The 'OK' [unless something happens] Economy
The good times are back. At least that is what everyone is hoping. Consumer spending has picked up again, factory orders and production are on the rise and the stock market is back in bubble mode. On the surface things seem to be holding together. The job market has stabilized, economic growth has accelerated, stock prices are sizzling and day traders have returned to the market. Everything looks good on the surface. Just don’t ask any pertinent or difficult questions.
But I'm a person who asks questions, and I see an economy and a market that is held together by band aids, staples, paper clips, ductape and chewing gum. The less you know and understand, the better you will feel about this so-called recovery. The economy may be on the mend, but it remains fragile and vulnerable to exogenous events from without and from within.
What is different about this recovery is that it has taken thirteen rate cuts, three tax cuts, annual credit growth of over $2 trillion, $1 trillion in home owner equity extraction and annual government budget deficits of nearly $500 billion in order to bring about a turnaround and keep the U.S. economy out of recession. For the “new era” and the “this time it is different” crowd, things really are different this time.
What Is Different This Time?
High Stock Prices
Let us begin with what is different. For one thing, stocks never got cheap as they normally do at the end of a bear market or a recession. Yes, stocks went down for three years, the NASDAQ lost over 75% of its value, and a lot of money was lost in equities. However, despite the drop in the major indexes, stock prices never fell as fast as earnings did. The result was that equity prices never got down to bargain or fair value levels as they did in past bear markets and recessions. Equity prices remained high at the end of the recession and at levels where crashes have occurred in the past. The bubble never fully unwound. Consequently when the recovery began stock prices remained historically high instead of bargain levels seen in past recoveries.
High Debt & Consumption
Another intriguing aspect about this recession and recovery was the behavior of the consumer. Unlike past recessions when consumers paired back spending, paid down debt and increased savings, just the opposite occurred this time around. Debt levels exploded and consumption increased. Savings increased only nominally. Throughout the recession as the Fed moved aggressively slashing interest rates, consumers used the opportunity of lower rates to go deeper in debt rather than repair their balance sheets. Debt increased all across the spectrum from credit cards and installment debt to home equity loans. The increased debt was used to buy bigger homes, new cars, home entertainment systems or take vacations. Another disturbing aspect of the recent refinancing boom is that over 60 percent of the proceeds from refinancing was used to pay for housing and medical care and other ordinary expenses of living. In other words the majority of refi money was being used to finance essential living expenses.
At the end of last year, total consumer debt outstanding stood at $1.8 trillion excluding mortgage debt. If we include all categories of debt, consumers borrowed $768 billion last year. Consumer debt levels continue to rise again this year with consumer spending now accounting for 88% of U.S. GDP in 2002.
The crucial point here is that with no pullback in consumption, there is no pent up demand that can lead to a sustainable economic recovery. Consumer spending will hold up only as long as consumers have access to cheap and abundant credit. The main source of that credit is their equity in housing. Access to that credit stops when rates rise and when homes stop appreciating.
A final aspect to this recession and recovery that makes it different is that the degree of speculation in the financial markets never stopped. As the Fed expanded the money supply aggressively and as record consumption led to record trade deficits, a surfeit of speculative capital made its way through the bond markets. The result is that the world’s largest debtor nation—a nation that is experiencing record trade and budget deficits—enjoys one of the lowest interest rates in the world. This has become possible through a highly leveraged carry trade.
Speculative hedge funds have been able to borrow at low short-term interest rates and invest that money into higher yielding bonds from junk bonds to Treasuries. They make their profits from the spread between their cost and their realized rate of return. The carry trade has become so large today that it in fact dominates the U.S. bond markets. It has fueled and led to another bubble in the bond market that has become ever so fragile and vulnerable to the slightest change in interest rates. This could be a possible market vulnerability.
The Good News
Now it is time to look at the facts. Because the U.S. is unique in the way it accounts for its economic data, I prefer to use industry data which is more reliable. Because of hedonic indexing, seasonal adjustments and statistical smoothing, U.S. economic growth and productivity growth is overstated, inflation is understated, and unemployment is underreported. Nonetheless, recent economic data from the index of leading economic indicators to the ISM manufacturing and service numbers have all pointed to an upturn in the economy.
The ISM Purchasing Manufacturing Index has been rising steadily since May. The latest August reading of 54.7 is the second consecutive month that the index has remained above 50, indicating an expanding manufacturing sector. The index's production component jumped to 61.6, the best reading since June of 1999. New orders are also on the rise.
