While investors take a break from the market - busying themselves with holiday plans and vacation days instead - the equity bubble is getting closer and closer to popping once again. And right now, one recession-prone industry stands to fall the furthest. Here's a look at why trucking stocks are headed lower...
The most reliable way for investors to lose money is to buy assets that have been inflated by a bubble. Considering the lofty prices investors are paying for highly cyclical trucking stocks, many must believe that they cannot lose - especially in today's echo stock market bubble environment engineered by the Federal Reserve and Treasury Dept.
Many stocks exhibit bubble characteristics, having rallied far ahead of evidence that earnings have really recovered. In typical economic recoveries, rallies often occur on scant evidence that fundamentals have turned. But we are dealing with a hangover from a giant credit binge.
This hangover will return after the effects of the stimulus wear off, and it will correct many of the capital spending mistakes made during the credit bubble. Some of those mistakes are obvious, including supply gluts in residential and commercial real estate. But mistakes were also made in asset classes you might not expect, like building too much capacity in the trucking industry.
If businesses react to misleading price signals, they can easily make capital spending errors. Credit bubbles cause misleading price signals. These signals are unhealthy because they act to pull future demand into the present.
This artificially boosted demand sends the signal to businesses to add capacity. Then, once the growth in credit slows, or even reverses, demand can fall far below supply. The industries that were most aggressive during the boom are left with excess capacity. Even the best businesses within each industry suffer from the investment enthusiasm of their peers, which winds up suppressing prices and profits.
Governments, central banks, the banking system, and borrowers worked together to inflate the biggest credit bubble in history. The bubble was so large that most of its fallout cannot be stopped - only delayed. Governments are running huge stimulus programs, which eases and delays the adjustment process. This temporarily restores some of the earlier boom conditions. But sooner or later, prices adjust until supply and demand fall into balance.
Inventories Are Critical for the Trucking Business
As the global economy adjusts to post-credit bubble reality, it remains to be seen how much inventory of physical goods is sustainable. The desire to hold inventory is critical for the trucking industry. Lower demand for inventory and lower final consumer demand translate into less frequent deliveries from 18-wheeler trucks. Inventory is in a constant state of flux, and reflects businesses' estimates of their customers' demand.
Most mainstream economists expect inventory replenishment to boost GDP growth in the coming quarters as government stimulus spending wanes. But I have my doubts. Those expecting an inventory replenishment cycle are operating under the assumption that 2006-2007 inventory levels were sustainable.
How much inventory do businesses really need?
This is something that each business must decide for itself. But with hindsight, we know that retailers in particular held far too much inventory heading into the 2008 collapse in retail sales. Inventory planning has its tradeoffs: Too much inventory leads to weak profit margins and returns on capital, while too little inventory leads to missed sales opportunities. The recent buying behavior of many retailers reveals that most are willing to sacrifice sales in order to protect profit margins and are not expecting a quick recovery to peak sales levels.
This nasty recession has forced every business involved with physical trade - from manufacturers to distributors to retailers - to reassess how much inventory is appropriate to hold. The inventory-to-sales ratio provides a rule of thumb. This ratio has historically trended downward as more businesses adopt just-in-time inventory management. But during the 2008 crisis, this ratio spiked as sales dropped much faster than inventories.
According to the U.S. Census Bureau, the economywide inventory-to-sales ratio was 1.3 at the end of October 2009, down from an early 2009 peak of 1.45. This ratio is now back to the 2004-2007 average of 1.3, so unless final demand picks up dramatically, the widely anticipated inventory rebuilding cycle will be tame.
With many businesses still shell-shocked from the crisis, it's unlikely that we'll see a rush to preemptively build more speculative inventories. Yet the trucking stocks have already priced in a robust recovery in freight volumes and pricing.
While I think that trucking is the industry with the most downside right now, a similar situation is likely to continue for a number of other industries, including bulk shippers and companies that operate in similar transportation niches. Stay away from these issues until further notice.
Dan Amoss, CFA