Barron's Streetwise - Bed, Bath, and Look Out Below. Plus, an Inflation Warning

Episode Date: July 1, 2022

The outlook for shopping and store stocks. And a money manager makes a contrarian case on prices. Learn more about your ad choices. Visit megaphone.fm/adchoices

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a little bit more limited selection as we move through the summer. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard is Seth Basham. He's a retail analyst at Wedbush Securities, and in a moment he'll talk about what led Bed Bath & Beyond shares to lose 23% in a day this past week, and what it means for stores in general. Seth says the health of the consumer is deteriorating. Another analyst we'll hear from says conditions aren't so bad. We'll also talk with a prominent asset manager who says that the inflation rate

is likely to end the year even higher than it is right now. year even higher than it is right now. Listening in is our audio producer, Jackson. Hi, Jackson. Hi, Jack. I know you're the right guy for this job. Describe for folks the difference between Bed Bath & Beyond and Bath & Body Works. Jackson, are you still there?

Okay. I know what Bed Bath & Beyond is, so that's easy. We're all listening. It's kind of like a home goods store with – there's always escalators. Exactly. Home goods and escalators. You nailed it. You get your toilet brush. You get your lamp and your lampshade.

You get your end table and all that stuff. And tell us about Bath and Body Works. I can't remember ever being in a Bath and Body Works. That's the one where you get wheezy on the way by in the mall if you're sensitive to perfume smells. It's all lotions and potions. I am looking at the website for Bath and Body Works just to give you a flavor. I see there's an online exclusive sea salt and lavender ultimate hydration body cream.

I think I know why I am unfamiliar with Bath and Body Works. And it's because I use a two in one for shampoo, soap and conditioner. That's pretty efficient. shampoo, soap, and conditioner. That's pretty efficient. There were actually three bath-related stocks that slipped on a bar of soap this past week. Bed Bath & Beyond plunged 23% after a disastrous earnings report and news that its CEO was leaving. By the way, that stock has now joined the 90% club. Those are stocks that are down more than 90% from their high prices. I count more than 50 such stocks, and that's only including U.S. companies that are still worth more than a billion dollars.

The list includes some cannabis and crypto and clean power generation companies, along with Peloton, Carvana, Virgin Galactic, and Robinhood, to name a handful. You don't want to become a member of that group, but that's just what Bed, Bath, and Beyond has now done. The second Bath stock is Bath and Body Works, which is also in between CEOs, and which fell 9% after JP Morgan downgraded the stock and slashed its price target by more than half, citing potential for sales declines. The third stock is RH, which owns Restoration Hardware. It doesn't have Bath in the name, but it does sell faucets and tubs, so I'm counting it. RH fell 10% in a day this past week after lowering its guidance for the

second time in a month. Now, the technical term for big simultaneous declines in three bath stocks is a bearish naked sprawl. That's not true, but it should be. And consumer spending is at the center of three big Scooby-Doo mysteries facing investors right now. Number one. Zoinks! Are we in a recession? I don't mean are we headed for one later this year or next year. I mean, has one already started? It's possible. Scooby-Doo mystery number two. Jinkies! Number two is whether the inflation rate is about to plunge. We'll hear more about that in a bit. The third.

And it would have been mine if it hadn't been for those meddling kids. The third is whether corporate earnings estimates are too high. I call these three things mysteries because I hear convincing arguments on both sides. Each of them will help determine what stocks do for the rest of the year and beyond. And shopping is at the heart of it. To learn more about the state of shopping, I reached out to a Wall Street analyst who covers dozens of stores. The health of the consumer is deteriorating. We have affordability challenges driven primarily by inflation, and that's limiting their purchasing power for especially discretionary merchandise.