Increased Business Spending
Other economic reports out recently point to a pick up in business spending. Real private investment in equipment and software increased at a 7.5% annual rate in the second quarter, the fourth increase in five quarters. As a result of cost cutting, corporate profitability has improved. It is profits that drive capital spending. In this regard, profits have improved, but are nowhere near where they should be at this stage of the economic cycle. This is one reason why business confidence is so fragile.
Because manufacturing utilization rates remain low, it tells us that excess capacity still exists in the manufacturing sector and will remain a drag on further capital spending plans by business. However, the outlook for equipment and software spending remains positive. As a recent BCA Research report points out, manufacturing only accounts for a modest share of overall capital spending. As the U.S. economy has evolved more towards a service economy, the service sector has become by far the biggest user of information technology and the fastest growing area for capital spending, especially in the financial sector.
The manufacturing sector is the largest user of traditional capital equipment. With the manufacturing sector plagued by excess capacity, it remains the weakest link in the capital spending arena. So what we are left with are certain pockets of strength such as IT spending from the service sector of the economy. The engine is running, but not all of the cylinders are firing. Therefore, even though investment spending by business has increased 4½% year-over-year, the pace is well below previous cyclical recoveries. So far the increase in capital spending has been confined mainly to the IT area with spending on other equipment hitting new lows during the second quarter.
Increased IT Spending
The increase in IT spending is what has lit the technology sector of the market ablaze. Recent reports indicate that handset sales will reach a peak this year. Unfortunately, robust handset sales have not translated into robust or record profits. Motorola continues to lower expectations for sales and earnings facing declining market share, reduced profitability and until recently very few growth options. Industry leader Nokia turned in a mixed performance for the second quarter as well. Various segments of its businesses are doing well; while others such as the infrastructure equipment division are struggling to return to profitability.
This same picture holds true throughout the whole gamut of technology. Economic conditions have improved, but in this competitive environment companies are having difficulty achieving growth projections, profit margins, and increased profitability. The best that can be said is that industry conditions have stabilized and have stopped hemorrhaging. However, they have not improved enough to move IT execs to start issuing bullish forecasts based on order books that extend out for any length of time. It could be one reason that insiders—given the recent run up in stock prices—are selling their company stock at record levels.
Inhibitors to Expansion / Growth
In a Word—Sputtering
The economy is okay, but it isn’t vibrant.
It isn’t expanding at a fast enough pace to create the confidence needed for business to expand. There have been too many false starts and stops over the last three years, which keep business executives on the cautious side. The economy seems to pick up with each new stimulus measure such as rate cuts, tax cuts or fiscal spending by government. However, because none of the excesses of the 90’s have been entirely eliminated, each new fiscal and monetary measure is followed by an initial burst of economic activity only to turn down again.
There are two major causes for the sputtering. The first is that all of the excesses of the 90’s have yet to be cleansed from the economic and financial system. We still have too much capacity and too many companies globally making widgets that have to sell at competitive prices. This keeps a lid on pricing power and on profits. The excesses have not been allowed to be liquidated from the economy. They have simply been postponed. Companies that are virtually bankrupt have been given a life extension. Lower interest rates have allowed these financially dead companies to refinance debt or tap the debt markets for more capital. This has kept these companies alive and prevented the elimination of excess capacity globally. This condition still exists today and will continue to hamper any recovery.
Economic Policy is Tainted
The second factor inhibiting the recovery is economic policy. It has been geared towards debt and consumption. In policy circles in Washington and on Wall Street the economic problem seems to stem from insufficient demand. In other words there isn’t enough consumption going on in the country. Disregard the fact that consumer spending habits throughout the recession and recovery has been on steroids and methamphetamines. The reader needs only to look at the debt graphs above to see that debt levels within all levels of the economy are at or close to record levels.
The problem is a supply issue, not one of demand. Demand is soaring. You need to look no further than the graph of America’s trade and current account deficits to see the obvious. If it wasn’t for our foreign trade imbalance meeting excess consumer demand, consumer prices for products here in the U.S. would be soaring as they are in consumer services.
There is too much debt in the economy and the financial system and that makes this recovery so fragile.
- What happens to the carry trade which drives the bond markets, if interest rates continue to rise?
- If rates continue to climb, where does this leave housing?
- Will the mortgage refi market remain strong driving consumer spending?
- Even worse, what will happen to interest rates if foreign central banks tire of propping up the dollar through their own purchases of our Treasury debt?
