It's that time in the economic cycle again. Often considered a strong recession predictor, the yield curve on the five-year Treasury note fell below that of the three-year note. What now?
In today's episode of MarketFoolery, host Chris Hill and Motley Fool contributor Emily Flippen tell investors what this inversing business does and doesn't mean for the market, some tips for staying calm when a recession eventually, inevitably hits, and why it's so important to keep investing throughout it all. Also: Toll Brothers' (NYSE:TOL) quarterly profit popped 62%, but the stock still fell on their report. Toll Brothers blames the media. Meanwhile, Restoration Hardware (NYSE:RH) popped about 15% on its earnings, but that doesn't speak to its long-term future. Find out more below.
A full transcript follows the video.
This video was recorded on Dec. 4, 2018.
Chris Hill: It's Tuesday, December 4th. Welcome MarketFoolery! I'm Chris Hill. Joining me in studio, Emily Flippen, back by popular demand. Thanks for being here!
Emily Flippen: Thanks again for having me!
Hill: It is by popular demand, although for those on Twitter who have asked, "Where is Emily Flippen? Why is she not on Twitter?" She has not yielded to that demand yet.
Flippen: But as the consumer demand rises, I may have to.
Hill: [laughs] We'll get to how Twitter can be helpful for investors, or certainly was helpful for us today. We're going to talk earnings, we're going to talk housing in a couple of different forms, specifically Toll Brothers and Restoration Hardware.
Let's start with Toll Brothers. Fourth quarter profit up 62%. That's the headline. And if that was the only thing that mattered, then you'd be very confused by the fact that the stock was down. The stock's not down as much as it was. It's down about 1.5% right now as we came into the studio. It was down a bit more earlier. When you look at what's going on with the Toll Brothers, what do you see?
Flippen: We're looking at the housing market in general, and a smaller part of that housing market, the niche, high-end, very expensive housing market. I think the reason why we're seeing the now-small decline, what was a very large decline, is just because of the fact that, that was the first fall in quarterly order orders in four years. They were hit by those rising interest rates, homes now not as affordable as they once were for the average person, at least. While their backlogs and deliveries are still very high, there's now a little bit of investor fear about whether or not that's going to be continued for the next few years.
Hill: Some of that fear was touched on by Toll Brothers itself in their statement. I'll just quote directly from the earnings release. "In November, we saw the market soften further, which we attribute to the cumulative impact of rising interest rates and the effect on buyer sentiment of well-publicized reports of a housing slowdown." Kudos to whoever on the communications team at Toll Brothers who said, "Let's use the tried-and-true playbook of blaming the media." There's a little bit of blaming the media when it comes to that. But to your point, it would just be crazy to ignore the reality.
Flippen: Yeah. You can blame the media all you want, but ultimately homebuilding is still one of the leading indicators of change in a business cycle. It's natural, when people see these houses stop being built, construction slowing down, to be a little bit afraid, because it is a leading indicator. I think it's silly to push it back on the media and investors in particular, especially because investor sentiment, while you can scoff at it all you want, does cause recessions, does cause economic turndown, and does affect your company. So, it's interesting to see that dichotomy between the way their PR people act and what's actually happening in the market.
Hill: As an investor, are the homebuilders as a group a way that you're interested to invest into the housing market? Or are there other ways? It seems like, for anyone who's looking at the housing market as an investor and thinking, "OK, this is a huge industry, there are a lot of ways to invest in it," it seems like investing directly in the Toll Brothers of the world is an intermediate level of difficulty.
Flippen: I would agree with that. You have people who are really bullish on real estate who like to get in on the ground level real estate, people who might buy into something like Toll Brothers, or people who buy into companies that maybe own a lot of their stores, so they own a lot of real estate, but don't act in real estate directly. There's lots of different ways to get involved.
