It's Not the War

By James J Puplava CFP, March 31, 2003

It was a blistering rally that ended after eight days. A war that was predicted to end quickly has been extended. So now the war is being blamed for what ails the U.S. economy. Wall Street has made several key assumptions that are not only erroneous, but ridiculous as well. The first Gulf War, which had a far simpler mission--to remove Iraqi troops out of Kuwait--took six weeks to prosecute successfully. The Kosovo War took two months and ended in a diplomatic stalemate. Where did the expectation come from that this war, which has far more complicate objectives, was to end in few weeks? The assumption that U.S. forces would go in and drop a few bombs and then the war would be over is naïve. It shows you how out of touch Washington beltway reporters and Wall Street analysts are from reality. It was always a ridiculous assumption to think that U.S. forces would occupy and replace the regime of a country in few days or a few weeks, so it should come as no surprise that the temporary rally has been halted and is now reversing.

What ails the U.S. economy is not the war; it is too much debt and consumption that has become unsustainable. Certain industries such as travel have been affected by the war. The airlines are in a perilous condition with reduced travel and rising energy and labor costs. It is an industry that is barely profitable in the best of times. However, the rest of the economy has yet to shed its bubble characteristics from the 1990s. The only thing that has sustained the economy post 9-11 has been a flood of cheap credit. The result is that consumers are more overburdened with debt today than where they were when the bubble burst back in 2000. What I believe you are seeing now with the drop in consumer confidence and sentiment is that years of declining stock prices, job layoffs and rising prices for most things that people need, i.e. food and energy and health care, are starting to take their toll. As I have opined before in this column, a laid off worker doesn't have the same borrowing and spending flexibility as one who is gainfully employed. Companies don't have pricing power and they have seen costs rise so they are reducing payrolls. It is a vicious cycle that is becoming self-reinforcing that is leading us into another recession.

PROFIT KILLERS

What investors should keep focused on is the coming bad news on earnings, which I believe will be far worse than expected. I am also convinced that Q2 earnings won't be much better. There are three profit killers at the moment that are going to be brutal on earnings the next few years. They are as follows: 1) Underfunded pensions, 2) Accounting for stock options, and 3) Excess production capacity

Point #1 Underfunded Pensions

Let me begin with the first point, which is pension plans. Since 2000 company pension plans have been losing money. During the 1990s mania phase of the bull market, companies quit contributing to pension plans. Not only did they stop contributing to pension plans, but they were also able to include excess pension returns in bottom line profits. It was like printing money. The stock market would go up double-digits each year, which enabled companies to forgo making pension plan contributions. Remember, contributions are an expense. The excess returns in pension plans were then included in profits. Many high profile American companies from GE and IBM to GM were able to slash pension plan expenses and actually profit from excess returns earned in the company plan.

That was the 90's, but we are now in a new century and also in a new economic environment. Instead of double-digit gains, we now have double-digit losses. Instead of including pension plan gains as part of net income, companies are now having to shell out hard money to make up for losses and keep company plans fully compliant. Close to 70% of S&P 500 companies have defined benefit pension plans and most are underfunded. Companies have two years to bring their plans up to compliance, so this year you are going to see many companies shell out extra cash to fund their plans. This transaction will greatly reduce net income this year. Many companies such as GE, IBM, and GM are still making high single-digit assumptions on their pension plan returns. Even though they are losing money, their plans assume that they are making money. Many company plans still assume 8-10% returns for their pension plans when in fact they are losing almost as much as they are assuming to make in their plans. The worse the bear market is, the further behind these companies will be in bringing their plans into full compliance. Over the next few years many of the S&P 500 companies will be playing catch-up with their plan contributions. This is going to directly impact their bottom line negatively, hence, lower profits unless you look at only pro forma numbers.

Point #2 Stock Options

The next profit killer coming down the road is the expensing of stock options. This week's edition of Barron's featured a story that could really impact the technology industry. The FASB (Financial Accounting Standards Board) is expected to issue a ruling by year end that would require companies to treat stock options as an expense starting in 2004. According to the article, if S&P 500 companies had to account for options as an expense, S&P earnings for last year would have been 61% lower. As the article points out, S&P tech companies, which are selling at 25 times projected 2003 profits if adjusted for option expense, would sell at 40 times forward earnings this year. This compares to an historical norm of 14-15 times earnings. As the table below shows, P/E multiples for many highflying tech companies are actually much higher than widely reported. The new accounting requirement will make these companies even more expensive as they are required to start properly accounting for expenses.

