Earnings Dictate the Market

"I'm living so far beyond my income that we may almost be said to be living apart." - E.E. Cummings

It is common knowledge that stock prices are based on company earnings and earnings potential.  The metric often used is the P/E ratio or the Price to Earnings ratio where a stocks price is divided by the company earnings.  The higher the future earnings potential the higher the stock price as investor bid up the price of shares in expectation of future earnings streams.  For this reason you often witness high flying stocks with P/E ratios at 200 plus and growth rates to match while low growth stocks often only command P/E ratios in the low double digits.  Mature companies that make up the S&P 500 usually hover around 15 which is considered a normal price level.  Anything higher than this number shows a market that is overvalued and lower than that shows a market that might be a buying opportunity.  This is all very basic and cut and dry but the market is anything but that as people's expectations of economic growth and their confidence dictate how high or low the market can go.  One thing that shines through is that the earnings of companies dictate the price of the stock and this determines the direction of the market.

Looking at the earnings coming out of the S&P 500 during the past few weeks and it is clear that company earnings are slowing.  With it the market is gasping for air and the oxygen is being provided by repeated Federal Reserve stimulus packages and low interest rates.  It is hoped that this stimulus will keep a bull market that by any metrics is very long in the tooth afloat, but as the graph below shows this is a long shot. (The chart is provided by href
='http://www.macrotrends.net/1324/s-p-500-earnings-history'>Source: MacroTrends)

The dark line is the S&P 500 index while the light line is the S&P 500 earnings.  As you can see the market moves in tandem with earnings.  You may also notice that the company earnings have faltered in recent quarters and that this is the first time that this has happened since the beginning of the recovery.  Admittedly earnings were incredibly low at the trough in 2009 but still to recover to new highs in such a quick time was incredible and could not be sustained.

The issue as I mentioned above is that when things are good and expected to continue, investors pay up for the promise of future growth.  This translates into a P/E in excess of 15.  At present and based on the current market price the S&P 500 P/E stands at roughly 22 well above its normal price.  This must mean that the market expects earnings growth to continue to accelerate to new highs.  Should this perception be met with continued poor earnings then the reverse will occur and the P/E will drop to below 15 plus earnings contraction will take the index even lower, the so called double whammy.  Assuming that earnings contract to $90 (from $94) and the P/E ratio falls to 15 (I do not want to get overly aggressive) then the S&P 500 index would fall to 1,350 from 2,200 or 40%.

As I cannot see why earnings will resume any time soon I have to conclude that this is more than probable and that the market is being held together with Federal Reserve loose money policies and at some point these too must end!

Adrift - Part III

"What Wall Street is, their market makers.  Wall Street's business model is making money on the velocity of money.  They're a click industry.  That's what Wall Street is.  They make a lot of money when there's a lot of turnover.  And they make a lot of money when that velocity is fast." - Laurence D. Fink

As we have seen in the previous two blogs the world is awash with debt and dollars and the problems associated with these are rapidly coming to the fore.  So why do the central bankers of the world think that continuing down the same asinine path will actually work?  I believe that it all comes down to the expectation that the velocity of money will turn its head up at some point creating the windfall everyone expects.  As you can see from the chart below the velocity of money has been in a tailspin for the past 15 years.  Dissecting this further you can see that entering the 1990's velocity of money was relatively stable.  The years prior were relatively quiet on the debt front with central bankers tinkering with free exchange rates and leaving the gold standard.  Once all of this was done they were free to explode onto the scene armed with the modern tools of economic warfare; control over interest rates and the money supply.  

Now no man is ever going to let his toys lie idle so they put them to work and under Greenspan the games began.  At first the velocity of money went into orbit as fresh dollars came into the market providing the stimulus that was expected.  In fact the stimulus worked so well that money velocity exploded higher through 2000 creating the NASDAQ bubble.  Once this burst the theory was that a little more debt ("stimulus") would fix the problem (it had before right?) and so more money was added.  This time however the amount of money required far exceeded the paltry $40 billion of the first test but velocity bounced creating the second bubble, the housing bubble (see the bounce in the velocity of money around the time of the housing bubble).  After this bubble burst the theory has been that more money should be added (as it worked the first and second time right?).  The thought is that once the velocity of money increases it will return us all to prosperity (read another bubble).

The problem with this theory is that the utility function of new money has not only lost its ability to provide stimulus but the amount of money has crowded out the private market, both of which have resulted in a velocity of money that continues to historic lows.  Adding more money to this pot of debt will not make it taste better; as any chef knows, adding more salt into a stew does not make it less salty!  As an aside the utility function refers to the perceived value of adding one more dollar to a person’s net worth.  So for example giving a dollar to a beggar will be meaningful but giving the same amount to a billionaire will be meaningless. 

Now should this velocity of money return to normal levels, based on the amount of “stimulus” ($30 trillion and counting) there would be massive bubbles across the globe.  It would be the boom of all times and it would all end in one massive global depression.  This however is what the central bankers of the world are hoping for, a return to "normal" velocity levels, but they they believe (unlike me) that that they can somehow control everything with their useless tools and provide us with a soft landing.  Furthermore the prosperity will result in such a tax and economic windfall that all debts can be brought down to normal levels avoiding any calamities.  Their argument is to print more money – just give it more time and it will work.  

