Perspectives: The Perfect Financial Storm?
Financial Storms Heading Towards the U.S. Economy
August 16,2001 © Copyright 2001 James J. Puplava

Introduction

The ocean and the atmosphere form a two-layer system that produces what we call climate or weather. The interactions that take place between these elements produce heat or cold, rain or drought, calm or storms. Climate is often referred to as the prevailing weather in a region. Weather is of interest to those who make their living on the sea as well as on land and it impacts every industry from agriculture to tourism.

The main problem with forecasting weather is it has too many variables. It involves an educated interpretation of air mass movements throughout the atmosphere. At best, forecasting boils down to educated guessing based on fundamentals and what is likely to occur.

Everyone is familiar with climatic seasons caused by the rotation of the earth’s axis around the sun. The angle of the earth relative to the sun’s radiation affects the amount of heat energy received, which in turn impacts weather patterns. During the winter months, the earth is tilted away from the sun; while during the summer, it is tilted towards the sun. So one man’s winter can be another man’s summer.

While it's summer or winter, the weather patterns are more predictable. We expect colder temperatures during the winter and warmer temperatures during the summer. It is when we transition from one season to another that unpredictable variations occur. If everything remained constant, we would have only one weather chart with few changes.

However in the real world, variations in the sun’s output of energy, evaporation rates, tidal flows, and a host of other factors make many weather forecasts unpredictable. This results in constant weather variations that produce an alternating mix of weather. The same holds true for the economy. Like the weather, it too has its seasons. We have recessions. We have recoveries. And busts always follow booms. The nature of our economic cycles also varies. Some are mild, while others are more severe. Our downturns (winters) have been recessions. When they become severe, they have turned into depressions. Our upturns (summers) have been recoveries. When they become severe, booms turn into bubbles.

In writing The Perfect Financial Storm series I have used the analogy of weather because it has many similarities to our economic cycles. I felt early last year that our economic cycle was changing. There were too many people talking about summer when we had summer for far too long. Wall Street and Washington were telling us that summer was a permanent condition. I saw too many telltale signs that the financial climate was about to change. Just as climatologists use barometers, anemometers, Doppler radar, satellites and other instrumentation to forecast weather, financial indicators were giving warning signals that a storm was brewing in the world’s financial system. The epicenter of that storm had its origin in the United States.

As with any storm, the severity, the duration and the direction are hard to predict. For these reasons I have discussed alternate courses that this financial storm may take. The storm’s path could end up being deflationary or inflationary in nature. Or something else may be brewing – something we haven’t experienced before – The Perfect Financial Storm, the simultaneous occurrence of two storm fronts that collide with each other to form The Perfect Storm. I do not pretend to have the answer as to the exact outcome or severity of the current storm that is now in its formative stages. There are others far smarter than I who may know the path this storm may take. However, I believe the financial maelstrom that is currently brewing will end up being of the Nor’easter variety. The severity of a recession or bust is oftentimes determined by the boom that preceded it. In this case we’ve not only had a boom, but that boom that grew into a bubble has rippled throughout the financial system inflating financial assets and real estate prices. In this final installment, I hope to help you chart your course so that you will be able to ride the storm.

I.  Where We Are Today

The Bubble is Still With Us

The boom that grew into a bubble is still being fed by a constant infusion of credit. We've seen the money recycled between the stock and bond markets with derivatives and day trading steroids adding volatility to the mix. It is also visible in real estate where new home sales, sales of existing homes, mortgage refinancing, and credit expansion continues unabated. Americans persist in spending money as they expand their balance sheets with debt. Consumers want to borrow more money and credit card companies are only too willing to lend it to them. Government Sponsored Entities (GSEs) such as Fannie Mae and Freddie Mac are still expanding their balance sheets providing ready credit to the housing market.

“Political Correctness” Enters The Financial World

No one mentions the R- or B-word. We’re still talking summer here. The mantra may have changed from second-half recovery to fourth quarter, but even the fourth quarter mantra is subtlety changing to recovery next year. Political correctness has invaded the financial world. Words such as bear markets; recessions, unemployment and losses have been replaced by euphemisms. We now refer to these situations as corrections, soft landings, recovery, and restructuring. I’m not sure that the investors who have lost trillions of dollars in the stock market tech bubble or the hundreds of thousands of workers who have lost their jobs would find the words “correction” or “restructuring” to be very comforting. See CBS Marketwatch's "Shadow of Recession".

Rough Weather Lies Ahead

As I wrote in Part 7, 2001 is the last of “The Seven Fat Years” that began in 1995. Right now times are still good with the last remaining pillars of the economy, consumer spending and housing, remaining strong. The Fed’s rate cuts and the tax rebates promise to hold up the economy for a while longer. As these graphs indicate, the housing market still remains strong fed by a constant influx of new mortgage money. Government Sponsored Entities such as Fannie Mae and Freddie Mac continue to expand their balance sheet with new debt issuance. This expansion of credit has fed into the housing market. Housing starts, existing home sales, and the average sales price for existing single-family homes rise unabated. The stock market may be down, but evidence of the credit bubble can clearly be seen in our housing markets.

Credit expansion charges ahead. This year’s domestic debt issuance is expected to top $1 trillion dollars. Asset backed securities are growing at an annual rate of 17 percent and should top $265 billion this year. Credit card borrowing is up 56 percent year-over-year. Personal income for the average American continues to grow at an above-average pace, but personal spending is outrunning it. Each month consumers go deeper into debt to support their lifestyles. The American credit machine is running nonstop. The money may not be going into the stock market like before, but the money has definitely found a home in the real estate market and in consumer spending.

TAX, SPEND & INFLATE

To better understand the course this storm is likely to travel, it is important to understand the storm’s origination. Its epicenter is located in Washington and on Wall Street. The credit creation mechanisms of the Fed and Government Sponsored Entities inflated our nation’s money supply. The result was an abundance of money made available at artificially low rates. This helped corporations to refinance existing debt at much lower interest rates. In addition, cheap credit allowed companies to finance acquisitions and buy back stock. Money was also made available for speculation in the financial markets helping to fuel a boom in stock prices that went well beyond profit fundamentals. At the same time, lower interest rates allowed consumers to refinance mortgages and take on additional debt to finance consumption and speculation in the stock market.

