Profits are rising, stocks are up and the economy is improving. For the first time in a long time, the experts seem to have gotten their forecasts right this year. The economy and market seem to be doing just what the experts have predicted. Call it luck or call it smarts, the stock market is up after three years of producing negative returns. Investors are hoping to recoup heavy losses of the last three years with expectations that the glory days of stock investing are back. Experts are guardedly optimistic and expect further market gains for the remainder of the year. Last week's cover story in Barron’s, ”The Wall Street Forecast: Measured Rally” calls for stock market gains between 5-10% by the end of the year. The consensus of opinion seems to believe that the S&P 500 will hit 1,100 to 1,150 in the next six months. Experts advise over weighting portfolios towards stocks.
The reason for this optimism is historically low interest rates, tax cuts, firming business sentiment and improving economic numbers. In the latest survey of Wall Street pros, very few bears walk the Street. There may be a few closet bears, but if they exist, they are keeping remarkably quiet about their views. One of the few bears out there is Merrill’s Richard Bernstein. Bernstein believes that reported earnings aren’t what they are cracked up to be, a view that this author shares and will illustrate in just a few moments.
"No Problem" Market Priced for Perfection
Currently the bulls are firmly in charge of the markets and John Q. has been drawn back into stocks. Public sentiment at all levels is decidedly bullish. It doesn’t matter what negative events transpire as the market just seems to shrug them off. Interest rates rise sharply—no problem. Violence in the Middle East and in Iraq—no problem. Aggressive earnings forecast and the return of shady to corporate accounting—no problem. The continuing saga of financial scandals is completely ignored as if they don’t exist. Not a week goes by without another scandal surfacing. This is a no problem stock market priced for perfection. On the surface it all looks perfect. In my view it is the set up for The Perfect Financial Storm. I believe—both fundamentally and technically—that the markets are being set up for distribution.
DISTRIBUTION:
At market tops those who have bought shares at or close to the bottom sell their shares to less sophisticated market participants at the top of the market cycle. The lesser informed public comes into the market attracted by rising prices. In effect, stocks are changing hands from strong hands who bought in early to weak hands who bought in late.
Digging Below the Surface
Stocks have risen this year on the basis that the economy and earnings are improving. This makes sense on the surface. If the economy is getting stronger, then profits would be expected to rise along with improving economic conditions. Yet we see that the employment rate remains high as businesses continue to shed jobs each month, unemployment claims hover over 400,000 typical of a recession, and capital spending by business along with business sentiment remains weak. The reason for this apparent anomaly between an economy that continues to shed jobs with the lack of capex spending by business and a rising stock market is all due to statistical illusions and creative accounting. In real terms, there has been very little improvement in the economy or corporate profits. Things have gotten better, but not to the extent that would justify today’s overly optimistic valuations for stocks. The simple truth is that economic growth is overstated along with productivity, unemployment is underreported, inflation is running much higher than official estimates and profits are grossly overstated.
I begin my case for distribution with the economy.
Defense Spending Pumped GDP
The financial community is forever preoccupied with the U.S. economy’s improving economic conditions. Everyone—from Wall Street seers to the Chairman of the Federal Reserve to the White House—is bullish over the U.S. economy's growth prospects. The recession has ended and everyone expects economic conditions to get stronger going forward. According to official statistics, the U.S. economy grew at an annual rate of 3.1% during the second quarter and current consensus believes that we’ll hit 5% growth rates by the Q4. (The U.S. is one of the few countries that annualizes its quarterly economic growth, a practice that distorts overall economic conditions.) While the revised economic numbers were widely heralded by the financial press that the long awaited recovery had finally arrived, very little was mentioned about the details of this economic miracle. Defense spending during Q2 rose sharply during the quarter due to the war. It accounted for 55% or $40.6 billion of $73.5 billion in GDP growth. In other words, defense spending due to the war accounted for 1.53% of the 3.1% GDP growth rate.
