Four More Weak Results: Green Shoots Wither

Includes: AMZN, AXP, COF, MSFT
by: Karl D'Cunha

So much for "green shoots."

Both American Express (NYSE:AXP) and Capitol One (NYSE:COF) reported earnings that were quite weak. The most important aspect of their reports were not the numbers per-se - it was the fact that both firms cut provisioning and their reasoning for doing so: card balances and available credit have both been significantly curtailed.

This is the 900lb Gorilla that nobody is talking about this morning, which is why I want to highlight it and spend most of this Ticker talking about it.

As everyone who follows the market and economy knows, consumer spending is about 70% of GDP. No consumer, no growth - period.

But consumers have "pulled forward" demand using credit for the last 20 years. This practice accelerated right into the maw of this recession; indeed, it was the reason for the recession, when credit outstanding and its debt service caught up to and surpassed earnings power. That is what began the chain of defaults that started with subprime and has spread through the economy (and which isn't over, by the way, since we've been hiding so many of them.)

The "green shoots" people who are predicting economic recovery all say that spending will rebound across the economy.

My argument with this is that the math does not support such a claim as the consumer has barely de-levered at all, as I have noted - some $60 billion in total from the top of consumer credit in January of 2009 has come off, out of more than $2 trillion outstanding. That is, about 3%: it simply isn't enough.

The credit card companies were literally being threatened with extinction by the default rates - 10% charge-offs will destroy you when you're levered; even at a "mere" 10:1 leverage its enough to bankrupt the company. These firms simply cannot allow that sort of default rate to persist, and they haven't - they are aggressively cutting credit lines back to the outstanding balance while at the same time increasing interest rates at the flimsiest excuse, all in an attempt to cut their exposure to people who would otherwise "charge and run" as a last act of desperation before they sink under the waves.

But without the ability to charge up the credit cards the "savings rate" is simply being absorbed as debt paydowns. This is good for the economy over time but in the short term - the next few years, since we have chosen not to force the bad debt to default - it will severely crimp GDP.

How much? Let's look at the credit line numbers from 2006-2008 - we went from 2.38 trillion to 2.56 trillion outstanding, an expansion of 180 billion dollars. More important the contraction in consumer activity has come almost entirely from a $43 billion reduction in outstanding credit since Q4 (there was in fact another 20 billion expansion in January, so the real peak was then - the peak to current decline is about $60 billion), meaning that consumer spending did not pull back enough to start reducing credit outstanding, that is, resulting in credit pay-downs, until February of this year!

Anyone who believes that credit will resume expansion at any time in the near future with unemployment near 10% (and going higher) while credit card companies are aggressively cutting lines back to open balance amounts is certifiably insane.

Consumer spending cannot increase materially as wages are stagnant, capacity utilization and hours worked are in the tank and earnings power is being consumed by desperate attempts to stay out of bankruptcy.

This was reflected in Microsoft's results last night - it was not only their commercial lines of business (server software and services) that missed badly, the miss also extended to their consumer lines of business. For the first time in the firm's history Windows sales declined on a revenue basis - a clear indication that consumers simply are not spending on discretionary purchases. Apple gave many people a rosy view, but the fact remains that the Macintosh is a small minority of unit shipments, and as such it simply doesn't represent enough of the market to indicate anything other than a local view of a shift toward their products - measured as a whole PC demand in the consumer segment smells like dead fish, and in the commercial marketplace its even worse.

Amazon underlined this even further - you'd expect that Amazon, which features low prices and online convenience to win big in a recessionary environment. That they were unable to continue their pattern of huge gains even though they are willing to operate on razor-thin margins should serve as a clear warning to anyone who has a "green shoots" philosophy: the simple fact of the matter is that the earnings results this quarter do not support the claims, with the "beats" coming from the bar literally being placed under the floor so one doesn't even have to pick up their feet to get over it.

This recession cannot end in a durable recovery until debt service ratios compared to incomes come back to a reasonable level. The proper thing for government to do was to force the bad loans into the open and make them default, but they and we have chosen the "easy way out", just as did Japan.

We can still correct this at a policy level but unless we do we will remain within the liquidity trap of our own making, as consumer credit cannot restart at anything approaching a normal level so long as debt-service ratios remain where they are compared to income, with unemployment simply adding further insult to injury.

The stock market is pricing in not just a "recovery" but 5-7% GDP growth over the next year! That is simply insane: there is zero support for such a belief anywhere in the macro economic view yet if you're long the market this is the view you've adopted through your purchases and continued holding of stocks.

Beware that position as all the data from the credit-granting firms, whether they be big banks or credit card companies, strongly suggest that we're going to be lucky to see a positive annualized GDP in either the 3rd or 4th quarter at all, and there is every reason to believe that if we're not negative in Q4 we will be in 2010.

The market is likely to react very badly when it figures this out, and reality will eventually gob-smack us in this regard.