Q2, 2003

By James J Puplava CFP, May 14, 2003

In financial circles, problems in Q1 for the economy and corporations were attributed to war fears. Financial professionals wrote off the first quarter. Fears over Iraq, possible chemical attacks on U.S. troops, and higher oil prices due to war uncertainty were the reasons that the economy and corporate profits were much weaker than anticipated. These reasons according to most analysts and economists were why the economy weakened and why real capital spending by businesses declined during the first quarter. Once the war was over the economy, consumer spending and corporate profits would begin to accelerate again. For analysts and economists they had a convenient excuse as to why the first quarter wasn't turning out as forecasted. This shouldn't have come as a surprise to anyone who listened to what companies were saying when they reported Q4 earnings. Profits were down and layoffs were up as companies struggled to contain rising labor and raw material costs. There was nothing stated or given by company CEO's in Q4 that would have created the impression things were improving or that Q1 profits would be a barn-burner. In fact, during January and February as companies reported disappointing profits, the markets headed south.

The Earnings Game

Then the Q1 warning season began. Companies began to warn that profits would be less than expected. Earnings warnings were three times greater than a year ago. Analysts panicked and ratcheted down their first quarter estimate to a low enough level that when companies actually reported earnings, they could easily beat them. Keep in mind when I refer to Wall Street earnings estimates I'm speaking about pro forma numbers. If real earnings numbers were used the valuations would scare off investors. As companies began to report Q1 earnings, they easily beat estimates because the estimates had been slashed. The story became as it does every quarter, that companies were beating estimates. All of this gives the impression that things are going well within corporate America and in the economy. Stock prices rose as investors bid up shares of companies that were either losing money or reported earnings that were weak but were beating estimates. The high valuations currently reported for most companies were justified on the basis of forward earnings. Some analysts are already quoting earnings based on 2004 estimates. The numbers are so poor and the valuations are so high that it becomes necessary to quote future year earnings in

I have to admit that I have been surprised at the degree of speculation and foolishness I have seen on the part of institutions and fund managers this quarter. It is almost as if I lived on Mars. I would hear early morning reports on a particular company reporting earnings that from the sound of it looked spectacular. There were plenty of stories of this company or that company beating estimates by one, two, or three pennies a share. The stocks would jump 10-20-30 percent in a single day. I would arrive at my office, read the particulars of a company report, and come away with almost the opposite impression. Yet this became the pattern throughout this entire earnings season. What made this season so different was the general level of complacency in comparison to previous quarters. The drop in the VIX and the VXN only confirmed this impression.

Despite deteriorating economic reports, poor earnings, and accelerating layoffs the Street was sticking with what is now its fourth year of predicting a second half recovery. Every single week we continue to receive more reports that the economy is decelerating and that corporations are laying off more workers, especially in the tech sector. If the tech sector, which has led this rally, is seeing improvement in its underlying fundamentals, it sure isn't showing up in company earnings reports or announced layoffs. Samples of layoffs from Q1 are as follows:

COMPANY	LAYOFFS
Motorola	3,000
Ericsson	7,000
Applied Materials	2,000
Nokia	1,800
Hartford	1,500

On top of current layoffs, many more companies, including the government, have announced more layoffs ahead. What is clear from the employment picture is that companies are struggling to maintain profits. They still lack pricing power thanks to stiff foreign competition. Without the ability to raise selling prices to offset cost increases coming from higher energy prices, increased taxes and regulation, rising labor and raw material costs, they are axing payrolls. This--from a business

One company may slash labor costs in order to gain a competitive advantage. However, whatever cost advantage gained by cutting costs is lost as competitors take similar actions. From a macro perspective, this causes the economy to contract. It is one reason why the Bush Administration is moving feverishly to get a stimulus package through Congress. Congress dithers why the economy wilts. The current debate is centered around a difference of $20-$50 billion in tax cuts over a ten year period, a time in which the government will collect over $25 trillion in taxes. Without any stimulus program the economy will most certainly head back into recession.