As we have seen in the past two blogs the pot is boiling over with little effect and so until they get their hands out of the pot there will be little in the way of growth and more than likely a debt laden slowdown and possible deflation.  In the meantime should a recession appear on the horizon they have no new tools with which to assist so this time around the markets will be left to sort themselves out and that will cause a lot of pain.

Adrift - Part II

"Let every man, every corporation, and especially let every village, town and city, every county and State, get out of debt and keep out of debt.  It is the debtor that is ruined by hard times." - Rutherford B. Hayes 

In order to stimulate the global economy it has been decided by the Federal Reserve and other central bankers that the only way is to print and monetize debt.  Back in 2005 the global public total debt was $27 trillion.  Ten years later this amount has more than doubled to $57 trillion.  As I mentioned in last week’s blog a lot of this debt is dollar denominated and while the “external” dollars are loosely controlled by the Federal Reserve there is still a level of control far in excess of the US's global economic clout.  This massive debt experiment was supposed to have achieved full employment and global prosperity but it seems to have done anything but that.

Taking a look at the incredibly weak employment numbers coming out of the US and one can see that things are anything but rosy.  Furthermore more than 94 million Americans or 38% of the total workforce are not even looking for work.  This is the lowest labor participation rate 38 years!  Inflation (according to the Federal Reserve) is close to a deflationary number and in many parts of the globe deflation has already taken hold.  In many countries interest rates are negative and still there is no end in sight to the low interest rate environment or even how low these rates can go.  I continue to believe that rates will go even lower for the simple reason that the global economy cannot be repaired with more debt.

As I have mentioned before adding more debt has the effect of crowding out market participants, clogging up the wheels of free enterprise and creating a drag on global growth.  In a chilling statistic the large cap stocks of the S&P 500 as a group paid out through stock buy backs and dividends all of their operating earnings last quarter.  No money was therefore spent on capital from which to grow.  Capital spending includes research and development, capital projects, factory expansions and heavy equipment and machinery purchases.  Money for operations was found in the debt market and used to buy stocks and pay dividends.  No wonder there is an ever increasing social divide!

This party is a massive problem for many reasons however it can last for years as long as low interest rates remain the norm.  Furthermore if those low interest rates are locked in for 20 or 30 years then there is also a benefit however this is not the case.  In fact there is almost $2 trillion of corporate debt coming due between now and the end of next year.  Now it appears that interest rates will remain low through that time however the spread between investment grade credit and junk is starting to widen to levels that are going to cause problems for a number of the companies planning to refinance.  This increasing spread is an indication that not all is well in the credit world and that there may be problems looming.  Should the Federal Reserve raise rates not only will this lead to a large increase in company defaults but the government itself would see a large increase in the deficit as the interest paid on its massive $18 trillion debt would rise pretty quickly. 

The main issue though is that at some point debt becomes deflationary and I think that we may have already reached that level.  Think about it in terms of your personal finances; if you are burdened with debt you cannot spend money on goods and services but are forced to pay down the debt.  The same occurs with businesses and, at some stage, government.  Companies already seem to have lost the incentive to grow their businesses mainly because there is no perceived or anticipated global GDP growth.  Instead they are juicing their numbers and their upper management with dividends and stock buy backs.  The has or will lead to a situation where companies are so burdened with debt that instead of using profits to fund growth it is used to pay down debt.  

The same happens with governments; they have issued so much debt that they are crowding the corporate world out and are getting to a tipping point where they will need to start to repay their debt.  With all eyes focused on paying the debt back not only is this not inflationary it in fact leads to deflation and slow growth both of which are being witnessed before our eyes.  Until there is some expectation of global growth large businesses will continue their financial trickery widening the social divide and removing any chance of a return to normalcy.

Adrift in Debt - Part I

"So you think that money is the root of all evil? Have you ever asked who is the root of all money?" - Ayn Rand

As the world is awash with debt and dollars I decided to take a look at the impact that all of this is having on global growth.  If one considers that the financial crisis occurred in 2008 / 2009 you would expect that by now with more than USD 27 trillion of new capital issued by the central bankers of the world that the global economy would be booming.  Furthermore you would also expect that by now central bankers of the world would be fighting the inflationary pressures of low unemployment and capacity constraints by raising interest rates and tightening the money supply however, as we all know, this is not the case.  In fact the global market is so weak that the Federal Reserve decided that it could not handle even a ¼% increase!

Delving into the facts and figures brought me to the conclusion that it would be impossible to take all of this on in one blog (well actually I could have but I doubt anyone would read all the way to the end) so I have broken my findings into three.  The first blog published below will deal with the currency market, the second blog will deal with the global debt and the third blog will pull all the findings together in a conclusion that will provide some insight into what I believe the future holds.

