November 2012 issueFor the first time since our markets reversed course in March of 2009 profits and revenues that have been reported so far for most US companies have been very disappointing. I suspect this marks the end of a brief era of four years or so that saw the perfect storm of goosed corporate profits that have helped the three major averages more than double in that period.
So let’s examine the mystery of faith put forth by investors in their expectations of S&P earnings since the crash of 2008-9. Since that period there is no doubt most large US corporations tightened their belts and became more efficient. They laid off tens of millions of Americans and were able to sustain or even grow their bottom line through the continued trend of productivity gains that have been evident since the mid-1990’s. However the law of diminishing returns is now catching up with them because the marginal utility of these gains is now eroding and cannot be sustained at previous levels due to the laws of nature.
This development has been widely reported and thus many investors have become aware of the limitations on future earnings growth coming from this. However there are several other trends in corporate earnings I feel are still widely misunderstood or ignored altogether that have supported the rally in stocks the past few years. Chief among these is stock buybacks from the companies themselves. As the opportunity to grow their business has ebbed, they have sought to goose their own earnings by buying back shares. This helps in two ways- there are now more buyers of the shares in the open market and there are also fewer shares out so any earnings reported seems higher when it’s reported. This is the best explanation for why stocks have risen in the past few years despite trillions in redemptions from stock funds by retail investors. This trend of stock buybacks is unsettling because it indicates that corporations don’t see many compelling opportunities for capital investment.
Another trick goosing corporate profits is the amount of reserves being released by the big banks in the past six quarters. Excluding these dubious manuevers that are at the discretion of management, bank earnings would surely be as aweful at the current return on equity that now averages 5-8%, near all-time lows. A case can be made that these banks should just close down because they cannot return more than their cost of capital. The top few banks control over 70% of all banking deposits in the US so their fate matters to you even if you despise them. Since the financial services industry still accounts for an over-sized portion of S&P profits and still has yet to revert to the mean average over this super-cycle, the goosing of this one sector does matter to the overall markets.
Yet another factor goosing earnings is coming to light each day that is not so sinister but in fact quite transparent. It’s the impact of the US dollar on corporate earnings. The US dollar index (measured against a basket of major foreign currencies such as the yen, the euro, etc.) has risen quite dramatically in 2012 yet no one seems to notice. This has hurt corporate earnings from so many multi-nationals such as McDonalds, IBM, Google,and so many others. What is worth noting today is not the quarter to quarter drop in revenues or earnings resulting from this but instead the dramatic gains that have been made over several years since 2007 from a falling dollar that goosed corporate profits substantially. And don’t look now but the Volatility Index (VIX) and the US Dollar index have both recently broken out above it’s 200 day moving average. The correlation of a rising dollar and lower stocks has remained in place for several years now since the onset of the financial crisis and a breakout of the USD suggests stocks will fall.
If in fact a new trend is in place where the US dollar remains strong in the face of worldwide currency debasement, then we are only in the early throes of systemic earnings revisions downward from a USD that was for the past few years the weak sister of global currencies. This may have reversed and the implications of this may has not be realized by investors. This so-called flight to safety where money managers sell assets to raise dollars has the potential to become a self- fulfilling prophecy since the global marketplace is still dominated by a reserve currency based upon US petrodollars and the USD is likely to remain the world’s reserve currency for a period far longer than most believe. If this comes to pass then US corporate earnings will be impacted for years to come. It may become clear one day just how much of reported US profits in recent years were borne of a weak dollar instead of robust output.
There’s one final source for goosed S&P profits that is most elusive. In fact I have never heard it discussed on CNBC or by the WSJ or other sources. It refers to the very notion that so much of our present and past GDP is directly realated to the perpetual expansion of consumer credit since the early 1980’s when then the bull run in paper assets (stocks and bonds) began. Since then, the Dow Jones went from 777 to now over 13,000 and 30 year US Treasury bond yields have dropped from near 20% to under 4%. Consumer spending has been the mother’s milk of economic output since the 1980‘s and has grown to over 70% of the US economy, a record in world history that can’t be sustained. What would occur if consumer credit were curtailed? Such a credit contraction is one of the key features of any Kondratieff winter.
It’s important to note that US economic activity as defined by GDP has been goosed higher for many years because fiscal Keynsian policy combined with Federal Reserve policies that monetize our debt have the collective effect of also goosing consumer spending far beyond the historical norm and this is likely to revert to the mean. One of the hallmark features of the Kondratieff Cycle theory is that unchecked credit expansion cannot endure past the length of the super cycle and we may now be close to that point.