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Weekly Wrap-Up: Distorted Economy

The following article was originally published at The Agile Trader (www.theagiletrader.com) Sunday, August 1, 2010. If you would like a free one-month trial to our twice-daily service, please click HERE and then click the red "subscribe" link at left.

At Ford Motor Company's Web Site they have posted a little piece of history, reproduced in part below:

The $5-a-day Workday

After the success of the moving assembly line, Henry Ford had another transformative idea: in January 1914, he startled the world by announcing that Ford Motor Company would pay $5 a day to its workers. The pay increase would also be accompanied by a shorter workday (from nine to eight hours). While this rate didn't automatically apply to every worker, it more than doubled the average autoworker's wage...

...Henry Ford had reasoned that since it was now possible to build inexpensive cars in volume, more of them could be sold if employees could afford to buy them. The $5 day helped better the lot of all American workers and contributed to the emergence of the American middle class. In the process, Henry Ford had changed manufacturing forever. (My boldface.)

On Meet the Press today, they had a terrific lineup for the latter part of the show, comprised of former Fed Chairman Alan Greenspan, Mayor Michael Bloomberg, and Governor Ed Rendell. Here is most of Greenspan's opening remark:

(The problem with the economic recovery)... is that we have a very distorted economy in the sense that there has been a significant recovery in a limited area of the economy amongst high-income individuals who have just had $800 billion added to their 401(k)s and are spending it and are carrying what consumption there is. Large banks, who are doing much better, and large corporations, whom..., everyone's pointing out, are in excellent shape. The rest of the economy, small business, small banks, and a very significant amount of the labor force, which is in tragic unemployment, long-term unemployment, that is pulling the economy apart. The average of those two is what we are looking at, but they are fundamentally two separate types of economy.

All well and good that Greenspan believes what he says, but do we have any hard evidence that what he says true? Yes. The first chart we have today shows 3 series from the Bureau of Economic Analysis' latest GDP report, which printed last week. The pink (top) line on this chart shows compensation of employees as a percentage of GDP. The red (middle) line shows employee wages as a percentage of GDP. The pink and red lines are scaled at left. The blue (bottom) line shows domestic industries' corporate profits with inventory-valuation and capital-consumption adjustments (scaled at right).

Compensation as Percent of GDP

Employee compensation (pink line) is at its lowest level (relative to the size of the economy) since 1955. Wages as a percentage of GDP are at their lowest level EVER (and that INCLUDES THE GREAT DEPRESSION, during which wages as a percentage of GDP never fell below 49%)! Meanwhile corporate profits have rebounded from their post-war low to very normal post-war levels relative to GDP, smack between the median and mean (now 8.3%).

Note: In this first GDP report for 2Q10 the estimate for corporate profits is omitted by the BEA. That number will be included in future revisions to the report. During 2Q SPX profits rose about 3.3% Q/Q (according to Standard & Poors). So I have estimated that in the GDP report corporate profits will have grown at that rate. Of course this estimate is subject to revisions, but unless those revisions are whoppingly large (very unlikely), the gist of our story will remain as described above.

You'll noticed on the chart above that there has been a downward trend in wages as a percentage of GDP since either 1970 (the peak of the red line) or 1974 (when the red line broke to a new low on the chart), depending on how you want to define a downward trend. Compensation, on the other hand, held up pretty well for a lot longer, achieving a local peak in 2000, and then heading down from there.

You'll also notice that the spread between the pink and red lines has been generally widening since 1970, indicating that wages (in the main skewed toward lower-income workers) have been losing ground relative to total compensation (which includes bonuses and stock options, for example, and are skewed toward higher-income workers).

Importantly, since 2000, including 2 recessions and 2 recoveries, consumers have been in a long-cycle declining trend in terms of all forms of compensation (earned income). Meanwhile corporations have rallied profits as a % of GDP with each recovery cycle.

It appears that we have utterly forgotten the lesson taught by Henry Ford with his "$5-a-day" revelation...which is, in actuality a lesson about the velocity of money.

If money stagnates as cash in bank accounts (and is not lent to businesses), and/or if it sits on corporate balance sheets (and is not spent on growth initiatives, including new hiring), then the broad economy will have lost a primary catalyst for growth. In that case the economy will suffer the "paradox of thrift," which is that if everyone saves, rather than spending, then everyone will become poorer! Why? Because the lack of spending inhibits the very growth of the economy as a whole upon which wealth-creation is predicated

I've been talking about this vicious cycle for months now (weak job and income growth begets a slow-down in the velocity of money). Unless employment and earned-income statistics begin to show marked improvement, confirming the rally in the stock market, the stock rally off the March '09 lows will likely exhaust itself and reverse in earnest.

This coming Friday we'll get the monthly employment report. And unless we begin to see significant improvement in the numbers that really count (like the Employment/Population (EM) Ratio), the stock market could be in for a rough August-October period.

SPX and EM ratio

The SPX has retraced about half of its bear-market losses. But the jobs market on the EM Ratio remains within a whisker of its generational low.

With weekly Initial Unemployment Claims printing in the 450K range, there's little in that more frequent series to suggest that we'll be getting a positive surprise in the monthly report.

To be sure, the earnings recovery has been impressive since '08. The SPX's bottom-up consensus for forward earnings per share (blue line below) is now at $88.89 (according to S&P).

Earnings Estimates

The top-down consensus (red line) is at $75.11 (showing some deterioration). Trailing operating earnings are now at $73.96. And trailing reported earnings are now at $66.71.

The question that plagues the market now is, Can the current consensus for robust earnings growth be trusted?