That's Seth Basham at Wedbush Securities. And as you can hear, he's cautious on the outlook for shopping because consumers are getting pinched by inflation. stopping because consumers are getting pinched by inflation. They're making more and more choices about what to spend on. And they're spending more of that discretionary money on experiences and less on goods, especially bigger ticket discretionary goods, and especially things that they've made purchases of in the last two years during the pandemic. And the prime area where purchases were on fire for the last two years in terms of discretionary goods was in home-related items, whether it be furniture, furnishings, consumer electronics, etc. Excess inventory is a big concern. Bed Bath & Beyond talked about it. So have Target and Walmart and some of their suppliers. it. So have Target and Walmart and some of their suppliers. Seth says there has been a double whammy.

Demand is slowing and there were delays in company orders. So some merchandise that they no longer need is showing up now. I happen to be in the market for patio furniture. I wanted to buy some last year, but pickings were slim. So I put it off and I made do with what we have. Seth says that's just the kind of item that will sell for big discounts this summer. The demand signals went through the roof over the last two years. So we saw more retailers get into the category and more retailers order more. And so inventories are very high of patio furniture. This year, we had first of the late spring in the northern part of the country. And then secondly, in this drop off in demand.

So there is a lot of excess patio furniture inventory out there. And we're starting to see more extreme discounts than normal. So you're in a good time right now to be buying patio furniture as a consumer. And you'll see even deeper discounts, a little bit more limited selection as we move through the summer. But I've already seen a number of promotions, whether it be from William Snowmore, Bed Bath, et cetera, et cetera. Okay, so what should investors do now with retail stocks? Seth mentioned a handful of defensive picks. We're still defensively positioned within the hard lines group.

So names we like the most include AutoZone, AZO. They include Petco, Wolf is the ticker, W-O-O-F. And Chewy, C-H-W-Y is the ticker, which we upgraded last week. Seth used the term hardline. That's a retail term. As an analyst once described it to me, hardline goods are mostly ones that would hurt if they were thrown at you. Auto parts definitely seems to fit the description. Dog bones too, I guess, although I'm not sure where that leaves squeaky toys. Seth says auto parts and pet supplies

are both defensive because even in a recession, we'll still keep our cars running and our furry friends fed. Okay, so what can the experience of Bed Bath & Beyond teach us? Some investors have viewed the company as a turnaround candidate, but sales are now plunging and the company's burning cash, which limits its ability to spend on a turnaround effort. Bed Bath owns a chain that sells baby goods called Bye Bye Baby. It seemed to have spinoff potential, but same-store sales there have been declining too, which makes a spinoff or sale seem less appealing. So what went wrong? Seth says that the company was

hit by some of the same supply chain challenges as other retailers, but that it also made some key missteps. Their systems are not up to snuff. They're not world-class systems when it comes to IT and inventory and supply chain management. They're caught with an assortment that's not appealing to the customer right now because it's too heavy in higher price point items, and it's leading to a deficiency in their ability to drive top line sales and profitability. The notion that Bed Bath & Beyond has fallen behind on technology. I heard that from another analyst. They were very late to the internet. And we know that a significant part of success in the pandemic, if you were a retailer, was how well invested you were with what we call an omni-channel retail. So that is how strong was

your inventory visibility online? How easy was it to do things like curbside pickup? do things like curbside pickup. That's Sucharita Kodali. She's a retail analyst at Forrester Research, which focuses on technology. She makes the point that Bed Bath's tech deficit has left it struggling to predict which goods customers will want. As for the broad outlook for retail, Seth says that much will depend on demand, but that order lead times for home goods are typically six months and that stores have already cut back on ordering and it could take them into early next year to clear out their inventory. You probably need, you know, nine months or so to clear through what you already have and what you already have ordered in excess. And the holiday season is a great time to do that because there's usually higher seasonal demand.