Where the ax fell Job cuts announced in April
INDUSTRY	TOTAL LOSSES
Government/Nonprofit	57,927
Telecommunications	11,397
Industrial Goods	9,614
Consumer Products	7,077
Commodities	6,995
Transportation	6,994
Aerospace/Defense	6,820
Financial Services	5,294
Health Care	4,201
Source: CNNMoney

As far as the second half recovery scenario is concerned, it depends on many "ifs," not the least of which are the following:

• No new Terrorist attacks on American soil
• No major financial defaults
• No spike in energy prices; they are already back to pre-war levels
• Capital spending recovers
• SARS is contained
• No new geopolitical crisis erupts
• Accounting scandals and restatement or falsification of earnings can be kept to a minimum

Those are many "ifs" to contend with for things to work out. Even then, it is a bit of a stretch. Everything has to go smoothly from this point forward because valuations are high, and confidence is fragile. The bulls have built their second half recovery hopers on a very weak foundation. Any crack in any one of the pillars such as consumer spending, capex spending, or some unexpected event, and the whole scenario for recovery collapses.

What will be especially important to watch going forward is tech earnings. The NASDAQ has soared since the beginning of the year all based on a story of hype, hope, and spin. Every time I feel like speculating in tech shares, I get sober by reading Fred Hickey's "The High Tech Strategist." According to Hickey's latest report, tech fundamentals remain especially weak. In Fred's own words, ‘The fundamentals stink” with the latest batch of reports for April show business conditions worsening, and not getting better." Hickey finds demand is sinking, supplies of goods are increasing, earnings aren't coming in as strong as predicted, and demand in Asia is weakening. China is not only important as a major importer of raw materials, but it is also a growing consumer of tech products. The latest SARS virus could cut China's growth from 8 percent in Q1 to no more than 2 percent in Q2. Hickey goes on to cite widespread weakness of end market demand for tech products in almost all western countries. Statements from CEOs collaborate Hickey's findings with most companies lowering sales and profit guidance for the remainder of the year. Typical of what is going on within the industry is yesterday's announced earnings by Applied Materials. The company announced that it would report a second quarter loss of $62.1 million as sales fall and costs rise. The company will close down factories and cut jobs. Sales fell 4.2 percent and new orders plummeted by 42 percent. The company CEO responded by saying that consumers of chip equipment are being cautious with buying additional capacity, and the environment for business is very difficult.

What Wall Street has difficulty understanding the words "excess capacity." One out of every four factories remains idle in the U.S. Everyone agrees that the 1990's were a big bubble but nobody understands the consequences. All of the malinvestments and excess capacity that was created during the bubble years has yet to work itself off. Until it does there will be no improvement or increase in capex spending. Why would customers of Applied Materials want to expand capacity when so much of their capacity remains idle? It is hard to see companies wanting to add more capacity with no revenue growth or the ability to raise prices. Whatever gains have been made in profits have come through cost cutting, not revenue growth. You can’thave increased capex spending without topline sales growth, which is essential to driving long-tem profits.

In a nutshell, there is a giant disconnect between what is actually occurring at the macro and micro level within the economy and our own financial markets. Normally profits and stock prices move in tandem over the long-run. Profits usually drive stock prices over long periods of time. Since 1997, we have seen profits fall only to see stock prices rise. The same thing is taking place now with stock prices rising while earnings remain anemic. In essence we are back

