Damn The Torpedoes, Full Speed Ahead

We are facing another earnings season directly ahead. Should we be worried? Well, that depends a lot on what you think the market thinks this earnings season will produce. If you believe that the market is expecting another big earnings season, you may be in for some disappointment. However, if you believe that earnings will grow at a decent clip, without much help from the economy in general, then you might just be in for a nice little surprise. Our guess is that earnings will grow at something above 10% year-over-year but not by the 30% that we had become accustomed to last year.

The economy hasn’t grown as quickly in the latest quarter as people would have liked. Most of the forecasts for the second quarter GDP growth focus on about 2% give or take, mostly take. So, how are companies going to show us even 10% growth? There are a bunch of reasons. The most obvious is that not all the growth has to come from the good old US of A. A lot of the growth will arise in foreign markets, mostly in emerging markets. Growth in many emerging markets is so fast that the local authorities are trying to rein in growth so as to avoid a huge inflationary cycle. So, that is part of it.

Another piece comes from the fact that corporate earnings are a nominal dollar exercise while GDP is supposed to be deflated to account for the inflation component. The US economy probably grew at a 5% annual rate in the second quarter on a nominal basis, 2% real and 3% inflation. So, we get growth from inflation, from real growth and from overseas. Where it the rest of it going to come from?

Unlike most governments (that don’t have high productivity) most corporations do have high productivity. They get operating leverage by driving higher revenues through a largely fixed stock of physical capital in the short run. With costs somewhat fixed and revenues rising, the marginal dollar of revenue is far more profitable than the average dollar of revenue. (Hopefully, we won’t have to explain that one because it is most of a term in college – ECON 102, micro-economics, the firm and capital allocation.)

We also have financial leverage. This is the last one, we promise. If firms had all their invested capital in equity, they would have no financial leverage, but they don’t. Companies issue bonds and bonds create financial leverage. As marginal dollars get past the operating leverage (physical leverage) mentioned above, they enter the capital structure. Any that are used to pay bond interest or preferred stock dividends are lost at this point, but the idea is that relatively more dollars escaped here than the relative weight of bonds and preferreds in the capital structure. So, again the marginal dollar falling to the bottom line is worth more to stock holders than the average dollar. We get lots of growth from financial leverage.

Financial leverage has been going up lately. We might have thought that after the latest recession and financial panic that leverage would be seen as a bad thing. But, when interest rates are near historic lows, it pays companies to sell bonds, buy their own stock with the proceeds and increase their financial leverage. A lot of this has been going on rather quietly. But, when companies authorize a $2 billion stock buyback or at $15 billion buyback or whatever, usually nothing much happens. They will buy some stock from time to time, maybe enough to offset the dilution from options issued to executives, maybe enough to offset the dilution from issuing new stock to the 410(k) plan as a match, but no wholesale buying of most of their repurchase authority. Lately, companies have been buying their own stock at record rates and issuing bonds at a similar pace.

This financial leverage will help get our 10+% earnings growth. The operating leverage is a bigger chunk of the growth than financial leverage and growth from emerging markets is probably a bigger chunk yet. But, we can keep up this sort of earnings gains for a long time, we are not at the end of the recovery yet, or near the end of this bull market.

Issue of the Week

The US Congress (the opposite of progress) has been playing politics with the debt ceiling for a few weeks now. Both sides have stated their positions and both have rejected the other side’s position. Now the bargaining can begin. What do Republicans have to give up to get a deal done? Revenues. Up until now, the House Republicans have staunchly refused to increase taxes. They will probably bend a little bit on this by allowing caps or elimination on many deductions in the tax code. We may see a blizzard of changes or just a few, but that is where the revenues are going to come from, not from straight tax rate increases. However, it looks like any further extension of the Bush era tax cuts is unlikely should Mr. Obama get reelected.

What do the Democrats want? They are all in favor of the status quo, but with more revenue. What are they willing to give up? Spending. We are likely to see a lot of not-so-sacred cows get slaughtered. We are unlikely to see any major overhaul of the big entitlement programs that are so necessary both to ensure their survival, but to save any meaningful dollars in the long run. But, we could see maybe a trillion dollars in spending cuts spread-out over the next decade. The numbers will seem impressive and there will be lots of political fodder for grandstanding on how terrible this is for the man on the street, but it won’t likely be meaningful in closing our deficit.

So, everybody will give up something and everybody will get something and nobody will be happy about it. That’s the American way.

So why is this the issue on everybody’s mind? Because both right and left wings of the US political spectrum are using the issue to further their case that the other guys can’t be trusted to run the country. Politics are getting in the way of economics. All this political discourse is confusing the populace, scaring the populace and discomfiting the populace. What good does that do for the populace?

So, if we’re going to raise the debt ceiling, and if we’re going to have to compromise a little bit to do it, let’s do it.

Economic News

WOW! What a horrible payrolls report!

The economy added only 18,000 jobs in June according to the Bureau of Labor Statistics. The private sector added 57,000 jobs while the government sector lost 39,000 jobs. The government jobs news isn’t really news. It was widely expected given all the financial troubles with states and cities across the country that employment there would continue to decline, even accelerate as the new fiscal year for many municipalities begins. That will also likely impact next month’s report as many of the job cuts at the state and local level will begin this month.

The Unemployment rate rose to 9.2% while the labor force actually slipped. The broader U6 unemployment rate, which includes all categories of un- and under employment, rose to 16.2% from 15.8%. Average hourly earnings were flat while hours worked fell slightly.

This is not good for the broader economy. While we had been enjoying a positive cycle of more jobs leading to more consumption leading to more jobs; that cycle is in serious jeopardy now. The slowdown in the economy over the last couple of months may now be ending, but it may also become entrenched. May’s job total was revised even lower, to 25,000 from the initially reported 54,000.

