Month: September 2013

Corporate Profits and New Orders

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Wednesday’s release of durable goods orders showed a rather large downward revision to July’s data and an increase in August’s orders.  The transportation component makes the overall reading of this report quite volatile.  A more consistent read is gained by excluding transportation and defense goods, which showed a less dramatic 3.3% decline in July, followed by a slight increase of 1.5% in August.  The year on year increase is 7.6%.

In nominal dollars, not adjusted for inflation, we have reached the level of new orders before the recession began in late 2007 – early 2008.  Had the economy stayed “on trend” new orders would be over $84 billion this year.

When adjusted for inflation, we are at about 2006 levels – seven years of no net growth.

Second quarter corporate profits are up almost 6% and have tripled in the past ten years.

Despite all the daily and weekly responses to political as well as economic news, the SP500 stock market index essentially rides the horse of of corporate profits.  The market’s fluctuations reflect changing current expectations of future profits.  Except for the “irrational exuberance” of the late 90s, there is a remarkable correlation between the SP500 and corporate profits.

Focusing on the past ten years, we can see these two forces as they dance around each other.   As sales and profit emerge over each quarter, companies guide analysts estimates of profits up and down.  The market renegotiates its value based on these revisions of emerging profit estimates.  As a rule of thumb, an investor with a mid term horizon of 1 – 3 years might grow wary when these trends diverge as they did in the late 90s and 2006 – 7.

 

As a percent of the total economy, profits have doubled over the past ten years.  At the trough in 2008, when some financial pundits were forecasting the end of capitalism, profits as a percent of GDP were at the 25 year average.  Investors had become used to this lop-sided economy where corporations grab more of the economic pie.

A growing share of profits is earned overseas; that growing globalization and two decades of effective lobbying have enabled corporations to lower the tax bite on those profits.

The taxation of corporations is a two-edged sword.  One effect of more taxes for corporations means less dividends to investors, who probably pay taxes at a higher rate than the effective rate of corporations.  During the 1980s and 90s, dividends averaged around 40 – 50% of earnings after taxes.  In the past decade and especially after the cash crunch of 2008, corporations have retained more of their earnings as an emergency cash cushion, paying investors about 30 cents on each dollar of earnings.  That rush to safety will probably reverse itself in the coming years, prompting corporations to pay out more in dividends as a percent of profits.

There may be volatility in the market in the coming days and weeks as Congress wrestles over the funding and implementation of the health care act, threatening to shut down most non-essential functions of the entire government.  A similar budget battle in late July and August of 2011 was accompanied by an almost 20% drop in the market.  The longer term trend is told by the rise in corporate profits, by the rise in industrial production and by the rise in new orders.  A move downward in the market may be a good time to put some cash to work, or to make that IRA contribution for 2013.

Home Sweet Home

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September 22nd, 2013

The monthly report of new housing starts was released Wednesday morning, the second day of a much anticipated meeting by Federal Reserve. On an annualized basis, builders started 891,000 homes, a 19% year over year increase. This figure includes both single family homes and apartment buildings. Starts were below expectations and may cause some Fed officials to postpone or soften their quantitative easing program.  (Note:  later that day, the Federal Reserve announced that they would not start tapering their bond buying program, a surprise that spurred a surge upward in the  stock market)

A 19% increase sounds great until we take a birds eye view of housing starts.

The 5 month average of housing starts has been declining since the spring. A decline in the volume of new homes sold is an early warning of recession.  Builders are motivated sellers and respond to changes in demand.  Because builders borrow money, called “bridge” loans, to manage their cash flow they are motivated sellers and respond more readily to changes in demand.

 

A common metric heard on the nightly news is the months supply of new homes for sale.  This is the inventory of new homes in a particular area.  More months is bad, less months is good but too little inventory puts upward pressure on prices.  New home inventory is low.

The months supply is a ratio of home sales to starts and can be misleading. The components of housing starts and sales tell another story.  Starts indicate confidence of builders in future home sales in their region. A thirty year graph of new one family homes started less one family homes sold shows a deep underlying caution among builders.  They got burned in this last downturn and are not sticking their necks out.

As the population grows, people need to live somewhere.  Below is the number of new privately owned housing starts per 1000 increase in the population.

