The Convenience Of History...It often times amuses us that history can be both our greatest ally and worst enemy. For those who expect tomorrow to play out exactly as yesterday would suggest, disappointment is often the order of the day going forward. In like manner, for those who disregard history, very often the conceptual lessons bestowed upon our forbears are once again taught in real time, only on a more expensive absolute dollar basis. One of the most important investment lessons which we try to reinforce in ourselves constantly is to avoid invoking history on a selective basis. It's often convenient to do so and usually quite self satisfying. But, certainly in a game where the minimization of risk is the key to long term success, maintaining balance in relating historical human decision making to what is happening in the here and now becomes a necessary art.
We've mentioned this in prior discussions, but we are convinced that in today's world where personal time seems to have become the ultimate scarce commodity, thinking for one's self takes on vital importance. The very nature of the service driven economy defines the fact that so many today are dependent on others for essential services. Food, shelter, clothing, entertainment, etc. These are givens. But, when it comes to investing, possibly the most dangerous current service related dependency is to allow others to think and make decisions for us. Especially when it comes to the popular media and mainstream messages from Wall Street. We find it nothing short of disturbing that many of today's headline financial pundits are now choosing to embrace history as the basis for declaring a classic economic recovery ahead. As you know, these were many of the same folks that would have absolutely nothing to do with historical precedent at the height of the mania. We certainly do not take the power of the classic recovery message lightly as it can and has influenced both short term decision making and asset price movement. Yet, at the same time, we need to continually look behind the headlines for the facts that will relate to the integrity and sustainability of economic growth, and more importantly the potential for corporate profit expansion ahead of us.
The prior bull market in financial assets and accompanying economic expansion was very far from what could be considered classic in terms of the experience of US financial history. The now ending so-called recession was one of the mildest on record from the standpoint of real GDP contraction. Yet at the same time, the downturn in corporate profits was one of the worst on record. On both counts, anything but classic recessionary experience. So now the economic recovery should be the only aspect of this cyclical economic experience that is classic? The jury remains out, but we have the strong feeling that the popular financial media is guilty of invoking the convenience of history at the moment. If ultimately true, how inconvenient for most investors.
Yesterday Came Suddenly...Well, it's now official. There never really was an academic recession in the first place, now was there? As is certainly clear in hindsight, the financial markets already knew this given the rally we have seen since the September lows. 4Q 2001 GDP reported this week came in at a real growth rate of 1.7%. As you know, GDP in this country is reported in real terms. In other words, adjusted for inflation. In nominal, or absolute dollar terms, year over year GDP growth in 2001 put in one of the worst showings since the early 1960's:
We find it instructive to look at nominal trends in that we live in a nominal world. Corporate profits are not reported in "real" terms. Just how many employees do you believe have an understanding of their "real" pay when they cash their paychecks? Outside of the economic academician crowd, we'd have to say the number is pretty close to zero. In nominal terms, which is ultimately coincidental with nominal corporate profit experience, the weakness in the current GDP report relative to historical experience suggests to us that investors will need to be shown reacceleration in corporate profits experience to validate current financial asset valuations.
At least for a while, headline GDP numbers ahead are set advance strongly. As we have mentioned before, the inventory rebuild cycle is upon us. It can be seen clearly in the economic statistics of late. Unquestionably, the fourth quarter of 2001 was the beneficiary of some very special assistance in terms of stimulating macro growth. Growth that materialized in significant consumer spending on autos and housing. The 4Q period witnessed dramatically increased government spending, unusually warm weather, tax rebate and refunds, low mortgage rates than spawned significant housing refi and new purchase activity, 0% auto financing schemes, as well as low retail gasoline prices. In many cases, strong tailwinds that have now dissipated. The stimulative influences of 4Q were not met at the time with increased production, but rather a continued draw down in inventories. The fact is that during 4Q, inventory draw downs lopped 2.2% from the real GDP number. Had inventories just stayed flat, GDP would have come in at 3.9%. The slowdown in inventory deceleration and partial restocking of inventories we are witnessing in 1Q 2002 will have a positive influence on reported GDP ahead. Perhaps dramatically positive. Be prepared for a 4-5%+ 1Q 2002 GDP number because it's coming.
