The CFO Nose
by Brian Pretti CFA, Contrary Investor. December 21, 2007
There's an old saying in the financial markets that "the CFO always knows." Think about it, who better in any organization to have their finger on the true fundamental pulse beat and financial trajectory of any company than the CFO? If the Andy Fastow experience at Enron isn't a poster child example of this truism, I just don't know what is. Although plenty of folks pour over publicly disclosed insider equity transactions in search of clues as to either positive or negative forward investment prospects for individual companies, I personally tend to put elevated importance on staying in tune with CFO option/equity activity. After all, the CFO always knows.
Luckily for us, the wonderful folks at the Duke Fuqua School of Business, in conjunction with CFO Magazine, publish a quarterly CFO Global Business Outlook Survey that gives us more than a fair amount of insight into current CFO community thinking. And the reason I want to have a brief look at this is that indeed CFO confidence levels have been quite accurate in either foretelling or coinciding with the directional trajectory of the real US economy over time. As a bit of a quick tangent, I have found myself increasingly addressing the subject or theme of dichotomies over the past three to four months. Despite equity markets that have tried their best to rescale heights of the recent past, macro breadth continues to deteriorate right before our eyes. It's a dichotomy in plain sight. As of late, continued meaningful turmoil in global credit markets stands in sharp and dramatic contrast to the relative complacency we've witnessed in the aggregate equity market. Another dichotomy of the moment. As I've written about recently, headline payroll stats this year stand in meaningful contrast to the direction and magnitude of the household payroll survey accompanying each Bureau of Labor Stat monthly labor market view of life. So once again I find myself staring at a glaring dichotomy as I look at the tone and actual survey responses of the CFO survey released last week. A dichotomy of importance? I think so. See what you think as we take a quick look at the history of this survey.
Before taking even one step further, the history of this survey is short, as you'll see in the following charts. But for now, it’s the best we have in terms of the CFO crowd getting a chance to tell us how they are viewing life at any point in time. Right to the bottom line, as of 4Q, the level of CFO optimism fell to a record low over the history of this survey. Correspondingly, levels of pessimism reach a record high. C'mon, have these folks stopped watching Kudlow and Company? Haven't they gotten the word that the current is the best economy seen in Hank Paulson's lifetime? God forbid they've stopped getting their "news and views" from CNBC, no? So here's the dichotomy I referred to above depicted visually below.
First, you can see in the chart the longer-term history of levels of CFO optimism by quarter stretching back to 2002. 2007 experience has essentially been an unbroken sequential decline to the now lowest levels ever seen in the short history of the survey. Overlaid is the year over year change in real US GDP. What is clearly noticeable as one looks back over time is the directional similarity between change in CFO optimism levels and rate of change in real US GDP, until now. Enter the dichotomy of the moment.
If historical experience is at all to prove a valuable guide ahead, as we look at the character of the relationship above, it appears either the CFO's are dead wrong about their forward view of the US economy, or perhaps the direction of real US GDP ahead is about to take a nasty turn south in rhythm with CFO optimism levels. Until proven otherwise, my money is with the in the know CFO's.
Another way I've looked at this survey over time is to very simply look at the "net" level of CFO optimism. Calculated how? Level of optimism less the level of pessimism during any one period. And here you have it.
I believe this relationship is most useful at extremes. Here's my thinking. If we look back over time, it’s clear that the net level of CFO optimism about the US economy was a bit off the charts to the upside in middle to late 2003. With the always-beneficial advantage of historical hindsight, the CFO community was spot on at the time. Had investors been "listening," they would have heard the CFO community clearly communicating that better days were dead ahead for the US economy. That indeed was to be the case. Moving into late 2005 and early 2006, net levels of CFO optimism subsided meaningfully, but had not yet turned deeply negative. Funny, again in hindsight, this dovetailed perfectly with the now identified top in the US residential real estate market and the current cycle peaking in the year over year rate of change in US retail sales. In my mind, CFO survey responses in late 2005 and 2006 were "telling" us change was afoot. Fast forward to recent quarterly results and I have to ask myself, are we again looking at an extreme? But this time warning of darkness on the edge of town now fast approaching? Are the current deeply negative net responses simply a cyclical bookend to the extreme in optimism seen in 2003? Personally, I take this message of an extreme in negativity to heart. From my perspective, it’s either adopt this stance regarding the forward trajectory of the US economy or believe the CFO's of this world are simply idiots. And that I don't believe for a second. At least from the point of view of the CFO crowd, you've been warned about the forward rhythm of the domestic economy.
