Stocks at All Time Highs Regardless of Higher Jan CPI Report?!

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Market News and Short-Term Predictions

The January 2024 CPI report revealed an unexpected increase in inflation, causing concern in the markets. The CPI for All Urban Consumers rose by 0.3% in January, slightly higher than December's 0.2% increase. 

This indicates persistent inflationary pressures, particularly in the shelter sector, which saw a significant 0.6% increase and contributed to over two-thirds of the month's overall rise. While the energy index fell by 0.9%, food costs continued to climb, with both home and away food indexes increasing. 

The core CPI, excluding food and energy, also rose by 0.4%. Year-over-year, inflation increased by 3.1%, with core inflation at 3.9%, surpassing expectations. 

These figures suggest the Federal Reserve may maintain higher interest rates to combat inflation, impacting market expectations for rate cuts. For more details, you can read the full report on J.P. Morgan's website: January 2024 CPI Report: Inflation Ticks Up in Unwelcome Surprise

We saw some whipsaw action in the markets, but definitely, the biggest swing was in small caps like the Russell 2000. That is because small caps are the most sensitive to any changes in interest rates as they have a higher % of companies that hold debt on the balance sheet that is variable rates.

This brings me to a move I made this week in the portfolio. I ended up switching out my IWM (Rusell 2000) position entirely for IJR (S&P 600). Now they are both small-cap ETFs, but here are some of the few reasons I made the move.

The S&P SmallCap 600 is favored over the Russell 2000 for several reasons:

• It has outperformed the Russell 2000 by an average of 1.6% annually over the past 25 years.

• The S&P 600 uses an earnings screen for index inclusion, requiring companies to have positive earnings, which leads to a focus on profitability.

• This focus on profitability has contributed to the S&P 600's higher returns and lower volatility compared to the Russell 2000.

• The quality factor exposure resulting from its earnings requirement makes the S&P 600 a tougher benchmark for active managers to beat.

• Fun fact: More than 30% of Russell 2000 members are zombie companies  That means those companies don't earn enough to pay interest expense on their debt  This causes a drag on the performance of IWM.

I do still believe that small caps will outperform in the latter half of this year if the Fed does start cutting rates. Granted based on the Jan CPI report, that outperformance may be pushed back haha

Lessons to Be Learned

Let's talk about something called stock compensation. 

This is when companies, especially new tech companies, give their workers a special deal. They let them buy stock at a cheaper price, or sometimes they just give them the stocks as a gift. It's a nice way to make employees happy and save some cash. But, there's a catch. While it sounds awesome for the employees, it can sometimes hurt current shareholders. Let's break it down into simpler bits:

1. Dilution of Ownership

When a company gives out stock to its employees, it's like cutting the pizza into more slices. If you were expecting a big slice of pizza and now you get a smaller one because there are more slices, you might feel a bit bummed. This is what happens to shareholders - their pieces of the company get smaller because more pieces are going around.

A perfect example of share dilution is AMC where they expanded 11 million shares outstanding to 163 million shares a few years later. 

2. Impact on Earnings Per Share (EPS)

When a company makes money, that money gets divided among all the stock pieces. If there are more pieces because of stock compensation, each piece gets a smaller bit of the money. This smaller slice is called Earnings Per Share (EPS), and when it gets too small, people might not want to buy the stock anymore because it doesn't seem like a good deal. That can make the stock's price go down.

That's why you should always look at metrics at a diluted per-share level to incorporate any share dilution that may have happened over the years.

3. Incentive Misalignment

Giving stocks to employees is supposed to make them care more about the company's future because they own a part of it. But sometimes, it makes them think too much about making the stock price go up quickly instead of focusing on what's best for the company in the long run. This can lead to choices that might not be good for the company later.

Conclusion

Stock compensation has its upsides, like making employees happy and saving cash. But, companies and shareholders need to think about the downsides too. Sharing the company with more people through stocks means everyone's piece gets smaller, it can make the company's earnings look less impressive, cost more money than expected, lead to short-sighted decisions, and miss out on other opportunities to grow. Companies need to balance making employees happy and keeping the company healthy for the shareholders.

If I can avoid it, I try not to invest in companies that dilute too heavily. Tech companies tend to be the biggest culprits :) It's also one of the tricks that companies use to boost their FCF, but their profitability remains low. If you want the true FCF, I always back out the stock-based compensation to account for what I see as a real expense.

Portfolio Update

Stock Watchlist

Stocks: TSLA, LLY, ADSK, SBUX, NOW, CELH, CVS

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