Wednesday, June 27, 2012

More on Corporate Profits

Back in September of last year, I showed this chart outlining that corporate profits as a percent of GDP were approaching a three-standard deviation event. Since that time, the relationships has gotten even more extended hitting an all-time high.

Which brings me to this morning's tweet from PIMCO's Bill Gross:
Simple formula: US profit growth rate = (real GDP x 5) – 10. No “ka-ching” at 2% or less GDP growth.
I appreciate the insight that profits can be thought of as being leveraged to economic growth (hence the wide fluctuations), but struggling to see why nominal profit growth would have a relationship with a real (after inflation) economic growth or why those specific numbers (why 2% real and not 2.5% real?) were used.

Anyhow... I was interested enough to see what this equation looked like using actual data, so I put together the below chart going back 60 years against corporate profits, as well as against my old simple standby of using nominal economic growth (my preferred long-term measure for corporate profits as simple math tells you that corporate profits can't grow faster than the economy over the long term or else they'd be bigger than the economy itself - hence profit growth tends to mean revert relative to nominal growth).

The chart...

What do we see?

Well corporate profits are basically right on trend (a surprise to me), but nominal growth is well below trend and the PIMCO formula (the formula based on 2% real growth) is WAY below trend, indicating corporate profits are significantly above trend (by that record 30% level relative to nominal growth and an off the charts 200% relative to the PIMCO formula).

Seems like the old nominal GDP standby has historically been more reliable, but I will be thinking more about the insight that corporate profits are leveraged to (and in need of) specific levels of economic growth. If anything, this may indicate earnings are potentially more stretched than I previously thought.

For those interested, there was a great piece by GMO on the topic of extended profits a few months back.

Source: BEA

Thursday, June 21, 2012

Leading Indicators Up in May

Marketwatch reports:

The risk of a downturn in the second half of this year is relatively low, the Conference Board said Thursday as it reported that its index of leading economic indicators rose 0.3% in May. "Economic data in general reflect a U.S. economy that is growing modestly, neither losing nor gaining momentum," said Ken Goldstein, economist at the Conference Board.

Update: while leading economic indicators held up in May, first signs of June are UGLY.

Source: Conference Board

Wednesday, June 20, 2012

Fed's Ugly Forecasts

Over the past two months, the Fed's FOMC has:

  • Reduced forecasts for growth in 2012, 2013, and 2014
  • Increased expectations of unemployment in 2012, 2013, and 2014
  • Reduced inflation expectations (from a level already below the 2% target) in 2012, 2013, and 2014

Tuesday, June 19, 2012

Financial vs. Capital Expenditures and Equities

Yesterday, I made a bullish case for equities over the long run (especially when compared to bonds), today I will outline one of the reasons I am a bit concerned over the intermediate time frame.

Meb Faber (via a paper by Mauboussin from Legg Mason) shows a table that outlines:
How companies have spent their cash over the past 25 years. Interesting to note is that they spend on average, about 60% of their total spend on capital expenditures, 20% on M&A, and about 10% each on dividends and executed buybacks. The total amount of spend bounces around a bit but is a fairly consistent 20% of market capitalization. Note that buybacks exceeded dividends in 7 out of the past 10 years
Along with the market cap of these corporations, the table shows (as part of a broader paper outlining the benefits and analysis of each) the amount corporations spent on:
  • Dividends
  • Share buybacks
  • M&A
  • Capital expenditures
I'll simplify things and group the first three as "financial expenditures" (or at least spending that isn't used for organic growth) and compare this figure with capital expenditures.

The first chart I'll show compares historical capital expenditures and financial expenditures, normalized as a percent of GDP. While Meb outlines the averages for each category above, what we see is financial expenditures have been trending higher while capital expenditures (as a percent of GDP) have been trending lower. This despite slower underlying economic growth (i.e. slowing growth of the denominator in the capital expenditure to GDP ratio), in part caused by a slowdown in (you guessed it)... capital expenditures. Some thoughts on why financial expenditures have increased in relative importance include the boom in private equity and financial engineering, the shorter-term focus of investors, and a lack of perceived opportunities to deploy cash on projects. Also note how volatile financial expenditures (mainly buybacks and M&A) have been.

The next chart shows the ratio between the two expenditures (financial expenditures divided by capital expenditures). In the late 1980's / early 1990's the ratio was consistently at or below 0.4 (meaning for every $1 spent on dividends, buybacks, and M&A they spent $2.5 on internal growth opportunities), whereas since the late 1990's the ratio has gone above 1 almost 50% of the time (i.e. corporations are now more interested in financial management then building their business through organic growth).

So what does this mean for an investor? Well, returned cash sounds good, but taking the above ratio and comparing it to the three year forward change in market cap (i.e. the value of corporations three years forward) we see a relatively strong (negative) relationship. Unfortunately (and not too surprising when you think about it), when corporations don't put money back into their businesses, the value of these corporations is negatively impacted (they are essentially liquidating vs reinvesting).

I'll leave with one additional point... this all likely reduces the impact of monetary policy (if a corporation is returning cash even at these low rates, why would they borrow more?).

Source: BEA / Meb Faber

Monday, June 18, 2012

Valuation Matters.... Equity vs Bonds Edition

I've shown that valuation matters numerous times over the years when it comes to long-term equity returns (see here, here, and here for some of my favorite examples). The below post uses the same concept in that it compares valuation (i.e. yields) with forward returns, but in this version we compare the relative performance of equities vs. bonds.