The 90’s – A Decade of Mounting Taxes

While credit creation was feeding a constant flow of money into the financial system and the economy, government taxes were siphoning off a good portion of that excess money in the form of taxes. President Bush increased tax rates in 1990 from 28 to 31%. In addition to an increase in the personal income tax rates, an additional Medicare tax of 2.9% was assessed against earned income. President Clinton followed Bush in 1993 with the largest tax increase in U.S. history. Rates were increased from 31 to 39.6%. The Medicare tax cap was removed. Itemized deductions were reduced through phase-outs. Social Security income subject to taxation was increased from 50 to 85%. At the same time, as shown in the table below, the wage base on which Social Security taxes were assessed went up each year. As personal income increased, the amount of Social Security taxes increased right along with it. Most Americans have felt the squeeze in this last decade. This table dramatically portrays one of the reasons why.

The end result of Fed money pumping and government taxation was the ravaging of household finances of the average American by taxes and inflation. The government, through an increase in the money supply, created inflation. The monthly budget for necessities for the average American went up each month as the cost of daily living rose across the board. Housing prices went up along with rents. Food prices rose. Medical premiums skyrocketed. The cost of a college education grew each year. Automobiles cost more. Utility bills rose each year. About the only thing that was going down was the cost of technology as we saw with personal computers.

Inflation rates would have been much greater had it not been for imports. The excess demand created through cheap credit was offset in part by imports. Foreign imports helped to keep a lid on domestic prices below what they should have been. Even so, the cost of most goods rose. Inflation statistics hid the true cost of living through statistical manipulation. I would challenge the widespread statement by the financial media that the 90’s were a period of moderate inflation. The effects of inflation were everywhere. They were visible in housing prices, food, education, medical, clothing, entertainment, automobiles and finally asset prices. The average household budget – the things people spent money on from Big Macs to movie tickets – went up each year.

Technologically Improved Statistics

Government statisticians massaged these inflation numbers by a “new and improved” accounting method for improvements in technology. The automobile you bought last year may have cost you more money than your last car, but the car was more technologically advanced. It had better safety systems. The car radio sounded better. It may have had a CD player or a GPS system on board. The car cost you more money, but it was technologically a better automobile. Therefore, in the minds of government statisticians, it was a cheaper car because it had been technologically improved. As a result, the price of the car was massaged to account for these improvements adjusting the cost factors lower.

During the 90’s as the cost of living was rising for Main Street’s average American, on Wall Street financial asset prices were also moving up. Inflation has two outlets. The excess money can either go into the economy, inflating the cost of goods, or it can go into financial assets, inflating their prices. They are essentially one and the same. One of the more remarkable aspects of the 90’s is that the outlet for excess money flowed into the financial markets more so than it did the economy. This accounted for the above-average returns of stocks throughout the decade.

While assets and the price of goods went up, Americans we’re taking home less money as a result of taxes. Taxes took a greater bite out of monthly income while the cost of daily living rose. The result was a reduced savings rates. When savings had been exhausted, debt levels increased. I believe the chief reason that the country has a negative savings rate is that household income has been ravaged by the combination of taxes and inflation. As the graphs of household debt and savings illustrate, debt levels are high and savings is negative. These two factors alone make a recovery scenario based on a continuation of consumer spending a precarious one. The consumer-spending bust will soon join the capital-spending bust with devastating consequences for the economy.

The end result is that the boom times of the 90’s weren’t the result of a new economic paradigm, as many Wall Street and Washington spinmeisters would argue. It was the result of a giant credit boom that fed itself through the financial markets and the economy. The 90’s were a result of a return to Keynesian economics: tax, spend and inflate.

II.  Four Arguments Against Recovery

There are four special circumstances that would argue against an economic recovery or even an anemic recovery at best. In many ways these circumstances are the result of policy decisions made in Washington and boardrooms of American corporations. They are 1) monetary policy, 2) taxes, 3) energy, and 4) corporate profits.

#1  Monetary Policy Isn’t Working

The first issue deals with monetary policy. The recovery scenario propagated on Wall Street is that Fed monetary policy will bail out the U.S. economy. All eyes and hope are on Mr. Greenspan. There is a blind faith that Mr. Greenspan will once again work his monetary magic. By lowering interest rates and flooding the markets with liquidity, it is hoped that the U.S. economy will metamorphose itself into a recovery. The belief in the efficacy of monetary policy has never been higher. Mr. Greenspan contained the collateral damage of the stock market crash in 1987. He single handedly bailed us out of the S&L crisis. He brought us out of the recession of 1990-91. He doused the fires of the Peso, Russian Debt and Long Term Capital Management crisis. Why wouldn’t he be able to fix the current economic crisis and restore economic growth in the United States?

As these above four graphs indicate, after six rate cuts in 2001 and a seventh expected soon, the economy and the stock market have failed to respond. For the first time in recent memory, the financial markets aren’t warming to the Fed’s touch. Long-term interest rates have risen since the Fed began cutting short-term rates back in January. That stands in sharp contrast to the last recession when long-term bond yields followed Fed rate cuts by heading lower.

Last Recession	Current Environment

Wall Street is cheering the fact that the economy hasn’t dipped into recession. Unfortunately, their myopic belief and optimism is misguided because of blinders created by past experiences. Never before has Fed policy failed to deliver. The result of rate cuts has always been a prolonged stock market expansion and an economic recovery. Why won’t it work this time around?

The True Nature of Economic Illness

Proponents of monetary policy argue that there is a lag between changes in interest rates and the time those changes are reflected in the economy. However, this is no ordinary downturn. The economy’s ills are structural rather than cyclical. Wall Street still holds the view that the slowdown we are experiencing is nothing more than an inventory correction and therefore the economic malaise is cyclical in nature. The believe that once inventories are reduced, the economy will be back on a growth track. If that were true, the stock market would have signaled its advance. As of this August, all of the major indexes are still in negative territory. The speed of the downturn and its unusual side effects suggest this downturn is structural in nature. A collapse in capital spending, mounting consumer and corporate debt loads, a catastrophic fall in corporate profits, and a sideways and collapsing stock market would suggest the problems are more structural rather than cyclical in nature.