This graph tells a different story than the usual “too many houses built” narrative.  The height of the 2000s boom was less than the heights of the 1970s and 1980s.  There were not too many houses being built but too many houses being bought by people who could not afford them.  Mortgage companies sold adjustable financing products designed to earn fees when homeowners refinanced every few years to avoid large interest rate increases.  Buyers were enticed by a hop-on-the-gravy-train mentality as housing prices rose dramatically, particularly in low income areas.

After the 2000 census, the Census Bureau summarized decades long shifts both in the type of housing and the characteristics of homeowners.   While there is a wealth of 2010 census data, I was unable to find a similar table that incorporated data from the recent census.  The Census Bureau notes that privately held housing starts do not include mobile homes, which grew to 7.6% of the housing stock in this country.   So the surge in housing per change in population of the 1970s and 1980s is understated.  This suggests that the new home market is not overbuilt but that people are less able or less willing to commit to owning a home than they were thirty and forty years ago.

Sales of existing homes, released Thursday, showed a recovery high of almost 5.5 million units on an annualized basis.  Realtors reported continuing strong demand in anticipation of rising mortgage rates.  The “churn” of existing homes is not a productive investment in and of itself since the home has already been built.  Sales in this category do generate fees for banks and realtors at the time of sale, and increased sales for Home Depot and remodelers as buyers remodel following the sales or sellers spruce up homes before they put them on the market.

The ratio of new spending per existing home is very small compared to the material and labor involved in building a new home.  The brisk pace of existing home sales does raise the valuation of existing homes, which leads people to feel that they are wealthier, which may induce them to loosen their purse strings.  Rising home values are good for those who own a home but increasing valuations make it that much more difficult for buyers trying to buy their first home.  People in their twenties and early thirties who are most likely to be first home buyers have been hit hard by the recession.

As the economy continues its muddling recovery and home prices rise, does this generation practice a stoic resignation as they look to the future?

Crises

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September 16th, 2013

September marks two anniversaries that we wish had not happened.  One of those is the financial crisis and the meltdown of the economy in September 2008.  In the fourth quarter of 2008, GDP fell about $250 billion.  By itself, this was not a disaster.  However, it came on the heels of a decline in the 2nd quarter and flat growth in the 1st quarter.

Almost overnight, consumers cut back on their spending.  Retail sales dropped $40 billion, a bit more than 10%.

There was little drop in food sales – people gotta eat.  All of the drop was in retail sales excluding food.

Retail sales are less than 3% of GDP.  Contributing to the GDP decline was the 33% fall in auto sales, about $20 billion.

Offsetting the decline in retail sales, however, total Government spending increased $40 billion in the 4th quarter.

Disposable Personal Income (income after taxes) fell $100 billion, about 1%, but was still on a healthy upward trajectory during the year preceding the crisis.

We routinely import more goods and services than we export.  In the national accounts of domestic production, imports are naturally treated as a negative number, while exports are positive. The difference, called net exports, is negative and reduces GDP.  For all of 2008, we had about the same net exports as 2007.

Gross Private Domestic Investment declined $200 billion or 9% over the year.  This includes investments in buildings, equipment and housing.  Housing accounted for $150 billion of the change.

The TV news media, a visual medium, focuses on crises because it is not well suited for more thoughtful analysis.  On camera interviews in a crisis do not have to be very detailed or accurate.  Viewers understand that it is a crisis.  But viewers are also an impatient bunch with trigger fingers on their remote controls. Video footage has to be loaded, sequenced and edited.  On air interviews and several short video clips run repeatedly during a news hour will have to do.  The recent flooding in Colorado is a reminder that there is only so much video footage available.  TV stations simply reran the same sequences over and over.  On the 9 PM local news, the station featured an on site reporter in front of a driveway heaped full with damaged belongings and furniture.  At 10 PM, a different local station featured their reporter in front of the same house.

In September 2008, the media focused on the financial crisis and the implosion of stock prices.  When the stock market opens up on a September morning 300 points down, what else is there to cover?  It is important to understand that the economy is a big organism with a lot of moving parts.  The housing decline was already two years old before the financial crisis hit in September 2008.