From at least 1994 into 2006, analysts did a pretty good job of forecasting earnings growth. The footprints of the quality of forecasting show up in the next chart, which shows the bottom-up analysts' consensus for forward earnings growth on the SPX (blue line) plotted against actual trailing earnings growth a year later (red line). The blue line shows what analysts thought would happen over the coming year. And the red line shows what actually happened.

Earnings Estimates

From 1994 into 2006 the red and blue lines did a pretty good job of tracking one another, at least in terms of direction, albeit less so in terms of the magnitude of change. But in '07 and '08 analysts got it completely wrong (note the huge spread between the blue and red lines).

Since '09, however, the red line has begun tracking the blue line very closely again, with trailing earnings now up 85% from a year ago, which is pretty darn close to the roughly 79% growth that was forecast.

Now, analysts are projecting about 20% in earnings growth over the coming year. If these analysts are correct (if the red line is going to continue to track the blue line going forward), then the stock market is indeed extremely cheap at the moment.

PE versus Dividend

The PE on the bottom-up consensus for forward operating SPX EPS is about 12.4. The consensus on trailing operating EPS is about 14.9. And the consensus on trailing reported EPS is about 16.6. All this while the Price/Dividend ratio on the 10-Yr Treasury (black line above) is up around 34.4. Historically the 10-Yr's Price/Dividend ratio averages about the same as the SPX's forwad Price/Earnings ratio, so if the analysts are right, then stock are currently under-loved while Treasuries are over-loved.

But, let's read what Howard Silverblatt, who compiles much of the data I use from S&P, wrote in a preface to his earnings numbers about what's underpinning stock-market earnings right now:

Posted July 21, 2010:

Last week U.K. scientists determined which came first: the chicken or the egg? They claim it was the chicken. But the Wall Street version is which comes first Sales or Jobs is still open. Consumers don't want to spend because they don't feel comfortable about the future, specifically the economy and their job; companies won't expand - add to plants, spend on capital expenditure, hire workers (full or part time, even extending hours) until their sales pick up. From the company's viewpoint, why invest to produce more when you aren't even selling everything you are making now, especially if their earnings are doing well (not to mention they have more cash on hand then at anytime in history). From the consumer's side, even those who feel secure with their job are watching their bottom line, and money remains tight (and don't even look at your retirement holdings or benefits). So how do you break the downward cycle of 'I won't spend' therefore 'I won't build'? For starters there were the jump start stimulus programs. But here we are trillions later and no jobs. Maybe it would have been worse, maybe we just need more stimuli or maybe we're just feeding a junkie. Pick a theory, stand at Broad and Wall and preach it. But whatever we're doing, wherever we are in the process, it hasn't worked yet, and Americans aren't known for their patience. So if we don't start to see some actual improvements soon the tie goes to the down side, and time is not on our side. I'm not looking for a home run, just someone on base would be nice - something to root for.

The above commentary is mine of course, and not part of my earnings review below, but the two do appear to be blending. Maybe I need to step back and look for bias in my reporting, or maybe a 38% increase in earnings isn't the whole story.

As of last night we had 24.9% of the Q2 earnings reported. So far, the Q2 2010 earnings results are encouraging at first glance. Based on the issues that have actually reported, earnings are 14.5% ahead of estimates, with 65.8% of the issues beating their estimate. Sales, however, are a different story. While 73.4% of the issues have beaten their sales estimate, the "beat" is only slight, with the overall aggregate sales coming in 4.4% ahead of estimates - far less than the 14.5% for earnings. The earning growth over last year's Q2 2009 is equally impressive, with earnings 38.4% ahead (excluding Citigroup which had a massive loss last year), but sales are a disappointing 6.7% ahead. Anyway you cut it - sales just aren't cutting it.

I believe comparisons should focus on quarter-over-quarter results to determine the recovery's progress, as well as the underlying momentum of the economy. And since I believe jobs are number one, and given that companies are generally in good financial shape with excess cash so they can ride out any short term disruption, I look to sales as a future indicator. On this basis, earnings are running ahead of Q1 2010, but sales are flat, and that's the problem. It's great that companies have improving earnings, but those improvements are due to high margins, which were the product of cost cuts - specifically job reductions, the very thing that we need to improve now. Until companies and consumers start to spend more, the job front will not get better, but they won't spend more until they believe things are getting better. The stimulus programs were suppose (d) to jump start the economy and break the downward cycle by convincing both groups that better times were here. But so far we're not seeing the sales or the jobs; but earnings are good, at least for now.

I read on Bloomberg.com that investors are becoming more sanguine about the market's prospects, as indicated by the narrowing of risk spreads on corporate bonds. But this view is contradicted by the latest data on the spread between BAA bonds and 10-Yr Treasuries.

With the 10-Yr yielding less than 3% and BAA bonds yielding almost 6%, the spread (blue line on the chart below) is now 3.04%, which means that investors require almost 3% more in yield in order to assume the risk of owning BAA bonds, compared to the 10-Yr.

BAA-TNX Spread and SPX

That blue line, at 3.04% is in the 93rd percentile of all readings going back to 1962.

Readings of >3% on that spread tend to be associated with good cyclical buying opportunities in the stock market. (Note how the SPX (red line above) tends to rally off spikes on the blue line.) On the other hand, we could see this spread widen toward 4% before another top forms, or, in a new crisis, toward 6%.

If the job market fails to strengthen, then growth prospects will continue to wane, and if growth prospects continue to wane, then earnings will not be able to sustain positive growth, and if earnings growth heads south, then the stock market will be doing likewise.

There are a lot of lines on a lot of charts (e.g., the EM Ratio, wages as a % of GDP, and the BAA - TNX yield spread) that need to change directions and levels in order for the environment to be ripe for a sustained cyclical bull market.

The stock market is cheap relative to earnings at the moment. The question is whether these earnings are sustainable, or if the economy and financial system that underpin those earnings are headed for another fall.

 

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