But as with many economic mysteries right now, there are different views on the health of the consumer. Sucharita is less convinced that consumer strength is deteriorating. I think that there were a lot of people who thought that when pandemic stimulus payments would run out last fall, that retail would collapse and that spend would decline substantially, but that didn't happen. And there's a lot that is happening that doesn't seem to fit with the conventional wisdom. So it's hard to tell. The high price of gasoline is a pretty clear drain on household finances, but at the same time, many drivers are still working from home. There's little doubt that lower income families are struggling with rising costs, but it's less clear for now how much other

groups of consumers are struggling. Here's Sucharita. I look at the census data, which shows record high levels of consumer spend. And it's hard to look at that and say that the consumer is hurting when food away from home is at a record high. That's like eating out at restaurants when we're spending on gas. And a significant percent of consumers still don't need to even go into the office. And unemployment's really low. These are things that suggest to me that the economy is stronger than there seems to be credit given to it right now. Coming up, the latest reading on U.S. inflation is 8.6%. Where will it be at the end of the year? Half of that? Less? Our next guest says, try closer to 10%. If the average inflation of the last 12 months

is the best predictor of the next month, then inflation hits about 10.8 around the end of the year. That's next after this quick break. Parents, when you visit California, childhood rules. If you don't remember how awesome childhood is, just ask yourself, What would kids do? Dance to a giant organ played by ocean waves? Yep. Camp in floating tree houses hundreds of feet off the ground?

Check. Jump in a big tub of mud on purpose? Call it rejuvenation. We don't care. Just pack your fun pants and let childhood rule your family vacation. Discover why California is the ultimate playground at visitcalifornia.com. Welcome back. Perhaps you've heard an investment strategist use the phrase Dr. Copper. That refers to the supposed ability of copper prices to predict the overall health of the economy. And it makes some intuitive sense.

Copper is a key raw material in manufacturing. I've never quite understood the doctor part. Some people say that it means that copper has a PhD in economics, but that's just explaining a weird nickname with a weirder backstory. I mean, now Dr. Copper didn't even go to medical school. Anyhow, Dr. Copper fell 13% in the month of June. Professor Platinum and Commander Coco, they were both down 8%. Inspector Natural Gas plunged 35%. Not all commodities had big declines. Superintendent Sugar, Chief Officer Cheese, they were down only a couple of percent.

But a broad commodity index called S&P GSCI fell close to 8% for the month. And that raises the question of whether inflation has peaked, which is exactly what you would expect if consumer demand is weakening. Calls for following inflation are now so widespread that I've heard some financial forecasters begin to discuss not just when the Federal Reserve might have to slow down on interest rate hikes or abandon them altogether, but also whether it might have to begin cutting rates again, perhaps by the middle of next year. I can't tell whether that's forward-looking or forward-hoping, but I spoke with one asset manager this past week who takes a contrarian view on the matter.

So this is one of the dynamics, and hardly anyone looks at the year-ago number that's being dropped. I don't get it. It's right there. You just look at it. That's Rob Arnott. He's the founder of Research Affiliates, which turns 20 this year and which recently had $168 billion tied to its strategies. We just heard Rob talk about numbers that are being dropped. What he means is that the annual inflation rate, recently 8.6% in the U.S., is the product of not just each month's new inflation rate, but also what was going on with inflation in the same month a year ago. Every month, you add a new month to the inflationary data and you drop an old month.

You don't know what the new month is going to look like. You know vaguely, but not with any precision. You do know exactly what's happening on the month that's being dropped. Okay, so what's happening with the months that are being dropped? The next one will be for June of last year, and it's a monthly increase of 0.9%, which is high. If you had 0.9% inflation each month, you'd have yearly inflation of about 11%. But Rob says that inflation for this June could come in even higher. The Cleveland Fed has an inflation prediction model called the Inflation Nowcast, and it puts inflation for this past June at 0.97%, slightly higher than the month it replaces. If that's accurate, the overall inflation rate could go up, not down. Beyond June, the year-ago comparisons for inflation are much lower,

with monthly rates of 0.5% for last July and 0.3% for last August. Here's Rob. Inflation would have to be below 4% annualized in the coming quarter in order for year-over-year inflation to drop in the coming quarter. And that means that, let's say, if it's running 8% instead of 4%, that inflation goes up another percent. So instead of showing us eight, it shows us nine and a half because we're replacing low months with high months. And the next quarter is a little better comparison, but still not good. If the average inflation of the last 12 months is the best predictor of the next month, then inflation hits about 10.8 around the end of the year. Rob's view is not a consensus view.

