2013 US Financial Markets: Part 2 - The TINA Hypothesis
Contrary to the “Bernanke Illusion” (money market funds are a zero return investment), history indicates that money market funds are likely to provide investors with returns approximating inflation over the next decade. As I pointed out in our last letter, the markets are pricing in inflation levels significantly higher than the prospective total returns of 10 year TBonds. The small additional return achieved by corporate bonds or US stocks (at current prices) is unlikely to compensate a buy and hold investor with sufficient gains to justify the interim risks. Much like the EBITDA (earnings before interest, taxes, depreciation and amortization) fantasy that investors used to justify the internet bubble, the TINA Hypothesis ( T here I s N o A lternative to stocks ) hypothesis has fueled the extreme overvaluation of the US stock market.
Since our last letter, US stocks have suffered a minor correction while gold prices briefly retreated below $1400/oz. TBonds have enjoyed a small temporary bounce in response to the stock correction (as usually occurs during a stock decline). Just because money market funds are a superior choice for buy and hold investors at current prices, does not mean we intend to remain in money markets for the next decade. Stock prices will soon retreat to levels that offer very attractive investment opportunities, while bond prices will retreat to acceptable levels.
In the near term this presents investors with an incredible opportunity to take profits on any remaining bond holdings (before interest rates rise). There is no particular reason to believe that gold prices have bottomed or will rally quickly, however gold is now cheap enough to start accumulating a position that will provide substantial long-term gains. Even the Japanese stock market (where we remain invested) will suffer some short-term setbacks in response to the declining US equity market. Those setbacks are buying opportunities. Finally, US stocks have farther to fall. Possibly much farther. That decline will present another amazing opportunity for those of us with large money market positions to reposition into stocks (as we did in late 2008/early 2009) and enjoy great returns. In this issue I will flesh out the details of why the next 12 to 18 months are likely to be costly for anyone still heavily invested in the US stock market.
The TINA Hypothesis takes the position that the only US financial asset offering potential gains is the stock market considering money market funds are returning zero and bond yields are at levels so low there is no potential
for appreciation beyond current coupons. On a purely theoretical basis, the limits on bond gains are certainly true, but the zero interest on money markets is only true if your investment horizon is very short, and the potential for stock market gains relies on a whole cache of conjectures about corporate earnings and the multiples of those earnings that investors will pay to own equities.
By definition, stock (or stock index) prices are the mathematical product of corporate earnings times something called the price-earnings (P/E) multiple (which represents how much investors will pay for those earnings).
Price (P) / Earnings (E) = (P/E) Multiple Price = Earnings X PE Multiple
The P/E Multiple represents the value of stocks as opposed to the price of stocks.
Earnings can only be determined accurately by generally accepted accounting practices after the fact. Of course this doesn’t stop analysts like me from predicting future earnings trends. How much investors are willing to pay for stocks (the P/E multiple) is largely dependent on two things:
- Alternative investment returns
- Their expectation that future earnings will exceed or fall short of earnings that have already been achieved
Investors have largely chosen to ignore the fact that US corporate earnings have been trending lower during the last few quarters. Instead they have focused on earnings forecasts and what they erroneously perceive as the lack of desirable investment alternatives (TINA).
Some financial calculations (i.e. “operating earnings”) are referred to by analysts and the financial press as if they represent actual earnings. Operating Earnings are effectively a calculation of what a company wouldhave earned if it didn’t have some particular expense(s) that is unlikely to recur in the near future. The fact that this particular expense is unlikely to recur doesn’t add a dime to how much money a company actually made. Operating Earnings may be a useful forecasting (as opposed to measuring) tool for a particular company, but are
not useful in forecasting actual earnings of the overall market. Every year a large number of companies incur these “one time” charges. Next year’s “one time” charges will be different, and they will happen to different companies, but year after year those charges recur across the market as whole and reduce stockholder returns.
It is possible that actual (as opposed to hypothetical) corporate earnings will grow this year. Expectations of higher earnings for the S&P 500 appear grounded in the idea that US economic growth is accelerating relative to other parts of the world. While I share the view that improving US prospects relative to other regions justifies cautious optimism, that optimism does not extend to corporate profit growth.
In the post financial crisis world, it is important to segregate the earnings of financial companies (which are predominately banks) from non-financial companies. The two have very different outlooks. During the crisis, banks (with encouragement from regulators) created massive reserves for loan losses. Most of these reserves were for potential mortgage defaults. Not only did banks reserve for an unprecedented level of foreclosures, but they also based the level of required reserves on the depressed value of home prices at the time. This process grossly overstated bank losses in 2008 and 2009 while setting the stage for huge boosts to reported income in subsequent years when those reserves proved unnecessary. Furthermore, the depressed state of the most interest rate sensitive sector of the economy (housing) virtually assured that the Federal Reserve would keep interest rates below normal for some time. These low rates not only allowed a recovery of housing prices (and reduced the actual loan losses) but also generated an unprecedented volume of profitable refinancing of mortgages. In the absence of a complete economic collapse, a big jump in bank profits was inevitable. This conclusion was enough to position our Diversified Sector Program portfolio with our largest equity concentrations in banks and other financial sector stocks from late 2008 through 2012.