Fast forward to this September.  A day ahead of the ISM Manufacturing report on September 4th came the news that China’s manufacturing sector has strengthened, a positive note in the Asian region where capital outflows from emerging nations have weakened the economies of other nations.  The prospect of higher interest rates in the U.S. has sparked a change in money flows to the U.S., strengthening the dollar against the currencies of emerging countries.  This change in flows promises to put pressure on companies in developed nations who had earlier borrowed money in U.S. dollars to take advantage of low interest rates.  The stream of capital follows the deepest channel.  The combination of risk and reward in each country can largely determine the depth of the channel.  Countries can, by central bank policy or law, control the flows of foreign investment into and out of their country.  China and India exercise some degree of control in an attempt to maintain some stability in their economies.  Like other developed nations, the U.S. has few controls.  In the run up of the housing bubble, foreign flows into the U.S. provided the impetus for investment banks like Goldman Sachs to initiate and bundle many thousands of mortgages into tradable financial products that met the demand by foreign investors.

Manufacturing data in the Eurozone was a big positive with several countries recording their strongest growth in over two years.  The Purchasing Managers Indexes (PMI) are not strong but are showing some expansion, a turn about from the slight contraction or neutral growth of the past two years.   The fragile economic growth of the Eurozone has been exacerbated by the concentration of growth in France and Germany, particularly Germany.  Recent strong gains in some of the peripheral countries, those in the former Communist bloc and southern Europe, suggest that economic activity is becoming more dispersed.  Dramatic differences in the economies of countries that share the same currency make the setting of monetary policy difficult and it is hoped that more even growth will take pressure off central banks in the Eurozone.

At an overall reading of 55.7, the ISM Manufacturing report released a week ago Tuesday showed even stronger growth than the previous month’s index of 55.4.  50 is the neutral mark that indicates neither expansion or contraction of manufacturing activity.  New orders began a worrisome decline in  the latter part of 2012 that persisted into the spring of this year, and the turnaround of the past few months forecasts a healthy manufacturing sector for the next several months.  Levels above 60 in any of the components of this index indicate robust growth;  both new orders and production are above that mark.

A few days later ISM reported their Non-Manufacturing composite was 58.6, indicating strong expansion in service industries which make up the bulk of the economy.  The Business Activity index came in at a robust 62.2.  ISM also reported that their figures for June had an incorrect seasonal adjustment.  The New Orders Index for June was revised up a significant 2%.  Prices were revised up 4.3%.  Other changes were relatively insignificant.

The constant weighted index I have been tracking smooths the ISM data so that it responds less strongly to one month’s data but it is showing strong upward movement in both manufacturing and non-manufacturing.

The Commerce Dept reported last Friday that Retail Sales continue to grow at a modest pace.  However, let’s look at retail sales as a percent of disposable income.  Consumers are still cautious.

Speaking of disposable income.  As we import more and export less, disposable income as a percent of GDP continues to rise.  This percentage rises sharply at the onset of recessions.  It is a bit troublesome that the 40 year trend is rising.

Labor Patterns

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September 8th, 2013

On Thursday, the payroll firm ADP released their estimate of monthly growth of private payrolls, showing a net job gain of 178,000.  The weekly report of new unemployment claims was also a positive, a steady decline that indicated that the labor market is healing – but slowly.  On Wednesday, the National Federation of Independent Businesses issued their monthly survey of small businesses. For the fourth month in a row employment growth has been negative.  Slowing layoffs have contributed to the decline in unemployment claims, but new hiring has also slowed.  What to make of that?  The market paused on Thursday in advance of Friday’s release of the BLS employment report.   Caution mixed with confidence – sounds like a weather report.  But there was hope that BLS job gains might approach the 200,000 mark.

The BLS composite picture of employment in August was a both a jaw dropper and a head scratcher, two actions which are difficult to do at the same time.  The headline number of 169,000 net job gains was disappointing, but the revisions to July’s job gains was a huge slash – from 162,000 as reported last month to a meager 104,000.  About a 150,000 net job gains are needed each month to keep up with population growth.

In a tumultuous job market when the flows of people within the labor market are undergoing a lot of change, downward revisions of this size are understandable.  In a supposedly stabilizing labor market, such revisions hint at an underlying fragility.

