🗞 An Empty Living Room

WHILE YOU POUR THE JOE… ☕️
History Can be Repetitive

This chart represents the Chinese tech sector versus the United States tech sector. Notice what happens every time their valuations deviate too much in favor of the US?

Yep, every time, and especially when coupled with a domestic crisis, Chinese stocks outperform 📈 US stocks for a more extended period.

This time, we won’t be surprised to see blue-chip Chinese tech names like Alibaba, Tencent, and Baidu take off.

A few posts ago, we wrote about Alibaba, breaking down the whole deal and explaining why we believe it could be worth up to $400 a share 🔥.

Speaking of breaking the deal down, let’s get on with today’s email 📧…

ECONOMIC DATAPOINTS PT 2
Doubling Down

Remember from Wednesday's post how we broke down the manufacturing PMI index? Well, today, we're doing the same with its cousin, the Services PMI index.

Look, manufacturing had historically been more important to investors and money managers, but let's be real… What does the U.S. even manufacture anymore?

Most jobs are now going to services, and a larger share of our GDP is headed there, too, so we should pay more attention to this as it comes out, just like the Federal Reserve is doing.

So, we have another month of expansion, though, at 51.5 (anything above 50 is expansion), we just don't see any reason to celebrate.

You see, markets typically don't react to this stuff unless it is a clearly directional reading, like a 54 or a 46, where it's obvious that we're headed into a boom or crash.

Anyway, let's see what really happened within this sector, maybe we can catch some ideas like we did from manufacturing. 💡 

Business Activity

Still pumping for the services sector, so if we’re looking for short opportunities here, industries with high business activity won’t be it.

Why the short bias? We believe that the dollar will weaken along with lower interest rates, causing domestic industries to suffer on consumer’s depleting buying power.

It also makes sense since a strong dollar is currently hurting most US stocks and their earnings per share, so a change would be welcome.

Let’s move onto the next segment.

New Orders

New orders actually expanded nicely for another month, but we still don’t have a fundamental reason to get long on this sector; it may be the last push before all the pipeline is out of the way.

So again, we won’t be looking for anything in particular here.

If anything, we want to match the same thesis we found in manufacturing, where industries riding off the top of the cycle are going to see falling margins and earnings.

How do we find them? It’s all in the next segment:

Inventories

So, just like in manufacturing, the cycle is going down harder now. The best way to pinpoint some of the weakest industries so we can find outsized returns by taking a short view is to align ourselves with the worst of the worst.

If you combine a rise in inventories with lowering new orders, you, of course, get idle supply that will eventually need to be marked down to spark new business.

That hurts margins, earnings, and, of course, the stock price 📉.

Here’s what we found in the business activity and new orders spread:

The common theme for the quarter is mainly in construction and agriculture.

Our big short post on Toll Brothers, a home builder, will start to make more sense after this new construction contraction; we’re up more than 8% on that trade now 🔥.

Anyway, let’s check how inventories did:

Sweet music, construction inventories are up and up for the quarter. This tells me that the potential markdowns in Toll Brothers inventory and backlog are going to continue, and that means I’ll probably double down on that short idea.

Where do we see it going?

It just broke down through our first low-volume node area, meaning there is really no sign of demand for this stock at the moment. After we double down on any uptick, we want it to trade at $130 before retest.

If $130 is broken, we can easily move toward $120, where we’ll consider taking half profits and a stop loss at the next low-volume area to lock in profits. 💰️ 

TRADE OF THE WEEK(END)
Being Bipolar is Necessary

By bipolar, I mean being able to go long and fall in love with one stock, then suddenly turn really bearish on it and sell it short.

That’s exactly what I had to do with Williams Sonoma here. I bought this stock in 2022 at around $115 a share, then turned around and sold it for close to $300 (this was before they did a stock split).

It was a thrill to nearly triple my money 🫰, but that’s what happens when you buy a great company.

By the way, I wrote a whole presentation on why I wanted to buy this stock, which you can find here at this link.

Anyway, after taking profits and still thinking this is a great company, I just can’t unsee what is going on in the furniture industry.

As a recap from our last post breaking down the manufacturing PMI, here’s what the space looks like (remember, we want lower new orders and higher inventory):

There you have it, furniture saw one of the worst contractions in new orders, falling from a complete slowdown over the past quarter.

At the same time, inventories are up to the second largest expansion in the manufacturing sector.

So, we went ahead and checked how Williams Sonoma stock looked against its peers in the furniture space:

Being a large cap makes it easier to short, as smaller companies are too volatile and have much more upside than downside, so it just doesn’t make much sense to go against them.

The sector's average forward P/E (PE2) valuation is 16x, and Williams Sonoma trades at 15.7x, so it’s not a screaming discount, but it’s not bullish either.

What caught our attention was the earnings per share growth (EG2) for next year, set at only 2.3%, well below the industry average of 36.5%. This makes its valuation way overextended compared to growth.

But

The ultimate reason to pick this as a short is found in the company’s financials, explicitly looking for inventory problems; we found them 👀.

Operating cash flows decreased by roughly $300 million 📉 over the past year, mainly due to inventory valuations.

Last year, Williams Sonoma had an inventory cash flow of $154.7 million, meaning it reduced inventory by making lots of sales.

However, this year, they saw an outflow of $1.4 million or a change in inventories of $156 million to the upside. This is English for they now have $156 million more inventory than last year.

That's not good, considering the industry's current state is down. It's especially bad since they will have to take a loss to move all this inventory, which will reflect directly on EPS 🙃.

No wonder the CEO has been selling the stock pretty much all year.

But, that doesn’t mean we’re going to come in Monday morning and short the hell out of Williams Sonoma, we need a better price.

We may be late to the party, but that doesn’t mean we can’t still join.

We are currently at a low-volume node for the stock, one that the market has recently rejected at $128-$130. Shorting here would be futile.

Looking for the stock to bounce toward the next node of $137-$139 is a better idea, but only halfway to a perfect position.

Ultimately, we are comfortable shorting this stock anywhere from $147-$150, potentially higher. 🎯 

If we get those prices, great; if not, it’s alright. We have about 20 other ideas we need to pursue, and letting one go doesn’t hurt our wallets or our egos.

NOW GO AND MAKE IT HAPPEN
A Trading Classic

You know how we can have done such a deep amount of work into an idea, have it be proved right in the market, and be okay with not taking it?

It’s because we invest and trade with a probabilistic mindset, and when the odds are against us, it just doesn’t make sense to pull the trigger, no matter how well-thought-out your idea may be.

Today’s book recommendation 📖 did a good job of showing me this mindset when trading, and hopefully, it will do the same for you.

To your success,

G. 🥃