Hog Butcher for the World,
Tool Maker, Stacker of Wheat,
Player with Railroads and the Nation's Freight Handler;
Stormy, husky, brawling,
City of the Big Shoulders...
– Carl Sandburg, "Chicago"
As you well know, via Jimbo's ample coverage these past few days, the Taipan Global Opportunities Summit just played out in the City of the Big Shoulders.
All work and no play makes for dull editors, so at least a few members of the Taipan brain trust (including yours truly) made time to play. We took in the Chicago air show... jumped up and down in the glass box at the Sears tower (now the Willis Tower), scaring the daylights out of our fellow tourists... ate mammoth steaks carved right at the table, drank beer at the House of Blues, and so on.
Walking around this imposingly muscular architectural jewel of a city, one thing became clear. On the streets of downtown Chicago, at least, there is no recession to be seen.
We had dinner one night at Carmine's, a longtime Chicago institution. The place was packed to the gills. Lawry's, another Chicago favorite – packed. Timothy O'Toole's, the Irish pub where we wolfed down some grub fresh off the plane on Wednesday night – packed.
The faux French Bistro that overcharged us, the House of Blues, the skydeck, the Navy Pier, the InterContinental hotel bar, Chicago's bustling downtown streets and shops and parks... packed, packed, packed.
"For the worst recession in 70 years or so," I ruminated to my colleagues over a frosty mug of beer, "this sure is bizarre. There are people everywhere. And they are all spending money."
The same seems true out west. In Reno/Tahoe, where your editor hangs his hat, the hustle and the bustle is still here. The cash registers still ring, the hot spots are still hot, and life very much goes on.
So what gives? Is the recession a mass psychosis? The downturn merely a figment of some statistician's overly active imagination?
No. The thing to remember is that things are not always as they seem... and the economy lives and dies at the margins.
It's All in the Margins
What happens at the margin – the edge, one might say – is extremely important. One could even say it is overwhelmingly important. A few examples should help make this clear.
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To start, imagine two businesses. The first business makes a 3-cent profit on every dollar's worth of goods it sells. The second business loses 3 cents on every dollar's worth of goods it sells.
That's not a very big swing. The difference is only 6 cents. And yet that swing, because it takes place at the margin, makes all the difference in the world. A business that makes a 3-cent profit on every buck can scale up into the billions and become huge. A business that loses 3 cents, in contrast, is destined to go bankrupt.
Nor is the example hypothetical. Wal-Mart's reported net profit margin falls somewhere between 3 or 4%. So does the reported net of Amazon.com. Wal-Mart and Amazon have bootstrapped themselves to market cap valuations of roughly $200 billion and $35 billion, respectively, by making three pennies off every buck, and doing it on a massive scale.
Or take an even bigger example – crude oil.
Global crude oil production is estimated to run around 85 million barrels per day, give or take. The price of a barrel of oil depends on how much demand swings above or below that number.
If demand falls, say, a million barrels per day below global production levels, then that's a million fresh barrels going into storage (surplus) every 24 hours. If, instead, demand rises a million barrels above available production, that's a million barrels being drawn down from storage – day after day until the surplus runs out.
See the lesson there? A million barrels is a scant one percent (1%) or so of total global oil production. And yet, because we're talking about the last million barrels – the swing at the margins – we're talking about a major driver for prices. A persistent enough uptick at the margins is enough to send oil back to $100. A persistent enough downtick could send it to $40 again.
The U.S. Economy as Vegas Hotel
Another way to picture it is to think about the U.S. economy as a giant Las Vegas hotel.
When you hear that Vegas is hurting (and it most definitely is), the temptation is to imagine a neon ghost town. But that's not exactly how it works. A Vegas hotel can be in hot water even with plenty of guests streaming in and out of the gilded doors – because, again, it's all about the margins.
A key metric for hotels is occupancy rates. Above a certain occupancy rate – say, for the sake of example, 90% of rooms booked – a well-run hotel can make money hand over fist. The first 85%-90% of cash flow goes to cover the hotel's huge nut of fixed expenses. Above and beyond that, the money coming in counts as pure profit.
But that fixed expense nut can be a killer. Month after month, payrolls and utilities and marketing and property and finance costs have to be met. It's a bit like the monologue from Goodfellas (slightly modified for decency): Business bad? Screw you, pay me. Oh, you had a fire? Screw you, pay me. Place got hit by lightning huh? Screw you, pay me.
And so, when a hotel's occupancy rate drops from, say, 90% to 80%, the fixed expense nut suddenly looms. Below a certain level, somewhere in the 85% range, the balance sheet goes from solid black to bleeding like a stuck pig – red ink everywhere.
The U.S. economy has a similar problem, in that it has long been driven by 70% consumer spending. Uncle Sam's "fixed nut" amounts to things like government budgets and fiscal obligations and entitlement programs. Corporate America, too, wrestles with the same fixed nut in terms of overhead costs that can only be slashed so far.
A Tempting Mirage
Oh, and by the way – in the opening paragraphs of this piece I gave you the impression that Chicago is booming, right? Just rolling right along?
Well, it's a funny thing... the City of Chicago government had to shut down on Monday for lack of sufficient funds. As Chicago's CBS Channel 2 reports,
The City of Chicago is basically closed for business on Aug. 17, a reduced-service day in which most city employees are off without pay. City Hall, public libraries, health clinics and most city offices will be closed.
Emergency service providers including police, firefighters and paramedics are working at full strength, but most services not directly related to public safety, including street sweeping, will not be provided.
That also includes garbage pickup...
Mayor Daley tried to put a good spin on it. "Every dollar we save from these measures helps to save jobs, and in the long-term, maintain services for Chicagoans," hizzoner said. But, spin aside, the bottom line is that Chi-town is bleeding cash and trying to scrape up funds as best it can.
There is an important trading and investing lesson here, because most investors just don't think about the margins. They don't realize how much power can reside in a 1 or 2% swing – that subtle difference between red and black.
It can be so much easier, and so much more pleasant, to focus on the signs that everything is hunky-dory. In Chicago's case, that would be the crowded streets and restaurants and bars... the outward indication that lots of folks are still spending lots of money.
Besides, who wants to dwell on "Debbie Downer" type warning signs, like the fact that July retail sales were shockingly awful... or that Florida is seeing its first population contraction in 63 years... or the fact that 1 out of every 9 Americans (one out of nine!) is now on food stamps. (If you aren't afraid to delve deep into the nuanced economic truth – good, bad and ugly – check out WaveStrength Options Weekly (WOW) or Macro Trader.)
This lack of investor familiarity with the margins – and the way things change dramatically at the margins – further explains why Pollyanna Pundits can be such a danger to your pocketbook... and to your retirement. Not only do most talking heads fail to pay attention to what's important (focusing on fluff instead), in many cases they refuse to even attempt objectivity, preferring to bolster a shiny happy viewpoint.
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So when you see some mutual fund manager break out the rose-colored glasses on CNBC, remember how appearances can be deceiving – and how important it is to know what's happening at the margins. In that light, many of the fabled "green shoots" are the equivalent of smiling, laughing customers packing the tables at Carmine's or enjoying the free drinks at a bleeding Vegas hotel. Their presence doesn't tell you what's happening at the margins... and that's where fortunes are won and lost.
Warm Regards,
JL
P.S. The good news is that this kind of legwork – digging deep, getting beyond the surface level appearance of things – is exactly what we do. At Taipan we are obsessive-compulsive detectives with this stuff, eating and breathing the data so you don't have to.
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