#2  Tax Rebates and Future Cuts Just Won’t Cut It

Another specious argument rests on the belief that tax rebates will fill in the gaps left by monetary policy. The only problem with this argument is that very few of the tax benefits occur upfront. Most of the tax benefits are phased in over periods ending as late as 2009 and all of the tax benefits will terminate after 2010. Retroactive to January 1, 2001, a new 10% tax rate will replace the 15% tax rate on the first $12,000 of taxable income for joint filers, $10,000 for heads of household, and $6,000 for singles.  Taxpayers won’t have to wait for the refunds until next year when they file. The Treasury will mail all refunds to those who pay taxes this year by October. Beginning July 1, 2001, the current 28%, 31%, 36%, and 39.6% income tax rates will be gradually reduced over a six-year period to 25%, 28%, 33%, and 35%. Starting in 2006, the limitation on personal exemptions and itemized deductions for higher-income taxpayers will be phased out.

The problem with this plan is that it will be phased in over a six-year period. All that taxpayers will get this year is the $300, $500, and $600 for single, head of household, and joint filers. What happens after this money is spent? Do economists really think that $300 and $600 rebates will turn this economy around? Do they really believe that it will ameliorate average credit card debt of $8,000, mortgage and installment debt that exceeds disposable income, or a negative savings rate? Even Keynesians acknowledge the need to reduce taxes during times of economic weakness. Tax decreases and government spending are supposed to be used to offset economic weakness. In this regard, the Keynesians running government have been far too stingy. Already there is talk about vanishing surpluses and the possible need to delay the phase-in of tax rate reductions. Dick Gephardt, the Democrat minority leader in the House, has already been speaking about the need to raise taxes. It would become a priority if his party retakes the House in 2002.

The deficit reduction mantra has become an excuse for higher spending and more taxes. Over the last two years of the Clinton Administration, government spending increased at an annual rate of 8%. Both sides shared in the spending orgy. Congress is already talking about delaying next year’s tax rate reductions because of possible deficits. It may be news to most congressmen, but recessions produce deficits! Tax revenues are reduced as economic activity slows down. At the same time, government costs rise as a result of transfer payments, which rise with unemployment.

Phasing in the benefits over a six-year period negated a possible policy fix that could have ameliorated the economic downturn. The stimulus that would have been created by lower tax rates is lost as a result of delaying them. Washington is a place of compromise. But in this case, you don’t compromise over the number of lifeboats you are going to release when the ship is sinking.

#3  The Future of Energy is A Crisis

A third argument that inhibits economic recovery is the state of America’s energy infrastructure. According to the President's energy report, “America in the year 2001 faces the most serious energy shortage since the oil embargoes of the 1970’s. A fundamental imbalance between supply and demand defines our nation’s energy crisis.” ¹ As pointed out in previous installments in my Storm Series, we have run out of spare capacity in oil, natural gas, and electricity. Our dependence on foreign oil has never been greater. We now import over 51% of our oil versus 25 to 30% during our last energy crises back in 1973-74 and 1978-79. Low prices and under investment have caused our energy infrastructure to remain neglected and decayed. We are now dependent on OPEC and other foreign powers for much of our oil and natural gas energy needs.

In the past, recessions have always been associated with higher energy prices. Higher energy prices were contributing factors to the recessions of the seventies, early eighties and the last recession in 1991. Higher energy prices are impacting the current economic downturn. Consumers and corporations are spending more for energy in the form of higher gas prices and higher utility bills. The tax rebates don’t come close to covering the higher energy costs hitting consumers. The way we handle this crisis will frame the severity of the approaching economic storm. This time, our energy crisis is not a temporary event caused by consumer hoarding as in the 1970’s. For far too long energy needs have been neglected. Americans were led to believe that technology would reduce demands placed on energy. Instead technology has created new demands. There is also widespread belief that oil is plentiful. Oil may be abundant in the Middle East, but not in the West. Industry insiders are alarmed at how fast our oil reserves are dwindling.

President Bush is the first president since Ronald Reagan to address this issue.  His plan strikes a balance between the need for more supply and the need for conservation, between drilling for oil and natural gas, and new sources of energy. Yet Congress dithers over the President’s energy plan. The fact that we are even debating drilling for oil at ANWR is a complete absurdity. The debate is over 2,000 acres of mosquito-infested, muddy terrain the size of an airport. ANWR contains close to 19 million acres of land. The area of drilling is not a pristine wilderness. It is tundra. The caribou are not endangered – they are thriving.²

The Facts on Energy Consumption

What is often forgotten in this debate are the facts. In 1990, energy consumption in the U.S. was 86 quadrillion BTUs. In a decade, it has grown to 100.  That is an increase in energy equivalent of 8 million barrels of oil a day. Over the last two decades almost no new refinery capacity has been added. The ability to deliver imported oil has also diminished. World tanker fleets have declined. Prior to the 90’s America increased its power grid capacity by 10% every five years. During the first half of the 90’s that capacity had declined to only a 4% increase. In the last half of the decade it declined further to only a 2% increase. At the same time, the demand for electricity grew by 2.5-3% a year and over the last few years, it has accelerated to 4% a year.

During this same time, the supply of energy has declined. Within OPEC, only one country, Saudi Arabia, has excess supply. Decline rates in production in the U.S. in the lower 48 and in Alaska continue to fall. Despite increased investment, output fails to match input. Gas well completions are up in Canada by 41% over the last year, but gas supply grew by only 2%. In the U.S., drilling activity over the past five years has increased three-fold, but output remains flat. New finds are smaller while technology accelerates production decline curves.

Instead of facts, Americans are deluged with irrelevant environmental drivel from the media. The Jimmy Carter Sweater Strategy is proposed as a solution to the crisis. More efficient cars and refrigerators are proffered as answers to our energy needs. According to Matthew Simmons of Simmons International, the savings of increasing gas mileage to 80 miles per gallon in one million new cars would only save us 40,000 barrels of oil each day.³ Imagine how long it would take and what the costs would be  if we converted our entire inventory of existing automobiles to more fuel-efficient cars. It would take over a decade. The idea that conservation will solve our energy crisis is as hollow as it is absurd.