As always, though, it will be the translation of GDP growth into corporate profits that will matter the most for the future direction of the financial markets. From the peak, after tax "nominal" corporate profits as a percentage of nominal GDP have plunged:
There is absolutely no question in our minds that the key question for the financial markets to sort out ahead will be the question regarding a corporate profits recovery. As we have said, the financial markets have correctly discounted an academic headline economic recovery, but have they given corporations too much credit for a profits rebound? Certainly the question will be answered ahead, but in the chart above, one can see that the directional experience of corporate profits relative to GDP is similar to the plunge in nominal GDP itself. Although the financial pundits are correct in that recent economic numbers suggest a classic economic recovery, the translation into equity market attraction is another matter altogether. One historical relationship currently neglected in the mainstream is to relate the chart above to the chart below. In our book, a vital relationship.
There certainly have been a number of periods in recent US financial history where corporate profits as a percentage of GDP were well above what would be considered a historical norm. Periods of very high profitability. The mid-1940's, the early and mid-1960's, and mid and latter 1990's. In each case, these periods of well above average corporate profitability were rewarded with above average common equity valuations in the financial markets. Deservedly so. What is also clear in the charts is that these periods of above average profitability were separated by decades, not by years. So were the periods of above average valuations.
Despite "depressed" earnings of the moment, the market is implicitly expecting a return to peak profitability performance ahead given current valuation levels. So what happens if corporate profit recovery is slower than typical post recessionary experience? What happens if absolute dollar corporate profits do not accelerate quickly from here? Can current valuations levels hold? What if the macro economic recovery itself slows post the burst in inventory rebuild?
ISM-Metrics...The so-far perceptual drivers of the classic recovery thought process is the improvement in manufacturing numbers and continued stability in housing as of late. Corporate capital spending is still quite subdued at best. Likewise on the retail consumer front, revenue growth strength is seen as the province of the discount sector. Humble question: Can an economic recovery be built on the back of profit expansion at WalMart alone? Strength residing in the low margined discount community simply begs the question of an improvement in macro corporate profitability. As you know, manufacturing is certainly one of the more volatile sectors of the economy historically. Both from a revenue and employment standpoint. A more true characterization of boom and bust than not. Ultimately our economy is dependent on consumption.
For the new age market historian crowd, the Institute of Supply Management (ISM) index has decisively crossed 50 in recent months for the first time in a year and one half. (Being a diffusion index, a reading above 50 connotes expansion.) At least for now, a manufacturing recovery is in process:
The ISM (former National Association of Purchasing Managers Index) along with other purchasing indices such as the Chicago PMI, etc., have been one of the cornerstones of predictive substantiation for modern day historians. In each post recessionary period of decades past, equity markets have performed very well after the ISM has broken 50 to the upside. But, as to how the real economy relates to the current financial markets, a further turning of the very dusty pages of history reveals the following:
|Post Ressionary Date ISM Exceeds 50||S&P Return |
(based on month end data)
|S&P Price To Operating Earnings|
To no one's real surprise, the historical twist left out of the modern day message is valuation. In no post recessionary period of the last three decades has macro equity valuation been as high as we now experience. We do not debate headline economic improvement in the least. It's the ability of the stock market to move significantly higher from here that is in question. The "history" contained in the table above suggests that to attain similar post recession S&P performance, currently depressed earnings are going to have to double ahead. Players, place your bets.
The Confidence Game...Recently coinciding with improving macro economic stats has been a dramatic improvement in Consumer Confidence from the lows. Important in that consumer follow through in terms of spending, or the continuance of spending, will be a big piece of the economic puzzle ahead. In fact, the March CC reading was the largest one month jump since the period near the end of the last recession in March of 1991. With the report, the headlines were filled with quotes such as the following from an economist at one of the nation's larger banks. "It clearly suggests that consumers now believe the recession is over, and that's an important milestone". The fact is that the history of consumer confidence readings at economic bottoms is anything but precisely predictive. History suggests quite the opposite:
The fits and starts of confidence during both the early 1970's, 1980's and 1990's is as clear as a bell. In our minds, post recessionary confidence ultimately rests with employment prospects. Do consumers currently believe the recession is over because they can feel it in their job prospects, paychecks and individual business opportunities, or because they have heard it on TV and seen it in print on the front page of financial tabloids?
