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The Profit Boom is Over
Gluskin Sheff
By David Rosenberg
March 28, 2011

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Equity markets are mixed to lower to start off the week — Europe is off fractionally while most of Asia is in the red (though the Shanghai and Kospi indices were barely higher); Asia-Pacific was down 0.5%. Concerns over production stoppages and electricity shortages in Japan seem to be at play here (see Fear of Shortages Drives Panic Buying of Japanese Goods on page B3 of today’s NYT). Even so, bond markets are also trading quite defensively today. The dollar is embarking on a countertrend rally, partly because it became hugely oversold (are there really buyers of the euro at 1.40+?).

St. Louis Federal Reserve Bank President Bullard became the latest to vocally support the end of any further quantitative easing programs (this followed Philly Fed Plosser’s comments — he is an FOMC voter — that the Fed should actually begin to raise rates soon!). The tone from the Fed of late has been a tad hawkish, to be sure. And the euro right now is contending with the implications for further sovereign debt bailouts in view of Angela Merkel’s growing political problems as her CDU party was crushed in the Baden-Wurttemberg elections, garnering just 39% of the vote in the worst showing since 1952 and eradiating its long-standing majority in the region (have a look at Poll Defeat Fuels Merkel’s Critics on page 4 of the FT). Mr. Sarkozy also faces signs of dissident as the French socialist party emerged victorious in France’s municipal elections over the weekend. The oil price is slipping a tad as the rebels in Libya score some more military points in the quest with NATO to remove Gaddafi from power.

On the data front, it was a very light start to a hectic week — U.K. business confidence declined in March to a two-year low with Sterling taking a hit on the news. The dollar’s strength is cutting into the commodity complex and the resource-based currencies. While the news of the Canadian election may have undercut the loonie, the reality is that the polls now suggest that the Conservatives either retain their strong minority or perhaps even gain a majority — when this happened in the fall of 1984, the Canadian dollar went on for a very nice rally in the ensuing four-week bout of market euphoria.


A seven-quarter run of positive profit growth ― six were double-digits ― came to an end in the fourth quarter as pre-tax corporate profits in the U.S.A. sagged at a 10% annual rate (looking at corporate earnings before tax without inventory valuation and capital consumption adjustments). That was the first decline since the fourth quarter of 2008. The YoY growth rate is still healthy at +16% but off the boil, that is for sure.

For all the talk about how the overseas economy has been the main driver of U.S. profit growth; that has very quickly become yesterday’s story. On a national accounts basis, which provides the broadest picture of U.S. corporate profits, earnings derived abroad actually fell at a 9.5% annual rate and that followed an 8.8% decline in Q3. The sharper economic recovery overseas played an equally large role this cycle in fuelling U.S. production growth, but this support does seem to be subsiding — have a look at page A2 of today’s WSJ (Foreign Shocks Temper America’s Export-Led Rebound).

By sector, the profit leaders in Q4 were by far the financials, followed by metals, tech, machinery, and energy. The areas with minus signs attached to their profit performance included transports, retail, autos, electrical equipment and chemical products.


The final figure for the University of Michigan consumer sentiment index came in below expected, at 67.5 in March (the preliminary number was 68.2 ― the consensus was looking for 68.0). This was a huge 10 point drop from the February level of 77.5 and consumer sentiment now stands at its lowest level since November 2009 when the economy was barely emerging from the worst recession since the 1930s. Take a look at the chart below and you will see that consumer sentiment is: (i) below the worst levels of the 2001 recession, and (ii) in line with the troughs posted during the 1990-91 downturn.

It’s not just the level but the change. Ten point plunges happen rarely, and when they do, the economy is either in recession or about to head into one, believe it or not. The lone exception was in September 2005 ― when Hurricane Katrina hit. Outside of that, declines of this magnitude only happened in October 2008, September 2001, August 1990, December 1980 and March 1980. As an aside, the slide in March actually slightly surpassed the 9.7 point plunge after 9/11, the Worldcom/Enron fiasco in October 2002 (-5.5 points) and the stock market collapse in October 1987 (-4.3 points). Just to put this into some kind of perspective. The equity market did take a bit of a stumble in March but a 6% dip followed by a rebound should not have been much of a factor. What could be at play here are four things.

