Sunday, December 22, 2013

The Stock Market

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

            Thomson Reuters (This Week in Earnings, December 6, 2013) notes another New World Record. We are breaking plenty these days. This often foretells a Grand Finale. For the fourth quarter of 2013, 103 companies in the S&P 500 have announced negative earnings revisions. Only nine have disclosed positive profit assessments. The ratio of negative-to-positive, 11.4:1, exceeds the previous high (negative-to-positive ratio) of 6.8:1.

            This is worth consideration. The 6.8:1 silver medalist was during the first quarter of 2001. Early 2001 was unpleasant. More importantly, for a ratio comparison, the unpleasantness was by then a protracted, dismal bust, and was not news, except to Alan Greenspan, who announced to the FOMC at its January 30-31, 2001, meeting that: "there is little evidence of which I'm aware that long-term profit expectations have deteriorated to any significant extent." A century from now, interested parties will need to address the dilemma of who possessed the tinier minds: members of the FOMC or the world that stood still in fear of its pronouncements, debating the layers of analysis that never existed at the Fed prior to post-meeting announcements.

          As a reminder of the moment: "By the end of 2000, the Nasdaq Composite had fallen 51 percent and the Philadelphia Internet Index had lost 77 percent from its peak. All told, investors in U.S. stocks had lost trillions of dollars and were constantly reminded of this by the wonder of technology's multicolored screens that flashed instant calculations of their attenuated portfolio holdings."  (Panderer to Power, pgs. 235-236).

          Announcements by companies of adjusted earnings predictions in a different direction usually lag a sharp break (from recession to rebound, or its opposite.) The first quarter 2001 reassessments were made by companies in the midst of liquidation, most of which had accumulated during the boom: "On December 4, 2000, Cisco Systems Chairman John Chambers delivered his annual speech to Wall Street analysts. 'I have never been more optimistic about the future of our industry as a whole, or of Cisco.' In January, Cisco Systems announced the value of its inventory rose from $1.2 billion to $2.0 billion in the previous quarter.Companies announced plans (or hopes) to reduce inventories by the end of 2002. This unwinding across the whole economy would take years to complete-unless some artificial paper printing inflated prices.... In April 2001, John Chambers admitted, "[T]his may be the fastest any industry our size has decelerated." Chambers was paid $279 million in 1999 and 2000 for his foresighted leadership." (Panderer to Power, pgs. 235, p. 237-238)

Since these moments of abrupt break are so easily forgotten, yet, so traumatic, some more color: "Hewlett Packard was 'buffered by the slowing economy in just about every segment of our business. Sales from dot.coms [are] essentially zero.' Gateway's sales 'plummeted below already lowered estimates.' The CEO of Nortel admitted, 'We now expect the U.S. market slowdown to continue well into the fourth quarter of 2001.' Lucent's CEO warned, 'We have serious execution problems,' after which, he immediately restored public confidence in his execution acumen by firing 10,000 workers. Oracle's CFO made the head-scratching admission, 'I haven't a clue what will happen,' and, 'We're still trying to figure out what happened last quarter.'" (John Hancock Quarterly Market Review, April 1, 2001. Thanks, Andrea)

So, what might we hear from CEO's in the first quarter of 2013? A schizophrenia exists in which "we're in a bubble" is stated, even by some central-banking bureaucrats. At the same time, the word from the Street is cheery. The S&P 500, Dow, and Russell 2000 periodically post new highs; there seems to be no concern (or knowledge) that 10-year Treasury yields have doubled since before Bernanke's QEIII trillion-dollar, asset-buying commenced in the fall of 2012. Corporate earnings as a percent of sales are the highest since records were first collected in 1947. From the mouths of the Experts, this is a good thing. So, why might we be on the verge of another first quarter 2001?

            Stock prices are artificial. They have been lifted by central-bank asset buying and the belief the Fed will not permit markets to fall. This same trust emptied the brokerage accounts of believers twice in the past 13 years, but it goes on. Zero Hedge recently reported the days on which the New York Fed has engaged in POMOs (Permanent Open Market Operations) of $5 billion or greater, between April 2009 and April 2013, the S&P 500 rose 540%. On days when POMOs were less than $5 billion, the index rose 15%. On days without POMOs, returns were -2%. (The New York Fed lists the daily schedules for POMOs with estimated sizes several days in advance. The Fed wires the electronic, keyboard money to primary dealers who relay electronically conjured money to recipients.)

            Andy Lees reports: "Asset prices have...continued to soar. Margin debt is at record levels in absolute terms, and is towards record levels as a percent of market cap. A week or two back I was told that hedge funds are running a gross exposure of about 258%. If I remember correctly, derivatives and financial sector lending is predominantly off balance sheet. What appears to be happening therefore is that the loan growth is driving or supporting asset prices, but it is being funded, at least in part, by taking liquidity out of the real economy, similar to the late 1920's. Why would a bank lend to the real economy where there is disinflation and the weakest nominal GDP growth outside of recession, rather than to the financial economy where there is massive asset price inflation and the banks can make returns very quickly?"

Andy Lees described one path through which the world's asset markets are inflated, by layers of leverage upon leverage upon leverage. The central bankers remain completely unaware of this since their holy DSGE model (dynamic stochastic general equilibrium model) does not acknowledge the existence of financial markets.

Lees' comment, "liquidity out of the real economy," is most apparent in falling household incomes. Falling incomes partially answers the reason for record profits. A large part of the increase in profit margins is due (as a percentage of revenues) to a reduction of salaries, taxes, investment, and interest payments on debt. The last would never happen except in a National Socialist economy, one that keeps setting New World Records in corporate debt issuance with practically no carrying cost (interest payments). When the Fed abandons its attempt to control the yield curve (see comment about the 10-year direction, above), interest payments will leave many a CFO admitting: "We have serious execution problems."

Companies also have serious liquidation problems of their capital investment. The first run at the third quarter GDP report pegged corporate investment at -0.1%. Record debt accumulation with negative investment is truly New Era management, but, as in many New Eras past, one that will vanish with a "poof." The main route for the debt is to repurchase common shares. Fewer shares with record profits raises stock prices and prods the cash-out rate of stock options by senior management: the 1%.

           We may be heading into a melt up (the opinion of some long-time market watchers), followed by a reckoning when it becomes apparent so many companies have been hollowed out. To note the obvious, after the central bankers lose the yield curve, their ability to support markets (first, the mortgage melt up, then, 2008 and onward) will also go "poof."