For me as an investor, it's important to remember two things. The first thing, I personally, and I think everyone here at The Fool, has a very long timeframe that they're investing for. You also have to be aware of the economic conditions of when you're investing. We are looking at a slowdown in the housing market, and there might be a pullback sometime in the future, I think that's inevitable. Business cycles are a natural thing that happens. If you're a long-term investor, hopefully you're aware of that, and you're not going to panic when that fall does inevitably come.
Hill: Let's move on to Restoration Hardware. Technically, the company changed their name to RH Holdings, but come on.
Flippen: It's not going to stick.
Hill: It's Restoration Hardware. They had a great third quarter.
Flippen: They did.
Hill: The stock popped about 15% this morning. To go back to Twitter, right before we started recording, I looked at Twitter and saw that Restoration Hardware was halted for trading. Then the news came out that the company is exploring a potential $300 million convertible note offering. Where would you like to start? Do you want to start with the quarter? Or do you want to start with the $300 million note?
Flippen: Let's start with the quarter. The $300 million note doesn't change much for me. Companies do it all the time. I think their quoted reason was "to pursue favorable long-term allocations of capital." For me, it doesn't change very much.
What's really interesting to me, that I really think is a perfect representation of the market right now, is that you have wonderful earnings, a 66% rise in earnings per share, 8% revenue growth. The stock is up a ton. And it's operating in the same segment that we've seen for Toll Brothers in the sense that they're not directly building houses, but this is a luxury product that they're selling to people, presumably, who are living in luxury houses. I don't think a person in an apartment is going to buy a $5,000 sofa. You're looking at home owners, home buyers who are buying premium furniture. So, while the company responded really well in terms of their wonderful earnings report, ultimately, they sell premium furniture. And while home building is one of the leading indicators of a change in economic cycle, inventory to sales ratio is one of the lagging ones. A lot of times, these companies are the butt end of that economic cycle, so they don't start to see poor numbers until people start earning less and they stop spending a ton of money on their furniture.
It was a great quarter. The stock is up a lot. For me, I don't think it says anything about, like I said, the next few years of what earnings are going to be for this company.
Hill: And it's down a little bit from where it was a couple of months ago. But this is still a stock that's up about 60% year to date, which is astonishing to me. Maybe I shouldn't be surprised, but it does surprise me a little bit. Not that it was this down-and-out retailer, it had struggled a little bit in 2016 into 2017. But they've really turned it around.
Flippen: Yeah, they have. Wonderful marketing efforts on their part. What's really interesting to see is that people were very happy to see a comparable store sales growth of about 6%, depending on how you define it, this quarter, which was great, especially when you think about the retail market in general. I've only looked back to 2014. That same number was like 22%, and it didn't see the same large pop that it has now. It's definitely been a stock that has been on a tear, but it's definitely slowing down, as well.
Hill: I'm also a little surprised that it's only about a $3 billion company. The market cap is like $3.3 billion. In part because of the business that they are in and the general footprint that they have, I would have guessed a little bit higher. When I see something like that, particularly a retailer that is doing well, that doesn't have a huge market cap, my mind automatically goes to them being a potential buyout candidate. But they're not really struggling. To go back to the $300 million note that they're offering up, it almost seems like they're saying, "Yeah, we're raising money not because we have to. We're doing it because things are going well, and we're looking to push things a little further."
Flippen: Exactly. Maybe part of that is the perspective that we may have right now as investors. We're kind of accustomed to these very high-value stocks. So, you're right, when we see a company that has a very small market cap that's doing very well, a lot of times, people think, "What's going on there? What's wrong?" When in reality, maybe it's just a small market. The total addressable market for premium hardware, furniture, it's going to be very different than your IKEAs of the world. So, I think part of that is just keeping it in perspective about how many times their average buyer buys one of these, and how large that average buyer base really is.
Hill: To go back to the $5,000 sofa, it's almost akin to the way local car dealerships, the smart ones, think about their addressable market, in that they're looking to sell several cars over a 15-year period to the same person. It's like, I'm going to sell you a car, and hopefully five years from now, I'm going to sell you another one. That sort of thing. If you have a good experience at Restoration Hardware buying a $5,000 sofa, then presumably, you're going to go back, maybe not for more $5,000 sofas, but for more large-ticket items.