Flaunting The Possible Solutions

Fixing the energy problem is simple. It involves rebuilding our energy infrastructure. It means finding new sources of oil and natural gas. It mandates using new alternate sources of energy such as clean coal technology, geothermal and nuclear power. It will involve building power plants, adding thousands of miles of pipelines, adding refineries, building tankers and adding capacity to our power grid system.

We have a problem in that this crisis hits our economy at a time of weakness and economic vulnerability. Instead of addressing the issue and turning it into an opportunity, rational debate has given way to demagoguery. The needs of plants, insects, fish and animals are placed above humans. Forests are being closed down. Loggers are losing their jobs. Mines are being closed and miners collect unemployment. Ranch lands and grazing rights are being taken away. Access to oil and natural gas on Federal lands is being denied to the energy industry. And now even lives are being threatened.  Recently in the Pacific Northwest four firefighters lost their lives because of a fish! ⁴  Many of these so-called threats to plants, fish and animals are questionable. There is a Pulitzer Prize waiting for the reporter who investigates the fraudulent arguments behind much of the environmental movement. I suspect that the reporter will find that political theory is taken as scientific fact.

The point to be made here is that energy is the lifeblood of our economic system. Without it, our economy shuts down. With it, our economic well-being is enhanced. The current crisis won’t go away. It will only get worse. Unless we begin now to address the problem, the prospects for economic recovery will be limited. We will have to rely on the good fortune of weather, which we know is unpredictable. Unusually cool weather has helped California to avoid blackouts this summer, but California is only a few degrees away from its next energy crisis.

The problem of energy has all but disappeared from the front pages. An aberrantly cool summer has led to cutbacks on air-conditioning loads and we’ve seen the demand for energy dampened by a weak economy. The government has imposed price caps in California. Weather and the economy have been the main factors in reducing our power consumption. The result is that electricity prices have receded. Now there is talk of a power glut. A recent article in Barron’s put forth that overbuilding by power producers could imperil the industry.⁵ I believe this issue of a power glut is short-sided and rests primarily on short-term pricing mechanisms.

Short-Term Thinking on a Long-Term Problem

So much of what happens in the financial markets and in corporate boardrooms is based on short-term thinking. Whether it is the current price of a stock or the current price of a commodity, too much emphasis is placed on short-term pricing mechanisms. Less than three months ago, the country was caught up with energy shortages. Now they are talking about an energy glut. Have the fundamentals changed that dramatically in so short a period that we have gone from shortage to surplus in just three months? A cooler summer and a slower economy doesn’t erase the fact that our energy infrastructure continues to deteriorate.

There is no question that an economic slowdown has reduced demand for energy. However, the perception that reducing demand for energy through a weak economy is an answer to the energy crisis is misguided. Power consumption in the Pacific Northwest was reduced when the Bonneville Power Authority asked 10 aluminum smelters, representing 40 percent of the nation’s aluminum production to shut down in order to reduce power. It is estimated that 7,000 workers will lose their jobs as a result.⁶ The shutdown will conserve energy at the expense of the economy. Surely, putting people out of work, and reducing economic output cannot represent a workable solution to a long-term problem. By this method of thinking, a recession or a depression would be even better since it would further reduce our energy needs. As absurd as this sounds, there are many in the environmental camp that indirectly argue for such an approach.

As far as the weather reducing demand, that can change at any moment. What happens if the weather this winter is also unseasonably cold? The reason prices spiked last winter was that capacity constraints existed within our energy infrastructure. If a refinery breaks down, if weather patterns change, or if demand heats up within the economy, the infrastructure still isn’t there to handle it. This is why prices spike when demand increases. Our existing infrastructure is old and badly in need of repair. What happens to this infrastructure when the next economic up cycle begins? A weakening economy may reduce energy demands in the short-term, but it does not solve the energy crisis. It just postpones it.

Supply and Demand Numbers Don't Lie

As these graphs depict, our production of oil and gas has steadily declined over the last three decades. We are no longer energy independent. As our production has declined, our imports have increased. We are now heavily dependent on OPEC for much of our energy needs. If they want to cut back production to maintain prices, we are held hostage to their desire for higher prices. As oil production decline curves accelerate over the next decade, we will have to import even more oil from the Middle East. The price of oil will only go higher over the long term. When you are heavily dependent on outsourcing your energy needs, you are not in a position to dictate the price you pay. Over the next decade the U.S. will be faced with paying higher prices for energy either through market mechanisms because of supply constraints, through government price controls that create shortages, or by higher prices dictated by foreign producers who sit on top of the majority of the world’s oil reserves.

One way or another, the price of energy will rise throughout this decade. How much it rises and what we do about it will determine the strength of any economic recovery or the severity of a decline. Cheap and abundant energy has been behind much of the progress that has been made in living standards over the last century. The real danger is that a recession will reduce energy demand short-term, but it will also accelerate the energy crisis and place a limit on any economic recovery. During a recession, we will still be consuming energy. Our production of oil and natural gas will continue to decline. Our aging energy infrastructure will continue to decay. The depletion of our natural resources will continue unabated. The danger of a recession comes from short-term price decreases. Lower prices discourage the necessary investment that is going to be needed to repair and rebuild the whole energy complex. To maintain our standard of living in the United States, we must continuously expand our access to mineral resources and energy. As the U.S. becomes more dependent on importing these resources, our balance of payment problem worsens. The more dependent we become on importing these resources, the greater danger it poses to our standard of living. A nation, which does not control its natural resources, loses control over its economic future.

War – A Very Real & Present Danger

Right now that dependency is on Middle East oil. This is a very unstable region of the world. Placing so much emphasis on imported oil is inherently dangerous to our national security. The consequences of another Middle East War are inconceivable to most economists or analysts. If war breaks out, what would happen to our financial markets, to the price of energy, to our imports of oil from the region, and to our economy? Right now no one is paying attention to this possibility despite the international headlines of conflict. Wall Street glosses over the heightened tensions and the escalation of violence. It does so at its own peril. Analysts ignored these conflicts in the past. Then they were taken by surprise in 1967, again in 1973, again in 1979, and once again in 1990. As I have mentioned in past installments of my Storm Series, our only energy policy at the moment is 25 warships in the Persian Gulf.