Without sounding too melodramatic, we're not so sure consumer confidence readings are reflecting short term movements in the equity markets. It's certainly far from perfectly correlated, but the coincidental directional movement is a bit too close to dismiss outright:
With about a one month lag (clearly due to the timing of the Conference Board survey periods), the directional change in consumer confidence approximately mirrors the directional change in the broad based equity indices. Almost like clockwork. The real question for the market is whether a survey reflective of stated optimism or pessimism will translate into needed actual corporate and consumer spending. As you know, the CC reading was hitting its lows during October and November of 2001 at the exact time auto sales were gearing up to set a one month record.
Although the current consumer confidence reading shot the headline statistic lights out, subcomponents of the survey were scurrying in the opposite direction. Despite current expectations, future expectations and business expectations rising, actual plans to buy real things fell across the board. Home buying plans fell to a reading not seen since November of 2000. Plans to buy a car fell to a nine month low. Plans to buy appliances also fell. Clearly purchasing plans are inconsistent with generally optimistic overall expectations.
Quickly referring back to the long term chart of consumer confidence above, we believe it fair to say that the volatile reality of sentiment at recessionary lows relates to real employment possibilities. As an example, the recession that ended in early 1991 did not see job growth pick up for at least a good year and one half beyond the recession end. During the recession of 1990 and on into 1991, jobless claims spiked and then stabilized at a high level for a long while post the official recession finale:
At the moment, current experience is not too far from the initially jobless recovery of the early 1990's:
This is not to say that job growth will not pick up from here, but rather that history suggesting a perfect economic recovery based on recent jobless claims experience may just be a bit premature.
The Wheel Is Spinning And You Can't Slow Down?...The last little tidbit of history as it relates to economic recoveries that often misses sensible discussion on CNBC's "squawk box" is how money and credit growth influence nominal GDP expansion. We simply will not drag you through a retrospective of money and credit expansion during the last decade plus. You already know that existing household, corporate and financial sector leverage relative to benchmarks such as GDP has no precedent in US financial history. That's fine. But what may be most important in the current environment is that money supply (ultimately reflective of credit expansion) growth is "buying" the lowest rate of nominal GDP growth seen anywhere in the last 40 years at least:
Another way of looking at this is to view the spread between year over year M3 growth and GDP growth:
Certainly credit expansion and money supply expansion have been a hallmark of economic recoveries past. Simplistically, usual pent up demand for consumer durables has lent itself to purchases financed with credit as consumers become more comfortable with job growth in an expanding economic environment. But the fact is that we have witnessed a historical anomaly during the recent economic weakness. Credit expansion and money growth never slowed in any meaningful way at all, but nominal GDP and corporate profits dropped like a rock. From our vantage point, the fact that excessive liquidity during the last few years bought us so little in terms of nominal GDP expansion is history screaming at us. History suggests that this type of leverage assumption should have bought us immediate improvement in nominal economic results. This little message of history is missing from current economic recovery headlines.
I Believe In Yesterday?...Very simplistically, we are simply arguing that we are in a period where a potential resurgence in corporate profitability is unproven at best. We are in a period where current valuations are implicitly anticipating significant improvement. Our academic economic recovery has started. Longevity, depth and ultimate acceleration remain to be seen. New media talking head converts to the "of the moment" importance of historical precedent may be conceptually guilty of violating SEC rule FD - selective disclosure. History can be a dangerous animal. We need to make sure we examine all sides to the story. And always important, we need to listen to the voice of the market as the final arbiter.
For now, the market has successfully discounted a near term macro economic rebound. From our perspective, the market still mistrusts a significant return in corporate profit acceleration as it looks ahead. After all, during this quarter that has proven to us that the economic rebound is on for now, the S&P was basically flat, the NASDAQ down and the new era institutional hiding place, the Dow, was up modestly. The macro market discounted the current economic rebound during 4Q. From a longer term standpoint, it seems that the market is now suggesting that the undisputed economic savior of the late 1990's, the Fed, is yesterday's news. Again, today's modern day history buffs have shoved the following table in a dark drawer as its only historical counterpart is a period you'd probably rather not know about:
|Date of 2001 |
Interest Rate Cut
|3 Mos.||6 Mos||1 Yr.||3 Mos.||6 Mos.||1 Yr.||3 Mos.||6 Mos.||1 Yr.|
|INDEX||Price Move From 1/3/01 to 3/28/02|
As you know, we are 15 months into one of the greatest periods of Fed accommodation ever seen in history. Is the market simply asking the economy and real corporate profitability to finally please stand up after all of these years? It appears so.