Flippen: I would imagine that assumption is correct.
Hill: You and I were talking this morning about something that has gotten some attention this morning. I wanted to get your thoughts on this. It's something that we rarely, if ever, talk about on this podcast.
Flippen: Well, it rarely, if ever, happens. [laughs]
Hill: Fair point! But, the yield curve. Explain to the dozens of listeners what's happening today.
Flippen: Sure. We say today that the yield curve on the five-year Treasury note fell below the three-year note. Essentially, what we normally see happen is, if you're going to lock your money up for five years, you're going to demand a higher premium than if you do three years. It's strange, if ever, when it happens that a three-year note has a higher yield than a five-year note, or a 60-day bond to a 10-year bond. It's just stuff that, when you think about a market, shouldn't happen.
When this happens, it's considered by many investors a very strong predictor of a recession. It's important to note that a lot of people saw this coming for a long time. The yield curve has been flattening, largely due to the fact that interest rates have been rising. We talk a lot about investor fears and investor sentiment. That pays into it a lot. When you think about an investor, if you're scared about the economic growth for the next 10 years, you're going to buy a 10-year note, something that locks up your money with a guaranteed rate of return for a long period. What that does is, it pushes down rates on the earlier notes, which causes the Fed to raise the rates on those notes to try to get more investors to buy into the shorter-term notes, which in turn raises those rates and causes an inverse yield curve.
When I think about it, I don't like to think about it as being a predictor of a recession as much as it is a predictor of the economic conditions that make a recession more likely. Ultimately, all it's doing is reflecting the fears and concerns that we have as investors.
Hill: When I hear the indicators are that a recession is more likely, in terms of stocks, as someone who is not looking to invest in three-year bonds, five-year bonds, 10-year bonds, I'm just not -- as someone interested in stocks, when I think about that, one of the first places that my mind goes is discretionary spending stocks. For me, the classic example is Dave & Buster's. I look at Dave & Buster's as a business that almost certainly is doing better in booming economic times than in recession times. Does the increased likelihood of a recession affect your thinking at all as an investor? Even so far as, "These stocks I was looking at, I'm going to put them on the back burner and I'm going to pay a little bit more attention to these other stocks that I think might do better during a recession."
Flippen: I had a great conversation with my colleague Jim Mueller today. He talked a bit about that same thing. We look at the economy and we think, "Oh, the economy is going to do poorly. I'm not going to buy into discretionary stocks." But it's important to remember that we're long-term investors. As Jim pointed out, a recession, even the Great Recession, doesn't last three to five years. You don't see something that's protracted that long. The stocks all made comebacks. So, I agree with you to the extent that it doesn't really matter to me. I'm going to be buying all the way to the bottom.
I do think that it's interesting when you think about the different plays you can make in a market that is maybe in the later stages of an economic cycle vs. very early on. For example, very early on, buying into the homebuyers like Toll Brothers; and the later stages, maybe not buying into Dave & Buster's. But ultimately, as long as you're buying into stocks and companies that you're confident about, and you're planning on holding them over the long-term, blips like recessions, which really are blips in the long run --
Hill: In the short-run, though, boy, they hurt!
Flippen: In the short run, they're very hard to deal with. I think it's important to think back to the recession that we saw in 2008. People will say, "Oh, the yield curve inversed before that recession. It's a predictor of the recession." You'll note that the yield curve inversed in December 2005, almost three full years before the recession. And it was more of a reflection of the fact that the Fed was rising the short-term rates because they saw low rates were causing a bubble in the housing market, and they were trying to deal with that. It was a representation of those consumer fears. The yield curve itself does not cause the recession. It's a symptom of a larger problem that we're seeing.
Hill: Emily Flippen, not on Twitter, but she is here on MarketFoolery.
Flippen: Maybe eventually.
Hill: Thanks for being here!
Flippen: Thanks for having me!
Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! Remember, the market is closed on Wednesday. We'll see you next time!
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