On more than a few occasions prior to the collapse in share prices that began in October, I highlighted the disconnect between credit markets and the economy, on the one hand, and the stock market, on the other. I also anticipated that equity investors would eventually have their ignorance spelled out for all the world to see when -- not if -- stock prices played downside catch-up with a bearish reality.
In my view, we are nearing another one of those "closing of the gap" moments. Among other things, optimistic share traders have bet that: 1) the unraveling credit markets have it wrong, even though they have been the best leading indicator of what is to come from the very beginning; 2) we face a mild, garden variety downturn, even though evidence suggests a nasty, consumer-led recession is on the cards; and, 3) the Fed will save the day -- as it has done in the past -- even though the facts suggest the central bank is behind the curve, in panic mode, and lacking the tools to deal effectively with an insolvency crisis.
Aside from that is the almost surreal unwillingness by equity investors to accept that the profits companies made in recent years have been out-sized and unsustainable, especially in an environment where the consumer is scaling back hard and the notion of global "decoupling" has been dismissed as the psychotic rant of Wall Street economists who drank too much ivory-tower Kool-Aid or who had not given up the mind-altering "recreational" drugs of their younger years.
In "US Earnings," the Financial Times' Lex column explores the misguided -- or delusional -- notion that corporate bottom lines are set to improve, thus helping rather than hurting share prices in the months ahead.
When an economic rough patch looms, optimists visualise a “v”-shaped chart, with a sharp correction downwards followed immediately by a vigorous bounce back. Such psychology is reflected in profit forecasts for the S&P 500. Earnings probably fell by 21 per cent year-on-year in the fourth quarter of 2007, according to data from Thomson Financial. Come the third quarter of 2008, however, and we are apparently back to the races, with growth of almost 19 per cent.
Growing earnings is easier once they have been massacred. Financials have just absorbed huge write-downs, so a second half rebound in 2008 looks plausible. Similar optimism on non-financial sectors, however, looks overdone. As Citigroup points out, stripping out the financials, S&P 500 earnings appear to have actually expanded by 10 per cent in the last quarter – so no easy comparator there. In 2008 the “real” sectors of the S&P 500 are forecast, in aggregate, to expand earnings at a racy 13 per cent.
More than two-thirds of that gain is expected to come from consumer discretionary, energy, industrials, and IT. The first of these sectors, however, must continue dealing with home price depreciation and rising credit delinquencies. With regard to energy, it is unlikely average oil price gains will outpace industry cost inflation this year, while refiners will be hurt by flat US demand for fuels. As for the other sectors, it seems unlikely capital spending will save the day when credit is tight and consumption growth is slowing. There may be a lag involved, as order backlogs are worked off, but new demand will probably slow. The jury remains out on how well international growth can weather a US slowdown.
The backdrop is that corporate profits relative to US gross domestic product are already at a four-decade high. Believing that they will rise further, by recording another year of outsized earnings growth in the midst of a slowdown, looks untenable. Expect expectations to be reined in this summer.
The decoupling debate is interesting. Wall Street-aligned economists have embraced decoupling as a thesis for why the gravy train can keep right on rolling for equities, and the US financial economy as a whole.
But we are certainly already past that point. The gravy train has derailed. And the world financial economy is already completely globalized, so whatever happens here happens everywhere (hence the subprime collapse ping-ponging around Europe).
Still, there is one valid point to consider for "decoupling": the real economies of surplus countries are unlikely to face the same impact the real economies of the US and other current account deficit countries are in store for. Surplus countries have to adjust to an abundance of wealth, not a lack of it. And the sooner they stop subsidizing the US and the rest of the anglosphere, the sooner they can spend their capital resources on realizing a real wealth increase at home.
E.g., to attempt to smooth over a collapse here in the US, we have to print or borrow money, a zero or negative-sum game. To boost ailing exporters in China, they could either use their surplus to subsidize them, or subsidize workers or natural resources generally.
Thus I see financial turmoil for all, but far less real economy damage for the surplus countries.
Posted by: Aaron Krowne | February 22, 2008 at 05:52 PM