August 7, 2006
Premises & Implications:
1: Corporate profit margins are currently at the widest levels in history. Profit margins for the S&P 500 are close to 9%, versus a historical norm of about 6%. Corporate profits as a share of GDP, at over 13%, are also the highest in history. Meanwhile the share of GDP claimed by labor is at the lowest level in more than two decades.
2: All of the above measures are clearly cyclical. Both very high and very low levels tend to revert to the mean, with a typical reversion time of 3-5 years. The Goldman Sachs Confidence Index, based on chief executives assessments of business conditions, declined sharply in the latest report, from 71 last quarter to 42, well below the neutral 50 reading. As the chart in Bill Hester's latest research piece indicates (Record Profits Don't Excite Company Executives), the Conference Board's CEO Confidence measure is now so punk that it suggests negative profit growth over the coming two-year period. The NABE reports that in the latest quarter, more manufacturing respondents reported declining profit margins than rising ones – the first negative plurality in over two decades – while service industries showed a still-positive but weakening trend in margins. Morgan Stanley reports that the ratio of positive to negative earnings pre-announcements has dropped to just 0.34 this quarter, versus 0.54 last quarter and 0.59 a year ago.
3: S&P 500 earnings (trailing net) currently reside at the top of a long-term 6% growth channel which connects earnings peaks as far back in history as one cares to look. Historically, when earnings have been close to this trendline, the average P/E ratio for the S&P 500 has been 9. The current multiple is 17.6.
4. The U.S. has moved from being the largest creditor in the world, to its greatest debtor, with a current account deficit typical only of banana republics. Historically, sustained economic expansions have begun from current account surpluses (which have thereby allowed gross domestic investment to boom, financed not only by domestic savings but large inflows of foreign savings). The current expansion began with a deep deficit and has been built on an ever deepening one. All of the growth in U.S. gross domestic investment since 1998 has been financed by foreign capital inflows.
5. Leading indicators of U.S. economic health are stalling, with a contraction in real liquidity growth, a clear downturn in housing, tepid employment growth, a modestly inverted yield curve, and a negative consumer confidence spread (future expectations below current conditions), among other factors. Meanwhile, inflation measures continue to demonstrate persistent upside surprises.
The chart below is the in-house “advance-decline line” of economic surprises (actual figures versus consensus estimates) that we maintain on a variety of inflation and growth statistics (employment, inflation, GDP, etc). Note that since early May, inflation reports have been relentlessly above expectations, while growth reports have been largely disappointments. This is picture-perfect stagflation.
6. Foreign interest rates continue to advance, and foreign central banks continue to tighten policy, while U.S. market interest rates have stabilized on the expectation of a near-certain “pause” by the Federal Reserve.
1. Profit margins are likely to contract in the next few years. Historically, wide profit margins have been followed by tepid profit growth over the following 5-year period. Large shares of GDP to profits, and low shares to labor, have typically produced above-average growth in wages and a concurrent narrowing of profit margins.
2. The U.S. stock market is likely to struggle. While the current price/earnings ratio for the S&P 500 (net trailing earnings) is a historically above-average but seemingly benign 17.6, it's notable that the current P/E would be approximately 25 on the basis of normalized profit margins. Alternatively, the current multiple of 17.6 should be evaluated relative to the norm of just 9 times earnings that has historically prevailed when earnings have been near the top of their long-term growth channel.
3. The U.S. economy is likely to experience weak growth in the coming quarters. Given the collection of evidence already in hand, at the point that the ISM Purchasing Managers Index drops below 50, or the 6-month growth in total non-farm employment declines below 0.5%, the likelihood of an oncoming recession will rise to near-certainty.
4. The U.S. current account deficit is likely to contract in the quarters ahead, but only because of a decline in foreign capital inflows. This is likely to result in flat or declining U.S. domestic investment, particularly in the housing sector. While the influence of the Federal Reserve on the U.S. economy may be a matter of debate, there is no debate that foreign central banks have been the primary buyers of U.S. Treasury debt in recent years, and the primary mechanism by which the U.S. current account (and the growth in U.S. domestic investment) has been financed. These central banks continue to tighten policy, so their absorption of U.S. Treasuries is slowing. When foreign investors fail to absorb the Treasury securities needed to finance U.S. government deficits, those Treasuries are forced into the hands of U.S. investors instead.
5. Inflation is likely to remain a persistent “structural” problem, rather than a “cyclical” one that will go away at the first hint of economic slowing. Meanwhile, U.S. nominal interest rates will most likely fail to track economic growth lower. Barring a credit crisis that would actually provoke investors to seek Treasury securities as safe havens, the increased supply of Treasuries on the U.S. market is likely to result in a reduction in their value.
6. The U.S. dollar is vulnerable. Foreign buying of U.S. Treasuries has to-date been the chief “flow” factor supporting the value of the U.S. dollar, and relatively attractive U.S. real interest rates have been the chief “fundamental” factor. The current withdrawal of these factors could provoke a dollar crisis (substantial weakness in the U.S. dollar and rising import price pressures). Meanwhile, weaker economic growth will probably be sufficient to keep the Fed from tightening in order to support the dollar.
In short, we should not be surprised to observe stagflation, falling stocks, weak profits, flat bonds, and a dollar crisis in the months ahead.
We don't rely on such forecasts, of course, since we always align our investment positions with prevailing market conditions. Still, for now, the outcomes of these conditions are likely to be unusually poor.
Personally, my opinion is that the major stock market indices are vulnerable here. I tend to be an optimistic realist, but aside from hedging positions (market-neutral investment positions, inflation-protected securities, precious metals, etc), there is presently little in the financial markets to be realistically optimistic about. Still, these opinions are also unnecessary – the objective evidence regarding valuations and market action is sufficient to hold the Strategic Growth Fund to a fully hedged investment stance (intended simply to reduce the impact of market fluctuations on the Fund's stock holdings). The dollar value of our shorts never materially exceeds our long holdings.
In short, the evidence suggesting that stocks underperform T-bills, on average, under current conditions, is enough to warrant a hedge. Any risks beyond that have no further effect on our positions.
June 26, 2006: Recession Risks are No Longer Dormant
June 5, 2006: The End of Excellent Earnings
March 20, 2006: Everything Looks Good at the Top of the Channel
January 9, 2006: Do P/E's Expand Once the Fed is Done?
August 8, 2005: Profit Margins, Labor Costs and Earnings Growth
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully-hedged investment stance. The Fund's hedge is essentially an interest-bearing short sale having the same dollar value as its long stock position. Currently, about 75% of this hedge represents an offsetting short-position in the S&P 500, with about 25% in the Russell 2000, largely reflecting the capitalization profile of the stocks held in the Fund.
In bonds, the Market Climate was characterized by modestly unfavorable valuations and modestly unfavorable market action, moving the Strategic Total Return Fund to an overall duration of just over 1.5 years, primarily in U.S. Treasury inflation-protected securities. On further evidence of weakening economic growth and inflation persistence, I increased the Fund's holdings of precious metals shares last week to just under 20% of net assets.
New from Bill Hester: Record Profits Don't Excite Company Executives
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