Market Commentary
by Byron Wien
 
03/05/2013

Money Is Everything

It is hard to believe but as recently as 2009 the entire balance sheet of the Federal Reserve was less than $1 trillion.  Today it is just under $3 trillion, and the Fed is buying $85 billion of Treasurys and mortgage-backed securities a month, so if it maintains purchases at that rate, the Fed balance sheet will grow by more than $1 trillion in 2013 alone.  The Wilshire 5000 index, the broadest measure of U.S. stock market performance, has risen from 8,000 in 2009 to almost 16,000 today, proving once again there is a high correlation between monetary policy and stock market performance.  The Fed hopes that the money it pours into the economy through bond purchases will stimulate growth and create jobs.  That doesn’t seem to be the way the world works, however.  A significant portion of the money would appear to flow into financial assets.  You could argue, though, that the Fed’s objective is at least partially being fulfilled because the Fed balance sheet has tripled while the stock market has only doubled in the last four years, but all this monetary expansion has not gotten the United States on a strong growth path.

It is no wonder then, that the recent severe sell-off in the U.S. equity market was attributed, in part, to indications in minutes of the Federal Open Market Committee that the Fed is considering pulling back on its monthly purchases sometime this summer.  The disappointing and inconclusive results of the Italian election also contributed to the decline because uncertainty about the economic future of Europe intensified.  It is doubtful that a deep market decline is beginning, however.  Many investors who failed to participate in the strong rise in the market in January have been waiting for a chance to buy equities at less than peak prices.

The January rally may have been related to the year-end events in Washington.  The much-feared “fiscal cliff” was avoided by making most of the Bush-era tax cuts permanent and reducing some deductions.  I hardly thought that the deal that was done at that time was something that should be celebrated in the financial markets.  The original discussions between House Speaker John Boehner and President Obama aimed at a $2.4 trillion combination of spending cuts and tax increases with the Republican and Democratic versions having differing proportions of each.  The final agreement was for $600 billion and it was mostly composed of tax increases.  The current deficits of over $1 trillion annually would be diminished somewhat but they would still be substantial.

One component of the agreement on taxes surprised me.  I had thought that the 2% payroll tax holiday would be phased out slowly, but the termination took effect immediately.  My worry is that this tax increase takes a bite out of the paychecks of all wage earners and has a negative effect on consumer spending, which is now at 71% of Gross Domestic Product (GDP).  The supposedly leaked e-mail from a Wal-Mart employee that “January was a disaster” was an indication of that possibility.  The market seemed to assume that the new taxes would have limited or no negative impact on the economy and, in my view, that is too sanguine an interpretation of the fiscal changes.

The strong market performance in January also ignored the so-called “sequestering” which was a plan developed in the fall of 2011 when Congress and the President couldn’t come to an agreement on cutting the budget deficit by $1.2 trillion over the next decade.  They decided then to impose automatic cuts on entitlements and defense that would go into effect on January 1, 2013.  The assumption was that the two sides would come to a more reasoned approach before then, as they had in such circumstances in the past, but here we are in the third month of the year and the sequestration has gone into effect, having been postponed for two months at year-end 2012.  This should have a further dampening effect on the economy and will cause inconveniences as a result of various cutbacks in government programs and services.  The January rally suggested that investors thought that the only factor they should focus on was the continuing purchases of bonds by the Fed.  Until that stops, stocks are going up, has been the prevailing reasoning.

The combination of strong stock market performance together with rising housing prices has had a positive effect on consumer confidence.  This may be one reason why overall retail sales have held up better than expected.  Those who are working feel somewhat more secure than they did four years ago and their net worth has increased.  The question is what will happen to this increased confidence if the stock market consolidates or declines.  Current measures of investor optimism reflect a more constructive outlook.  While not quite at euphoric levels, investor attitudes have reached a point where corrections have begun in the past.  It is just hard to determine what the trigger event will be. 

For a long time I have thought the economy would grow at a modest rate, but that profit margins, which were at a high, would decline because revenue growth would be slow and companies would experience some cost pressures.  The negative GDP report for the fourth quarter of 2012 was a warning signal, I thought.  The Bloomberg median GDP forecast of growth for 2013 has dropped from 2% in October to 1.8% now.   I also believed the fiscal pressures which became clear at year-end would increase investor skepticism, but that clearly did not happen in January.  Now we have the sequestration, the prospect that the government won’t be able to pay its bills after March 27 and the debt ceiling facing us, and we’ll see what impact these fiscal factors have on the equity market.  Europe, also, has taken a negative turn with the Italian election.

