Storm Watch Update
THERE WERE SOME SIGNIFICANT STORIES THIS WEEK...
by Jim Puplava
www.financialsense.com
September 7, 2001

The most significant events to occur this week in Storm Watch relate to the economy. There were three significant stories that support the Storm Thesis. The first of these stories was the government’s revision of the productivity numbers for the U.S. economy from 2.5 percent to 2.1 percent. Over the latter half of the 90’s one of the constant themes of the investment markets was the new paradigm theory for America’s economy. The technological and managerial revolution had transformed the U.S. economy. American workers were more productive and corporations had become more profitable. The “New Paradigm" theory was behind the parabolic rise in stock prices during the latter part of the decade.

Productivity Down
Greater productivity and higher profits were used to spin higher stock prices for American corporations. Initially, the government reported that productivity growth averaged 3.4 percent during 1999-2000. It then revised those numbers to 2.6 percent. This week productivity numbers were revised for the second quarter from 2.5 percent to 2.1 percent.

Productivity measures economic output compared to labor hours worked. The greater the economic output per hour of labor, the higher the rate of productivity. Higher productivity keeps inflation in check and improves living standards by making goods more affordable. As pointed out in “The Gathering Storm” most of this improvement in productivity was a result of statistical wizardry. It was the result of artificial inflation of the GDP numbers through the use of hedonic price indexing and the lower of the inflation rates. Hedonic indexing of computer output added billions of dollars to GDP. The result was that it inflated the productivity numbers. Now government revisions are bringing those numbers back down. What originally looked like a productivity miracle is turning out to be a statistical myth.

Earnings Growth Down
The other myth that went along with the productivity miracle was the earnings growth model of U.S. companies. It turns out that the actual profit miracle was also a myth. It had more to do with creative accounting than it did actual profit growth. As this graph indicates, pre-tax profits (EBITD) before interest, taxes, depreciation and write-downs actually peaked in the third quarter of 1997. Furthermore, the increase in corporate profits in the early 90’s were mainly due to lower interest rates and a change in the tax laws which lowered depreciation expenses and reduced effective tax rates. Pre-tax profit margins are now at the lowest level since 1992.

In its latest revisions to the national income accounts within GDP, the profit numbers appear even more dismal. According to the new government figures earnings of non-financial corporations, as measured in the National Income Accounts, fell from $463.3 billion to $448 billion between 1996 and 2000. Profits fell by 3.3 percent while stock prices rose by 284 percent for the Nasdaq and 105.8 percent for the S&P 500.

The actual reality of the 90’s was that profit growth was sub par along with lower productivity. The “New Paradigm” theory used to push stock prices higher and justify even higher P/E multiples was nothing more than Wall Street spin and Washington hyperbole. For a further look at the real picture, please review corporate profits at U.S. Department of Commerce, Survey of Current Business. Companies are running out of gimmicks to hype their earnings, which is one reason the profit numbers have been so terrible. It accounts for why corporate profits have fallen off a cliff when compared to a slowdown in the economy.

NAPM Non-Manufacturing Index Down
Another storm tell tail this week was the NAPM non-manufacturing index, which fell to 45.5 in August from 48.9 in July. The NAPM report shows that the economic slowdown has spread to the service sector of the economy. Service sector activity has fallen for the sixth consecutive month. The drop in service sector activity indicates that the economy is heading closer towards a recession. A reading below 50 reflects declining activity. Both the manufacturing and service sectors are in the process of contracting.

Unemployment Numbers Up
Source: CNNfn

The drop in the service sector this week was followed by this Friday’s bombshell of a rise in the unemployment numbers. The jump in the unemployment rate to 4.9 percent hit a four-year high. The manufacturing sector job cuts have already surpassed the one million mark. The combination of NAPM reports, the rise in unemployment, and the drop in stock prices this week may indicate that the Fed is losing the battle to rescue the financial markets and along with it the economy. One wonders how long consumers can keep propping up the economy by spending on goods and housing when their portfolios are hemorrhaging and the daily headlines are led by job losses and plant closings. The ability of consumers to keep taking on more debt to maintain spending seems to me to be a very shallow argument for predicting an economic recovery.

Consumer Spending Down
Regarding the consumer, there were several key stories this week that point to a slowdown in spending. One of which was a story that consumers were flocking to discounters while sales at Department stores were in downturn. This is a deflationary indicator. It points to a very cautious consumer who is now counting pennies. There is additional evidence that supports that the consumer-spending binge is grinding to a halt. Mortgage refinancing is slowing down. The ability of consumers to extract equity out of their homes from rising real estate prices has been an important prop fueling purchases by households. Debt burdens may be finally taking their toll. This week’s story of U.S. homeowners falling behind on their mortgage payments shows that financial stress levels are mounting.

There were other stories out this week that point to continuing deflationary trends in technology. Semiconductor companies are reducing prices; while PC demand is slowing. The big stories to watch out for in the weeks ahead will be what come out of this quarters earnings pre-announcement. Depending on how bad they are and what companies say going forward may determine how far the markets fall in September and October. The financial markets in September and October are a lot like the Grand Banks; stormy and perilous. If they the financial markets continue along the course of this week I would not be surprised to see the Fed may a surprised move by cutting interest rates aggressively? Greenspan better than anybody knows that once confidence is gone the battle is lost and is over. If the Fed loses control look out! The metals markets could explode while the dollar implodes. Its time to put on the safety harness as barometric pressure drops.  ~ JP

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