Statistical Massaging
The other 1.32 percentage points of economic growth were mainly a statistical mirage. The remaining part of GDP growth was attributed to the statistical magic of hedonic indexing. Government statisticians turned a real increase of $6.3 billion in fixed investment in computers into a major increase in capex spending on computers of $38.4 billion with the flash of a statistical wand. Actual spending in current dollars rose from $76.3 billion to $82.6 billion during the quarter. Government statisticians turned a real increase in investment spending of $6.3 billion into a GDP number of $38.4 billion. The $38.4 billion was the number used to compute GDP growth—not the real number of $6.3 billion. The hypothetical increase in business spending of $32 billion did not exist in reality. Actual business spending on computers only increased by $6.3 billion—not by $38.4 billion as widely reported. This means that over 40% of GDP growth during the quarter was purely fictional. In a moment I will get to the implications of this number for the technology sector and the NASDAQ.
Kurt Richebächer has done a great job of tracking these statistical anomalies in his monthly newsletter, The Richebächer Letter. According to his recent newsletter, real economic growth during the second quarter was only $26 billion, a growth rate of 0.27% or 1.04 annualized.[1] That number is a far cry from the widely reported and revised 3.1% growth rates trumpeted by Wall Street and the financial press.
The statistical massaging doesn’t stop with hedonic indexing. The government can inflate the GDP numbers in other ways. For example, GDP is measured in dollars then the government subtracts the inflation numbers to arrive at real economic growth minus inflation. In the first quarter, the annualized inflation rate was 2.4%. Then in the second quarter, the inflation rate miraculously dropped to 0.8%. Does anybody really believe that the inflation rate dropped by two-thirds in one quarter?—a time when oil prices hovered above $30 a barrel for almost the entire quarter, a time when natural gas prices remained stubbornly above $4, when insurance premiums are jumping double digits, and food prices are escalating? By lowering the inflation rate, the government was able to make the GDP numbers look better. Remember, the inflation rate is subtracted from the GDP numbers. A higher inflation rate reduces GDP. Want a higher GDP number? Just lower the inflation rate. This kind of statistical tinkering made the jump in last November and December’s oil and gas prices come in as reduction in energy prices rather than an increase. This is the kind of statistical wizardry that is starting to make U.S. economic numbers as untrustworthy as corporate profits. The smart money doesn’t believe these numbers, nor should you.
Government Fiscal Stimulus and Shortfalls
Another issue that the economic community and financial press looks to as a positive for the economy is the huge fiscal stimulus generated by government. The government’s budget deficit this year is estimated to come in at $455 billion. It may be more if rebuilding Iraq is thrown into the numbers. The current deficit numbers are going to eventually lead to a fiscal crisis. This crisis is going to come from entitlement programs that are growing annually at high single digits and show no sign of letting up as the economy remains weak and the population of the country ages. The problem with the known deficit numbers is that they don’t include future shortfalls associated with Medicare and Social Security. The combined annual shortfall of both these programs is huge and growing at an estimated rate of $1.5 trillion annually. That’s right—$1.5 trillion annually! If the government was required to fund 90% of its future pension and entitlement liabilities the same way companies are required to do, the annual budget deficit would be averaging $2 trillion a year. The future Social Security and Medicare liabilities are nowhere to be found in federal government budget reports.
Unfunded Government Obligations
Our government operates on a cash basis. Government accountants simply add up all revenues received each year and then subtract expenses. Expenses have been exceeding revenues for close to three decades. That is why the Federal debt is now approaching $7 trillion and rising. Nowhere in the budget deficit numbers is there any allowance or accrual for unfunded obligations for Social Security, Medicare, Medicaid, federal employee pensions and many other federal programs. They are simply not accounted for.
