Juggling Dynamite

Second quarter earnings season is now ending with nearly 75% of US companies having reported earnings better than the consensus expected. Before we get too excited about this outcome though, it is important to take a realistic view of the numbers.
First, as I have noted before, most of the positive earnings “surprise” last quarter was a direct product of two key features: drastically reduced analyst expectations (that were easy to beat), and heavily slashed expenses (which will be hard to repeat).
Euphoria based on such narrow results is sorely misplaced. Evaporating demand is the over-arching theme that the market rally has so far been ignoring. Industrial revenues dropped 20% year over year in the second quarter, and more worrisome looking forward was a 30% drop in new orders. Sales are still falling and based on this week’s poor data on retail sales, weak consumer confidence, and rising un-employment, sales are not likely to bounce back substantially anytime soon. See WSJ: Industrial Stocks living in the past.
Weak demand is a major problem for forward profits. Not only will they be harder to find now that costs have already been slashed, but over-supply/ over-capacity across the world’s export nations will continue to put downward pressure on prices and margins.
And there is something else. There is presently an ominous gap between Q2 reported earnings and adjusted operating earnings. Reported earnings are governed by GAAP. But adjusted operating earnings are at the discretion of management and exclude many expenses such as write-offs. Write-offs are at record highs and so are exclusions. This has led to a record gap between the reported earnings and the adjusted operating earnings. This gap is a black cloud over future earnings. Studies suggest that $1 of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.
“Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor’s is $7.20 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are down 34 per cent [just] from the 2007 peak. This $54 gap is a record.”
See FT: Insight: Cause for caution on US earnings.
Earnings growth needs increasing profit margins, increased inventory turnover or increasing leverage. Increased leverage is unlikely in a de-levering world. Increased profit margins are unlikely for some time. Higher inventory turn-over may also be tough without expanding credit.
Despite recent sprinting in the stock market, this recovery is likely to be a marathon with many hills.
Bad debts and bad assets aren’t just in the financial sector and they will have to be accounted for eventually. Pretending they aren’t there is unlikely to work indefinitely.
For a good update on bad loans and pending write offs in the US banking sector watch this recent clip with Elizabeth Warren, Chair of the US Congressional Oversight Panel (COP). While you watch, keep in mind that Europe, the UK and some emerging economies are likely to have bigger write-downs and write-offs than the US.

These days world markets are being moved by the crazy people. This happens; we have seen it many times over the years. It’s one of the realities that sane investors have to contend with every day. Lately it has become extreme again. We can try to ignore them, but make no mistake– crazy people make it more dangerous for everyone.
The world is in trouble. We cannot 'spend our way to prosperity' right now and China cannot pull the rest of us out of hock. The Chinese government (and others) have been pouring free money and forced lending and it is puddling into the natural formations of speculative fervour—asset bubbles–again.
If the Chinese have greatly stimulated domestic demand, this would seem to be a good idea on the surface. However, the Chinese economy is 60% domestic and 40% exports. If the demand for Chinese exports isn't there, then domestic stimulation will lead to a short term increase in production/GDP, but could lead to a massive build up in inventories and downward pressure on prices if global demand doesn't return.” See: Busch: Chinese Reality Reckoning.
With free-flowing government money, Chinese people are not investing in homes, cars and business development they are back at the track to double or nothing. Real estate, stock and commodity markets have melted up. Investor participation has been narrow, volume has been weak, but prices have spiked into a new high-pole now teetering over many unsuspecting heads. See: Dollar will rise and punish assets.
Oil supplies in the U.S. are at almost 20 year highs, heating oil supplies are near 25 year highs, consumers are doing everything possible to cut back, and yet oil prices are hovering at $70 again. See: Oil should be priced at $50-$55. As we saw repeatedly over the past few years, when supply drowns demand, the inevitable corrections come fast and hard. Export dependent nations are hurt the most.
Let us be lucid. Today world demand is still driven by western consumption. Western consumers have found the religion of frugality; millions are now like addicts clamouring to rehab, and for a while at least, they are holding on to “the wagon” for dear life. Fear of financial demise will do that to you. Suddenly all the 'things' one thought essential become cumbersome trash in the light of day.
The stock and commodity rally since March started out with some rational connection to valuation fundamentals and then, along about May, things went postal. The familiar chant from simpletons has been all about emerging markets decoupling themselves and pulling the world economy over the corpse of an insolvent west. But so far at least, that is just not working.
Meanwhile US reports today showed that total retail sales fell 0.1 percent in July notwithstanding Obama’s much heralded “cash for clunkers” program which was expected to prompt a 0.7 percent gain in retail spending.
At the same time the Labour Department showed first-time applications for unemployment insurance benefits climbed 4,000 to a seasonally adjusted 558,000 last week. And this says nothing of the thousands of people who are now falling off the unemployment insurance rolls having exhausted their entitlement. No jobs and expiring unemployment benefits equal no spending ability and a fresh new wave of credit defaults and foreclosures. See: Green Shoots?
We need to see a return to growth in the world economy before we can rationally price the future. We need real consumption, not stockpiling and speculation—need based consumption– to fuel a recovery. Until we see that, sane people have no choice but to keep a defensive posture of their net worth while the crazy people run amuck.

William Black speaks very clearly on the biggest theft in world history. The first few minutes are two speakers introducing him, and then Black's presentation lasts 25 minutes, followed by question and answer. The facts of what happened would be almost amusing if they weren't so sad.