Wednesday, May 21, 2008

the next leg lower

the stock market sold off for a second day again today... it's playing out more or less as I expected earlier this year. after being spooked by a two-month knee jerk of bullish optimism, the full gravity of the problems facing US stocks is starting to sink in. originally we were just worried about contagion effects from a credit crunch. now we face multiple problems, many of which have their own unique origins:

1-falling home prices: this is simple enough

2-tighter credit standards: banks and the "shadow banking system" (mainly special-purpose entities such as CDOs and SIVs that functioned as banks by marrying up savings and borrowers) are growing less eager, not more eager, to lend.

3-capitally deficient banks: banks such as B of A need to sell things like preferred stock as they build a cushion against mounting loan losses resulting from the collapse of consumer credit.

4-rising fuel and food costs: oil has obviously hit new records for the last several sessions. it's essentially following the path I predicted about 8 weeks ago. petroleum is becoming the new wampum. after all, for something to be money is has to be both scarce and desired. the dollar fits that bill less and less every day.

5-doomed profitability: as was demonstrated by companies like Whirlpool and Campbell Soup, higher prices have consequences. higher oil prices are of immediate concern to almost everyone. imagine being a baking company in this environment, forced to pay more for everything from flour to natural gas to diesel/gasoline. but that's not all: leverage is harder to come by. it will be harder to boost per-share profits by buying back stock, harder to term out debt and harder to make investments with borrowed money. during the credit bubble of 2005-7, easy borrowing conditions made life easier in most board rooms. those days are history. furthermore, the beneficial deflationary effects of globalization are over. for years, companies could cut costs by finding cheaper suppliers in other countries. with the dollar plunging and incomes rising abroad, that game is also more or less over. profit growth will be constrained for several years, in my opinion.

6-demand destruction is underway: bizarrely, one money manager overseeing more than $20bln told me this week not to worry about high oil prices because "it will soon cause demand destruction." first of all, I am not sure this is even true. the sheer number of people entering the middle class in india and china ensure huge demand growth at almost any price. if you are buying a car for the first time, you are much less effected by higher prices than if you already own one.
but secondly, how can an asset manager see demand destruction as positive? it's essentially another word for less economic activity. assuming he's right, and lower prices will result from less output, that means we need to contract to get there. that process of contraction will be marked by profit warnings, layoffs and bankruptcies... a good example of this was AMR's decision to cut 300 flights and fire 6,000 people.

7-bankruptcies: speaking of bankruptcies -- they're bad for business and bad for stocks. and they're rising. even without higher fuel prices, this is normal at this stage in the credit cycle.

8-lower stock multiples: some research I saw today from Goldman Sachs highlighted how faster inflation hurts P/E ratios on stocks... in other words, even if companies' earnings weren't going to fall, their shares would still trade at lower prices relative to those earnings. this was the case in the 1970s and appears to be the case today. P/E ratios have been falling ever since they peaked out above 30x in 2000. it started as a socio-cultural development as people fled the market in disgust after the dot-com bubble. now, the trend will accelerate as inflation diminishes the value of everything denominated in paper money.

9-secular change in economic paradigm: societies and economies follow big, broad economic paradigms over time. like popular music, politics and art, stock markets reflect these forces. for years, the US society followed a clear paradigm: ever-cheaper products allowed growing consumption and economic efficiency. this started in the 1930s, when the economy found itself capable of producing far more stuff than anyone needed: steel, oil, food, cars, houses, etc. there wasn't enough demand to absorb all this stuff, making prices collapse -- the basic keynesian dilemma. aided with the advent of the car, FDR essentially invented suburban sprawl to find a market for all this extra stuff:

  • fannie mae, freddie mac and the FHA were created to finance home purchases.
  • to make homeowning practical, parkways such as the taconic and merritt were built in the 1930s.. after WWII, the process accelerated with the interstate highway program.
  • projects like the Tennessee Valley Authority and Hoover Dam brought electricity to areas previously outside the realm of the modern economy.
  • after WWII, this process was augmented by the rise of the sunbelt. the government also used military spending to transfer hundreds of billions of dollars from wealthy northeastern states to areas that weren't even on the map a 10-20 years earlier.
underlying this model was the integrated industrial company: firms such as Procter & Gamble, Kellogg, and General Motors. this entity was built upon cheap commodities, which permitted teams of managers, salespeople and other personel to be layered atop. that's why a box of Special K cereal with less than 1 pound of cereal costs over $5. (that's more than a pound of meat!) even with higher prices for commodities, the costs of making the physical product is a small fraction of what we pay in the stores.