If the general public really knew the real, unfunded story about entitlements, there would be an outcry for reform of the entitlement process. Left uncorrected it is going to bankrupt the federal government by the end of this decade when the baby boom generation crosses over into retirement and begins drawing on and using Social Security and Medicare benefits. Instead of telling the public the truth, our dear public servants have been promising more cookies and lollypops to the voters. The recent debate over a new prescription benefit program is a prime example of this. With both Social Security and Medicare grossly underfunded in regards to future obligations, our elected government servants are promising us even larger entitlements. This is not only irresponsible and fiscally reckless, but is also financially insane. At some point in the not too distant future, there is going to be a fiscal train wreck between government’s insatiable urge to spend money and its ability to raise revenue and print new money. We are not there yet, but that day is getting closer.
Employment Numbers Always Revised
Now for the employment numbers which are much worse than what is widely reported. Here again what we see reported each month is another example of statistical fiction. The most common practice is that the actual job losses each month are underreported. The initial reports come in at a very low number. In the following month the job losses are revised. The trend has been much larger than what is reported initially. Job losses for May were revised upward from 17,000 to 70,000. The June numbers were revised upward from 30,000 to 72,000. In May the government reconciles their assumptions for their hypothetical job growth numbers. Each month the government assumes that 30,000-50,000 hypothetical jobs are created by small businesses. Once a year the government's assumed numbers must be reconciled with actual facts. This past May, 400,000 assumed jobs reported earlier in the employment numbers disappeared into statistical heaven. The jobs never existed.
Investors will notice this revisionary trend. If they begin to look for these revised numbers each month, they will find them usually buried in the back pages; while the new monthly numbers—which are much lower—become headlines on the front page. There are a few experts such as Martin Weiss of the Safe Money Report who believe that the real unemployment rate is closer to 10%. Weiss points out that the only unemployed workers the government keeps track of are those workers currently receiving unemployment benefits. Workers who lose their job and don’t apply for benefits, workers whose unemployment benefits expire, college students who can’t find a job upon graduation are not counted in the monthly unemployment report.
Transference of Jobs Overseas
The lack of new jobs, the continuing firing of workers by corporate America and the jump in the actual unemployment numbers have been explained away as a lagging economic indicator. According to the experts as the economy improves, eventually the employment picture picks up. Well, if the official recession ended in November of 2001, then unemployment has now lagged the economy by close to two years. That is one heck of a lagging indicator! It's more along the lines of Rip Van Winkle deep in slumber.
I don’t expect this picture will improve in the short run especially as corporate America appears to be in the process of transferring much of our highly paid service sector jobs overseas. The financial services sector, one of the few bright spots in this last recession is now in the process of transferring over 20 percent of its workforce overseas from call center employees to highly paid financial analysts. A call center employee costs a company -25,000 here in the States compared to ,500 in India. A high caliber Wall Street analyst commands a salary of 0,000 in New York compared to ,000 in Bombay. The jobs that have been leaving our shores in manufacturing and now the service sector over this last decade are not coming back. It is one more reason why this recovery will continue to remain a jobless one.
The Profit Picture Is Not Pretty
One of the real reasons why capex spending and unemployment picture haven't improved much is that the majority of what you see reported as earnings is fiction. Last week I highlighted the growing gulf between CRAP and GAAP earnings. The chart is featured here once again.
There is another gap in earnings that is showing up in the national accounts. These are the profits that companies report to the IRS and the numbers used in computing GDP numbers.
Most companies try to minimize what they pay in taxes to the government. So you will not find inflated profits in the national account figures. Since about 1997, when we know that companies began to artificially inflate their numbers, reported profits for the S&P 500 and the national accounts began to diverge. Just as there has been a wide gap between GAAP and CRAP earnings, there is also a wide gap between what companies report as profits to shareholders and the public and what they report to the IRS. It appears that accounting tricks are once again making reported earnings look much better than they actually are.
Depreciation Schedules Changed
Company accountants are up to their old tricks again. One reason profits improved last quarter was that many companies changed depreciation schedules. By stretching out depreciation schedules and keeping assets on the books beyond their useful life, costs can be reduced on paper and therefore increase profits. According to a recent report in Fortune, lower depreciation costs accounted for 25% of second quarter profits. Another boost to profits came from currency gains due to a depreciating dollar that inflated foreign sales and profits.
