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When Profits go Poof

Wall Street executives are always creatively stating reasons why investors should buy stocks. Because corporate profits have been so good, they want investors to look forward to the inevitable year-end stock market rally and forget any negativity they've heard about investing in stocks, or rising interest rates. It's not necessary to look to the future they say; just close your eyes and buy now!

When looking in my rear view mirror, I have to admit that profits made on Wall Street have been great. Indeed, as a percent of GDP, profits are pushing a record. Following are some reasons why this has occurred:

--> Making money in banking and finance was a breeze when the fed funds rate was 1 percent and the yield curve was steep;

--> The housing bubble has created economic growth and job gains through the building of new homes, the hiring of mortgage bankers, and the issuance of 400,000 more real estate brokerage licenses (America now has over 1.2 million real estate agents who make over $60 billion in commissions a year;

--> Home equity extraction (in 2004 alone, Americans took out $600 billion);

--> The Trade deficit in the United States has given the Chinese, and the rest of the world, mountains of dollars with which to buy oil and other commodities.

Next year, however, could be a totally different vehicle as this profit engine runs out of gas. Much too much profit has been made in energy and finance. These profits won't last. In addition, the high cost of gas, heating oil, and natural gas (especially as we approach the home heating season), will drag down consumer spending, while increased producer prices dig into corporate profits. Quick energy profits today will come at the expense of every other industry's profits tomorrow!

The financial industry has grown fat on the carry trade. Low short-term interest rates have made it easy for banks and Wall Street to borrow short and lend long. Indeed, everybody has gotten into the financing act; 40 percent of S&P reported profits are from financing activities. With the fed funds rate at 4 percent and rising, the domestic carry trade is dying and there is little to be made borrowing short-term and lending long-term. Moreover, at current credit spreads, there is very little profit to be made borrowing at a high credit rating and lending to a lower credit rating. Making marginal loans today, means only loan losses tomorrow.

This past year, banks and financial institutions have kept their reported profits growing by running down loss reserves, and playing games with derivatives. The joy of derivatives is that a financial institution can always enter into a trade that shows a profit today, even though the likelihood of a loss tomorrow is virtually certain and potentially catastrophic. All those institutions that accepted a fixed interest rate and agreed to pay a floating rate (based on the Federal Funds rate), are starting to suffer as the Fed raises floating rates. Buyers of synthetic CDO equity and insurers against credit default will also see easy profits vanish as the credit cycle turns.

For financial institutions, REFCO is a stunning example of how loans and accounting can be used to hide losses. One can only imagine that as interest rates rise into 2006, there are likely to be some spectacular financial fire works. Much of the profits from financing activities are about to go up in smoke!

The next problem for corporate profits is growth in corporate sales. It's really hard to keep profits growing when consumers don't have the money to buy the goods and services. The consumer, who has been spending more than they make and living off home equity extraction for the past two years, is tapped out. Their debt service is already a record - over 125 percent of disposable income - and is still rising. Borrowers will also be getting hit by higher monthly credit card minimum payments by year-end, and homeowners with adjustable rate mortgages can certainly count on higher interest rates.

Wages and salary growth obviously affect consumer spending and corporate profits in a big way. However, wages haven't kept up with inflation, and high paying manufacturing jobs are still heading to Asia. A clear indication of this is Wal-Mart's announcement for an increase in the minimum wage. The cynics view this request as a ploy to raise the payroll costs at Wal-Mart's competitors. The realists clearly see this move is intended to increase Wal-Mart's sales because their core customer base would be taking home a bigger paycheck and, thus, spending it in their store.

Corporate profits in the United States increased as the dollar depreciated in value. Now that the dollar is rising in value (the dollar is back to a 2-year high against major foreign currencies), profits will be harder to come by. The dollar is particularly strong against the Japanese Yen, where the Yen dollar carry trade - the ability to borrow Yen at almost 0 percent and invest in dollar assets at 4, 5 or 6 percent - is pushing the dollar up and the Yen down.

Today, Japanese cars are even made better than American cars and their prices are going down while sales increase. Toyota is now the number one automobile company in the world, and Detroit is still rotting at the core. Sport Ute sales at GM and Ford are off as much as 40 percent, and these auto makers and their workers are on the road to ruin. A rising dollar makes our country's trade deficit worse and pushes down corporate profits while sending jobs abroad!

If the outlook for corporate profits weren't bad enough, evidence is mounting that many housing markets peaked in June and July and home sales are now at prices 5 percent below the peak! When home prices are rising, taking out a home equity loan is equivalent to a homeowner giving themselves a bonus or winning the lottery. When prices decline, taking out a home equity loan is clearly an act of desperation needed to raise cash to pay the bills! Housing has truly driven the U.S. economy. Construction spending is estimated to be over a trillion dollars a year (building one new house may add 20 jobs to the economy when all the materials, transportation and labor are factored in), and residential construction makes up about 70 percent of this amount. However, last quarter results show residential construction is down from its peak.

It certainly appears that economic and business profit cycles have peaked. Falling corporate profits and rising interest rates at this stage of the economic cycle are not a "wall of worry" to be climbed, but rather a brick wall that investors are headed for at high speed.

So, if you understand that profit growth and the level of interest rates are important for stock prices, any year-end rally looks like a great time to sell stocks! Also, if you understand that rising consumer spending is required for rising corporate profits, the tooth fairy will need to leave plenty of dollars, not dimes, under our pillows. Cash under the pillow or in the bank is the only rational place to leave those dollars as we rest and wait for better opportunities. Besides, cash will soon offer a risk free 4.5 percent!

Sweet Dreams!

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