If he's right, I think it might be fairly shocking for investors. The Federal Reserve might find it difficult to justify any slowdown on its rate hikes. Share prices could fall. The economy could weaken. Rob says to plan now for a recession. His view on inflation isn't just about calendar comparisons. There are other factors, and housing is a big one. We've talked before about runaway house prices, but house prices don't factor into the inflation rate, at least not directly. They used to, and they contributed greatly to a painful burst of inflation more than four decades ago.

Here's Rob. That led to peak inflation north of 14.5 in March and April of 1980. The Bureau of Labor Statistics was so appalled and so embarrassed at that huge surge in inflation that they looked around for an alternative. And they came up with what they called owner's equivalent rent. The logic was simple. If you own a home, you don't feel the rises in the home price. It doesn't feel like big inflation.

You feel it only if the cost of owning a home goes up. And so let's create a series of owner's equivalent rent, what the homeowner would pay in rent. Well, how do you get that? It's not a published number. So you ask thousands of people, what do you think your home would rent for? The problem there, Rob says, is that most people have no idea how to answer. I've asked lots of audiences out of 100 people. Typically, there's five or 10 homeowners who think they have a pretty good

handle on what their home would rent for. 90 plus percent don't. So they're going to pick a number out of the air. They're going to then ask the question the next time around. What did I say last time? 4,000. Okay, let's call it $4,100. It's anchoring, smoothing, and lagging. So when home price is super, what we find is that the owner's equivalent rent starts to ratchet up a little faster for years afterwards. That's a big problem now for two reasons, Rob says. The first is that over the past two years, house prices are up 37%, but owner's equivalent rent, or OER, the measure that goes into the inflation rate, is up only 7%. That implies that there's much more house inflation that has to make its way into the overall inflation rate.

The second reason is that housing is a big part of most people's spending, which means it's heavily weighted in the consumer price index used to measure inflation. We're expecting OER to come in high single digits, let's call it 6% to 9% per annum for the next three years, certainly the next two years. You can't get inflation back down to two if one third of CPI is playing catch up. I asked Rob what investors should be doing now, and he recommends increasing exposure to emerging markets.

The Russian-Ukraine war has crushed valuations in emerging markets. Now, what exactly does Ukraine have to do with Chile or Indonesia? It seems to me that emerging markets economies both have very cheap currencies and very cheap stock markets and bond yields that are higher than U.S. junk bond yields, even though most emerging markets bonds are investment grade. So all of this would suggest to me that investing in emerging market stocks and bonds is one place to go. It's not a safe haven. It's volatile, but it's cheap, which means that the volatility when they rebound is likely to be pronounced. Rob says that Europe and Japan face serious growth concerns, but that their stock markets appear around half as expensive

as the U.S. His view on the U.S. is more bearish than the consensus view. The problem, he says, is that corporate earnings look unusually high. So if you look at a measure that takes a long-term average of earnings, like the so-called Shiller price-to-earnings ratio, it suggests that stocks are still expensive. U.S. doesn't seem to be at peak fear. Using a Shiller PE ratio, price relative to 10-year smooth earnings, the valuations in the U.S. are actually higher than they were at the peak in 2007. Even now, after the fall off this year, the peak was 28 times. It's now about 29 or 30 times, even after this meltdown. So it went from almost unprecedented valuations to valuations that are still very stretched, higher than they've been any time other than 1929, 2000, or 2007. Thank you, Seth, Sucharita, and Rob, and thank all of you for listening.

Jackson Scrappy-Doo Cantrell is our producer. Come on, you gave me Scrappy-Doo? Are you more of a Fred? You don't even own an ascot. I'm at least a shaggy. Subscribe to the podcast, rate it, and write us a review. You can follow me on Twitter. I haven't tweeted in like a week or more, but I

could think of something clever any day now. That's at Jack Howe, H-O-U-G-H. See you next week.