The Good, the Bad, and the Ugly
By James J Puplava CFP, April 3, 2003
The Good: stock prices have rallied. The Bad: the rally is artificial and prompted by direct intervention in the financial markets. The Ugly: if intervention keeps up it sets up an artificial prop underneath the market that is subject to unexpected events and a severe crash. The news out this week couldn't be worse for the economy or profits. Listed below are a series of economic reports that indicate the economy is headed back into recession.
Purchasing Management Report drops to 48.4 from 54.9
2) ISM Manufacturing Report falls from 50.5 to 46.2
3) ISM Service Report drops from 53.9 to 47.9
4) Initial Jobless claims jump to 445,000, claims have exceeded 400,000 for the seventh consecutive week
Besides the deteriorating economic reports, there were more signs of credit stress in the economy with more bankruptcy filings. There were also plenty of profit warnings indicating that profits have deteriorated during the first quarter. Corporate profits in the US peaked in 1997 and have been on a downhill slide since that time. Although profits got a brief bounce in the final half of last year, due to cost cutting indications from company CEO's this quarter's picture has deteriorated once again.
The profit trend can be seen in the chart on the left, showing the downward spiral over the last three decades.
Warren Buffett first commented on this trend in the November 1999 issue of Fortune magazine. However, at that time the U.S. equity markets were going through their mania phase so very few investors listened. It wasn't until well into the downturn in 2002 that investors began to listen to Buffett again. The slowdown in profits these last five years led us into recession and is the reason that capex spending has been subdued.
|U.S. Nonfinancial Profits|
|The Richebächer Letter|
The growth in profits that were trumpeted during the boom period of the late bull market was artificial and nonexistent. I use the word "artificial" because we know that many of the sales and earnings numbers were the product of creative accounting. This became evident in last year's accounting scandals that revealed many of these miracle earnings to be fictional.
Now Wall Street is once again trumpeting fictional earnings in the form of pro forma numbers as a reason why investors should be investing in stocks. Finally, after three years of failure the often-forecasted second half recovery should finally take hold. Based on forward pro forma earnings stocks are now selling at bargain prices. Forward and pro forma can mean anything and the ability to forecast where profits will be one year from now is minimal at best. Warren Buffett admits to the fact that he doesn't know where profits will be near the end of the year, much less the end of the quarter. To base one's investment decisions on future numbers that are wrong about 85 percent of the time is strewn with major risks. The best that can be done is to look at current numbers and decide if present prices represent a price that would allow for an adequate return on investment or if present prices are too expensive. The current valuation metrics based on trailing earnings are listed below for each major index.
|Current Valuation in Major Indexes|
|S & P 500 Index||30.8||1.84%||4.0x||1.3x|
|Source: Barron's 3/31/2003 & Bloomberg|
We hate to keep repeating this table, but find it necessary to counter the cacophony of voices that keep telling investors stocks are a buy. It may be true that certain issues are a buy, but certainly isn't true when applied to the market as a whole. Once again, valuations are at levels that most bear markets begin, certainly not where bear markets bottom. It would take, assuming present profit levels and dividends hold up, a drop in the Dow to around 3,000, 300 for the S&P 500, and around 300 for the NASDAQ.
As I mentioned in Monday's WrapUp, there are three profit killers at the moment: underfunded pension plans, stock options and future accounting changes requiring them to be expensed, and excess plant capacity especially in the technology sector. Added to these three profit killers there is another macro variable that is also harming profits, which is America's burgeoning trade deficits that are now at truly historical records. If workers earn their wages from American companies but spend those wages on foreign goods, then American companies are deprived of the sales and profit potential. Wage earners earnings are diverted into the hands of foreign producers instead of domestic producers. The trade deficit figures correspond directly with the meager sales growth numbers reported by American companies. Over $500 billion a year is being diverted from domestic manufacturers to foreign producers. This is contributing to part of the problem of corporate profitability in addition to the issues listed above.
Finally, it must be mentioned that debt levels at the corporate level, debt levels at the consumer level, and debt levels at the government level are another inhibitor to the economy's recovery. When you analyze the logic behind the arguments made for economic recovery they don't pass the smell test. Companies lay off workers to improve profitability. These laid off workers go out and borrow more money to maintain consumption. Governments raise taxes to offset growing budget deficits, which reduce workers take home pay. Can anyone explain to me from a macro perspective how all of this works? Raising taxes and firing workers is a prescription for a recession, not a recovery. You don't need to be an analyst, economist or many a nuclear physicists to understand that reducing a worker's income through taxes and reducing a worker's income from unemployment doesn't build purchasing power. Besides, it is savings and investment that build a recovery and create wealth; not debt and consumption.