A few last parting comments. First, again thanks to the data generosity of the Duke/CFO Mag survey, the CFO's reveal to us their top five concerns for the US economy in each survey as they look ahead. In descending order from the current 4Q survey, here's what's on their minds collectively:
Top Concerns For US Businesses
- Consumer Demand
- Cost Of Labor
- Credit Markets/Interest Rates
- Cost of Fuel
- Cost of Health Care
- Housing Market Fallout
C'mon, let's face it; these are largely intertwined and interrelated concerns that center on the headwinds facing the US consumer. The bottom line is that CFO's are primarily concerned about a cost and credit contraction squeeze on US consumers occurring at the exact time their largest household asset is deflating, ultimately negatively impacting the rate of change in domestic consumption. After all, these CFO's are US consumers too, facing the same personal dynamics as does the breadth of US households as we move into the New Year.
One final comment about the dichotomy I spoke about above regarding the directional disparity between the rate of change in US real GDP and levels of CFO optimism. To me, this current directional differential absolutely reinforces the continual need to dig beneath the headlines for factual character of any data upon which we rely to make decisions. Although I always argue this important point, the 3Q GDP report puts an exclamation point behind this observation in my mind. A bit sarcastically, I've been questioning lately whether the next recession in the US will actually be published. Again, although this may sound humorous, I find less and less to laugh about as the days pass. Let me get right to the point and the real world observation. As you know, each quarter the BEA (Bureau of Economic Analysis) releases the "real" US GDP number. This is the number you see in the press and the carnival barkers on CNBC await in excited anticipation. It's also the number over which reams upon reams of analysis is spilled every 90 days, along with the inevitable revision periods. To get that number, the BEA takes nominal GDP and subtracts an inflation adjustment called the deflator. Nominal GDP less the deflator gives us real GDP, appearing on Bloomberg screens from sea to shining sea. So the deflator "estimate" takes on massive importance in the final outcome of the level of real GDP. Having said this, it just so happens that in 3Q of this year, the GDP deflator estimate was the third lowest number in 43 years. Have a look.
So in digging beneath the bright neon GDP report headlines, one must ask themselves, did the US economy really experience the third lowest quarterly inflation pressure in 43 years in 3Q of this year? Well, did it? Was it a decline in energy prices that did the trick? How about food price deflation? Big drop in health care costs? Educations cost imploding? C'mon, with meaningfully heightened inflationary pressures all around us, does the 3Q GDP deflator number pass the simple smell test? Well, at least according to the CFO nose, it does not. The smell test at the CFO nose level says the CFO's know something else. And hence the dichotomy I highlighted above. The CFO survey results tell us they believe 3Q US GDP is overstated based on a low-balled deflator relative to historical context. If indeed this is even close to being right, then the dichotomy between record low CFO optimism and headline US real GDP in 3Q makes sense.
As we look ahead, pinpoint quarterly GDP numbers will not matter as much to investment outcomes as will the trajectory of corporate earnings, the state of the US credit markets, conditions in US residential real estate markets, and US consumer well being. All items the CFO's appear to be watching quite intently, and not necessarily liking what they are seeing. So, in that spirit, I suggest watching the CFO's and "listening" to what they have to say. As opposed to viewing the world from Wall Street's cherry wood lined offices, the CFO's are on the front lines of the US economy. Who do you think has the best US economic vantage point; the CFO's of this world, or Kudlow and Cramer sitting in a New Jersey television studio?
My very best wishes to you and your families for the Holiday season and New Year ahead.
© 2007 Brian Pretti