Today's Market Observation  08.21.2009  Mon  Tue  Wed  Thu  Fri  Pretti Archive

An Important "Conference Call"?

BY BRIAN PRETTI | august 21, 2009

Boy, are we getting a number of mixed messages these days. Like trying to navigate the current environment isn’t tough enough already, right? Sheesh. A month or so back we were treated to the surprising current period optimism from the Duke/CFO Magazine quarterly CFO survey. These folks have had a good short-term historical track record, so we at least listen when they speak. Next, maybe a month-plus back we were served up the Business Roundtable CEO Survey which was very much subdued in comparison to their CFO brethren. A tick up in confidence? Sure, but nothing to write home about and nowhere even close to the magnitude of the snap back in optimism from the CFO office. Well wouldn’t you know it, now comes the quarterly Conference Board version of the CEO business confidence index and point blank, it’s a near moon shot to the upside. Admittedly rebounding from a near record low, the survey shot up 25 points for the current quarter. In the entirety of the history shown in the chart below, this is the second best quarterly gain on record. The best (26 points) came in the quarter after 9/11 for very obvious reasons. As I may have mentioned when looking at this survey in past years, we’ve only seen these near vertical kind of moon shot advances in this survey very near the conclusions of official US recessions over the last three decades (the time for which data is available). Take this for what you will, but the Conference Board CEO participants are quite the much happier bunch as of late. And given their track record, we need to at least acknowledge and listen.

If there are any flies in the ointment of this survey, it’s the fact that the bulk of CEO’s were more optimistic about future results due to cost reductions in their respective businesses. Here’s a direct quote from the report.

“Among chief executive officers who expect profits to increase, 56 percent believe cost reductions will drive profits up, while 33 percent cite market/demand growth as the main source of improvement. Only 7 percent cite new technology as a driver of growth and the remaining 4 percent cite price increases.”

In recent months I have tried to extensively address the fact that reported corporate revenues were the key and relatively disturbing issue in aggregate 2Q earnings reports. The year over year drop in so many top lines of global behemoth corporations was nothing short of breathtaking. Couple that with the lack of forward guidance for many and the question becomes, for how many quarters can corporations cost cut their way to “beating the numbers”? And this brings up a key point about the present. Can the US economy recover and begin to grow based on cost cutting? In a primarily credit and consumption based economy of the moment where the greatest corporate cost is labor (and the one cost that is being attacked the hardest), cost cutting may boost corporate bottom lines for a number of quarters, but what about corporate customers that in a sense are their very employees?

Although I’ll save this for further elaboration in a discussion to come, we have all heard the thinking lately that recent productivity measures are indeed quite the silver lining due to the apparent positive short term impact of subdued per unit labor costs, etc. Subdued unit labor costs will act to academically boost bottom line results, but for how long? What is good for corporate bottom lines is not good for employee wages, job growth, etc. We are currently seeing extremes in labor stats never seen before. Average hours worked hit a record low in June before recovering very slightly in July, as did the year over year change in aggregate weekly hours (the combo of wages and hours). We’re seeing record highs consistently month by month in average weeks of unemployment. And in terms of job growth so far in to the current decade, NEVER have we experienced anything like what you see in the table below. Without reaching for melodrama, I consider current decade payroll growth experience a secular game changer.

The number for the current decade will clearly be negative (a first) before the year is out. And this is what CEO’s are increasingly optimistic about? The fact that their own domestic customers are under labor market pressure like perhaps never before? Sounds counterintuitive, but what the heck do I know? One thing I do know is that when it comes to wage and benefit costs, it’s no wonder the CEO’s are happy. It’s also no wonder 56% percent of CEO respondents expect cost reductions to drive profit gains.

But the ultimate proof of business confidence will be seen in the capital expenditure and payroll numbers as we move forward. So far there’s not a lot to get happy about in terms of cap-ex or payrolls, but we’ll be patient and see what comes our way ahead. I believe the important question for investors in the here and now is just how much does one pay (valuations) for cost cutting driven bottom line earnings growth in the absence of revenue gains? At least as per 2Q results, we should just check in with the owners of IBM, Intel, and a whole host of companies large and small. Because that is exactly their story, while investors for now have uttered a huge sigh of relief that “it could have been worse”. Although it’s just me, whether it’s now or a number of quarters from now, revenue growth is going to take center stage in assessment of corporate fundamentals.

Historically the wonderful CEO confidence survey has served as a pretty decent leading indicator of the forward rate of change in nominal GDP. In uber simplistic fashion, the chart below chronicles the same CEO confidence data along side the year over year change in nominal US GDP. You can see the leading relationship referred to here. The CEO’s get happy maybe a year or so in advance of a rate of change positive snapback in GDP from interim rate of change cycle lows. In 2001 they were very early. The current directional dichotomy is clear.

For now, I put a pretty high probability of the US printing a positive GDP quarter most likely in 3Q. Why? First, we are currently experiencing an auto rebuild cycle that has been driven by a prior period collapse in production post-Lehman and into the auto maker bankruptcy (and I use that term loosely here) period earlier this year. Initial success of the cash for clunkers program is pulling forward a lot of tomorrow’s demand for autos into today and adding fuel to the auto rebuild fire. This rebuild and clunkers program will at least temporarily juice manufacturing and production stats as well as consumption numbers going into 3Q. Lastly, if you looked at the 2Q GDP numbers, you know full well government spending added 2.4% to the headline number and the deflator calculation (reduction from nominal GDP to get real GDP) collapsed from 1.9% to .2%. Magic. And I expect the “magic” to continue into 3Q (magic, of course, being heavy government spending and lowball inflation assumptions). Is this what the CEO’s are getting excited about, or is there more to it than that?

Whoever said this was easy, right? It’s wonderful to see what the CEO’s and CFO’s have to say about life. We listen and integrate the messages into our thinking. But looking ahead, and as is so true with so many opinion surveys in this wonderful world, it’s not what folks say that counts, but what they do. If indeed CEO’s and CFO’s are feeling much better about the future of the economy and their business prospects, then we would expect to see a number of tangible real world events occur in the not too distant future. Among other things, we would expect to see the hiring of temporary help pick up (a leading indicator for headline payrolls), and perhaps quite substantially and very soon. We would also expect to see corporate capital expenditures begin to advance. These are just two very simple examples of real world expressions of “confidence”. As always, it’s what the CEO's do, not what they say, that’s the important tell. Confidence surveys are for show, business spending, revenue gains and actual hiring are for dough. Stay tuned.

Brian Pretti
Contrary Investor

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Brian Pretti
ContraryInvestor.com
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