Stocks are now pricing in a huge earnings recovery. And it would have to be a huge recovery because the earnings decline was absolutely gargantuan! We have no idea if this decline on S&P 500 earnings is reflected in a similar chart on the S&P ASX/200. We’ll get back to you on that.
In the meantime, the chart below shows that the since peaking in the third quarter of 2007-global financial crisis eve-S&P 500 earnings adjusted for inflation have fallen 98%. In fact, according to the chart providers, “real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.”
This wipeout of S&P profits is the largest of any S&P profit cycle since anyone’s been gathering earnings data on the index. That includes all financial panics and wars of the last one hundred years. What we have here is a profits depression (to go along with the Credit Depression). But it makes sense once you suss it all out.
If the profit cycle is determined by business investment, and business investment is goosed by credit bubbles, then we’d be coming off the biggest increase in S&P profits in history-followed by the biggest bust. Having boomed with the bull, profits are going bust with the bear.
But isn’t that all backward looking? Shouldn’t we be focused on the future? And isn’t that what stocks are doing now? Doesn’t the rally show that the past is not really prologue at all, but simply past?
In one aspect, the stock market’s current behavior isn’t all that remarkable. It is the nature of markets-and probably human beings-to be forward looking. Investors look at the profit crash on the S&P 500 and assume it can’t get any worse. Thus, the index is being priced for a profits recovery.
This also shows that investor psychology may have recovered from capitalism’s near-death experience in the last eighteen months. When things get really bad in markets, stocks are not priced on a forward looking basis. The future is so murky, dark, and uncertain at these despairing moments that investors price stocks as if yesterday’s business conditions will be tomorrow’s enduring reality. This is traditionally-but not always-a buying opportunity.
Once you get over the fear that the body of capitalism is on its death bad, there’s a flush of optimism about future earnings. After all, they have to recover sometime. And coming off extreme lows, the recovery could be powerful, swift, and for shares-extremely bullish. Right?
All of that may be true up to point. And we think that explains why so much cash that’s been on the sidelines is now getting back in the game and bidding up shares. But in the rush to conclude that stocks are cheap based on a future earnings recovery, we’d pause to consider the fact the contribution of credit growth to corporate profits and cash flows over the last fifty years-and the last ten especially.
And after we consider the impact of the credit boom on S&P 500 earnings we’d say that corporate earnings are never going to be the same again. They may revert to the mean. But it will not be nearly as high as it was at the highs of the credit boom. It’s undeniable that the expansion of the credit bubble and the advent of securitisation and derivatives led to a huge and unsustainable increase in the profits of financial firms-especially as a percentage of S&P 500 earnings.
Writing over at Hussman Funds in December of 2007, CFA William Hester showed that, “It’s clear that without the contribution of the financial sector’s wide profit margins, overall margins for the index [the S&P 500] wouldn’t be nearly as stretched as they currently are.”
“Over the past 25 years,” he continues financial companies have earned a growing share of the total earnings in the U.S. economy, and the wide profit margins of the past few years has exaggerated that effect. At the bottom of the 1982 bear market, profits from the financial industry made up about 10 percent of GDP, while manufacturing earnings contributed more than 40 percent. The most recent data show that manufacturing’s contribution has fallen by half, while the percent of financial profits contributed to GDP has tripled.”
Hester also shows that, “The contribution from financial earnings to the overall S&P’s margin quickened over the last few quarters, up until the most recent quarter… Margins in the S&P 500 Ex-Financials had already begun to flatten out in recent quarters, while margins for the financial group continued to increase. With a flat yield curve since 2005 and a U.S. housing market in decline since 2006, it was difficult to explain the level of financial profit margins earlier this year.”
Of course the next four quarters after Hestor wrote that, the entire financial sector experienced an earnings collapse. That showed up in the shocking earnings performance of the S&P 500. Now, investors think that collapse must inevitably be followed by some sort of recovery. And maybe they’re right.
But we’d suggest that financial stocks, along with insurance and real estate-related stocks, are not going to be reborn from the ashes of the credit bust to fly high again. The survivors in these particular industries (Goldman Sachs, for example) will recover and capture more market share. However, we reckon that the composition of S&P earnings is going to change in the next few years. And we reckon what investors are willing to pay for those earnings will return to trend as well.