Shortsighted and Apathetic Views Inhibit An Effective Energy Policy

The real problem in looking at our energy crisis is that short-term pricing mechanisms have been allowed to dictate our energy policy. For almost two decades, low prices and low returns within the industry took their toll on oil producers and the whole energy complex. The result was industry consolidation that neither added to capacity nor repaired infrastructure. Lower prices fueled strong economic growth at the expense of the energy industry. From exploring for oil and natural gas, building power plants, laying pipelines, to building tankers and our power grid system, the whole system was ignored. Returns were so low that the industry didn’t have the capital to modernize or expand and keep the industry healthy.

Another concern is the data on which energy decisions are being made is badly flawed and need of re-evaluation. Price has become everything. Price cannot tell you about the condition of our energy complex, the age of our tanker fleet, OPEC spare capacity, or production decline curves in the West. Price doesn’t tell you that capacity constraints exist within the energy complex until severe weather places extra demand on the system. Only when prices rise do we pay attention. And even then, it is only briefly. Any time prices rise, we think they are an aberration or part of a conspiracy by the industry or some insider wanting to make an extra buck. When prices rise, the natural reaction by politicians and the media is to begin pointing fingers and find a villain. Rather than thinking the problem through, politicians only propose band-aids like price controls as a solution. It may mollify voter wrath, but it also gives false signals to consumers to continue their use of energy without regard to conservation and to oil producers who look to their bottom line.

Energy Will Be A Permanent Problem

This time around, our energy crisis is not temporary. It will become permanent unless we do something about it. Unless we solve it, our future prosperity and that of the world could become imperiled. We have been fortunate in the U.S. in that our excess demand for energy has been supplied by imports from OPEC and other foreign producers. This has come at the expense of a deteriorating trade deficit. However, a day is coming in the not too distant future when our voracious appetite for energy will compete against the demands from emerging world economies. The desire of growing populations in lesser-developed nations to maintain and increase their standard of living intensifies the demand on the world’s mineral resources. The United States, with only 5% of the world’s population, uses about a third of the globe’s annual energy supplies. As we import more of our energy and raw materials (resources in which we were once self-sufficient), we will increasingly lose control over our future economic destiny. Many in the U.S. just don’t get it. The era of cheap and abundant energy is gone.

Energy and minerals are the basis of our modern civilization. Without these resources, nations are doomed to remain at poverty levels. If denied access to supplies, countries will either resign themselves to a position of poverty or as in the case of Japan in 1941, go to war. With no new frontiers to explore, nations will continuously face conflicts and jostle for position for access to the earth’s raw materials. Future military conflicts like the Gulf War and the current conflict in the Middle East will be over access to the earth’s remaining resources of energy, water, fertile soil and other base minerals. It is for these reasons that we must begin now to solve this crisis. The severity of a recession, or the strength of a recovery, will depend on the job that is done.

I’ve identified three special situations that would argue against an economic recovery or against a recovery of any sufficient strength. I’ve discussed the ineffectiveness of monetary policy to arrest a market decline or stop the economy from weakening. I’ve shown that the tax bill lacks the necessary stimulus to ameliorate the downturn because of the phasing in of most of its benefits. I’ve discussed the danger of the energy crisis and how it has weakened the economy and what it portends for the future unless it is solved. The final situation that does not bode well for the economy or the financial markets is the condition of corporate profits. It is the sorry state of corporate profits that presents the most compelling argument against a return of the bull market of the 90’s.

#4  The Truth About Corporate Profits

To fully understand the precarious position of our financial markets requires both an understanding of both macro and micro economic issues. The unparalleled returns in our financial markets during the last decade have been explained as a result of a new paradigm shift within the American economy. Many portray our prosperity as the result of corporate restructuring, management efficiency, our technology edge and the emphasis on shareholder capitalism. This is a myth that is now unraveling with a vengeance. Upon closer inspection of the profit miracle, the rise in profits had more to do with events in Washington than it did on Wall Street. The advancement in profits during the early part of the decade can be attributed to two factors: 1) a lowering of interest rates by the Federal Reserve and 2) a favorable change in the tax laws.

As this graph illustrates, corporate profits peaked by mid-decade. As the U.S. worked itself out of the 1990-91 recession, corporate profits rose at above-average rates. This above-average rise in profits had its genesis in two macro causes outside corporate boardrooms. The contributing factor in the acceleration of profits during the first half of the decade was primarily due to lower interest rates. 

As the graph on bond yields indicates, long-term interest rates fell with Fed easing. In an effort to re-liquefy the financial system and bail out the Savings and Loan industry, the Fed brought down interest rates. This made it easy for the banking system to borrow money from the Fed and reinvest the money in long-term treasuries which helped to restore profitability within the banking system. Banks and S&L’s could borrow at lower interest rates from the Fed and then turn around and earn higher returns on U.S. Treasury debt. This helped the banks, but it also helped to bring down long-term interest rates in the process.

Lower Rates ... A Finance Department's Dream

At the same time, corporations took advantage of lower long-term rates to refinance their outstanding debt. This accounted for the majority of the surge in corporate profits at the beginning of the decade. As long-term rates came down from the high single digits, companies could refinance expensive debt with lower rates. This lowered their interest expense, which increased earnings. In addition to refinancing debt, Congress changed the tax laws and lengthened depreciation charges on buildings and equipment. As the period for depreciating equipment and buildings was extended, depreciation expense at companies fell. This reduced expenses, which also contributed to higher profits. However, once these two benefits were exhausted, corporate profits began to under perform the economy.

