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.


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.


stockmarketreviews said...

we should use electrical energy as alternative of oil

Duncan said...

Not sure your interpretation of spending up on needs vs spending down on wants quite works, but the point is good.