Company	Microsoft	Intel	IBM	Cisco	Oracle	Applied Materials	EMC	Hewlett- Packard	Texas Instr.
2002 Earnings	$0.92	0.51	3.95	0.39	0.41	0.19	-0.05	0.79	0.22
Option-adjusted 2002 Profits *	$0.71	0.34	3.28	0.19	0.33	0.00	-0.22	0.48	-0.01
2002 P/E Ratio	27.2	34.5	20.6	34.6	27.7	67.5	NM	20.8	80.7
Option-adjusted 2002 P/E	35.3	51.7	24.8	71.1	34.4	NM	NM	34.3	NM
* 2002 Fiscal Year, NM = Not meaningful Source: Barron'sOnline (Company reports; Thomson/Baseline) March 31, 2003

Point #3 Excess Capacity

The final profit killer is the excess capacity of American industry, especially technology. With one out of four factories remaining idle in this country, there is very little incentive to build or add even more capacity. Industries plagued by excess production capacity can’treally profit from increased demand until that excess capacity is used up. Excess capacity also causes another problem as it leaves no room to raise prices. In fact, excess capacity usually leads to price wars and lower profit margins. This is what we see now in the technology industry where inventories are building and sales growth has declined. Companies have to fight for every dollar of sales, which means discounting is running rampant.

Until excess capacity and all of the malinvestments of the boom are liquidated, industry will have a hard time recovering. The more the Fed or the government interferes with this process, the longer it will take for the economy to recover. The bottom line is that the stock market is still grossly over valued, which remains one of its chief problems.

Meanwhile, U.S. stocks fell for the fourth consecutive day. The reason given for the fall was that the war might last for months. However, ignored in the reports were bad economic reports coming out of the manufacturing sector. The National Association of Purchasing Management-Chicago factory index fell to 48.4 from 54.9 in February. A reading below 50 indicates that the region's factories are contracting and in recession again. Sales of semiconductors fell 3.3 percent last month, another sign that the recovery is losing steam. Other factors affecting the markets today were the possibility for Altria to post a $12 billion dollar bond over tobacco litigation. American Airlines narrowly avoided bankruptcy, and AOL Time Warner is under investigation by regulators for possibly overstating revenues by $400 million. WorldCom also finds additional accounting errors of $2 billion. In other words, it was another typical day in the markets.

Wall Street focuses on the war as the reason why the markets are having difficulty. They are ignoring the fundamentals such as the Purchasing Management Report and valuations. It isn't the war that is hurting the economy, but the bubbles that are unwinding. Government's insistence on interfering with the market place is only hindering the healing process and making matters worse. As often repeated here in this column, the markets in the end will have their way.

The first quarter, which ended today, was on a down note. Blue chip averages such as the Dow and the S&P 500 ended the quarter in the red. The Dow lost 4.2%, and the S&P 500 was down 3.6% for the quarter. The NASDAQ was the only bright spot. It was up .4% for the quarter. Volume rose today on heavy selling. Volume hit 1.34 billion shares on the NYSE. Market breadth was negative by a 4-3 margin. The VIX rose 1.19 to 33.37 and the VXN fell .04 to 43.05.

Overseas Markets

European stocks fell for a fourth day after U.S. officials signaled a battle for the Iraqi capital of Baghdad won't begin soon. Insurance companies including Munich Re and Aegon NV led the decline, as slumping share prices reduce the value of insurers' equity investments and hurt earnings. STMicroelectronics NV and Infineon Technologies AG dropped after a semiconductor-industry group said sales growth worldwide slowed in February. The Dow Jones Stoxx 50 Index tumbled 3.8% to 2098.89, with all 50 members falling. The Stoxx 600 index slid 3.5% to 176.41. Both indexes have lost about 13% in the first quarter, the biggest declines for the period in their 16-year histories.

Asian stocks slumped on concern a war in Iraq and the spread of a killer virus will zap consumer confidence. Japan's Nikkei 225 Stock Average and South Korea's Kospi index posted their fourth straight quarterly drop. The Nikkei sank 3.7% to 7972.71, ending Japan's fiscal year with the biggest loss in six months. Toyota Motor Corp. led the decline.

Charts courtesy of StockCharts.com

James Puplava

© 2003 James Puplava

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