Corporate Earnings and Inflation

A few months ago our 2015 forecast emphasized several points we began making late last year. Taken together, those points differed dramatically from the prevailing wisdom of the time. As we begin May, they are falling into place.

• The US corporate earnings cycle peaked in the third quarter of 2014, and will trend lower in 2015. Declining profits will be driven by the combination of an overvalued dollar, lower average oil prices, and rising wages.

• The rapid appreciation of the US dollar during the last year which was widely expected to continue in 2015 is peaking in the first half. The dollar will decline later in the year. • Energy prices, which plunged in late 2014 and were generally expected to fall further this year, are bottoming in the first half of the year. Energy prices will end 2015 at levels higher than they started.

• US economic growth will decelerate in 2015 rather than accelerate as was widely assumed.

• A tightening labor market (driven by baby boomer retirements) is pushing wages higher. Rising payroll costs will reduce profit margins going forward.

• One of the biggest boosts to corporate bottom lines in recent years – reducing corporate tax bills by stashing profits abroad - may be coming to an end.

Corporate Earnings

Aggregate growth in US corporate earnings has been meager for several years. The perception of rapid growth is the result of a rising “earnings per share” resulting from massive share buybacks that reduce the total number of shares outstanding. While reducing the number of outstanding shares has legitimately increased the value of each remaining share, the recent downturn in actual corporate profits reduces the ability of corporations to finance more future buybacks. When shares are cheap, earnings are rising, and interest rates are falling, buybacks offer the prospect of substantial longterm gains. Currently, shares are expensive, earnings are falling, and interest rates are rising (although rates will temporarily drop when stock prices suffer a major setback).

Growth in aggregate earnings has slowed to the point that earnings per share are declining, despite the fact that buybacks now represent a record percentage of shares traded. Perhaps even more importantly, a significant portion of the buybacks have been financed by the issuance of a record level of corporate debt. The financial engineering that has maintained the appearance of rising earnings can no longer be sustained.

The combination of lower energy prices, reduced global competitiveness (resulting from a falling dollar), and rising wages are pushing profit margins down from recent record levels. Earnings per share fell in the final quarter of 2014. That trend almost certainly continued in Q1 (currently being reported) to levels lower than a year ago. Consumers compounded the problem by saving rather than spending. All reasonable expectations indicate further earnings erosion in the current quarter (Q2 which will be reported over the summer). These year-over-year declines will continue despite a partial reversal in both the dollar and energy prices. Beyond summer, there is a wide diversity of opinion as to whether the earnings shortfall will extend into subsequent quarters. Even with a bounce in earnings later in the year, after 3 quarters of earnings declines, history provides some market guidance: Since 1937, there have been 17 times that earnings have declined for 3 consecutive quarters. Most of these occurrences were within three months of a bear market decline greater than 20%. If earnings continue to disappoint beyond the current quarter, that outcome seems inevitable.

Falling profit margins at companies directly affected by the dollar, energy revenues, and rising wages are already reducing the pace of US economic growth as companies try to minimize damage to their bottom lines. The evidence is clear in the form of declining industrial production and capital spending, as well as weak retail sales and a reported drop in Q1 GDP growth to stall speed (which may be revised lower). As the year progresses, slower growth will weigh on the profits of other sectors not directly impacted by energy and the dollar.

Corporate debt, already at record levels, continues to grow at a record pace. Corporations have already borrowed an additional $600 billion this year (about 7% above last year). Net leverage for non-financial companies is more than 10% greater than it was at the market top in 2007 preceding the crash. Profit margins 50% above historic norms combined with rates that are much lower than eight years ago have made servicing that debt manageable. A drop in profit margins to even the still very high levels of a couple of years ago would add debt service to the list of profit threats. Declining profits not only reduce the ability to make interest payments, but make it more difficult to refinance that debt on favorable terms. Like a snowball rolling downhill, the rise in interest payments relative to profits will squeeze margins further (for drought-stricken Californians, a snowball is a white ball of frozen water that grows when rolled over snow).