The bottom line is that there has been very little improvement in the actual operations of most businesses. Outside one-time improvements from layoffs and improvements made from comparisons to previous write downs, (there were a lot of those in Q3 & Q4 of last year) most improvements made to earnings have been achieved by a stroke of a pen by the company accountant. That is why there has been such a wide gulf between GAAP and CRAP earnings and between reported profits and national account profits.
What Can We Conclude?
1. Reported Numbers are Mainly Fictional
Now that we have looked at the economic numbers and the earnings numbers, we find that so much of what is reported by the financial press is fictional. That is a topic for another day. Suffice to say that the financial press has been asleep on the job. There are very few investigative journalists of high caliber in the financial industry. If there were, then I wouldn’t need to be writing these kinds of reports. Their stories would already be featured on the front page of most financial publications.
Getting back to the mystery of the lack of capex spending, the dearth in new jobs on the corporate front and the current record of insider selling, all can be explained by the reality of fictional numbers and the current bubbles that proliferate everywhere in the economy and the financial markets. When a company isn’t experiencing a real improvement in its operating numbers and when the profits it reports to the public are fictional, it is unlikely to spend money on new capital equipment or to hire new workers. You can’t pay for new plant and equipment or pay the salaries of new workers with pro forma profits. New plant and equipment and new workers require real profits and real cash flow from operations.
2. Real Improvement is Missing
This disparity between what actually is occurring at the ground level in the economy and on Main Street and corporate America is one reason why companies have remained so cautious and why insider selling is now at record levels. If the prospects for a real improvement in earnings is as good as Wall Street would have investors believe, why then would company insiders be dumping their company stock at record levels? Certainly if the economy was really improving and company operations were benefiting directly from this improvement, real profits would also be improving. There would be no need to jigger the numbers through accounting tricks.
However, if what you actually see is a tough operating environment of rising labor and raw material costs, rising regulatory burdens and stiff competition from imports, this allows for very little room in pricing power. You know that the profit picture can not improve. One-time adjustments are just that—they are nothing more than a temporary boost. Talk to most corporate execs in every kind of business and they will tell you they can’t raise prices. This lack of pricing power is killing the bottom line. So companies have had to resort to one-time adjustments or to old accounting tricks to meet Wall Street expectations. Brand power isn’t what it used to be. In the Information Age, pricing power has been reduced by the Internet. Pricing power is still out there. It just isn’t as prevalent as it used to be.
3. Sales Aren't Consistent
All business profits begin with a sale. Without increasing sales, a business can not grow its profits. Companies can temporarily boost profits through cost cutting measures, but in the long run business profits are dependent on increasing top line growth. That is what has been missing in this economic recovery. Companies have stopped the hemorrhaging in profits through cost cutting, but these measures are only short-term. You can’t grow your bottom line forever by firing workers. At some point a company has to figure out a way to increase sales or else its business will begin to contract. So far what we have seen is that most companies have had to rely on cost cutting to drive profit growth. Companies are generating earnings by cutting payrolls and not spending money on new plant and equipment. Plant and equipment are long-term investments. The decision to build a new plant, replace or order new equipment is dependent on the business environment. These major capital decisions are long-term decisions and are made only if there is a payback in either increased sales or reduced costs.
4. Imbalances and Bubbles
That is what companies are not seeing on a consistent basis. Sales were up for the S&P 500 companies in Q1, but then they slowed down in Q2. If energy sales are backed out of the S&P sales only grew by 6.8 % in Q1 and by 6.2% in Q2. Even then the weak dollar over-inflated sales figures for many firms. This on again and off again economy is what has made it so difficult for companies to make long-term decisions such as hiring new workers or spending money on plant and equipment.
The economy is still plagued by a plethora of excesses and imbalances leftover from the 90’s, which have yet to work themselves off. Furthermore, the Fed has been fueling these excesses by its policy of flooding the markets and the economy with liquidity. All that it has managed to do is create additional bubbles in real estate, mortgages, the bond market and consumer consumption. Instead of creating healthy and balanced growth in the economy, it has created more imbalances and bubbles in the financial markets. This will not only prolong the recovery process, but also make it more severe when it inevitably corrects. The risks these imbalances pose to the economy will be covered in next week's Storm Update.