More worrisome this time is that valuations, despite three years of falling stock prices, are still at extreme levels. In the late 90's investors were sold companies that didn't have any profits or have any prospects for making money. Yardsticks for evaluations were thrown out the window. Instead of value or earnings metrics, investors bought and sold companies based on clicks and stickiness. Today they may no longer be buying on the basis of clicks or stickiness, but instead are basing their buy decisions on pro forma numbers that in reality don't exists. The bottom line is still the bottom line. You can't routinely exclude the cost of making bad investment decisions and writing them off. You shouldn't be able to eliminate normal business operating expenses such as closing down a plant, firing workers, writing down inventory, issuing stock options, or any other routine cost of doing business. What we have seen happen in each one of these bear market rallies is that pro forma numbers have replaced the goofy clicks and stickiness measures used in the bubble years. One might argue, based on the recurring calls for a second half recovery every year and the speculative rallies they trigger, that the bubble never fully burst. The bubble simply mutated. It is still evident in the stock market, especially in the tech laden NASDAQ. It is also visible in the mortgage and bond markets, real estate, and consumer spending. Like John Law in the 17^th century, Mr. Greenspan faced with a bursting bubble has simply created an ocean of money and credit to replace the trillions in lost bubble dollars he helped to create.

Déjà Vu

As for the current climate in the market, it speaks volumes about risk.

Wild assumptions have been made over future earnings growth that bear no resemblance of reality or stand a chance of ever being realized. Analysts are still predicting 10-15 percent profit growth for the S&P 500 companies over the next five years. In addition to excess capacity, lack of pricing power and very little top-line growth, there is also the danger of a falling dollar.

Today is very reminiscent of the mid-80's when the dollar began a precipitous decline between 1985-1987. The U.S. trade deficit was accelerating, budget deficits were growing and the U.S. was transitioning from the world's largest creditor nation to the world's largest debtor country. Stocks and bonds continued to rise while deficits rose, and the dollar fell. Fast forward to today and multiply by a factor of 3-4. The trade deficit is much larger as shown in the graph below. The dollar is falling, and stock prices are rising again. In typical Wall Street fashion, this is all viewed as bullish. They're right to be bullish. However, they are bullish over the wrong asset class. A rising trade deficit, rising budget deficits, and a falling dollar are bullish for hard assets especially gold and silver, not stocks.

In the markets today stocks fell from a combination of bigger losses from Applied Materials and an unexpected drop in retail sales during April. Truth be told it looks more like distribution is taking place. There has been a big run up in stocks based an improving fundamental picture. It is becoming more obvious by the weak that is not what is happening. Therefore, I suspect the big boys are getting out quietly. The major indexes all declined despite bond yields reaching a level today that we haven't seen since the 1950's. Yields on 10-year notes fell to 3.56 percent and 30-year Treasury bonds dropped to a yield of 4.545 percent. The Fed may be aggressively pushing down yields by monetizing debt to generate another round of refis. what has become increasingly apparent is that there has been no improvement in capex spending, or consumer spending as result of the end of the war. If the May unemployment numbers go up it is very likely that the Fed will move aggressively to push rates even lower. If you liked 5 percent mortgages, get ready for 4 percent mortgages.

Volume came in at 1.36 billion on the Big Board and 1.8 billion on the NASDAQ. Advancing issues were about even with declining issues. The VIX and the VXN rose today. The VIX rose .73 to 22.76 and the VXN edged up .30 to 33.14.

Bloomberg's Overseas Market Summary

European stocks rose for a second day on speculation that the European Central Bank may lower interest rates next month, reviving economic growth and boosting earnings. Bayer AG and BASF AG helped lead gains. The Dow Jones Stoxx 600 Index climbed 0.1 percent to 194.52 as 13 of its 18 industry groups advanced. The Dow Jones Stoxx 50 Index was near unchanged, down 0.12 to 2304.90. Benchmarks climbed in 11 of Western Europe's 17 markets.

Japanese stocks rose, led by Sony Corp., after the company said it plans to sell a portable game player, challenging the dominance of Nintendo Co.'s Game Boy. The Nikkei added 0.7 percent to 8244.91. The Topix index rose 0.3 percent to 832.00.

Charts courtesy www.stockcharts.com, Grandfather Economic Report, AGaryShilling

James Puplava

© 2003 James Puplava

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