Issues in the financial sector are different. Bank earnings, which have disappointed investors for years, have been temporarily insulated. A few big Wall St. banks even had a recent boost in profits from currency trading. Over the past few years, short-term rates have been stuck at zero while long-term rates have declined. This has depressed bank lending margins across the board. Margins will be squeezed further as the Fed raises rates and the gap between short and long-term rates gets smaller. The bottom line is that profit margins, which for several years have been 50% above historical norms, are now declining and poised to decline further going forward.

Energy Prices

The severe decline in energy prices that began last summer has been the single biggest contributor to the recent profit decline. The story is simple and obvious. While various parts of the US economy expanded or contracted since the financial crisis, the net growth in the US economy and employment was 100% attributable to the boom in energy. Industries that supply the energy industry or sell to their stockholders and employees are also dependent on energy growth. This includes industries even beyond the direct boom in exploration and development. Energy sector growth has been mirrored in aggregate corporate earnings growth during the same period. The drop in energy prices from over $100/bbl last summer to $45/bbl this spring has triggered the turnaround in the sector from rising profits to plunging profits. Even with the recent recovery to above $55/bbl (and I suspect somewhat higher levels later in the year), oil prices and related profits will remain much lower a year from now than they were a year ago. Some industries like airlines and gold miners as well as retail sales will benefit from lower energy costs, but the boost to earnings is unlikely to offset the profit reductions in the energy sector.

US Dollar

The drag on corporate profits from an appreciating dollar over the past year is second only to energy costs. Prior to that time, round after round of quantitative easing (QE) left the world awash in dollars. The economic gains from recent rounds of QE may have been limited, but the Fed certainly succeeded in keeping the value of the dollar depressed. When the Fed recently backed away from QE, things started to change. The previously explosive growth in the monetary base has slowed to 2.5% during the past year. Shortly thereafter, the European Central Bank (ECB) announced a credible plan to introduce a quantitative easing program in Europe. One obvious objective of the ECB was to reduce the excessive valuation of the euro vs. the dollar. Like the Fed, they also succeeded. The prospect of the supply of euros growing at a much faster pace than the supply of dollars (combined with similar policies in Japan) caused the euro to soar. The soaring euro triggered a short squeeze on the dollar forcing traders to reverse long-held short positions (many of which were highly leveraged). Unlike the Fed during the last couple of rounds of QE, the ECB is dealing with an economy strangled by tight credit. So like the initial Fed rate cuts 5 years ago, the ECB cuts are likely to provide economic boost beyond foreign trade.

It is important to remember that every transaction has two sides. When you sell anything short you are betting on its decline in value vs. something else. In this case the biggest shorts against the dollar were in euros and gold. The soaring euro altered the value of the dollar vs. other assets as well; most obviously gold, but the yen declined further as well. When markets suddenly change direction, traders are forced to sell what they can, not necessarily what they want to. When the ECB cut rates, traders faced with massive losses on their long euro positions used their holdings of gold, yen, and other currencies to obtain the US dollars that were suddenly in strong demand. This caused the prices of gold, yen, etc. to drop sharply in sympathy with the euro. Currency expansion at a faster pace in Europe and Japan than in the US left little doubt that the yen and euro should now be fundamentally weaker than they were a year earlier. The same should not be said of gold which has seen supply reduction with the closure of high cost mines.

A year ago the dollar had been undervalued, but by early this year valuations had moved way past parity (as markets tend to do). The dollar instead became overvalued. There are those who argue the dollar rally has farther to go based on several familiar arguments. These arguments made sense relative to the value of the dollar a year ago. What they fail to recognize is that the factors which justified a stronger dollar are diminished or reversed when the dollar becomes overvalued.