This is illustrated in the graph on the right. In fact, in terms of profitability, profit growth at companies in relation to the economy was sub-par. Throughout the 80’s and 90’s, profits for companies remained at the lower end of their historical norm. As Warren Buffett pointed out in his November 1999 article in Fortune magazine, you can’t have a subset of the aggregate growing at a faster pace than entire aggregate. Eventually it reverts to the mean.⁷

After-tax Corporate Profits as a % of GDP

The combination of lower interest rates and changing the tax code helped to accelerate profit levels back toward the upper range of 6 percent experienced throughout most of this century. However, these were “one time events” and were unlikely to be sustainable. To keep profits growing at rates that Wall Street and investors were clamoring for took creativity. Over the last half of the 90’s profit growth had more to do with “creative accounting” than it did to real, sustainable earnings. Corporate earnings growth has had more to due with an accountant’s pen, than it did with the fundamental success of the corporate enterprise.

Corporate CEOs and their accountants began to manage earnings in such a way that pleased both Wall Street and shareholders. The creative ways in which earnings were manipulated are too numerous to cover in this article. Suffice to say they would fill volumes from textbooks to investment best sellers. I’m going to cover just a few.

Convenience Parking

“Parking” allows the company to show increasing sales without actually completing the sales process. Sales are shown on the books of the selling company, but the actual items remain off the books of the customer. In essence, the manufacturer is inventorying items meant for its customers. This may involve the manufacturer keeping the shipped goods in a truck trailer at the customer warehouse or plant until such time as the customer has need for them. The problem occurs when the question is, “To whom do the goods belong?” Do they belong to the manufacturer who sold the goods and booked them as a sale, or do they belong to the customer who has still not moved them into inventory as purchased goods or raw materials?

In the meantime, the buyer has been billed for the goods and the manufacturer has booked a sale and a receivable on its income statement. In reality this has become a deferred sale. It helps to enlarge sales without concurrent increases in costs. This procedure manifests a false profitability.

I remember my first year out of graduate school as an auditor on a job site in the month of December. We were at a plant in preparation for the year-end audit. Beyond the plant a long train loaded with raw materials was parked outside the gates. Throughout the month I noticed that the train remained parked and unloaded. I asked my senior supervisor why this was so and he remarked that if the train unloaded the goods, they would be booked into inventory and increase the cost of goods sold. It now made sense. When I came back from the New Year’s holiday, the train was gone and the goods had been unloaded and booked into inventory. Of course it was a new fiscal year for the company.

Events like this happen much more frequently than you imagine. Creative accounting gimmicks like parking contributed to the problems at Sunbeam, Rite Aid, Waste Management and many other companies. The pressure to meet earnings expectations places enormous burden on management to perform to those expectations. This practice has led many companies to restate earnings as accounting irregularities become more frequent.

The Share Buyback Strategy

One way chief executives have been increasing their earnings is through share buybacks. By purchasing their shares in the open market, companies have been retiring stock at unprecedented levels. The idea behind this concept is to enhance shareholder value. By retiring stock, the company divides its profits between fewer shares of stock.

For example, if a company earned $1,000,000 and had 1,000,000 shares of stock, the profit per share would be $1 a share. Let’s suppose that the shares were trading in the market at $10 a share and the company used all of its profit of $1,000,000 to buy back its shares. At $10 a share, the company could use the money to buy back 100,000 shares of stock leaving only 900,000 outstanding.

The following year, if the company made the same $1,000,000 profit, it would be divided over 900,000 shares of stock instead of 1,000,000 shares. The result would be that earnings per share would have risen from $1 per share to $1.11 per share. Even though total profits were the same, earnings per share would have risen by 11%. Thus, through the Share Buyback Strategy, the company’s earnings per share increased without a fundamental improvement of the business.

Imagine what a company could do if it used debt, along with profits, to buy back shares. The number of shares could be retired at a much faster pace, leaving fewer shares to participate in the profits. This strategy could in turn accelerate earnings per share at an even faster pace. Wall Street and Day Traders reward rising earnings per share by higher stock prices. Rising earnings get analysts attention. Why? Because analysts tend to issue strong buy recommendations on companies whose earnings per share are rising at above-average levels.

Look at the balance sheet and income statements of many of today’s big cap growth stocks and you will find this strategy as a contributing factor behind their earnings growth story. Share buybacks make sense when your stock is selling at a low multiple or if you have no business opportunities in which you can expand the enterprise. Buying your shares back when the price is inflated and leveraging your balance sheet to do so is a prescription for trouble down the road. It sacrifices future earnings and impairs the safety of the company.

The Corporate Restructuring Strategy

Another way in which earnings have been enhanced is through corporate restructuring. This technique has become commonplace and a permanent fixture in financial headlines. This practice involves writing off a large amount of expenses in one year or quarter.

Suppose a company is going to downsize its workforce. This could involve closing down plants and result in a large number of employee layoffs. Although this process takes place over a few years, the company books the expense up front in the first year. The write-offs are huge and of course would capture headlines. ABC Company is shutting down 5 plants and laying off 10% of its workforce! The expenses of doing this should be written off over the time period of completing the plant shut down, which could take several years. The beauty of this strategy is that you write off all of your expenses in one year. Wall Street applauds the move because they know that booking all of those expenses in one year makes the next year more profitable.

The write-offs are so big analysts ignore them. Indeed, stock services such as Value Line, exclude the losses from their earnings per share figures. It becomes a footnote listed at the bottom of the page. In the future, if those losses turn out to be less than originally estimated, they become a source of profits by adding them back into earnings. In some ways they become a ”profit reserve” that can be called upon when a company needs to make its next quarterly profit objective.

The Acquisition Strategy

Another way to bolster profits is through acquisitions. An acquiring company uses its stock as a currency to buy other companies in an effort to buy another source of sales and profits. The problem here is something accountants call goodwill. Goodwill represents the excess value of a company above its tangible assets such as plants, property and equipment, cash and inventory. If you bought a company for $110 a share but its tangible net worth was $10 a share, the $100 excess value was attributable to goodwill. That goodwill reflected the company’s brand franchise or the reputation of its products. It was intangible, but it was part of the company’s success. An example of goodwill might include the franchise value of Coca-Cola.