1. Home prices are sliding again and two-thirds of Americans are homeowners.

2. Gasoline prices have surged and other surveys show that households are already cutting back on discretionary spending as a result. Inflation expectations have risen to nearly a three-year high of 3.2% (five-year median) from 2.9% in February, and there is a 30% inverse correlation between this component and the headline consumer sentiment reading.

3. Real average weekly earnings have contracted now for four months in a row. And, as the chart below illustrates, the index measuring expectations for “real family income” slid to 58 in March from 60 in February and 64 at the end of 2010. Only one other time in the last 30 years have we seen this subindex so low and that was in June 2008.

4. While jobless claims have trended down, new hirings are not improving based on the broadest surveys we have. Moreover, unless productivity growth is tailing off, why would anyone expect job creation to accelerate with the pace of overall activity slowing down from over 3% in Q4 to something closer to 2.5% this quarter and very likely a post-fiscal-stimulus hangover that leads to even slower growth the next quarter?


In addition, the internals of the University of Michigan report were very soft, especially when it comes to depicting the future:

• 27% see higher unemployment ahead; 22% see it declining (mostly economists!);

• 53% see lower real incomes in coming months; 11% see increases;

• 25% cite business conditions as deteriorating; 21% see it improving;

• 12% rate government policy as “good”; 41% say “poor” (in November 2008 these figures were 6%, and 55%, respectively) ― not good news at all for the White House then, and not now either.

In this environment, the question is, how can anyone believe that interest rates can go up? Well (and this is a great contrary indicator for the bond market), 53% believe rates are going up and a mere 7% see them going down from here. These are almost the same numbers we had in April 2010 and the yield on the 10-year Treasury note went on to rally about 160 basis points in the next six months.

The sharp drop in consumer sentiment in March was broadly based across all socio-economic groups and regions, but what really caught our eye and supports the notion that gasoline prices are at play here, was that sentiment among low

The “expectations” component absolutely fell out of bed ― sliding 13.7 points to 57.9. Only three other times in the data’s history have we seen such a decline, and as for the level, we are back to March 2009 when the recession was at its worst point. Again, following the 9/11 tragedy, the decline was 11.7 points. Incredible. The difference is that, back then, we did have a market that responded to the incoming economic data.

Note that the University of Michigan “expectations” component leads consumer spending with a 75% correlation going back to the 1990s. A further big slowdown in spending is coming our way, in our view.


It is interesting to see the U.S. stock market rip. The correction is yesterday’s story and momentum has clearly taken over. In each of the past three days and on days when poor economic data releases came out (home sales, durable goods and consumer sentiment). Now we see that the good old ECRI weekly leading index has stopped going up, and this is happening along with the downward revisions to real GDP forecasts and the stalling-out and moderate reversal in analyst upside-downside EPS revisions. The “spot” ECRI index is down in each of the past two weeks and three of the past four weeks; the “smoothed” index just turned in only its second decline since the ‘double-dip days’ of last August.

Momentum seems to have taken over. Real GDP forecasts are coming down. Profits in Q4 actually contracted sequentially, and analysts are no longer taking up their EPS numbers. It is an interesting market, no question ― and probably more dangerous now than any other time this cycle. Or maybe I just spend too much time thinking about risk. Nobody else seems to talk much about it any more. But the outlook is fraught with risk and many investors cannot see the forest past the trees and are ostensibly still tempted to play into the short-term euphoric behaviour of the market place. much time thinking about risk. Nobody else seems to talk much about it any more. But the outlook is fraught with risk and many investors cannot see the forest past the trees and are ostensibly still tempted to play into the short-term euphoric behaviour of the market place. Syria Crackdown as Unrest Spreads (front page of weekend FT).