When the dollar was undervalued, imports (like oil) were expensive and US exports were highly competitive in global markets. The 15% appreciation of the dollar over the past year (a mix of 30% vs. the euro/yen and 5% vs. the Chinese yuan, etc.) changes the calculus. The sudden speculative appetite for dollars was triggered by the prospect of US rates rising at the same time rates in Europe were poised to fall. Clearly this made dollars more valuable than euros at the exchange rates prevalent in the early part of last year. Traders were overwhelmingly “long” dollars early this year (just like they were “long” housing and lender stocks eight years ago and internet stocks fifteen years ago). Crowded trades invariably overshoot “fair value” and recent experience was no exception. A now overvalued dollar diminishes or may even undermine the 3 strongest premises that supported the widening of rates that triggered the trade; US economic growth will radically outpace foreign growth; economic risks in the US are much lower than in other economies; commercial demand for dollars to buy US exports will continue to grow. As the markets begin to digest the impact of an overvalued dollar, the dollar will surrender a portion (but not all of) its recent gains. Some of the retrenchment vs. the euro and yen will be offset by gains vs. the Chinese yuan, which did not collapse like the other currencies. That surrender of dollar value appears to have started. Had the dollar remained at its highs, or continued to appreciate, the damage would have been more than diminished profits. The risk of recession would increase substantially. The more likely outcome is a dollar valued below recent highs, but substantially below year ago levels. That level will continue to pressure profit margins.

Wages And Benefits

For the last couple decades, competition from automation and foreign workers has eroded the purchasing power of workers’ wages in advanced economies. Higher levels of regulation, taxes, and environmental restrictions have further reduced workers’ competitiveness vs. less developed countries (LDCs). Although wages in LDCs remain a fraction of wages in developed economies, the relative benefit of hiring a worker for pennies on the dollar in some backwater is diminished greatly if that worker is running a machine that is producing thousands of units per day. Any savings in unit costs may easily be offset by the additional expense of security and transportation required to get the product to market. This reality has fed the American recovery. The bad news is that automation eliminates jobs globally and is completely eliminating low skilled or repetitive jobs in developed economies. Any growth in employment must then be driven by an even higher level of broad economic growth. Job destruction implies that real wages in developed economies will remain static or fall, as they have for the past couple decades, indefinitely. Job destruction is not however, the whole story.

Unlike the past, the work force is shrinking. Some of the recent shrinkage was driven by the combination of stagnant wages juxtaposed against growing government transfer payments. However the 900lb gorilla in the room remains the retirement of millions of baby boomers, as well as aging populations in Europe and Japan. It’s true that many of us are working longer than our parents. Some are working out of necessity, while some (like me) think retirement would be boring. We may work a few more years, but every year, more and more of us join the ranks for retirees and daisy pushers. Make no mistake; retiring baby boomers are creating a worker shortage. Shortages always push prices higher than they would otherwise be. Unemployment is rapidly falling toward 5% in the US, while companies complaining of an inability to hire qualified workers is at or near all time highs. There are some statistical distortions as highly paid oil field workers get laid off and lots of hotel, restaurant, and nursing home employees get hired, but wages are beginning to trend higher as well. Higher wages hurt corporate profits. The only offset to higher wages is greater investment to boost worker productivity. But that takes years. So far corporations have resisted that investment, using their cash to buy shares back instead. A sudden surge of long overdue investment in the US is exactly what we need for long-term growth, but over the next few years the cost of that investment would be another big hit to profits. It comes down to a choice of reducing profits with new investment or reducing profits from an ongoing drop in worker productivity that boosts inflation.

Bringing The Cash Home

The rapid appreciation of the dollar means that the cash hoards kept offshore to avoid US taxes (in euros, yen, dinars, reals, yuan, or whatever) is suddenly worth 5-30% less. The currency losses might turn out to be worse than the taxes corporations have been postponing. Also, the taxes may someday still need to be paid in addition to the currency losses. Adding insult to injury, borrowing money at relatively high US rates to continue to fund buybacks and dividends will be a drag on profits year after year going forward if they maintain cash overseas earning lower rates. A few companies are starting to figure this out. The most blatant example is the recent announcement by GE that they are bringing home billions of dollars despite a huge tax bill. There is an additional risk of the future tax bill being higher, not lower, even if rates are cut. Countries around the globe are working on new tax treaties to deal with the ongoing shrinkage of corporate tax receipts. The recent turmoil in currency values and interest rates creates an incentive to bring that cash home to the US. When money comes home, it gets taxed, which as you have probably guessed, reduces profits.