The first chart shows the factor that serves as our starting point for valuation... earnings yield of the S&P composite (i.e. the inverse of the P/E ratio) and the yield of the ten year Treasury bond going back 100 years. What we see is a relationship between the two starting about 50 years ago that was non-existent the previous 50 (and the recent divergence that is the widest in almost 40 years).

But the lack of a relationship from 1912-1962 doesn't mean it the relationship wasn't always important. The next chart outlines the forward ten year return differential (annualized) for each starting point against the starting excess yield (the equity earnings yield less the bond yield). Interesting to note that we can easily see the unwarranted excess return that equities saw over bonds starting in the 1980's (i.e. the equity bubble), that was given back over the past ten or so years.

To summarize the above, the next chart outlines the forward ten year return differential (annualized) for each starting point by "bucket" (note that at current valuations we just made it into the 5-7.5% bucket, hence the yellow highlight). The takeaway is that starting yield differentials matter... a lot. To be more specific, the current 5-7.5% bucket means that for every period over the past 100 years when the yield differential was between 5-7.5%, the average annualized ten year forward return differential was a bit more than 8% (8% over the current 1.5% ten year would be 9.5% absolute returns for equities).

While I refuse to state that returns will be anywhere near this 9.5%, by almost all measures stocks appear cheap on a relative basis to Treasury bonds. Unless earnings collapse back to a "normal" percent of the overall economic pie abruptly (definitely possible, but in my view not likely) or the economic pie contracts abruptly, stocks are going to outperform bonds over the next ten years.

Wednesday, June 13, 2012

Retail Sales Sluggish

BusinessWeek details:

U.S. retail sales declined in April and May, pulled down by a sharp drop in gas prices. But even after excluding volatile gas sales, consumers barely increased their spending.

The Commerce Department said Wednesday that retail sales dipped 0.2 percent in May. That followed a revised 0.2 percent decline April. The back-to-back declines were the first in two years.

The weakness reflected a 2.2 percent plunge in gasoline station sales. Still, excluding gas station sales, retail spending rose just 0.1 percent in May. And it dropped 0.1 percent in April. That left retail spending roughly flat outside of gas sales for the two months, a sign that slower job growth and paltry wage increases may be leading consumers to pull back on spending.
The one thing not mentioned above that I find interesting is that furniture and motor vehicles (i.e. large purchase retail items) are #1 and #2 respectively in terms of strength. Perhaps (though not certain) people are just putting other items on hold as they make these purchases.

Source: Census

Monday, June 11, 2012

The End of the Middle Class

The NY Times details:

The recent economic crisis left the median American family in 2010 with no more wealth than in the early 1990s, erasing almost two decades of accumulated prosperity, the Federal Reserve said Monday.

A hypothetical family richer than half the nation’s families and poorer than the other half had a net worth of $77,300 in 2010, compared with $126,400 in 2007, the Fed said. The crash of housing prices directly accounted for three-quarters of the loss.

Families’ income also continued to decline, a trend that predated the crisis but accelerated over the same period. Median family income fell to $45,800 in 2010 from $49,600 in 2007. All figures were adjusted for inflation.
The chart below outlines median family net worth among different percentiles. While all wealth brackets have witnessed a hit since 2007, the wealthier you are... the less you've likely been impacted in percent terms (they were less levered / more diversified in their investments and are less reliant on income from a job for their wealth). Since 2001, it is even more divergent as the only bracket to have seen an increase in wealth are those in the top 10% decile of all wealth.

Thursday, June 7, 2012

Drop the Inflation Concerns

As I've outlined before, wages tend to be the one of the better predictors of inflation (or deflation) out there as wages tend to be very sticky and stable (so when they move, it tends to mean there is a new underlying trend).

So how are wages currently holding up?

Well, earlier this week, the BLS released compensation figures for Q1 and even with negative real interest rates and multiple quantitative easings, there is absolutely no wage inflation in the pipeline. In fact, the year-over-year change in nominal wages came in at just 1.3% at the end of March and 0% over the last six months, the lowest since the crisis and below the rate of inflation.

Even more concerning (to me) is that these figures are as of March, before business sentiment took a turn for the worse on renewed European concerns.

With no inflationary pressure and limited growth potential, a low yielding Treasury bond almost appears justified.

Source: BLS, BEA, Fed

Tuesday, June 5, 2012

Dividend vs. Treasury Yields

The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950's to find a time when this was the case.

The kicker... stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.

My take... stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).

The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950's (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).

Monday, June 4, 2012

Europe's Core / Periphery Imbalances Going Parabolic

George Soros' recent speech on what created the Euro bubble (and how it will need to play out) is making the rounds (although he deleted the speech from his personal site for some reason, a pdf version is here). While I strongly suggest reading the whole thing, a key takeaway is that:
The authorities didn’t understand the nature of the euro crisis; they thought it is a fiscal problem while it is more of a banking problem and a problem of competitiveness.
The result is that the issues have not been addressed and problems have only gotten worse.
The real economy of the eurozone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.
Which can be easily seen in a variety of metrics, including unemployment which is shown in the below chart and is simply unbelievable. It shows the current unemployment rate of Spain (currently an unreal 24.3%) divided by Germany's (less than half 2005's level at 5.4%) going back to 2000. It was only 5 years ago that Spanish unemployment was actually lower than Germany's (though that employment coincided with a massive housing bubble in Spain funded by cheap German financing from excess German savings).

Source: Eurostat