The fear of resurgent inflation will continue to dominate financial markets no matter how tame actual inflation remains. This is well and good: Not only is inflation the single worst enemy of financial assets, but our vigilance against it occupies the attention of economists and assorted other Deep Thinkers who thus are prevented from doing some real damage to society at large.
This column has taken, and will continue to take, the position that inflation leads eventually to higher commodity prices, not the other way around. By this construct, the commodity price jump largely confined so far to energy markets represents signals to reallocate resources within the economy -- this means you and your Godzilla-sized SUV, buddy -- and are not the harbinger of general price increases. The additional dollars you spend at the gasoline pump are dollars you can't spend elsewhere.
Various of my columns have explored the relationships between the prices of key commodities and stocks of companies in associated industries. Most of the time, not surprisingly, the relationships flow directly from price, processing margins, or both. A quick glance at the confectionery industry shows this is not always the case, however.
The Candy Man
Sugar has risen 50% in price since March 28. At first, we might think this rise in raw material prices would squeeze the operating margins of confectioners and other major sugar users. However, we should first place this move in a longer-term perspective. On an inflation-adjusted basis, this jump in sugar prices has put the commodity at just 21% of its January 1972 price. The real price of cocoa, the key commodity in chocolate, is 38% of its January 1972 price. In this sense, sugar buyers aren't getting squeezed, they're just giving a little bit back to the producers for a change.
Inflation-Adjusted Prices for Cocoa and Sugar
Source: Bridge/CRB Infotech CD-ROM
Have the stocks of confectioners benefited from this long period of declining raw material costs? First, please keep in mind one of the largest and "purest" candy plays in the U.S.,
, is privately held. In addition, many of the largest international confectioners, such as
, are diversified across dozens of product lines.
Tootsie Roll Industries
come closer to pure confectionery plays now that the latter has shed its San Giorgio pasta business.
If we compare the relative performance of selected confectionery stocks to their national benchmark index -- the
for Hershey, Tootsie Roll and
( WWY), the
for Cadbury Schweppes, and the Swiss Market Index for Nestle -- several patterns emerge.
First, the group began to outperform the respective benchmarks in late 1997, and this period of outperformance continued through the third quarter of 1998. Then, relative performance declined markedly through the first quarter of 2000. Finally, relative performance turned sharply higher starting in April 2000.
The group's relative performance since the third quarter of 1998 has been inverse to the price of sugar. If these stocks were sensitive to the price of this key raw material, this behavior would be nonsensical in the extreme. Something else is suggested by the above history.
A Matter Of Interest
To paraphrase Mark Twain, we have lies, damn lies and statistics. Two of these are important in business. Let's pop some candy in our mouths and hold it firmly tongue-in-cheek for the
tour de force
The group's relative performance is oddly parallel to the course of interest rates over the past three years. As bond yields fell steadily in 1997-1998, confectioners outperformed. Once the various international crises dissipated by early 1999 and the central banks started tightening, relative performance declined. The strongly inverse relationship between monetary policy, displayed here as the forward rate between one- and 10-year Treasury notes, and the smallest and "purest" of our firms, Tootsie Roll, is illustrated below.
The Toostsie Roll Indicator:Something to chew on
Is this just spurious correlation, or is there a reason for this relationship to be so strong? After all, Tootsie Roll has a debt-to-asset ratio of only 1.4%, so it's hardly carrying an interest-rate burden, and few consumers borrow to buy candy bars.
The answer is simple and quite possibly defensible: Tighter monetary policies eventually create a favorable environment for bonds as they slow economic growth. They also reduce investors' appetite for risk. By this spring, investors were fleeing nonprofitable tech stocks, but why dump Tootsie Roll and its 26.3% operating margins? Maybe it won't grow at 50% a year, but it won't blow up, and it can withstand higher sugar prices as well.
There you have it, a market-based indicator to rival the famous
Indicator. It flashed a buy signal on bonds while most
watchers were diving under the table. The Tootsie Roll Indicator still is flashing a buy signal, which is great news for bond investors to take to the beach this summer.
Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites your feedback at