It has been impressive ― through all the adverse global political news, weak U.S. leadership, spurious U.S. data releases, the S&P 500 has managed to rebound 4.5% from the recent lows. The major averages rose more than 2% last week but let’s keep in mind that they are also down over 2% from the time of the Japanese disaster.

The volume has been extremely light, and in fact, was near 2011 low on Friday (down 6% on the major exchanges).

The VIX index has just undergone its sharpest seven-day decline on record and down 40% from the recent post-Japan crisis high back on March 16th. Yet a cursory glance at the headlines would suggest that if anything, the risk is now for heightened volatility ahead. To wit:

• Japan Accelerates Evacuation Around Nuclear Plant Amid Fresh Leak Fears (front page of the weekend FT).

• Starvation Risk Seen in Korea (weekend WSJ, page A11).

• Tokyo Residents Grapple With Shortage of Life’s Basics (weekend WSJ, page A8).

• Crackdown on Bahrain Unrest (weekend FT, page 2).

• Riot Police in Jordan Clear Camp of Protesters (Saturday NYT, page A8). Syria Crackdown as Unrest Spreads (front page of weekend FT).

• Japan Accelerates Evacuation Around Nuclear Plant Amid Fresh Leak Fears (front page of the weekend FT).

• Starvation Risk Seen in Korea (weekend WSJ, page A11).

• Tokyo Residents Grapple With Shortage of Life’s Basics (weekend WSJ, page A8).

• Crackdown on Bahrain Unrest (weekend FT, page 2).

• Riot Police in Jordan Clear Camp of Protesters (Saturday NYT, page A8).


Whether you are perma bull or perma bear or everyone in between, the column by Paul Lim in the Sunday NYT business section (The Bounce Isn’t Enough to Recover From a Bubble on page 4) states that fully recovering from a bubble burst usually takes a long, long time, notwithstanding the flashy 100% rally from the March 2009 lows. The economic recovery is less than spectacular, and in fact, ranks as one of the poorest ever ― 3% growth so far whereas GDP usually expands at a 5.5% pace. And outside of exports, no real economic variable is close to coming in anywhere near the levels prevailing before the recession began in 2007 (and the revisions the Fed made to the industrial production statistics on Friday show that output is further away from the cycle highs than previously thought ― by an additional 2.6 percentage points (now IP is down 7.6% from the pre-recession peak). The data up until January were looking okay but since that time the vast majority of economic indicators have come in below expectations. Look for nonfarm payrolls to disappoint, yet again, this Friday (consensus around 200k).

Also have a look at page B9 of the weekend WSJ ― Stocks: Bracing for Falling Profits. And then go back and have a look at Bob Farrell’s Rule 1 ― the concept of mean reversion. Profits relative to GDP stand at a historical high of 12.7% compared with the long-run norm of 10.5%; while S&P 500 margins at 8.2% are also far above the historical average of 6.1%.


Well, let’s just say that the eurozone really does not have a concrete strategy to deal with its sovereign debt crisis (see EU Draft Lacks Details on Bailouts on page A11 of the weekend WSJ). It is apparent that Angela Merkel is dramatically losing support at home for funding any more bailouts for member states. No doubt there is enough in the rescue fund to help out Portugal ― a bailout estimated at $80 billion ― but now all eyes will turn to Spain where the housing market and banking system (cajas) is in tatters and heavily exposed to Portuguese debt.


The events in the Middle East are such that the geopolitical risk premium in the oil price is not going to subside anytime soon. In fact, it could well intensify depending on what happens in Bahrain and the Shiite demonstrators are surely looking at the insurrection in places like Syria and now Jordan. And Chinese corn imports are about to hit a 15-year high, which will only serve to exacerbate the exceedingly tight global grain markets. Hundred dollar oil and seven dollar corn is going to take a very big toll on U.S. consumer spending in coming months. Forewarned is forearmed.



(c) Gluskin Sheff


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