as a result, I believe these companies will also struggle in the coming years. so far I don't think the stratospheric rise in grain prices have yet been fully priced in. companies will push through price increases, but as consumers feel increasingly poor, they will opt for other choices such as generics. (generics basically come from companies that don't have to pay for all the extra layers of extra staff. because they don't bother to manage brands or advertising, their jobs are much simpler.) Alfred Chandler's The Visible Hand offers a good history of how the integrated company was developed as a way to keep sales flowing into the industrial beast.

I don't think the modern integrated corporation is going anywhere. but I do believe their business model will grow less profitable.

getting back to the paradigm shift ... in an economy, money moves in big streams. people learn how to tap those streams to enrich themselves. in the 19th century mass-production created a new stream of wealth by allowing products to be made ever more cheaply. when henry ford introduced the $5 day in 1914, he allowed workers to tap this river of money. this model spread over the next 50 years, pushing up worker incomes as companies shared more of their resources with employees. this reached its peak in the 1970s when companies were run as large bureaucracies and businesses like GM and Ford promised to pay pensions and benefits on millions of retirees.

the next great stream of money was discovered by leveraged-buyout firms, which tore these same industrial companies apart. they got rich by shutting down factories and destroying jobs. larger companies such as GE and IBM followed these patterns by outsourcing and off-shoring production, a process that continues to this day. once again, great fortunes were made from the resulting torrent of money.

running alongside that river was a second related stream: finance. thanks to the defeat of inflation, cheap oil and offshoring, a pair of asics gel running shoes that cost me $110 in 1992 cost $50 by 2005. as money could buy more stuff, people regained confidence in money and wanted to invest. that triggered a two-decade bull market for stocks and bonds.

separately, the original flow of wealth unleashed by henry ford slowly turned on its head to create another steam of money. ford allowed workers to share in the riches that flowed from the efficiencies of modern mass production. over time, companies found they could make that river run in the opposite direction with consumer finance. it started with GMAC in the 1920s, but over the years obviously spread throughout corporate america. over time, consumer finance became a completely new source of earnings... by 2008, many large retailers have some kind of financing operation. in general, this business of lending to consumers became its own stream of money for companies, and later wall street (the mortgage bubble). see the chart below for the growth of household debt.

throw in the financial supremacy of the US, which made everyone willing to hold dollars, and a distinct cycle developed:

  • because of off-shoring, companies imported ever-cheaper shoes, shirts, cars and other stuff from taiwan, malaysia, china and mexico. corporate executives made billions on the savings.

  • awash in US dollars, those countries starting lending that money back to the US by investing in our bonds.

  • banks tapped this new river of money by channeling it back to the consumer with easy mortgage and consumer credit. wall street and hedge funds make billions.
but now the consumer is tapped out. it's unlikely we can continue to borrow against our future. everytime this process makes another cycle, more IOUs build up. household debt is now close to the size of our entire economy:

it seems clear this process reached its apogee in subprime and the housing bubble. now that it has stopped, the economy needs to find a new river of money. exports are slowly becoming a new source of wealth, but this transition will be long and arduous. the Goldman Sachs note today also predicted imports will decline further next year. that means less consumption .. that means a less happy populace and, potentially, social unrest. the big danger is: will our politicians respond to with cures that are worse than the disease?

to me, this future is fairly clear. all of the causation is in place for hard times ahead. and, everyone from warren buffett to george soros agree. as a result, I predict the S&P 500 will close the year around 1190. It may then fall all the way to 1000 or do in the next 1-3 years. by that point, everyone will have given up on stocks, so they will be attractive again and due for a good rally. but even then I feel we won't have entered into a new economic boom. our problems are deep and probably lasting. I think we might have to wait for a significant number of baby boomers to die before things really start improving. but because of growth in other parts of the global economy, the S&P 500 should break back above its 1550 resistence sometime in the next 5-7 years.

one final thing I would like to end with: now that the consumer is leveraged to the hilt, government is next in line.. the federal government obviously faces some huge liabilities. but the less commonly discussed story is the huge trainwreck coming to states and local governments across the country. not only do they face huge retirement expenses for their armies of baby-boom workers.. as the owners of thousands of police cars, road-maintenance machines and other vehicles, they'll also have to grapple with skyrocketing fuel costs. never mind the mounting problems with foreclosed properties! these kinds of municipal money problems could also curse regions with higher taxes, underfunded schools and highways, further discouraging economic growth.