It is debt and excess that make this recovery so tenuous. The U.S. economy needs higher and higher levels of debt each year just to keep it afloat. Without ever-increasing amounts of debt added to the economy and financial system each year, the whole system comes crashing down. This fact is often ignored in economic forecasts. Without large injections of new money and credit, the economy would be back in recession or yes, even depression. This blatant fact stands out when you consider that last year, total credit growth in the U.S. was $2.3 trillion; while nominal GDP growth was only $375.3 billion. It took over $6 of debt just to produce $1 dollar of GDP growth. This figure keeps getting larger each and every year. We have not eliminated our day of reckoning. We have simply postponed it. Simply put, the U.S. economic recovery is unhealthy. It is based on consumers going ever deeper into debt in order to maintain consumption from ordinary living expenses to simple or extravagant luxuries.
Earnings: improved, but full of pot holes
The markets are continuing their upward climb with the Dow and NASDAQ at 14-month peaks. The NASDAQ is sizzling this year based on optimistic forecasts and expectations for a robust second half recovery. Capital spending on IT has risen lately, so there are high hopes that the technology boom will be resurrected. We now must look at earnings to see if a real profit rebound is at hand or are investors suffering from myopic delusions. Specifically, an investor should want to know if the recent run up in stock prices, especially in technology, is justified by what is about to unfold on the earnings front over the next twelve months.
On the surface like the economy, things have improved on the earnings front thanks to a large dose of cost cutting by companies. Earnings comparisons will also be made easier this year due to large goodwill write-offs and restructuring charges taken by companies last year during the final quarter of the year. The following table illustrates actual S&P earnings according to GAAP were erratic last year dropping in Q2 & Q4. There is also a wide gap between what is reported as profits in the financial press, company press releases and sell-side analysts. As the table below illustrates, there is a wide gap between real earnings and pro forma earnings. This gap is even larger if an investor were to look at S&P's core earnings, which accounts for stock option expense, restructuring charges, writedowns, revised pension cost, R&D expenses, mergers and acquisition expense and unrealized gains and losses from hedging activities. If those expenses are subtracted from earnings, the earnings number for 2003 is NOT $53.72 (CRAP) or $43.72 (GAAP), but $23.34! If one takes the core earnings number of $23.34, the S&P is selling at close to 44 times earnings. That is an earnings yield of 2.3%. In other words, investors willing to buy the index at this point, are only earning 2.3% on their capital.
The financial world still operates under the sham of pro forma profits, which grossly overstates earnings and understates valuations.
The Earnings Game Continues
It doesn’t impress me the least—nor should it impress you as an investor—that a company beat estimates. Estimates were dramatically lowered just before the quarter close. The fact that companies were then able to beat them was an easy feat to accomplish. In fact it was the Dollar's fall that contributed the most towards beating analysts’ final revised estimates. Without the Dollar's fall during the quarter, several companies would not have had the revenue or profit gains that were finally reported. During Q3 the dollar has risen, so there will be just the reverse effect this quarter. I doubt that it will make much difference because if it did impact profits, it would be excluded in the way pro forma profits are reported.
What we saw during the last quarter was the same old earnings game that is played each quarter. The only difference is that the level of hype has been ratcheted up considerably. Analysts and bubblehead anchors couldn’t contain their enthusiasm. Almost every negative was turned into a positive and very little mention was made of how low actual earnings came in when compared to initial forecasts. If you take the forecast made at the beginning of the year—or for that matter the forecast made at the beginning of the quarter—there has been only a moderate upside that mainly came from currency translations gains. What is even more remarkable is that the gulf between GAAP earnings or CRAP earnings remain as large as ever.
The earnings game has already started for Q3. Remember during the second half of the year we have been told to expect a levitation of earnings that will border on the miraculous. Already there has been a deluge of pre-announcements of which more than half have been negative or below expectations. Negative-to-positive announcements are currently running greater than 2:1. Moreover, companies are still playing with how they arrive at their numbers. Cisco beat the street by using a whole bag of tricks that will only produce one-time gains from the way the company amortized intangible assets to generous adjustments for doubtful accounts. Without these accounting tricks pre-tax income would have been down rather than up.
Funding Corporate Pension Plans
It is not just Cisco who has made generous use of accounting gimmicks to spruce up earnings. We still have a large segment of S&P companies who are not accounting for stock option expenses or who are overstating earnings through generous assumptions made on the returns of the company pension plan.
Most pension plans now use the yield on the 30-year bond as the basis for calculating pension liabilities for workers. Companies must annually contribute amounts that would grow at the rate of a 30-year bond and would at least cover 90% of the benefits promised to workers. If the plan doesn’t cover 90% of future plan liabilities, the company must kick in the difference from its own pocket. During the 90’s bull market this was not a problem. Many companies such as IBM did not have to contribute to their pension plans. Stock market growth in the investment portfolio made up for the lack of company contributions. However, the bear market wiped out pension plan paper gains. As a result with many pension plans deep in the red, businesses are lobbying Washington for help. New proposals on the books with bipartisan support would lower yearly contributions for companies.
