The Profits Depression

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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.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Rather than trying to be colorful and witty how about looking at things from the human perspective. If the market is on the rise LET it be! Why offer a psychoanalytical interpretation of why YOU think it has rebounded? Would you like a pat on the back for being a smart fella, then here you go, you are the dumbest smart person I know. Who cares why the market has risen? I want to know why every time it does, one of you people have to jump in with your show stopping paranoia. It’s rising, that’s good for everyone, so forget about your pat on the back and stay out of its way.

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  2. Equities have traditionally done it tough during a depression but I believe that real bread and butter business equities that can sustain finance for their inventories may do far better deeper into this cycle.

    Once you separate the insolvency of the financial sector after the bad debts are finally accounted, and then the knock on affect of the diminished savings of the people relying on those institutions that have taken short term returns when getting sucked into building the unsustainable dominance of financials in the markets explosion, then the lower economic impetus of the anglo current account deficit fueled economies, well we are then likely to concurrently get the heat of both bread and butter inflation and asset deflation.

    But I also believe that the equity price rise at this stage of the cycle is a sham built on Goldman led index trades using recycled funny money capital bsed on trash securities now sitting on reserve bank balance sheets.

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  3. Dan:
    “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.”

    How about “Some national income WILL be generated from the resource industry”. Otherwise we are no better than a continent-sized quarry. My point is that whilst I agree they will play a part in our income, putting all your eggs in the Australian resources basket may be a bad idea. Are there any cases whereby we may not thrive from resource-related revenues? For instance:
    – if resources demand is not as high as expected
    – if resource prices are not as high as expected
    – if protectionism and trade sanctions come into play
    – if resources are sourced from elsewhere (perhaps countries that have less environmental and labour constrictions?)

    John: You completely miss the point of this website.

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  4. Interesting “twist” w/ the Dickens quote. Can you imagine what Charles Dickens would say about Britain’s finances (and financeers)if he were alive today? Or if he could somehow be on his third visit to America right now?

    Of course, he’d be publishing on the internet.

    Maybe we’d be treated to Hank ‘Fagin’ Paulson. ‘Colonel’ Jamie D., in New York City. And, with his two daughters, President ‘Pecksniff’ Obama.

    Remember what Dickens penned about (we must assume) Thomas Jefferson?

    “–oh noble patriot, with many followers!–who dreamed of Freedom in a slave’s embrace and waking sold her offspring and his own in public markets.”
    (From: “Martin Chezzulwit”)

    63 y.o. American
    July 30, 2009
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  5. Worth watching ‘Freefall’ if you haven’t already. Shows Britain’s financial blunders very dramatically and effectively. Found myself wincing as I watched… .

    Biker Pete
    July 30, 2009
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  6. Pete: “John: You completely miss the point of this website.”

    John, for once, Pete is right… . :)

    Biker Pete
    July 30, 2009
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  7. I’ve been reading nay sayers warn us to stay away from financial stocks for months because thier earnings will not return to normal for some time. Why avoid stocks that are 1/4 thier previous price only because earnings will only go to 1/2 what they were? Stocks are currently on sale based on earnings 6 to 12 months down the road. I picked up a US regional bank for 10% of it’s 52 week high (it’s 2 year high was twice that). It’s since been a 5 bagger. The rate of return on that original investment from earnings (i.e. dividends) 1-2 years from now will be 25% per annum ($2 share price with a historic $1 per share dividend in good times so lets assume .50 going forward). Thats not counting capital appreciation (shares now $9 and headed for $20 long term) where can you get that return other than the equity market? The big boys want us on the sidelines for several reasons,and the media machine dances to thier tune. Don’t listen to the fear mongers. This is a generational buying opportunity. That said, don’t take stupid risks; use risk capital only and avoid unmanageable leverage. Good luck.

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  8. Canuck Brian, many people have been saying over the last year to avoid stocks in general whereas in my view that is the opposite of what should be done. It is almost impossible to time the market so I look for bargains when everyone is heading out of stocks and then wait for the eventual return of a bull market. Of course to do this you have to believe the global economy will survive and despite rumours of it’s demise, world trade is still ticking over and paper money can still be used at the local shops. (not need to get a fallout shelter just yet)

    Are the gold bugs still buying gold I wonder? And where are the cries of “sucker’s rally” that were tossed in my direction earlier this year? :)

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  9. I’m still keen on gold Greg. SUPRISE :)

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  10. US commercial media tout gold _non-stop_: TV advertisements, newspaper ads, the lot. Despite that, I’ve never seen anything updating the current price of gold, so far… . Everything else, but not gold. Curious… .

    Biker Pete
    July 31, 2009
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  11. Lachlan you might turn out to be right about gold. None of us know for sure what is going to happen so your guess is as good as mine :)

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  12. Gold is what it is – An inflation hedge plus something that spikes (potentially a very, very great deal) during crises. I’ll be sniffing at AUD 1,100, buy a little at AUD 1,000 knowing full well it could hit AUD 800 and going chunner, chunner I knew that could happen if it hits AUD 600. Smile! (Ignore the Yank salesmen Biker – Yanks would tell their own grandmas cow dung was perfume if they thought the poor old biddies had lost their sense of smell.)

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  13. “Yanks would tell their own grandmas cow dung was perfume…” Yeah, you’re right there, Ned. Actually found a one-line reference to the gold price in ‘USA Today’while munching on a cardboard bagel this morning! Greg, you’re correct. New York _is_ overrated. It’s impossible however to not be awed by the sheer immensity and visual spectacle of it all. My first assumption was that they must need two coalmines operating 24/7 to keep it all firing… it’s more likely three. Miss the fresh sea air of coastal WA. You’d never know there was a recession here, though. New York is non-stop consumption, coast-to-coast Lexuses (Lexi?), some queues stretching five city blocks… overservicing in every building… truly frightening rental prices on one bedroom apartments… and despite all the razzamatazz… still worth doing… just once.

    Now for a month in the Canadian Maritimes, before we exercise our minimal parisienne a les quebecois. We expect Newfoundland and Quebec to be the two provinces most affected by the GFC… .

    Biker Pete
    August 1, 2009
    Reply

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