(as a quick side note, it's observing that the military could well be the ones to lead us out of this, as the Wall Street Journal recently reported:
WHITE SANDS MISSILE RANGE, N.M. -- With fuel prices soaring, the U.S. military, the country's largest single consumer of oil, is turning into an alternative-fuels pioneer.
it will be another cruel twist of fate to the peaceniks, but it should come as no surprise. from aviation to the internet, the military has always been one of the principle vanguards of positive technological change -- a subject I addressed in an earlier blog entry.)

the looming crisis in muni-land demonstrates once again how problems first emerge in financial markets. subprime bonds blew up months ago, and foreclosures are still surging now. auction-rate problems rocked municipal finance around the same time, and no one is yet talking about the problems for municipalities -- yet.. in each case, the market foresaw a real fundamental problem that would develop later. this downturn isn't just caused by mean-spirited short sellers. the problems are real.

Saturday, May 17, 2008

uncle sam, mama spider

the animal kingdom provides many examples of how a parent can nurture its offspring to ensure survival. male emperor penguins guard eggs under their bellies for months in extreme cold and keep an emergency stash of food in their throats for the newborn chicks. in another sex-role reversal, female seahorses inject fertilized eggs into the male, whose body nurtures the young in a process that resembles pregnancy.

spiders offer one of the more gruesome methods of child-rearing: a mother Diaea ergandros spider lays about 40 eggs and then fattens herself up eating insects. when the eggs hatch, the babies grow strong by sucking blood from her legs. this might sound like a charming version of nursing, like we see in mammals, but there's more. as the mother weakens from this feeding the babies then inject her with venom. she then dies and they devour her entire body.

obviously, the mother allows this to happen. because her offspring survive, she has fulfilled the darwinian mission of reproduction.

I believe a similar process is now underway in the global economy. for years, the US nurtured countries such as taiwan, japan, germany and china with a steady flow of dollars. by running large trade deficits and educating their executives, we let them boost employment and build a middle class. they sucked money from our economy much as baby spider suck the blood their loving mother. let's view the size of china's economy relative to its trade gap with the US to illustrate:




(source for china GDP ... source for US trade gap)



our massive demand for everything from electronics to cheap clothing and and shoes provided sustenance for other economies as they took baby steps into the modern capitalist system. but it went further than that. like other doting parents, we provided leadership and protection. washington was the strongest proponent of trade integration, pushing for the creation of pro-trade institutions like the WTO, NAFTA and even european integration. while the US was never a perfect parent, there can be no argument that we provided an umbrella under which trade could expand .. we provided a model: the integrated industrial corporation. our business schools and universities educated their leaders. our currency served as a global gold standard, and our debt market still provides benchmark interest rates to anyone needing to borrow. finally, our military supremacy and commitment to wilsonian principles allowed countries to feel safe and focus on economic growth rather than self-defense. (while many will dispute this and look to things like the war in iraq, I contend that the US was pretty well behaved for a country that so clearly had global dominance. if we thought like other countries, such as russia after WWII or european kingdoms before 1800, we would have used our supremacy to conquer the world.)


so far, we've merely nurtured our offspring with our lifeblood and leadership. but now, the US seems determined to go all the way and sacrifice itself so that its children can move all the way to adult status. friday's WSJ offered some deeply troubling examples of this trend:


1-After embracing Washington in 2003, Libya is now souring on its ties to the US. an american law passed in january lets people sue libya and companies that do business there, like exxon and chevron. why? to compensate victims of libya's state sponsored terrorism, even though most such action occured more than 20 years ago. the article also points out how companies from south korea, iran, india and thailand are growing rapidly in libya, while US firms are nowhere to be seen. most important, libya is an exciting emerging market. not only do they have oil. but quaddafi now realizes he has more to gain from liberal economic policies than he does from the country's old-fashioned statism. its oil, beautiful country and location, plus its relatively moderate islamic practices, seem to lay the groundwork for a very bright future. instead of nurturing ties with libya, our government seems determined to burn bridges with it. this also reminds me of congress's inability to approve the free trade pact with colombia.