The question naturally follows what impact this may have on the longevity of our economic expansion? We suspect that this is not going to fully derail the expansion, but it does throw a lot of sand on the tracks. Growth in the second half is likely going to be slower than previously thought. But, the counter argument is that this is likely the result of the first half having been slower growth than expected.

Let’s go back to the basic math of economic expansion – labor force growth plus productivity set the pace for expansion. In the US in the early 21st century, that number is about 3.5% to 3.75%. From that we can deduct the loss to our trade deficit and the production of the unemployed that won’t occur. So, we’re at a lot less than 3.5%. This is the new normal. But, we still had a fairly decent growth rate going until something like the Japanese earthquake and tsunami upsets things. Japan probably cost us 0.5% to 1.0% in production in the second quarter. That might also show-up as lost employment a couple of months later.

Employment is a lagging indicator. We have had to rediscover this truth every few years. Employment trends don’t predict anything. They reflect what has gone on before. They remind us of what has already passed. There is every reason to believe that in this case the sudden lack of momentum in employment is the reflection of the sudden loss of momentum in the economy last quarter. It probably isn’t forecasting anything.

The Institute of Supply Management Non-Manufacturing survey which covers all the service segments of the economy showed persistent growth albeit at a much slower pace of growth than in recent months or than was expected. The newest reading at 53.3% in June from 54.6% in May shows continued growth at a subdued rate. Any reading above 50% indicates growth in the service sector. This is nice at four out of five US workers works in services and three-quarters of the US economy is services of one sort or another. The employment sub-index showed continued growth in services employment with a reading of 54.1%. The prices paid index fell to 60.9% from nearly 70% last month.

China raised interest rates again, the third rise so far this year. Besides raising rates, the Chinese have also increased reserve requirements on Chinese banks, which hampers lending. Chinese rates are now 6.56% as their effective prime rate and 3.50% as the prevailing deposit rate. And no, you can’t get in on that.

The European Central Bank which has the world’s most prominent crisis right in their midst raised interest rates to 1.5%. Also, the Bank of England left their rates unchanged.

Weekly Stuff

It was another good week for equities here in the US and in much of the developing world, and pretty good for the other developed markets. The small decline registered for the EAFE is largely due to currency (the dollar was up last week against the Euro) and to weakness in French stocks. The week would have been terrific were it not for the Friday news that jobs are still not being created in the US (see above for our take on that).

We have commented before about the way sentiment plays on stock prices. When your typical investor is more bullish than bearish, stocks tend not to do well. When there are more bears than bulls, it is usually a good time to invest. As weird as this sounds, the contrary nature of this series is well founded and can be generally counted on to work, maybe not every day but over a time frame of weeks and months. Back in April, near the last high in the market, sentiment got very rosy and we were nearing those levels again last week. We had seen the number of bears dissolve before our eyes, falling by about half in a month’s time. When everybody is bullish, there is a lot of good news discounted in share prices. When bad news hits, it is a bigger hit to sentiment than when investors are bearish. Bears expect bad news, bulls don’t. Last Friday’s employment report hit the bulls where it hurts, in their sentiment.

We were pleased to see the emerging markets break back into the black for the year to date, even if it doesn’t last long. The correction in the emerging markets has gone on quite a long time and we think it will end soon. Many of the individual emerging markets have taken quite a pounding, down the best part of 20% in many of the major markets. That is much worse than any of the developed markets. The sentiment on emerging markets has been pretty badly dented, but is still a deeply held concept that where the growth is good things will happen.

It was actually a pretty good week for bonds, pretty much all on Friday. The bonds were able to absorb much of the prior good news without having rates rise all that much. So, on Friday, when they got their ‘good news’ it wasn’t hard to get back on the winning track. Corporate bonds and other high grade areas followed Treasuries to gains for the week. High yield bonds did very well early in the week and hung in like stocks for weekly gains.

Foreign bonds were generally ahead in their home currencies, but dollar strength capped the overall gains or lead to losses for US investors. The 1% gain in the dollar is kind of odd given that it was weakness in the US economy that caused the dollar strength, more of that risk-on/risk-off trade.

Real estate gained nicely on the week, following financials mostly. We don’t have any really good idea why commercial real estate would suddenly get a lot better just because the US can’t develop enough jobs. There was the germ of a concept that with a growing economy and really no new supply for the next several years we could actually develop a nice shortage thesis. But, that requires a growing US economy, which is now a question.

Commodities were the generally strong last week. Strength in energy and foodstuffs, precious and industrial minerals was pretty broad.

The Bastille was a medieval fortress that had long outlived its usefulness. The French used it as a prison, but also as an armory. While freeing the prisoners in the Bastille was important, the real prize was the thousands of muskets and barrels of gunpowder held there. But, that was hardly the beginning of the modern French republic, just as American leaders declaring independence didn’t automatically create a new nation. It took years and thousands of lives before the French would actually get the republic they wanted. They had to survive the Reign of Terror when tens of thousands were sent to the guillotine or died in prison. They had to make it through the Napoleonic years of almost non-stop wars. They had to endure the Bourbon restoration and its collapse. Only in 1848 did the French manage to make a republic out of the carnage of half a century of revolution, counter-revolution, empire, collapse and finally rebirth. But, even the 1848 republic didn’t last long. By 1850, Louis Napoleon, nephew of the former emperor, grabbed power in a coups d’état which created the Second Empire. This empire ended with the crushing defeat of France in the Franco-Prussian War in 1870, which ushered in the Third Republic and the one that more or less stuck.

And, you thought we Americans had it tough getting started.

Have a great week.

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.