As the above chart on profits shows, over the last four decades the US economy has been transformed from an economy that saves and invests to an economy that borrows and spends. This is an eventual prescription for impoverishment. The lifestyles and profit growth that we have witnessed over the last two decades were the product of capital consumption and not one of savings and investment. The result is that the US transformed itself from the world's largest creditor nation to the world's largest debtor nation. This is why we are in fact a declining economic power and why the dollar is in jeopardy of losing its status as the world's reserve currency. There are simply too many IOU's that are being accumulated worldwide by foreign producers, investors, and governments. At some point, this is all going to come home to roost. The hourglass is running out of sand.
The Good, the Bad, and the Ugly Part II
It is quite possible and even probable after the next severe downturn that we could in effect reach a period of time that a firm countertrend emerges that would be a favorable climate for investing. If markets are allowed to take their natural course and aren't interfered with as presently is the case, a severe enough correction may bring stock prices to valuations that would then be somewhat reasonable. Despite the obvious intervention in financial markets, there will be some unexpected event that will suddenly appear. It will come either from the financial sector or at the geo-political level. This event whatever it turns out to be will take the markets down. It will be an event that overwhelms the markets. It will also be beyond the ability of authority's to control. If such an event happens and I don't see how it can not occur given all of the malinvestments, debt levels, speculation and preponderance of the moral hazard at work. Add to this all of the uncertainties in the geopolitical realm and it is difficult for me to imagine we would get this lucky and get by without such a mishap.
I suspect that once such a mishap occurs and it plays itself out in the financial markets authorities will respond with massive monetary and fiscal stimulus. This will give a temporary boost to the economy and to the markets in a similar way that the "new Deal" programs did in the aftermath of the 1932 bottom. Things will appear to be improving this will be the good part. The bad part will be that these measures will only be temporary and will only postpone the inevitable. In the end all of the debt and malinvestments of the boom will have to be liquidated before any meaningful recovery ever takes root. This final phase of liquidation will give us our bear market bottom but this period will be ugly. Stock prices will fall to levels that will once again make them attractive for investment. It will however be a painful adjustment process and I believe it is going to take The Perfect Financial Storm that takes us there.
However, like the seasons of nature where spring follows winter good times follow bad times. Once the markets cleanse the economy and the financial system of all of the excesses of the 80's and 90's boom the foundation will be set for a more permanent recovery. However, it is going to take a complete transformation in economic and investment thinking. The U.S. will have to abandon the faulty alchemy of Keynesian economics that consumption, regulation, taxation and government interference can create prosperity. It is through savings and productive investment that real wealth is built.
Looking at today's market action stocks fell initially on bad economic news before taking investors on another spin to the upside only to fall again. More profit warnings are starting to come in as analysts downgrade sectors from telecomm to tech. PeopleSoft and Affymetrix both warned of disappointments coming this quarter. Stocks keep bouncing around from losses to gains as various theories and recommendations keep being challenged by actual news events. Even steady predictable companies such as H& R Block aren't meeting profit expectations.
The major indexes finished down for the day with 19 stocks falling for every 11 that rose on the NYSE. Breath was about even on the NASDAQ. Volume came in at 1.3 billion on the Big Board and 1.44 billion on the NASDAQ. The VIX advanced 1.05 to 32.34 and the VXN edged up .49 to 42.05. Both indicators are at levels that suggest complacency.
European stocks rose for a third day as U.S. forces closed in on Baghdad, suggesting the war in Iraq may be over within weeks, not months. The Dow Jones Stoxx 50 Index advanced 1.2 percent to 2234.43, bringing its gain in the past three days to 6.5 percent. The Stoxx 600 rose 1 percent to 186.38. Benchmark indexes rose in all of the 17 Western European markets, except Germany and Austria.
Japanese stocks fell led by banks after Mitsubishi Tokyo Financial Group Inc. more than doubled its full-year loss estimate as slumping equities cut the value of its shareholdings. The Nikkei 225 Stock Average declined for the first time in three days, dropping 0.7 percent to 8017.75. The Topix index fell 0.5 percent to 793.68. Banks were the biggest drag, accounting for a third of the Topix's drop.
Charts courtesy of StockCharts.com & The Richebächer Letter
© 2003 James Puplava