Bank profit growth for the last three years, and 2012 in particular, have come almost entirely from mortgage refinancing and the accounting adjustments reducing loan loss reserves. With interest rates bottoming and almost all qualified homeowners having already refinanced at sub-4% rates, refinancing activity is drying up. Furthermore, three years of boosting earnings with reduced loan loss reserves has depleted the pool of excess reserves, which will eliminate this income source bank by bank as the year progresses. Certainly new loans to consumers for auto and home purchases as well as loans for business expansion in the US will keep banks profitable this year. Unfortunately, remaining profitable is different from increasing profits. Profit growth will be an amazing feat when the two primary profit drivers of the last few years are contracting. Even worse banks rely heavily on leverage to generate earnings. Post-crisis bank regulation is set to require banks to increase capital ratios (i.e. reduce leverage). This makes it almost impossible to expand, and puts great pressure on banks to contract. When you add it all up, profits in the financial sector have nowhere to go but down.
Non Financial Companies
The TINA Hypothesis relies heavily on the belief that corporate earnings will continue to grow at a high single digit pace. Believers in this hypothesis are not deterred by the fact that earnings have actually declined in the last two quarters. The core thesis of the belief is that continued recovery of the US economy will result in larger profits for US based corporations. Although TINA believers acknowledge recent earnings disappointments, they argue that the disappointments have been the result of shrinking top line revenues. Therefore, growth will certainly translate into higher total revenues from domestic US corporate operations.
Our contrary view is that those domestic revenues will not necessarily translate into bigger corporate profits for the multinational corporations that represent 80% of US stock market capitalization. As I outlined last year, “…thefleeting gains that I anticipate in 2012 are not likely to be supported by long-term earnings growth as payroll gainsrecapture a bigger portion of GDP from corporate profits. Ultimately this sets us up for a major market correction.That unhappy story is inevitable, but it is a story for 2013 not 2012.” 2013 is now here. Like last year, most forecasts for 2013 corporate profit growth are strong. Last year those forecasts proved incredibly optimistic as actual reported per share profits declined (even with buybacks that boosted reported profits on a per share basis in the face of declining total profits earned by the businesses). I expect a repeat of that forecast error this year for different reasons.
In 2012 the constraint on earnings growth was revenues. In 2013 rising expenses will drag down corporate profit margins. After soaring for years, US productivity has started to decline as the US private sector expansion requires businesses to rehire less productive workers. At the same time, both private sector payrolls and wages are rising and planned investment in new plant and equipment is accelerating. Investors are encouraged by these positive developments, and for the sake of America’s economy and Americans who need jobs, so am I!
However, as an investor those developments don’t bode well for corporate profits. Profit growth in recent years has relied almost entirely on cost control. While non-financial domestic revenue should grow, it will soon become apparent that costs are rising even faster. Our expectations are reinforced by unusually negative earnings guidance from major corporations recently. One of the clear warnings near the market top in 2007 was that there were about two and a half corporations warning of earnings disappointment for every one that expected earnings improvements. Recently that ratio reached a truly scary level of three and three quarter warnings for every one offering positive guidance! In most years, total earnings have little direct correlation with stock prices. When earnings consistently surpass (or disappoint) market expectations however, investors and speculators react. They increase or reduce how much they are willing to pay for those earnings (P/E multiple). Contrary to prevailing forecasts, I am speculating that price/earnings multiples will decline this year along with earnings.
Over the last few years, several factors boosted per share corporate earnings. Falling interest rates, rising exports, contributions from foreign subsidiaries, tax manipulation, reduced US payrolls per unit of output, reductions in bank reserves, deferred investment, and share buybacks. Until 2012, those factors enabled corporate profits to rise sharply from the record low earnings of 2009. In 2012, it took all those factors to simply maintain per share earnings near 2011 levels. Earnings peaked in the second quarter of 2012 and have now fallen for two consecutive quarters. That downward ratcheting trend will continue in 2013. To a large extent the decline will be the result of the very reason most bulls are optimistic, a gain in US economic growth relative to the rest of the world. That shift will change trend in every one of those expenses from down to up. Let’s tackle the components one by one.
