per year. This makes sense, but seeing the numbers is still surprising.
In short, the higher the TIPs yield, the worse it is for stocks. The lower the TIPs yield, the better it is for stocks. Nothing more complicated than that.
The TIPS tipping point seems to be at 0.5%. Anytime the yield on the 10-year TIPs is 0.5% or greater, then the stock market has delivered an annualized return of 5.1%. That’s probably less than the return of the TIPs bonds. But when the 10-year TIPs yield is under 0.5%, then the stock market has delivered an annualized return of 23.3%.
As I said before, the current yield on the 10-year TIPs is -1.05%. That isn’t just low – it’s close to as low as it’s ever been. The 10-year TIPs yield hasn’t been positive in 18 months. For now, the bond market is signaling more good news for stocks.
Stock Focus: Paycom Software
This week’s featured stock is Paycom Software (PAYC). Paycom’s job is to make your human-resources department more manageable. This isn’t so easy in the modern business climate. HR departments have to deal with lots of government regulations on top of needs specific to their industries. That’s not so difficult for a large corporation, but the HR requirements for a small start-up can be a major headache. That’s where Paycom comes in.
Paycom describes itself as a “leading provider of comprehensive, cloud-based human-capital management solutions delivered as software as a service.” The company makes and sells software that lets companies easily hire, manage, train, and most importantly, pay their employees. The advantage that Paycom brings is that its software centralizes the whole process.
For example, consider the process of finding a new employee. This is a major decision for any young company. Paycom can help with every step of the process. That includes tracking interviews and background checks.
Once a new employee joins up, there’s more paperwork to deal with. The employee has to make decisions regarding health insurance and retirement savings. On top of that, there’s on-board training. Paycom streamlines the entire process. This saves a company money, and, just as importantly, it saves time. Paycom currently has over 30,000 clients, and they’re very popular with their clients. The company’s annual retention rate consistently exceeds 90%.
As this chart tells you, business has been good for Paycom:
Even after a new employee joins, Paycom still helps. Its software helps manage sick and vacation days as well as keeping track of training. Paycom provides functionality and data analytics that businesses need to manage the complete employment lifecycle, from recruitment to retirement.
Employees at customer firms love Paycom’s ease of use. Their software lets employees manage their own HR needs in the cloud, which reduces the administrative burden on employers and increases employee productivity.
This is a very lucrative sector. I project that Paycom’s earnings next year will be ten times what they were in 2015. This is one of the most innovative mid-cap stocks I can think of. You might assume that Paycom is another tech outfit based in Silicon Valley. Nope. Try Oklahoma City! But that shouldn’t be surprising. This is the world we live in today.
The company was founded in 1998, and it IPOed seven years ago. Paycom’s business has been growing at a rapid clip. Earnings-per-share jumped from 19 cents in 2014 to $3.49 last year. I think they’ll clear more than $4.40 per share this year and as much as $5.60 per share next year.
Last month, Paycom reported fiscal Q2 earnings of 97 cents per share. That topped estimates by 13 cents per share. Total revenues rose 33.3% to $242.1 million. Importantly, 98.1% of those revenues are recurring. That’s a very good sign.
Investors should also look at cash flow instead of focusing solely on earnings. For Q1, Paycom’s adjusted EBITDA, which is a measure of cash flow, came in at $87 million. That’s up from $61.2 million in the same period last year. Traders were impressed by the results. The stock jumped 11% after the earnings report.
Chad Richison, Paycom’s founder and CEO said, “The fundamentals of our business continue to strengthen, as demonstrated by our very strong second quarter results.”
For Q3, which ends in a little over two weeks, Paycom expects revenues between $249 million and $251 million, and EBITDA between $87 million and $89 million. For all of 2021, Paycom sees revenues of $1.036 billion to $1.038 billion, and EBITDA between $410 million to $412 million. The earnings report will be due out in early November.
I’ll caution you that Paycom is hardly a value stock, but its growth potential is very strong. Paycom is trading at 80 times my already optimistic forecast for next year.
This is an excellent company. I’m going to keep a close on eye it. If Paycom falls to $300 as it did this spring, it could be a welcome addition to our portfolio.
I’ll have more for you in the next issue of CWS Market Review.
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Posted by Eddy Elfenbein on September 14th, 2021 at 7:17 pm
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.