Cramer's Miss On The Corporate/Economic Relationship
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As I sat down to do my regular tradition of reading and research I was hit by a CNBC article in which Jim Cramer was discussing his views on why a market reset was looming. He stated that:
"A 'giant reset' is looming for the markets because the improving economy is simply not trickling down to companies' bottom lines. Macro is great, but when you have to go deal with companies, it's bad."
He goes on to say:
"We have to deal with the four walls of the corporate canvas, and they are simply not able to turn this macro positive into micro earnings gains, and that's a real conundrum, particularly when the 10-year is signaling that happy days are here again."
Is Jim right? Does a disconnect exist between the economy and corporate balance sheets? Moreover, are interest rates really signaling that "happy days are here again?"
The Great Disconnect
I find the first statement by Jim the most interesting, and perplexing, with regards to the improving economy. While there has undoubtedly been some economic improvement from the recessionary lows; that current data suggests that the economy has likely peaked for this current expansionary cycle. The 4-panel chart below shows annual rate of change in incomes, employment, production and overall GDP.
While quarterly data, when viewed solely from one quarter to the next, may show some improvement - these improvements have only been bounces within the context of a longer term down trend. When you look at the charts above it is quite evident that the expansion of the U.S. economy ended in 2011. Since then the rate of growth has been on the decline.
However, I have to disagree with Jim's statement that the economy is not trickling down to companies' bottom lines. The chart below shows corporate profits as a percentage of GDP.
With profits, as a percentage of GDP, near record levels it is hard to claim that corporations are not able to turn the "macro positive" into "micro gains." The reality is that they have done this exceptionally well. However, unfortunately, they have done this at the expense of the American worker. The chart below shows the ratio of corporate profits to employees.
The use of technology, increases in productivity, running lean work forces and suppressing wages has led to a level of profits per employee that are historic levels. This drive to generate profitability by reductions of workforces and increases in productivity has also been a primary driver behind the "labor hoarding" effect which is why falling initial jobless claims is not translating into higher employment.
In Jim's defense he is focusing his attention on the current trend of weakening profitability and weak forward guidance. However, this is a bit myopic given that the economy is already more than four years into the current expansion, economic growth is clearly showing signs of weakening and cost inputs have been increasing. Furthermore, as I addressed in the "4 Tools Of Corporate Profitability:"
"The problem with cost cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness."
In all likelihood what we are witnessing, and what Jim is missing, is that this is more than just a "soft patch" in the economy. It is highly likely, due to the weakening trends in the underlying data, that we are in a late stage economic cycle. My friend Cullen Roche recently commented on this issue stating:
"We’re in the backstretch of the recovery. We’re now into month 47 of the current economic recovery. The average expansion in the post-war period has lasted 63 months. That means we’re probably in the 6th inning of the current expansion so we’re about to pull our starter and make a call to the bullpen. The odds say we’re closer to the beginning of a recession than the beginning of the expansion."
Good Time Are Here Again?
Jim went on to state that:
"It's almost like the CEOs are saying 'whoa' to the market bulls, because the boots on the ground—the companies providing guidance—are seeing that things are just 'OK' and 'inconsistent.'"
The guidance that corporations are providing is based on the income data, and demand, that they are dealing with. My recent NFIB survey analysis quoted Bill Dunkleberg, Chief Economist, clearly stating this issue:
"The amazing stock market continues to surge ahead, even as prospects for earnings growth fade. On Main Street, there is no evidence of profit growth. The economy remains bifurcated, exports turned in a good performance, mostly activity for the large manufacturers, energy companies and agribusiness. Sales for small businesses, especially at service firms, continue to languish. Job openings improved, signaling a tightening in labor markets due as much to departures from the labor force as to the creation of new jobs (of which there were few). But this puts downward pressure on the unemployment rate. Plans to create new jobs also advanced, in spite of pessimistic views of future sales growth, but still historically low and not typical of periods of economic growth."
For Jim, the disconnect between the fantasy of Wall Street, which has been artificially inflated through trillions of dollars of liquidity being pushed into the system, and the reality of underlying economic fundamentals remains a mystery. As Jim stated above, for him, the conundrum is why corporations are struggling when the rise in interest rates are signaling "happy days" are here.
The problem is that when you have an economy that is growing at below 2% annually, real unemployment remains high and wage growth weak - rising interest rates, particularly when driven by artificial influences rather than increasing demand for credit, is historically an economic anathema. Furthermore, it is also important to keep the recent rate "spike" in perspective which has been nothing more than a bounce within a 30 year downtrend.
The rise in interest rates negatively impacts corporate profitability, raises borrowing costs, reduces capital expenditures, slows housing and decreases consumption. With the economy and inflation already trending lower it is unlikely that the recent increase is rates will last for long. As shown above, historically, rates closely track the direction and trend of the overall economy and inflation.
One of the main reasons that investors so often get caught up in major market meltdowns is due to the short-sighted, near term, focus of market analysts and economists. The data has to be analyzed with relation to the longer term trends and a clear understanding that all things, despite ongoing central bank interventions, do eventually end. The problem with the current environment is that the artificial inflations have detached the market from the underlying economic fundamentals which has historically led to larger than expected reversions and outright crashes.
As an investment manager we remain currently invested in the markets because we must avoid suffering career risk. However, it would be naive to neglect the rising risks of the technical extensions, deviations from underlying fundamentals and weakening momentum that exists currently. Yet, despite all the evidence to the contrary, investors are piling into equities in the "hope" that the markets will continue to advance indefinitely. As Yogi Berra once stated:
"You've got to be very careful if you don't know where you are going, because you might not get there."
Originally posted at Lance's blog: streettalklive
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