Rising Expense #1 – Interest Rates
Falling interest rates since 2008 have created huge demand for all grades of corporate bonds. This reduced corporate borrowing costs to the lowest level in history. Don’t look for rates to fall further aside from a short-lived bond rally when stocks decline. Falling rates enabled corporate treasurers to refinance existing debt long-term at low interest rates. Initially either corporate profits were boosted and/or balance sheet risk was reduced. Recently the non-financial corporate borrowing mania has gone much further. More junk bonds were issued in 2012 than were issued in the two years preceding the financial crisis. The proceeds of these issues financed dividend hikes and share buybacks as well as any expansion of domestic operations. Rates are still low, but total interest expense is now rising for non financial corporations.
To minimize the rise in interest costs, corporate treasurers have recently shifted to floating rate debt. In the process they are reinstating the risk of higher rates in the future. The markets have largely ignored the fact that recent growth rate of corporate debt is a multiple of the growth in much ballyhooed corporate cash. Most of that additional debt was incurred to avoid the big tax bite that would come from using cash on hand. Remember that 60+% of major corporate cash is sitting offshore. Using it in the US for any purpose will incur the 35% US corporate tax assessment. The good news is that big cash reserves and locking in low long-term borrowing costs radically reduce the risks for future corporate failures in the next recession. But those positive effects will not translate into earnings growth in the next few years. Whether or not interest rates rise later this year (and we think recent Fed statements are preparing the market for exactly that), the total interest expense non-financial corporations must pay in 2013 will be higher than last year.
Rising Expense #2 – Corporate Taxes: Foreign vs. Domestic Profits
Prior to 2012, the weak dollar increased the competitiveness of US exports and enhanced profits earned in other currencies (when measured in dollars at a time when the rest of the world was growing faster than the US). Now with global growth slowing those profits will turn down. Profits held offshore are taxed at 14% on average, rather than 35% when earned in or repatriated to the US. That means that profits earned in the US are less valuable (after tax) than profits generated offshore. Big domestic earnings growth will be required in order to offset even a small decline in foreign earnings to produce the same after tax result.
Rising Expense #3 – Payrolls
In addition to postponing taxes by keeping money offshore, corporations have maintained profits by reducing US payrolls. US workers have seen real wages decline over the past decade, as corporations elected not to reward increased US worker productivity with increased compensation. US workers faced with high levels of domestic unemployment were in a poor negotiating position for higher wages. That unemployment was driven by competition from foreign workers, an imploding housing sector, governmental work force reductions, and record low levels of investment in new plant and equipment. All of these factors are reversing.
A decade of falling real wages (that occurred simultaneously with double digit annual wage gains in China and elsewhere) has made many US workers globally competitive. Combine that with reduced shipping
costs, protection of intellectual property rights, greater control, and relatively low US energy costs and US firms have little choice but to shift hiring to the US, despite higher taxes. After all, it is better to make a little profit after tax than no profit at all. The housing industry, although a fraction of its former self, is growing strongly and hiring. Fracking for natural gas and building related infrastructure is also creating jobs. Government employment is still shrinking, but the massive state and local retirements are slowing as most states have now balanced their budgets. All of this is good for America. The best thing is that unemployment is falling faster than almost anyone (except us) expected. The second best thing is that rising wages are not far behind. The better than expected drop in unemployment is driven as much by work force shrinkage as by job growth. Retiring baby boomers not only shrink the workforce but in the process they are creating an acute skills shortage. There may be plenty of people out of work but few of them have the aptitude and skills to replace the retirees. Even to the extent there are many unemployed, potentially capable echo boomers, making them productive will at the least involve a great deal of training expense. Unfortunately child-rearing theories prevalent in the 1980’s and 1990’s seem to have imbedded many echo boomers with a sense of entitlement. They are smart and will eventually learn, but it won’t be cheap. This creates a problem for corporate profits that will see payroll expense rising.
Rising Expense #4 – Investment
US GDP registered only modest gains in 2012, so even though corporate profits flat-lined, they remain near record levels as a percent of GDP. Corporations have boosted profits by postponing investment in plant and equipment (investment expenditures are only 55% of corporate profits in recent years, well below the six-decade average near 90%). This effectively steals profits from the future. The theft is a double whammy. Not only is increased investment the primary source of gains in future productivity and profits, but future investment will be an expense that drags down profits when it is eventually incurred. “Eventually” starts in 2013, unless the US economy sinks into recession (even worse for profits). Like increased hiring, increased investment is a good thing for America and a good thing for long-term corporate profits, but it is a drag on corporate profits in the year it is incurred. Not only do corporations need investment to shift operations to the US, but a key driver of the limitation on revenue growth will be smaller US government deficits this year. One of the fundamental concepts elucidated by Lord Keynes in the General Theory of Economics that is still agreed upon (even by this economist who vehemently disagrees with much Keynesian thought) is that for the economy as a whole: Savings = Investment. Investment by the business sector must always equal the net savings of the government sector, household sectors, and export sectors. When budget surpluses and household savings increase, investment displaces consumption.