The problem with the merger wave over the last few years is that many companies over paid for the value of their acquisitions. With their stock value flying high during the heydays of the bull market, it didn’t matter. Now that overpayment is coming home to roost as more companies take restructuring charges to rid themselves of goodwill, it has to be amortized over a period of years. Recently, JDS Uniphase will adjust its Quarterly Report on Form 10-Q to reduce the carrying value of goodwill by $38.7 billion. In addition to reductions in goodwill, merger related expenses, realized and unrealized losses on equity investments, intangible amortization, and payroll taxes on stock option exercises, will cause the company to report a $50.6 billion loss for the year. That is the largest loss in corporate history. Even tech titan, Microsoft, had to write off $2.5 billion in bad investments. When combined with other charges, the write-off produced a $3.9 billion charge for the recent quarter.

The Financial Accounting Standards Board has aided companies in their earnings game. FASB is the private group the SEC relies on to set accounting standards. They have eased the earnings impact of accounting for goodwill from acquisitions. Goodwill, as previously mentioned, is the amount a purchaser pays beyond book value for a company’s assets. In the technology boom of the late 90’s these sums have been substantial. New rules passed in July allow corporations to assess the value of goodwill on their books periodically and take charges only when it has fallen – hence, the JDS Uniphase hit of $38.7 billion. The FASB backed away from tougher standards that would have forced companies to continue to amortize, or write off, the value of goodwill over 20 years or more.

From a macro perspective, the wave of corporate mergers has done little to improve the prospects of the economy. It is one of the reasons that economic growth and corporate earnings throughout the last decade have been below historical trends. Enduring economic prosperity comes from savings and capital accumulation in the form of real productive assets such a plant and equipment. The wave of corporate mergers, downsizing, and restructuring may boost profits in the short run, but they do nothing to improve long-term economic prospects.  When all businesses begin to cut back on plant and equipment, shed assets and employees, they are contracting the economy from a macro perspective. They are reducing revenues and ultimately profits. The result is that corporate capital stock is in decline. In essence, the U.S. is consuming its capital by selling its assets in order to pay for consumption.

Corporate Profits in Decline

This profit deluge is becoming more evident in recent days as the financial markets witness the greatest plunge in corporate profitability in a decade. The downturn in profits at major corporations has been swift and brutal. It has stunned Wall Street analysts and investors alike. The numbers are horrendous from JDS Uniphase fiscal year loss of $50.6 billion to a plunge in the profits of Intel by 94%. The profit squeeze isn’t limited to the hard hit technology sector. Profits are down dramatically across most industries outside of energy, utilities and the drug industry. So far second quarter profits fell more than 16% based on the 424 companies reporting in the S&P 500 index.

The precipitous drop in corporate profits, which is only now gaining attention, has been obscured over the last few years by hype and flagrant propaganda. Profits have been falling for years. The decline in profits has been overshadowed by the run up in stock prices. There has also been the game of corporate earnings and how they are reported. The game keeps getting reinvented. Companies, with the help of analysts, are looking for creative ways to bury the earnings story. When a myth like “the new paradigm” or “the profit miracle” is formulated, it becomes difficult to perpetuate it. These days Wall Street diverts the investor’s attention from the bottom line to earnings of a different sort. In the old days of principled accounting practices, earnings used to represent after-tax profits from operating the business. These days, when companies talk about profit, they can mean almost anything. In this new paradigm age almost anything goes. Profits can mean cash profits, profits before taxes, profits before write-offs, pro-forma profits, or in the case of technology startups, “potential” profits.

Profit calculations mirror the new math taught in today’s public schools where 2+2= 5, 6, 8 or anything you want it to be. The revisionists on Wall Street and the financial analysts turned media personalities are hard at work creating new and improved math with which to understand earnings. In the future, instead of just one bottom line, there may be three.  Actually, “whatever works best” seems to be the new motto. A few examples illustrate how this process works.

Examples of "Whatever Works Best"

Example #1  Fudging Cisco’s Pro Forma

When Cisco reported its fiscal third quarter profits at the end of the first quarter, analysts and the media concentrated on Cisco’s pro forma earnings. According to Cisco’s definition, pro forma earnings excluded acquisition-related costs, payroll taxes on exercises of stock options, restructuring costs, investment gains and a $2.25 billion pretax charge for writing down the value of inventory. Media analysts and Wall Street focused only on Cisco’s pro forma net income of $230 million. The real number was a loss of $2.69 billion.⁸

In the latest quarter, Cisco reported its fiscal 2001 and fourth quarter results. Its pro forma net income was $3.09 billion for the year or $0.41 per share for fiscal 2001. That was down from the previous year where the company reported pro forma net income of $3.91 billion or $0.53 per share for fiscal 2000. However, after taking into effect acquisition charges, payroll tax on stock option exercises, restructuring costs, and inventory write downs, the company reported an actual net loss for fiscal 2001 of $1.01 billion or $0.14 per share. This compared to actual net income of $2.67 billion or $0.36 per share for fiscal 2000. For its most recent fourth quarter ending July 28, 2001 pro forma net income was $163 million, or $0.02 share compared to $1.20 billion or $0.16 a share – an actual decrease of 87%. Actual net income was only $7 million or $0.00 per share, compared with actual net income of $796 million or $0.11 per share for the same period last year.

Example #2  SCI’s Slippery Numbers

Another example of how earnings reporting distort actual results was the previous quarter's earnings for SCI Systems, an electronics maker acquired recently by Sanmina. The company bragged and the financial press reported that its fiscal fourth-quarter numbers met or beat Wall Street estimates with “cash earnings per share” of $0.27. The actual numbers showed $46.9 million in non-recurring ”special charges”. These nonrecurring charges reduced the bottom line to an actual loss of $843,000, or $.01 a share. The company disclosed these costs as nonrecurring, even though the company may take a charge ranging between $70-100 million for job cuts and plant closing in the upcoming quarter.⁹ Personally, I define the word, nonrecurring, as “not occurring again”.