2-Exxon CEO rex tillerson says the US should pump more of its own oil rather than asking for OPEC to produce more. he apparently criticized president bush for failing to pursuade congress to permit more offshore drilling. given congress's hostility to bush and his previous failure to open up ANWR, there's little surprise in this. but it shows how much the average american is vulnerable to swings in the internation energy markets. with oil breaking out to record levels, this problem is only going to get worse. every extra dollar americans spend on gasoline means one about one fewer dollar that stays in the US economy. (I say "about" because the US still produces a lot of oil, so some high prices help people in places like texas.)


3-the government's approval ratings are at record lows. bush's is 31%, while congress has an 18% approval rating. it should come as little surprise as both political parties skirt major issues and focus on empty rhetoric.


4-democrats in the house refuse to fund troops in iraq and use the bill to promote more unemployment benefits for ordinary americans. while both of these issues might be important, the backhanded way of separating hiding them like this does little to promote transparency or good will. if the democrats want to deny funding for the troops, they should come out and say it openly.


5-evidence suggests hank greenberg did nothing wrong and never should have been forced from the helm at AIG. it's increasingly clear that eliot spitzer's antics as attorney general did little to help the economy or financial system. no victims were helped by his attacks on wall street. if anything, he just made it harder for one of the most lucrative industries to do businesses in the state.


now, for disclosure, #4 and #5 are both opinion pieces. but they illustrate how unaccountable government has grown in this country.

many people like to blame george w bush for our country's problems. I think he has been a terrible president for his poor leadership and inability to execute on many of his objectives. but I think the seeds of these sad years were planted long before he took up residence at 1600 pennsylvania ave.

in fact, on many of the cases I cite above, bush is on the right side of history. he has supported closer ties to countries like libya, opposing the bill that would expose them to mass-tort actions. he has obviously tried to promote more domestic oil production from places like ANWR, only to fail. in fact, the scariest thing for me is that he seems to be taking the right side on many issues, and he will soon leave office in disgrace.

given the current weakness of republicans, I fear the possibility obama will be elected president. I don't dislike him, but also don't like him very much. looking over his website, I see little that distinguishes him from the great mass of liberal democrats out there. there are a few random ideas like promoting manufacturing and promoting free trade, but considering his own party's recent actions on these fronts, I don't have high hopes for anything to get done.

watching his speeches, I also have the sense that he's just another politician. his youth and race make him seem different. his moderate and likeable persona and off-beat looks make him more palatable to voters tired of bush's swaggering patriotism and black-and-white morality. but, I see little more than a longing for "change" in his message.


I might add that this impulse for "change" often produces some of the worst outcomes in a political system. for example, voters' disgust with business as usual in caracas brough hugo chavez to power in 1998... an election I personally witnessed.

while obama is clearly more respectable now than chavez was then, it shows the danger of a disenfranchised and alienated electorate. I personally think if obama is elected, little will change and in four years, we'll be seeking something else. I think the next president faces the hardest challenges of any leader in a long time.

anyway, each of these actions listed above show how the US seems determined to destroy its leadership position in the world. look at how we refuse to make citizens of iraqis who have served as our intepreters. look at how we treat leaders in other countries like colombia and libya who have made efforts to work with us. look at how our own mechanisms of government undermine our own businesses such as AIG to little positive effect. the fact of the matter is the US is still living in the 1980s, when we could do as we pleased because we were the world's leading power. when the other option in the world was the USSR, others were willing to put up with a lot of our nonsense. now that we're increasingly just another country, their goodwill towards us will fade rapidly. I still think we have ugly prospects ahead, characterized by a weakening economy, capital flight and self-delusion about our own greatness. the worst thing is we still have so much further to fall.

Tuesday, May 13, 2008

running out of gas

everyone knows gasoline prices are moving higher. but how much of a problem is it really? to quantify the question, I did some calculations and found some interesting results. at current prices, I estimate the average american can afford to buy about 10,677 gallons of gasoline a year. that does sound like a lot of gasoline, but it's down 47% from the 20,379 gallons that we could afford in 1994.