Earnings Are NotThe Sole Determinant Of Stock Prices

It is obvious that falling corporate earnings are not good for the owners (stockholders) of the affected companies. Long-term stockholders can take comfort from the fact that stock prices track earnings trends pretty well when you compare one peak in the market to the next. If you had bought an S&P index fund at the 2007 market top, then suddenly got lucky enough to be marooned on an internet-free island until last week, you would discover the ratio of stock prices to earnings (P/E ratio) hardly changed. Those of us who stuck around through the financial crisis, or needed to cash in our chips a few years back, had a somewhat different experience. Stock prices and earnings experience violent cyclical swings as they move from peak to peak. It is for this reason we consider minimizing the swings in portfolio values critical, even when caution sacrifices some potential gains.

Investor Risk Appetites

It is a mathematical truism that stock prices are the product of corporate earnings and the multiple of those earnings (P/E ratio) that investors are willing to pay. At the risk of oversimplifying, the P/E ratio reflects the risk appetite of investors for stocks in relation to other assets. P/E ratios are very “mean reverting” over long periods. A 20yr moving average P/E ratio is pretty constant, while a two or three year P/E ratio can be reminiscent of Mr. Toad’s wild ride. This is why short-term indicators, like the Fed Model which compares stock yields with interest rates, have historically had the predictive accuracy of a coin flip at any point in time. In some environments, like the last few years, it seems to work very well with stock prices rising as rates fall. In other environments, (like 2008-early 2009) stock prices plunged, despite sharp declines in rates. This is consistent with behavioral studies showing that people tend to overweight recent experience when making decisions. Assuming things won’t change much makes perfect sense for most things in our daily lives. Life slowly improves or deteriorates (excluding those who regularly engage in big financial risks). We all have our ups and downs, but unlike asset prices, life tends to be more progressive than cyclical. Asset prices are highly cyclical.

Only a year or so after the market has changed directions do most investors accept the new direction as normal. Markets get increasing overextended (up or down) before reaching a breaking point. Although there is no way to predict when that proverbial last straw will break the camel’s back, the degree to which prices are extended can be measured. P/E ratios are an accurate measure of investor risk tolerance, but an insufficient measure of actual market risk. Sometimes high levels of optimism or pessimism are justified. Whether that optimism is or is not justified depends heavily on where we are in the earnings cycle.

Earnings And P/E Ratios Combine To Define Market Risk

When, like now, both P/E ratios and earnings are simultaneously near cyclical highs, the risk of loss is the greatest. This condition is unstable and unsustainable. Current excess optimism and market instability is also reflected in the record level of margin debt outstanding. Investors who own shares outright typically tolerate large portfolio losses before reacting. Only when those losses become very large or are sustained for a year or so do they liquidate positions. Conversely, investors who have purchased shares with borrowed money (margin debt) have a much lower threshold of pain. Margin sales typify the first big leg down in a bear market. While individual participation in outright share ownership remains relatively modest, the ownership of shares purchased with borrowed money is at unprecedented levels. Not only is margin debt at record highs, but most of the record level of corporate debt issued in the last few years has also been used to purchase shares. This makes the market more vulnerable than ever to even a modest tightening of the easy credit conditions that have supported stock prices.

In each new cycle the excess of investor optimism and unsustainable earnings are focused in a different part of the economy with a different breaking point. In 2000, we experienced uncharted territory when investors believed the myth that internet stocks (most with no reasonable prospect of ever generating earnings) had infinite potential. In 2007, investors believed the myth that housing values would be an endless source of liquidity that fueled profits in other industries. Today the market relies on the myth that liquidity supplied by central bankers will guarantee ever rising stock values, while ignoring the almost total disappearance of liquidity from the banking system and recent indications of an inflation resurgence.

Traditionally the banking system (fueled with Fed rate cuts) mitigates the damage when stock and bond prices plunge. Big investment banks historically buy when prices become low enough. The last bear market became a financial crisis when banks facing insolvency failed to step in despite Fed rate cuts. In the recent financial crisis (like the Great Depression), banks needed to reduce, not increase, their investment portfolio. It simply didn’t matter how cheap stocks became or how easy it was to finance their purchase.

Bank insolvency no longer poses a serious threat (although some may still need to sell securities in a downturn). The current risk is that the Fed can’t cut rates significantly below zero. Even if rates were higher and could be cut, banks are now prohibited by post-crisis financial regulation from making massive purchases of securities for their portfolios. Banks may not compound the crisis by dumping securities in a downturn, but there is no safety net currently in place. Only if the downturn becomes as severe as the last one might the Fed take the unprecedented step of buying stocks and corporate bonds for its own portfolio.