Example #3  IBM’s Bottom Line Boosters

IBM is another example of how companies play with numbers. The company helped to ignite a rally in the NASDAQ this spring when it reported EPS numbers that grew by 15%, easily beating analysts’ estimates. But IBM’s earnings are another story. A good amount of IBM’s earnings gains over the last few years have nothing to do with the company’s underlying business. Stock buy backs and gains in accounting from retirement benefits have given a nice kick to the bottom line. According to a recent analysis of IBM done in Forbes magazine, pension-related gains boosted the company’s bottom line by $820 million last year. Those pension gains that flowed to net income represented an improvement of 63% from the previous year. The company has shifted away from the traditional defined benefit plans to cash balance plans, which cost less.¹⁰

IBM also boosted additional gains for its bottom line by dipping into its reserve account for doubtful accounts, inventories and reserve restructuring charges. IBM has also been enriching its EPS numbers by share buybacks. Since 1995 IBM has retired 423 million shares. Last year, buybacks added $0.13 to EPS. All is fine and dandy as long as there is plenty of cash to support buybacks. But with the tech sector slowing down, cash flow is falling. IBM’s debt has risen to $24.9 billion as of 2000; while free cash flow dropped from $3.7 billion in 1999 to $3.1 billion last year.

IBM’s bottom line continues to benefit from share buybacks this year. During the second quarter, the company spent $1.2 billion on buying back its shares. The buybacks reduced outstanding shares from 1.77 billion to 1.74 billion. The company also got a boost to its EPS by reducing its overall tax rate to 29.5% from 30% a year ago. IBM reported that its revenues continue to decline hampered by an 18% decline in personal computer sales. Sales are being hurt by a fall-off in the binge in corporate spending. The company warned analysts that its microelectronics business is likely to see a 15-20% decline because of the glut in inventories of semiconductors. And yet, the EPS numbers continue to look good – thanks to the help of accountants while the underlying business slows down.

Example #4  Others Enter The Earnings Game

In recent years, companies have used everything from pension savings to including investment gains in their earnings reports. Investors need to pay close attention to income statements to sort out how much of earnings actually come from running the business, versus outside activities from interest expense, investment gains, to gains writing options on their own stock. Many companies used gains from writing options on their stock when times were good. Companies ranging from Intel, Microsoft to Dell and others would often include investment gains in their earnings numbers. Analysts would include them until recently, when those gains started turning into losses such as the recent $2.6 billion loss on investments reported by Microsoft in the second quarter. Let me make that last statement plain and simple. When it is to their advantage, numbers are being included. When numbers are a detriment to the bottom line, they are being dropped.

Even companies like Procter & Gamble have resorted to using “special” reporting in how it accounts for its earnings. Traditionally, P&G included sales of its product line as a continuing part of its business. But this June, the company announced it would take $1.2 billion in charges to cut jobs and phase out lines such as Olay and write off food manufacturing charges. Wall Street excluded those charges from their earnings forecast. They have also excluded an additional $2.59 billion in other charges since 1999.

Wizardry in the Finance Department

Even more revealing than these accounting games is the composition of corporate earnings themselves. As shown above with Cisco, a good portion of profits reported these days doesn’t come from making widgets or the business of the enterprise. At Intel a sizable portion of the company’s depressed earnings now comes from interest income. It seems that an ever-increasing trend in corporate profits comes from their finance departments as financial activities are contributing a greater portion to the corporate bottom line. The business of American companies is rapidly moving from making things to making money on money. Financial service companies are expected to contribute a record 25% of profits for the S&P 500 this year.

Excluding energy, one of the few sectors reporting above-average earnings today is found with finance-related companies like Fannie Mae, Freddie Mac, Capital One and MBNA. It is all part of a by-product of the credit boom. As the Fed and GSEs inflate the money supply, that money is fed into the financial markets and into the economy. It is only natural that companies move into this profitable realm of the incredible American Credit Machine.

Many of today’s large industrial companies derive an ever-increasing portion of their earnings from financial maneuvers. From industrial giants like GE, Ford, and General Motors to department stores like Sears Roebuck, many generate a sizable portion of their profits from their financial subsidiaries. Actually, some of these companies are beginning to look more like financial companies than they do industrial giants. As this table shows, a greater portion of sales from these companies is coming from their financial subsidiaries.

Looking Closer At GE Sales

In the case of GE, close to 50% of its gross revenues are coming from financial services versus the industrial side of the business. GE reported record second quarter earnings, with a good portion of those earnings from its financial unit. Further, GE reported that earnings increased by 15% in the recent quarter to a record $3.897 billion. Of that amount, $1.476 billion came from GE Capital Services. GMAC accounted for 70% of GM’s profit in the second quarter.

Ford is expected to report similar earnings percentages from its finance unit. In the case of Ford, it is taking $300 million in profits from securitizing gains.

An Upside Gain Can Be a Downside Potential

The problem with industrial companies turning their business to financial activities is that there are two sides to financing. On the one side are profits that come from the spread in the cost of money and what is charged on lending. The other side of the credit equation is what happens to earnings and the balance sheet when loans go bad. This is a hard lesson that is being learned by companies ranging from technology to banking and finance. American Express reported that second quarter profits fell 76% as the company warned their earnings would take a hit of $1.2 billion in losses in its junk bond portfolio and job cuts. The bulk of those charges would cover losses in junk bonds and the expectation for future defaults. Other companies ranging from Lucent to Microsoft have had to write off bad investments. Many of these giants goosed their sales by lending to customers. Unfortunately, many of those customers have since gone bust. To quote a recent article in Barron’s on the subject, “It’s fortunate Corporate America is making money on money while it’s not making much money making things”.¹¹

Corporate Profits ARE in Recession

As the above examples indicate, the long held view of a new profit paradigm in the American economy is more illusionary than it is factual. While the economy isn’t technically in a recession, corporate profits have entered into one. Lately, the stock market has been discounting the economic environment, while not improving, it's saying it won’t get worse. But on the corporate side, things are getting worse. Profit margins are being squeezed and losses are mounting. What would happen to these dismal profits, if the economy were to go into a recession? Wall Street is only recently coming to grips with this dilemma. The second half profit recovery has been thrown out the window, but the Street has merely postponed their forecasted recovery into next year. Right now earnings estimates are still too high. Rising costs are currently hurting corporate profits the most. Among those costs are rising wages, medical and energy costs. To make matters worse, companies are unable to pass those costs along to consumers.