(to arrive at these numbers, I used gasoline prices from the Energy Informaiton Administration. Because the last per-capita income data was from 2006, I estimated the numbers for 2007 and 2008, assuming it rose about 4.3% each year... that was the average annual increase in the 1994-2006 period.)


anyway, this is a sobering thought. essentially, the average american can now afford to drive about half as much as was the case in the 1990s. and, in the 1990s, that same consumer was carrying many fewer unpaid liabilities... in 1994, consumer debt represented about 75% of personal income, versus 116% in Q3 of 2007.

this news hit bank of america said yesterday:

May 13 (Bloomberg) -- Bank of America Corp., the nation's biggest consumer bank, said losses on home-equity loans will be even worse than predicted three weeks ago, adding to evidence that more consumers are falling behind on debts.
More customers are under financial stress and using credit cards to pay for necessities, said
Liam McGee, president of the consumer and small business division, at an investor conference today in New York. Losses on the bank's $118 billion in loans linked to home values may top 2.5 percent, higher than the 2 percent to 2.5 percent projected last month. He didn't specify a time frame.

one more thing I would like to add: most people on Wall Street have long known that B of A is a lousy company. they tended to have much less profitable investment-banking operations than other securities firms. they essentially made all their money from high-fee consumer banking... when they announced plans to buy Countrywide, I knew their future would be even worse. they are marrying themselves to a collapsing market and an increasingly impoverished customer base. most daytime TV pundits praised the move, but I predict it will be a millstone around ken lewis's neck for the next several years. it might have been cheap -- but that doesn't mean it was a good value.

getting back to the broader economy, some very strange news came out today: the government is claiming that fuel prices declined last month -- at least according to how they calculate inflation. this is downright bizarre, given the obvious fact that energy prices are, in fact, rising. this year alone, the average price of gasoline rose 22%. the anomaly actually results from the fact that gasoline prices didn't go up as much as they're supposed to go up this time of year, based on the normal driving patterns. why didn't they go up more? because americans are already feeling squeezed and driving less. I don't consider that good news.

that didn't stop the stock market from charging higher... I have stayed bearish through this entire market bounce, and remain so today. many technical conditions make it hard for stocks to fall now.. basically, so few people actually own stocks at present .. one strategist told me recently that the amount of cash in money market accounts is at the highest level since the last bull market began in 2003. these strong cash positions, plus relatively cheap stocks, make big losses more difficult -- at least for now.

anyway, my basic point is that it's hard for stocks to decline because of this technical condition. I am a technician at heart. if there is anything we learned in 1999-2000, it is that people will buy assets completely devoid of fundamental value, such as shares in pets.com, if they have the money and the will. I don't believe in sitting around, arguing about what should be: "investors shouldn't pay 100x earnings." there is no "should." there's just the market, and what it will bear at any point in time.

still, the fundamentals cannot be ignored. when stocks rally on what is essentially bad news, like today's inflation report, you have to question the durability of such a rally. it worries me when stocks are strong despite inflation and a collapsing consumer.

let's consider what happened in 1999: after the asian crisis hit, billions of capital flooded into the US market, which had already been enjoying a strong rally. that made US stocks the logical destination for this "hot money." the key thing to remember isn't just that the hot money was available... but people it tends to gavitate to the sector that's already established as the leader.

now, a little bit of that hot money, the swing money, is returning to stocks. much of it remains in treasuries. in my view, that kind of money tends to follow the sector enjoying the most momentum. right now, that's not stocks, it's oil and other commodities. they have done far better than stocks over the past few years... but they have not yet formed a bubble. as a result, I fear that commodities might attract this fast money, allowing another surge of prices. so far, the fundamentals have supported commodity prices. it hasn't yet gotten to bubble status. the normal market behavior patterns would suggest that commodities have yet to enjoy that final lunatic surge higher we saw in stocks in 1999-2000, in credit we saw in 2006-7, and tulip bulbs in 1636-37.

the underlying fundamentals for stocks are bad and getting worse. for instance, many daytime pundits applaud the rally in the US dollar. it's hard to see the benefit of that after people were taking solace in the weak dollar as a way for US companies to boost their earnings... for example, IBM.

right now, we seem to have at least three separate crises hitting our economy simultaneously:

1- the death of the consumer. after years of borrowing to keep spending, people are at the end of their ropes, especially as home prices decline
2- a generalized credit crunch / banking contraction. it's not as bad as we faced in the S&L crisis, but it still means less credit is available in the system. lending standards are tightening.
3- inflation: despite the government's fantastictical report today, it's a problem.