5. Ok, But Not Robust
So what then can we conclude from the economic numbers. What is the implication for both the economy and for company profits? The economy has stabilized and in certain pockets, there has been strength directly related to various stimulus measures such as lower interest rates, defense spending and tax cuts. Defense spending has made up for the slack in manufacturing. Lower interest rates have helped stimulate housing and auto sales. Finally, lower interest rates have stimulated refis and home equity loans. When combined with tax cuts, these rates have bolstered consumer spending. So the economy is okay, but not as robust as the economic numbers would indicate due to various statistical fudge factors. The stop and go pattern of the economy over the last few years can also be explained by a continuous pattern of both fiscal and monetary stimulus. These stimulus measures have acted as steroids on the economy. To become effective, they must be constantly injected into the economy or else it begins to falter.
6. Fewer Bubble Options Available
Now that interest rates have backed up again, the home refi boom has faded. It is also unlikely with government deficits approaching $500 billion annually the President will get another tax cut. So what then is the next catalyst or stimulus? Policymakers have very few options left outside of creating another asset bubble that can be monetized. Hopes are high that the stock market can become the next stimulus by generating gains for investors and capital gains taxes for government. However, this is a high risk policy with stock valuations sprouting bubble-like valuations again. The NASDAQ is already selling at 42 times next year's optimistic earnings forecast. The Dow and the S&P 500 are also not cheap selling at 21 and 29 times trailing earnings. Can the market go up from here? The answer is yes. Can it turn into another sustainable asset bubble similar to the late 90’s boom? Highly unlikely. I’ll leave it to the technicians who write on this site to explain why this rally isn’t sustainable. It is already showing signs of decreasing momentum and the record amount of insider sales is a forewarning of things to come. There are signs that distribution is taking place and a market top is close at hand.
There are far too many imbalances and risks out there that threaten the various bubbles the Fed has created. It remains only a question as to which bubble is the next to burst. My guess is that it begins with the dollar, then moves to the bond market, next the stock market and finally real estate in that order. Next week's essay will explain my reasons why we’ll see a series of storms in the financial markets this fall and winter.
For now the economy remains okay as long as we don’t experience any unexpected rogue waves that could topple the markets and spill over into the economy. As I have already alluded to in this missive, the economic and financial numbers bandied about in the press are more of a financial illusion then they are reality. They are a statistical and accounting mirage created by company accountants and government statisticians. The economic numbers and the profits numbers are determined beforehand and then the accountants and the stats department back into them. In Washington policymakers come up with an economic number that policymakers think the economy should be growing at, then the statistical department tweaks the numbers to come up with the number. On the corporate front, it is the same story. Analysts and company execs come up with an earnings number then the company accountant gets creative with the numbers to reach the goals. Like the central planning that was done in the former Soviet Union, today’s economy and financial markets are centrally planned. The only problem is that just like the five-year plan in the Soviet Union, the economic and the earnings numbers are all an illusion. When you begin to realize this, then what appears in the papers each month makes more sense. You then begin to realize why companies aren’t hiring more workers or building new plants. That is why companies continue to slash payrolls and why job growth has been nonexistent. It is same reason that capital spending by business has been so anemic. Phony profits and trumped up economic numbers also explains why insider selling is now at a record. You can’t grow profits in an economy that isn’t really growing nor can you hire new workers or order new equipment with pro forma profits.
The economic and profit numbers the experts point to as a sign the long awaited economic recovery has arrived is all an illusion. It remains only a question of time before investors wake up and discover this deception. When they do, the second phase of the bear market will begin and enter its most deadly phase. The insiders already know of this deception, which is why they are selling. When the captain and crew have already jettisoned from the plane, isn’t it time you think of putting on your parachute too? ~ JP
Endnotes
[1] Richebächer Letter, September 2003, p. 4