It’s possible that the S&P rally is the resurrection of the equity premium in stocks. But don’t count on it just yet. The equity premium in stocks is based on an unsustainable expectation of corporate earnings and profits. People are staking a claim on national and corporate income that may never materialise.
The expectation of a 2007-level equity premium is unsustainable because there is still heap of deleveraging and asset write downs to go in the global financial system. The banks have fought these tooth and nail, aided by liquidity measures from their servants in the central banks of the world. Of course we’re wrong about this we’re going to miss some of this reality (although Gabriel is busy trading it).
However, we’re not keen to buy the banks and financial stocks just yet. We reckon the bottom line is that corporate profit margins in the financial sector will never again be as good as they were in the last twenty years. Liquidity can’t make up for a decade of bad investments.
If regulators introduce higher capital requirements and there is a reduction on the use of leverage in the financial system, it will simply mean lower average corporate profits for financial firms. That’s clearly bad news for Wall Street. But it’s not necessarily bad news for everyone else.
In the bigger picture, a restricting of national income and profits means that finance will be less important to the American and Australian economies and less profitable for the companies in those industries. But national income has to come from somewhere, unless national income itself experiences a net decline, which is also possible in a hyper-competitive world.
But assuming national income in English-speaking economies doesn’t just disappear but is restructured to more productive enterprises that use capital more efficiently, the obvious question is: where will national income and profits come from, if not from the finance sector? Well that’s a very good question!
Here in Australia, the national income is balanced between the financial industry (banks, insurance, real estate, funds management) and natural resources (capital intensive extractive industries). Both are experiencing some tough times. But one of the things we like about Australia is that the country has a meal ticket in the future. National income WILL be generated from the resource industry.
The big challenge for investors is to figure out who’s going to claim the largest share of that income. You hope it will be the individual firms you put in your self-managed super or buy for your portfolio. But maybe it will be the Chinese. Who knows?
These are the issues we grapple with everyday at Diggers and Drillers (where lately we’re on to lithium and tight gas) and that Kris Sayce grapples with at the Australian Small Cap Investigator (where he’s on the unconventional LNG story in Queensland).
Of course we can’t guarantee we’re going to get the stock pick winners right. But as far as asset classes go-we’d much rather be looking at Australian resource stocks than U.S. government bonds. Resources are scarce. American government bonds, on the other hand, are multiplying faster than cockroaches.
The U.S. government is auctioning off another US$200 billion in debt this week, according to Min Zeng at Bloomberg. That’s a lot of borrowing. We picture the future where Treasury Secretaries stand in expensive suits waiting in long lines, hoping for a meagre helping of capital from the world’s savers.
“Please China, may I have some more,” asked Timothy Twist.
Min reports that, “This week’s auctions include a record $109 billion supply in two-year, five-year and seven-year notes, up from $104 billion in June and $101 billion in May. The government is also selling $90 billion in three-month, six-month and 52-week bills and $6 billion in 20-year inflation-linked securities, topping up an existing issue.”
Strangely, Bloomberg is also reporting that real yields on U.S. Treasuries are at their highest inflation-adjusted level in fifteen years. We find this strange because the article suggests that Treasuries are helping investors beat inflation with great yields, even as the supply of Treasuries explodes on the U.S. borrowing binge. Bloomberg reports that the spread between yields on ten-year U.S. notes and the rate of consumer price inflation is 5.10%, whereas historically (for the last twenty years) it’s been 2.74%.
Ah, now it makes sense. Because the government is lying about the rate of consumer price inflation, bonds appear to promise an attractive yield.
Australia, of course, is ramping up its own borrowing on the global capital markets. The Australian Office of Financial Management will hawk another $1.4 billion in government securities this week. Will this crowd out private borrowing? Does it threaten Australia’s sovereignty by transferring power to foreign creditors?
These are some of the questions we plan to take up at this Friday’s Debt Summit. We promise to report back. And tomorrow, as promised, more on Australia’s rising net debt position.
for Markets and Money