Market Cracks and Opportunities Are Beginning To Appear

Over the decades, corporations have an almost unblemished record of doing most of their buybacks near market tops. Although still near record levels, buybacks in early 2015 are lower than last year. Simultaneously individual investors are retreating; as evidenced by net sales of mutual funds focused on US stocks. This selling is despite record levels of securities financed on margin. Trading volume remains low and would be absolutely tiny in the absence of buybacks. It is only the dominance of buybacks as a percent of total trading that is supporting prices at current levels. This lack of liquidity raises the possibility that any major selling pressure would result in a precipitous drop in stock prices. Similarly, liquidity in the bond markets has virtually disappeared meaning any major seller of bonds would have to slash prices to find price sensitive buyers. For the last year the NYSE composite has been stuck in a trading range. Recently the S&P, along with the Dow, have also been range bound, despite a token new S&P high this month (2117.69 vs. 2117.39 earlier).

There are a few more reasonably priced markets for those with a long-term view. Most of these sectors are trading at lower prices in response to the recent overvaluation of the dollar. Many of them are in the commodity space and will benefit if the very recent uptick in consumer prices continues. The combination of a soaring dollar and falling energy prices that decimated these sectors is now moving in the other direction. Although prices in these sectors represent decent long-term investments, they are not immune to temporary setbacks if the bear market turns severe.

Just as the 50% drop in energy prices to $45/bbl completely offset other price increases during the last year, the recent 33% rise in energy prices from the lows will pump up US inflation numbers in 2015. Further upward pressure on energy costs seems likely given that prices are rising despite record levels of US oil output and near record output from Saudi Arabia. With much of US production capacity uneconomic at current prices and the US oil rig count plunging, only higher prices will prevent a decline in US output. Oil prices are unlikely to reach the $100/bbl+ of a year ago for a long, long time.

Low inflation has held down interest rates for some time. The prospect of higher prices is removing the impediment to higher rates. A stock market crash would temporarily interrupt, but not end the rising rate trend. With inflation creeping back up, the best way for traders to capitalize on a short-term bond rally if stocks fall is probably TIPS (Treasury Inflation-Protected Securities). Whether or not TIPS will prove to be a good investment (as opposed to a good trade) will depend on whether inflation or rates rise faster.

Years ago I accurately forecasted that individual investors (after having been burned by two market crashes in a decade) would not return en masse. I assumed incorrectly that this would preclude the type of stock market bubble we have experienced in the past two years. As it turned out, the lack of investor exuberance was replaced with unprecedented corporate buybacks. The net effect has been to boost stock prices to levels (relative to aggregate earnings and inflation) just as crazy as they were before the last market crash. Now corporate profit margins are eroding and earnings are in decline. Compounding the threat is the likelihood that inflation bottomed in the first quarter setting the stage for higher rates later in the year. The threat is so obvious that even the notoriously dovish Fed Chairman Janet Yellen warned that stocks are very expensive and there is substantial risk they won’t be supported by low rates in the future.

The bottom line is that the combination of falling corporate earnings and higher interest rates will reduce investor risk appetite for US stocks and will most likely result in significantly lower US stock prices. A number of other outcomes seem likely to evolve this year including:

• US economy will continue to grow but at a somewhat slower pace. Although not imminent, the risk of recession is rising.

• Income will shift from corporate profits to wages.

• Inflation has bottomed. Higher consumer prices will result in higher interest rates and lower bond prices.

• Commodity prices will partially recover in response to both a drop in the dollar from recent levels as well as faster growth in Europe and Japan.

• The corrections in the stock and bond markets are at serious risk of evolving into major bear markets due to the lack of liquidity.

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. This commentary may contain forward-looking statements and FSG offers no guarantees as to the accuracy of these statements. The information and statistical data contained herein have been obtained from sources believed to be reliable but in no way are guaranteed by FSG as to accuracy or completeness. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and the author believe the information in this commentary to be accurate and reliable, however, inaccuracies may occur.

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