In today’s world there is one currency that transcends all others and it is the United States Dollar.  Trillions of dollars of transactions occur around the clock and around the globe all denominated in dollars.  In fact in a recent report the Economist Magazine estimated that more than 60% of all global trade is conducted in dollars.  If one looks at the dollar market it can be broken into two pieces; those that are issued by the US Treasury and those created with a stroke of the pen in banks outside the United States.  These so called Euro or Asian dollars are backed by the bank issuing the dollars rather than by the US Treasury but they are still dollars and can be exchanged as real currency.  This second set of dollars used to be quite small in value but now estimates place the size of these “external” dollars at roughly 60% the size of those issued by the US.

The reason countries hold these dollars is for ease of trade but also to hedge against movements in the value of the dollar itself.  Back in 1997 when the contagion of the emerging market currencies was in full force countries decided that the best way to protect their currency was to hold a lot of dollar reserves.  These can be used to mitigate massive currency swings and also can be used to acquire strategic resources if the local currency devalues sharply.  The idea is that if you can control your currency swings you can control the level of economic growth.  This theory was put into practice and worked well for a while however recent events have shown that there is a problem with this theory; you are now open to the vagaries of the Federal Reserve.

As we have seen, with the US economy being the supposed shining beacon in a world of poor economic results, dollars can move easily back to the mother-ship stranding the emerging economies and destroying their currencies.  Furthermore as the dollar gains strength the commodities and inputs so desperately needed become more and more expensive crippling the local economy further.  At the very moment that the local country is hurting most the Federal Reserve raises rates creating further havoc in the local economy.  With the economy in tatters dollars pour out of the weak economy to the strength and higher returns of the USA and so the spiral continues.

We have already witnessed this to some degree as the currencies of many emerging economies have seen both their currency and their economies crater as the world waits to see if the Federal Reserve will raise rates.  For this reason the Federal Reserve has more control over the global markets than most people seem to realize which is why I have repeatedly mentioned that they need to look more globally when raising rates.  So while the US economy is losing ground as a percent of global GDP the Federal Reserve is still in control of a large portion of the globe's destiny due to the massive amount of trade handled in dollars and their veto power at the World Bank and the IMF (both of which are in a serious state of neglect and under funding).  Interestingly then at the time when the US so desperately needs to show global leadership they are more intent on political infighting and this will have a massively negative impact on global growth for years to come.

Amazing

"Sometimes it takes the worst pain to bring about the best change." - Anonymous

Today the US economy sputtered out truly weak employment numbers.  This was followed up with a 1.7% factory order contraction.  Neither should have come as much of a surprise but what is amazing is the recovery in the stock market.  Initially the market sold off almost 1.5% before staging a massive recovery and accelerating into the black on the basis of a rally in the NASDAQ.

What is amazing to me is that anyone is buying stocks at these levels and particularly in the face of weak economic numbers and a future that is looking increasingly weak.  I understand that the stock market is forward looking so it must be seeing a new round of quantitative easing coming as there is nothing that I can see that should spark a rally outside of the Ponzi scheme that is Federal Reserve money laundering.

Let's take a look at what the market faces from here; the weak oil prices will continue to put a lid on any growth out of that sector while providing some relief for the consumers, however with the weakness in the economy coming from the strength in the dollar layoffs should continue undermining the resilience of the consumer.  Furthermore China, Europe and Japan are slowing so limited growth can be expected from those regions.  Weakness will continue in emerging markets as the strong dollar is creating havoc with those financial markets and their access to capital; money is repatriated to the safe haven of the US hurting access to capital forcing governments to raise rates to protect their currencies.  Corporate earnings season is also about to start and we should start to see the impact of a slowdown overseas plus a strong dollar so I expect those to be weak. Finally margin cash is at an all time high so the ability to continue to buy stocks is limited.

With all of this bad news it certainly is a wonder that the market participants see a reason to buy but that is exactly what they are doing this afternoon.  Who cares about all of the above when you are convinced that the Federal Reserve will once again step in to rescue the poor and needy investment bankers.  The fact that after more than $4 trillion dollars of stimulus we are still grinding forward is of no concern to anyone it seems.  In fact the Federal Reserve is still talking up the coming interest rate hike and this is right after they voted 9 to 1 against raising rates at the last meeting!  Market strength is coming from the massively over valued bio tech sector so I guess market participants are finding a last banner of hope on which to fly their flags.  It is certainly working for now but don't get fooled.

Another interesting fact is that the government will spend nearly $4 trillion this year while collecting roughly $3.5 trillion.  These are records by the way.  Tax revenues are up 25% since the market crisis but our leaders have managed to increase their spending by 33%, way to go!  By now we should be firmly into budget surplus particularly when you are borrowing money at close to zero.  If interest rates were to rise we would quickly see this deficit balloon back into the trillions as the cost to the government of a 1% increase in borrowing costs is $200 billion.  Were we in a budget surplus position right now I would have to say stocks would be the way to go but with all of the above it is truly a marvel to me to see the market rally.

I guess I should not be surprised but even after all of these years it can still amaze me to see resilience fly in the face of reason but, more often than not, reason wins out.  So for now I will remain firmly on the sidelines and watch with amazement as the global experiment that is money printing plays its manipulative tune on the markets.