An improvement in housing will offset some of this, but it is clear that the economy is going to suffer from some of these taxes and expenditure cuts during the course of the year.  The biggest problems could emanate from service reductions as a result of the sequestration.  The Federal Aviation Administration would have to furlough 4,000 employees daily, causing flight delays; 70,000 children would no longer have access to their Head Start programs; 125,000 families would lose rental assistance and possibly become homeless; and numerous other programs including the maintenance of military ships and aircraft would be cut back.  The Democrats are said to believe that the electorate will be in an uproar over these changes and force the Republicans to agree to tax increases on the wealthy and loophole closures to pay for sustaining the programs. That may turn out to be a risky strategy. 

Almost everyone agrees that the current cost of government entitlements and other services needs to be scaled back. However, when you actually take a hard look at what reducing expenses entails, it is clear that elected officials will be forced to make some hard and unpopular choices.  Aside from the possibility that the economy might suffer from higher taxes and less government spending, there is the possible problem of a profit margin squeeze.  Profits increased rapidly after the recession troughed in June 2009 as one might expect, but something happened in this cycle that had not happened in the five previous recoveries: profits increased faster than revenues.  In a typical cycle sales climb almost exponentially; labor compensation comes next as laid-off workers are hired back and employees who endured the slowdown are rewarded with raises or bonuses.  Profits recover less dramatically.  Not so this time.  Companies used the ample cash on their balance sheets to buy labor-saving capital equipment, enabling profits to grow even faster than sales.  That’s one of the reasons the unemployment rate has remained so high.  In past cycles it would have dropped to 5% by this time.  The rate is now 7.9%. 

Substituting capital for labor caused productivity to surge in 2009-10.  U.S. profits as a share of national income are at a record of 14%.  Profits as a percentage of corporate sales are also at a high of over 9%.  Income from foreign operations has contributed to this performance.  A recession in Europe this year may reduce the positive influence of this factor.  According to an analysis by Tony Boeckh of Boeckh Investments, profit margins of listed American corporations are higher than they are for listed companies in any other developed country.  Although non-residential investment is still reasonably strong, productivity for all businesses and manufacturing is well off its peak.

Another reason for the surge in profitability is the low level of interest rates for corporate borrowers.  Boeckh points out that from 1950 to the early 1980s interest rates rose and corporate profits declined, but when interest rates headed down after the Mexican financial crisis of 1982, corporate profits began a prolonged period of steady improvement.  There is no sign that interest rates are going to rise in the near term, though they are not likely to decline from present levels.  Wages are the other factor that has a heavy impact on profits.  In the 1920s profits were 24% of wages; they declined to 11% by the 1970s.  Profits are now back to over 20% of wages.  Real wages have made little progress over the past decade and that has contributed to the inequality argument.  The growth and compensation in the financial sector has been a factor in the change in the wage/profit relationship, but manufacturing as a share of total profits is increasing and finance is declining, which is an overall positive for the U.S. economy.

My thesis is that a combination of modest revenue growth and increasing costs would put pressure on margins, but Boeckh points out that corporations have relatively lower levels of leverage than in past periods and banks are more than willing to lend to quality borrowers.  By increasing their leverage at low interest rates, companies may be able to maintain high margins in spite of cost pressures.  Doug Kass of Seabreeze Partners has pointed out, however, that at the start of the current fourth quarter earnings season, the estimate for Standard & Poor’s 500 profits was $25.50.  Now with 80% of companies reporting he says $23.50 looks more likely, an 8% shortfall.  He further notes that in January 56 companies provided 2013 guidance.  The ratio of negative to positive was 45 to 11. 

The performance of the market so far this year has largely been a function of monetary expansion, in my opinion, and the low level of interest rates has also had a positive impact on corporate profits.  I have maintained that earnings will be disappointing this year, although the evidence on this point is mixed so far.  Right now stocks are on their way to deliver another double-digit year for the S&P 500, but if margin pressure begins to appear, as I suspect, then a more modest return is likely.

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