briefly back to inflation: the main reason it declined was this bizarre estimation that gasoline prices fell 2% and a 0.4% drop in public transport costs. these numbers don't seem real or sustainable to me... I think they are poor reasons for stocks to rally.

on the other hand, I can see the other side of the argument. it's possible the global economy will go into a recession, causing commodity prices and inflation to fall. this could flood money back into U.S. stocks. it has happened before. but given the bad economy and bad momentum in US stocks, I don't think it's likely. instead, the chief danger at this point is for the hot money to chase commodities, causing another world of pain.

one thing to close on that could fit into that. oil prices are up on demand and speculative buying by people like me. political instability has not yet been priced in. when people talk about the notion of the US simply withdrawing from Iraq, I wonder how serious they can be. if we leave iraq, how long will it take before Iran, Saudi Arabia and Turkey are fighting over it? iraq already has some of the best and cheapest oil fields in the world. it seems likely some kind of conflict will result. after all, if you threw $10mln into a room occupied by 10 normally peaceful people, how long would the tranquility last? I hope I am wrong, but human nature doesn't change.

Monday, May 12, 2008

illusions of oil ... the great profit pinch ahead

one thing I have heard much of recently on some daytime business programming is that americans are capable of coping with rising fuel prices because they'll just drive less. shazam! the gasoline problem is solved... don't worry about high prices -- we'll just consume less!

it sounds wonderful until you think about what it means... after all consumption is one of the biggest components of GDP, which is another word for the economy. given the unfortunate sprawling nature of our post WWII society, people need to drive to do consumption. less driving means less GDP.

while some may view a more frugal populous as good news, in reality it isn't. people won't get excited about stocks when the average american is just scraping by. investors want to see an improving story... more consumption, more wealth, more purchasing power. that's the environment that will drive earnings growth ... I will return to earnings growth shortly, but first a few more facts regarding the increasingly tight-fisted american shopper:

in March, people spent less on:
  • consumer electronics
  • building materials
  • health & personal care stores (not healthcare itself)
  • home furnishings
  • clothing

they spent more on:
  • autos & auto parts
  • food
  • gasoline
  • restaurants & bars

(click here for the source material)

interestingly, people seemed to spend more on stuff they need, versus stuff they want. that's not bullish.

now, as much as people love to hate big evil corporations, they're just as susceptible to these price pressures. if americans are getting squeezed, so are businesses... for example:

ATLANTA (Reuters) - Whirlpool Corp. the world's top appliance maker, posted first-quarter profit well below Wall Street estimates on Thursday on declining U.S. sales and rising oil and steel costs, and it slashed its full-year earnings outlook, sending its shares as much as 11 percent.

or

SAN FRANCISCO (Dow Jones) -- FedEx Corp. warned Friday that fourth-quarter earnings are poised to come up well short of prior targets, adding that if oil prices continue to rise from this point, more damage to the bottom line could be on the way.

once again, I am feeling increasingly vindicated by my objection to the Fed's rate cuts starting last year. gentle ben has clearly let the inflation genie out of the bottle. instead of letting wall street take the pain and blow up, he passed the costs on to the average american, and to the average american non-financial business. it seemed so necessary at the time, so obvious. but anyone with knowledge of financial crises in other countires or basic economics should have realized it was the wrong move. central banking is a bit like what warren buffett said about value investing ... to paraphrase: if it feels good, you probably shouldn't be buying. if it feels good to cut rates, you probably shouldn't be doing it.

if he had jacked up rates last year, oil would be in the 60s and materials costs would be rock bottom by now. yes, we'd be in the midst of a serious recession, but we could also be getting ready for some nice fat rate cuts. and, they'd be sustainable. that's really the stock market's dream scenario.

instead, we now stand naked and defenceless before a dangerous enemy.. the economy is teetering on recession, much of the stimulus is already spent, and prices are still spiraling higher. rates can't be cut further. we're like germany in february of 1945... hitler had just hurled 500,000 men against the allies. it made germany feel good to kill over 19,000 americans and british soldiers. but the foolish move -- the battle of the bulge -- spent the last of his reserves in the west and made the defence of germany impossible.

now, we face a situation where we'll eventually have to raise interest rates much higher. ben could have jacked them up maybe 50-100bp to about 6%. instead, to deal with the kind of inflation we're going to have, they'll have to climb well above 10%. sure, I am just pulling these numbers out of thin air, but it's more or less what the Fed did in the early 1980s. it's also what many latin american central banks did within the past decade.

getting back to profits.. let us consider a few facts gleaned from the Fed's quarterly flow of funds report.

