Down profit cycle has more to run
The S&P 500 can still rally another 15% from here without violating any long-term trendline that has defined the bear market. So, who is to say that this upturn does not have more legs? But we are still convinced that the down profit cycle has more to run.
Look at the nearby chart (), which presents National Account profits relative to GDP – a proxy for margins. People who look at the earnings plunge and deem this to have been the worst setback ever and note how we have broken all the peak-to-trough declines in the past fail to take into account the starting point – the profit-to- GDP ratio at the 2006 peak hit an all-time high of 10.9% – not once did it ever even cross above the 10% threshold in the 60-year history of the data. A normal peak was typically around 7%, and today it is 6.6% – after the sharp slide this cycle, it is actually close to prior bull market peaks, believe it or not. The average recession trough is 4.6%, so on that basis we are basically two-thirds of the way though the margin compression phase and seeing as we think nominal growth is likely to be flat over the next two years, a complete normalization of this ratio would imply a further 30% downside potential for corporate profits. Applying that to S&P 500 operating earnings would actually put them at risk of bottoming at $35 at some point over the next two years, which in turn means we have a forward multiple of very close to 25x, which is simply too rich for our liking.
Cyclical spending weakened sharply in March
Retail sales came in markedly weaker than expected in March, down 1.1% M/M versus estimates for a modest gain. The results also suggest that the majority of tax refunds (up 15% Y/Y) are being directed toward paying down debt or savings at the expense of spending.
That retail sales decline, while startling based on all the bullish prognostications, was actually a flattering result. The cyclical sectors weakened sharply – vehicles/parts was down 2.3%, furniture was down 1.7%, electronics/appliances fell 5.9%, e-tailing was down 1.7%, building materials dropped 0.6%, restaurants slipped 1.4%, and clothing sank 1.8%. These discretionary sectors declined 2% or at an annual rate exceeding -20% in March. The only areas of the retail sphere that managed to eke out any gains at all were the ones that would ordinarily be associated with an economy knee-deep in recession – food and pharma with 0.4% increases apiece.
CPI deflates for the first time since 1955
Overall CPI fell by 0.1% M/M in March, in line with Bank of America Securities-Merrill Lynch estimates, but below consensus forecasts for a 0.1% gain. As was seen in the PPI report, energy posted a large decline, down 3.0% M/M and partially led lower by seasonal factors. Food prices were also soft, down 0.1% M/M, following a similar drop in February. Outside of food and energy, the core CPI rose by 0.2% over the month, led by an 11% jump in tobacco prices, which alone added 0.1ppt M/M. Higher wholesale prices and a record hike in federal taxes (set to go into effect in April, but started to pass through in March) were reflected in the tobacco index.
Too much spare capacity to be concerned about inflation
There seems to be a lot of market chatter about how the dramatic fiscal and monetary stimulus is going to reignite inflation. Let’s look at the bigger picture. We have a real unemployment rate of nearly 16% and a capacity utilization rate that looks about to decline to 65%. We think there is simply too much spare capacity to absorb to be concerned about what the government is going to do
except prevent an outright deflationary environment from taking hold. The inflation trade is totally an overplayed card, in our view.
The reality is that it is not economists or market pundits on television who determine the pricing of goods and services that go into the CPI and the PPI. As the latest NFIB small business survey shows, the net share of companies intending to raise prices has plunged for eight months in a row to now stand at ZERO. Nada. For the first time ever, the net share of small businesses that are planning price increases over the next six months has totally vanished. NFIB intentions regarding wage increases have also collapsed to zero – again for the very first time. Based on this data, we would have to conclude that even with all the gobs of government intervention, deflation risks continue to trump inflation risks. That the equity market has enjoyed a very sharp and snappy short-covering rally over the past month has not dissuaded us from this viewpoint.
Housing starts at their second lowest level on record
While starts did come in below expected, down 10.8% to 510,000 annualized units, the pundits are claiming that the number was a market-positive on two fronts: (i), the decline in new construction activity is good from a supply perspective since it shows that the builders are making even more headway at shaving the unsold inventory, and (ii) all the decline in March was in multi-family,
which collapsed 29%. Single-family starts actually held on to the February surge and stabilized at 358,000 units. The fact that (i) and (ii) are just a tad contradictory does not seem to matter. While it may well be true that starts have bottomed – they aren’t going to zero – the bottom line is that housing starts are at their second lowest level on record despite the best affordability conditions in over a generation (data going back to 1959).
Sustained deterioration in consumer credit quality
What does not seem consistent with the newly found pervasive view that we are seeing a significant thaw in the credit markets is the sustained deterioration we are seeing in consumer credit quality: Nearly 10.2% of borrowers who took out an FHA-backed loan in the first quarter of 2008 became delinquent in the next ten months. The comparable data a year ago covering 1Q07 loans were 9.4%. In February 2009, 12.3% of the FHA mortgages that were issued in 2007 were seriously delinquent (more than 90 days past due). This was just one development among many that boosted the total FHA default rate to 7.46% in February from 6.16% a year ago. Is this a green shoot or a yellow weed? For the first time in its 75-year history, the FHA is considering a request for taxpayer funds.
Of course none of this is relevant in a market trading on technical factors. But it will be once the unwinds end and the speculators leave the casino.