This may solve company problems in the short run, but it raises long-term issues as to the plan's viability—a concern that has not gone unnoticed by the Pension Benefit Guaranty Corp. (PBGC) According to the PBGC, single employer plans remain underfunded by $300 billion. The PBGC insurance pool, a safety net for workers whose plans fail, has plunged from a $7.7 billion surplus in 2001 to a $5.4 billion deficit at the end of 2002.
At the time of this writing, the PBGC just issued a report that estimates that by the end of this month, financially troubled companies will have pension liabilities that will exceed plan assets by $80 billion. Underfunded pension plans are now on the front burner in Washington. In the future, companies could be forced to contribute more money, benefits for retirees could be reduced and ultimately taxpayers could end up picking up the bill.
Pension costs, restructuring charges, stock option expense and a host of other routine business expenses that are excluded from pro forma earnings numbers and GAAP earnings have led S&P to come up with their “core earnings” numbers. S&P’s core number, which is considerably lower than CRAP & GAAP numbers, are more indicative of the true earnings picture. If an investor was to use these numbers instead of the highly inflated pro forma numbers, there would be no sane reason or justification for owning stocks at today’s high market valuations.
The Sorry State of Affairs Over P/E
What makes this issue so troubling is that understanding value or what an investor is really paying to own a piece of corporate America is really a simple concept. This concept is expressed in the Price-Earnings ratio or P/E. This ratio is relates a corporation’s profitability (earnings per share) to the price of the common stock in the stock market (company market value). This ratio expresses market value as a multiple of earnings per share. The formula is shown on the right.
Although the concept is easy to understand and compute, the problem lies in substitutes or the number used in the bottom half of the equation. The P/E ratio is a widely used and often-quoted number used by Wall Street and the financial press. The confusion for investors is figuring out what the real numbers are. In computing the P/E ratio, the standard practice used to be looking at past earnings over the last 12 months which correspond to GAAP. This number is what is called the trailing P/E ratio since it is based on earnings over the most recent four quarters. The problem arises when we start using forward numbers, which are earnings estimated for the future or pro forma numbers. Earnings estimates are always optimistic and in the majority of cases they are usually off their mark. Analysts can make any stock look cheap simply by ratcheting up their future estimates for the company to a high enough level to make the stock look like a bargain.
At the beginning of the year, the estimates for a company are usually much higher than where they end up. Each quarter—just before the quarter ends—these estimates are usually lowered; thereby allowing companies to come in and beat estimates. With an 80% probability of being wrong, investor reliance on optimistic Wall Street estimates for a stock are taking a large risk in that the numbers will actually be much lower, especially in today’s difficult operating environment.
S & P Wants The Whole Truth
That is why analysts, anchors and companies prefer to deal with pro forma numbers. The pro forma numbers are really nothing more than earnings before all the “bad stuff” is subtracted from earnings. Analysts prefer to use these numbers under the guise that many of these expenses or large write-offs are not recurring. Standard & Poor’s disagrees. That is why they have come up with their “core earnings” concept to correct these abuses to arrive at a more realistic earnings number reflective of what the firm feels are ordinary business expenses. The reader can view S&P’s position by clicking on the link here.
I believe that the only important number an investor should concern themselves with is a P/E valuation based on trailing 12-month earnings according to GAAP. These are real numbers. The forward numbers so widely bandied about by analysts, anchors and company PR representatives are nothing more than could be—would be—should be numbers that may—or may not—materialize. By the same token, pro forma numbers—which are really nothing more than earnings before all the bad stuff or expenses and problems the company and analysts would really not like you to know about—are only half-truth numbers. An investor must understand that pro forma numbers are numbers that are derived from no accounting standard. What expenses the company or the analyst decides to exclude are purely discretionary and can change from quarter-to-quarter and from company to company. If you use these numbers to make investment decisions or earnings comparisons is akin to comparing apples to oranges to avocados to walnuts.
Based on 12-month trailing earnings for the S&P, what we know is this: the S&P 500 is currently selling at 29 times trailing GAAP earnings, which equates to an earnings yield of 3.4%. If we use the S&P’s core earnings—which include stock option expenses, write-offs and other normal and recurring expenses—the S&P 500 index is selling at 44 times earnings, equivalent to an earnings yield of 2.3%. Perhaps that is why insider selling is now at near record levels—a concept we refer to as “distribution”. Smart money is getting out and selling their shares to weak hands. John Q. is back in the market again buying in at the top. This will be the subject of next week's Storm Watch, “The 'OK' [unless something happens] Economy, Part II: Distribution”. ~ JP