Since 2003:

  • the US economy has grown 29% to $14 trillion
  • non-financial profits have risen 144% to about $1 trillion
  • exports have gained 66% to $1.7 trillion
  • imports have risen 59% to $2.4 trillion
  • the market value of US stocks has climbed 37% to $2.4 trillion
  • stock buybacks rose 2656% more than $1.1 trillion.

essentially, US companies have done a terrific job of growing earnings. but, the big question is whether it's sustainable. judging by the news from companies like Fedex and Whirlpool, I am betting isn't not sustainable.

first of all, most of the profit gains happened from 2003 to 2005. in the first quarter of 2003, corporate profits were about $407bln on an annualized basis... three years later, they reached $1016bln. by the end of last year, they had barely gained, standing at just $1022bln. (if you're curious about this, see table f.102 in the z.1 report.) so, profit growth basically stalled, starting in 2006.

interestingly, something else happened around that time: import prices were starting to increase. my personal theory is that companies had been relying on cheap imported materials to cut costs and widen their profit margins. this resulted in a broad deflationary impact on all merchandise and components. I don't have time to delve into it here, but there was obviously no shortage of products that were sourced to china during this period.

most of these goods were delivered under multi-year contracts denominated in dollars. on top of that, china deliberately dumped goods on the market at unsustainably low prices. this kept workers in their jobs, even if it didn't produce profitable companies. (who cares about that when state banks will keep lending to you, anyway?) the problem now is that these exporting countries are starting to raise their prices on US companies. this will result in a broad, multi-year squeeze on any management team that thought it was being clever by off-shoring production in recent years. it could also potentially be devastating to American jobs linked to those cheap items.

the takeaway from this is that US companies had a huge surge in profitability, but it could never last. and, as always seems to always be the case -- almost magically -- the stock market just knew the truth: the average company was valued at less than 21x pre-tax earnings in the last quarter of 2007, down from 26x 10 years earlier. (this is not normal stock market P/E ratio, but something similar.) as a true beleiver in markets, I maintain equities are already pricing in rising inflation ahead... rising inflation means higher yields, which means higher costs of capital. it also means input costs will go up, squeezing profits. it's really all the same thing at the end of the day.

as I said above, profit gains stalled about two years ago.. but here's the kicker: since then companies have been growing their earnings per share by buying back stock. in the last three months of 2007, they bought back stock an an annualized pace of $1158bln, compared with just $42bln in 2003. this is a truly awesome increase of over 2600%. instead of hiring americans or building new factories in the US, they bought back shares at what some might consider an obcene pace.

here's my take on the last 10 years of economic activity in this country. while may will consider it distorted now, I believe in another 3-4 years, it will be increasingly common:

  1. american companies outsourced production to cheaper countries to increase profits
  2. foreign countries amassed huge piles of dollars, which they then lent to us by purchasing our bonds. this permitted americans to spend the same dollars multiple times.
  3. because US companies were no longer hiring americans, they stopped investing in this country. (there was actually a massive slowdown in capex, which will be the subject of another posting in the future.)
  4. american incomes stagnated because jobs were leaving the country. as a result, they put less money into the stock market.
  5. stock prices lagged gains in other countries and failed to keep up with profit growth.
  6. flush with tons of cash and a lack of investing needs, corporate executives bought back vast amounts of their own shares.

the unfortunate outcome of this process is that jobs and production capacity have both left this country. most importantly, because they lent us so much money, american consumers are now highly leveraged, further reducing our ability to grow consumption. because we are capable of consuming less, we'll attract less investment internationally, and global capital will gravitate to faster growing developing countries. the US will stagnate and find it has less and less control over key commodities it needs. as those prices climb, higher inflation will eventually erase the value of our debts (and many people's savings). we'll eventually have to raise interest rates, blowing the entire thing up in a big final crash before the balance can be restored. this could easily take 5-10 years, if not longer. once again, I believe my earlier posting is particularly relevant.

this process will be very painful and unpleasant. sadly, it's only getting started.