Rising Expense # – Health Care
Finally, we have the increased costs of Obamacare. Projections of premium increases of 10-20% to compensate providers for cost of mandatory coverage not only raise business expenses across the board, but also reduce income, which consumers could spend on other things. Theoretically the increased premium income will benefit healthcare providers, but whether or not that will compensate for the costs of taking on high risk/high cost customers remains to be seen. The first quarter results from United Healthcare say costs are rising faster than revenues.
Before moving on to the risk of falling P/E multiples in the next edition it is important to reiterate that the myth of rising earnings depends heavily on the recent market focus on Forward Operating Earnings. Rather than the Reported Earnings that shareholders actually “share”. Shareholders never get to cash in or reinvest ForwardOperating Earnings.
Operating Earnings are a slightly less egregious earnings estimate than either Forward Operating or EBITDA earnings estimates that fueled the internet bubble. Both measures are useful when evaluating individual companies, but are typically misused when valuing the overall market. Earnings measures that disregard very real expenses just don’t add up.
By excluding those costs, Operating Earnings on average have been about 10% higher than Reported Earnings since inception of the concept two and half decades ago. Therefore the average Price/Earnings multiple of Operating Earnings is historically about 10% lower:
IF X(E) = P/E
X(OE) = P/OE = P/1.1E = (1/1.1)(P/E) = .91 P/E
Further, beware the misrepresentation of multiplies when analysts forecast future (Forward Operating) earnings. Future (Forward) Operating Earnings estimates are wrong 75% of the time (in both directions) making them useless in any given year. If that weren’t enough, while actual Operating Earnings have been 10% higher than Reported Earnings over time, Forward estimates have exceeded actual Reported Earnings by 16-18%! Using the same math:
IF X(E) = P/E
X(FOE) = P/FOE = P/1.17E = (1/1.17)(P/E) = .85 P/E
Therefore the historical average P/E multiple using forward estimates is closer to 12.75 versus 15 for Reported Earnings. According to Yardeni Research1, the current Forward Operating Earnings estimate consensus is in the neighborhood of $115/share for the S&P 500. Recent S&P prices (1600) produce a multiple of 14.
Consider the apples to oranges comparison the financial press is using when they say that stocks are cheap compared to historical multiples. Comparing the current multiple on Forward Operating Earnings estimates to the historical average for Reported Earnings is meaningless.
Additionally, earnings tend to be highly predictive of long-term stock market returns when those earnings are normalized over several years (to eliminate cyclicality). Unfortunately the same cannot be said for single year comparisons (stocks were hardly expensive in early 2009, even though the bottom in earnings ($7) and bottom in the S&P (667) represented a multiple of 95!) The most important impact of earnings in any given year is whether they exceed or fall short of investor expectations. Positive surprises cause stockholders to demand higher prices, while negative surprises motivate stockholders to accept lower prices. Those prices translate into higher or lower price/earnings multiples, a behavior I plan to discuss in the next letter. Bottom line is that we believe that 2013 US corporate earnings will disappoint stock market investors.
Our current market outlook is unchanged from earlier in the year.
The logic of my arguments notwithstanding, US stock prices continue to rise. In a market where investor trading activity is relatively small (compared with computer driven high frequency trading), even modest but relentless demand for stocks created by corporate buybacks translates into higher prices in the short-term. Like earnings estimates, those buybacks help the short-term relative performance of individual stocks. Unfortunately buybacks don’t negate the need for true growth in total after-tax earnings. It is not a horse we choose to bet on to win even though it is leading the race at the moment.
FSG Client Portfolios
Our managed portfolios remain concentrated in funds that mimic money market returns. As you would expect given our earnings outlook, our exposure to US stocks remains at the lowest level in decades. While our overall posture is extremely defensive, we have a substantial position in mutual funds holding Japanese stocks. Japan is the best performing major stock market recently and we expect that trend to continue. With gold prices recently plunging below our oft stated target of $1400 per oz, we have increased our small position in Gold Mining funds and plan to add more in the near future. We continue to hold small positions in European and Latin American stock funds that we expect to opportunistically add to during market declines.
1. Yardeni Research, Inc, Earnings, Revenues, & Valuation: S&P 500/400/600, May 6, 2013
Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Corporations. The opinions expressed in this newsletter may change without notice due to volatile market conditions. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and Clyde Kendzierski believe this information in the commentary to be accurate and reliable, however, inaccuracies may occur.
Investors should consider the charges, risks, expenses, and their personal investment objectives before investing. Please see FSG’s ADV Part 2A containing this and other information. Read it carefully before you invest.
Past performance is a poor indicator of specific future returns. It, however, may be useful in your evaluation of how FSG performs in different market environments. Investors have the ability to achieve results similar to benchmark indices by investing in an index fund or Index-tracking ETF, typically with lower fees.
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