Is this large downward revision typical of the summer months?  In September 2012 the BLS reported upward revisions of over 80,000 jobs for June and July.  This year, revisions are down almost that amount so these wild swings may be typical.  Businesses may neglect to return the BLS survey on time because they are down at the lake 🙂 In perspective, a revision of 70 – 80,000 jobs is an insignificant percentage of the total working force of over 136 million.  But there is no doubt that it affects the mood of investors.

Once again, the usual industries contributed the most to employment gains:  professional and business services, retail and drinking establishments and health care workers.  I’ll look at some disturbing long term patterns later on in this blog post.

The unemployment rate dropped 1/10th percent to 7.3% but the decline is more a matter of attrition than strength in the labor market. Retirees and others continue to leave the labor force.

A bright note in this month’s report is the decline in the number of involuntary part-timers, those people who are working part time but want and can’t find a full time job.

The core work force aged 25 – 54 shows little improvement.

Gains in construction employment have moderated recently.

Government employment at the local level is providing a slight boost to the employment gains.  Yearly changes in Federal employment continue to show a decline.

As the economy increasingly focuses on services, employees in those industries have become a greater percent of total workers.

Let’s take a look at the labor mix, or the percent of some occupations of workers to the total work force.  During the past thirty years, the ratio of management and professional workers has increased by approximately a third.

In the early decades of the 20th century, agricultural workers made up about 45% of the work force.  In the first decades of the 21st century, they have declined to less than 2% of the work force.

A decline in manufacturing and construction has caused a gear shift in the components of the labor force.  Service occupations as a percent of the work force have risen steadily.

The conventional narrative says that this has been a natural long term shift from manufacturing to service.  But a longer term perspective calls that into question and shows that we are returning and surpassing – this is not new – to a more service oriented labor force.

The BLS does not have data before 1983 for this composite of service occupations but the trend indicates that the labor market is much healthier when service occupations are less than about 16.5% of total workers.  I’ll call this the Service Occupation Ratio, or SOR.  Let’s now look at this thirty year trend and add the unemployment rate.

Until the housing bubble of the early 2000s, the unemployment rate followed increases and declines in the SOR.  Largely fed by robust employment related to housing, the unemployment rate parted company with the trend line of the SOR.  As the recession sparked large job losses, the unemployment rate snapped back into trend with the SOR.  Since the recovery, declines in the unemployment rate have not been accompanied by a decline in the SOR.

The trend patterns are even more closely aligned when we look at the wider unemployment rate that includes those who want full time work but can’t find it and discouraged job seekers – or the U-6 rate.

How long will this imbalance last?  In the early 2000s, the imbalance lasted about five years.  This current imbalance is about three years old, meaning that we may have a few years before the unemployment rate returns to the SOR trend line.  What is particularly worrisome is the degree of imbalance.  As the unemployment rate drops further away from the SOR trend line, as it did in the early 2000s, it signifies greater tension between these two labor “plates.”  Like the movement of land mass tectonic plates, the greater the tension, the more severe the “snap back” to trend.  We see the same pattern developing in these past few years.  A lower participation rate and more people working part time out of necessity have contributed to a decline in the unemployment rate but the SOR has plateaued.

History is a river; history repeats itself; pick your aphorism.  An old Chinese maxim says that a man never crosses the same river twice.  History does not repeat itself exactly so that it is unlikely that the current anomaly will resolve itself in the same way as it did in 2008.  We can hope that the SOR starts to decline, indicating a healthier labor market.  These anomalies can take years to develop but we may find that the correction is as abrupt as 2008.

Each month starts off with a wealth of data. Next week I’ll cover industrial production, retail sales and an update of the CWI composite of manufacturing and non-manufacturing data that I have been charting the past few months.

Labor and Money Flows

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September 1st, 2013

On this Labor Day weekend, I’ll review some things that caught my attention this past week.

The employment picture has shown steady but slow improvement.  The weekly survey of new unemployment claims continues to show downward movement.  In a survey that is about 13 years old, called the JOLTS, the BLS gathers data on Job Openings, Layoffs and Turnovers.  A component of this survey includes the number of employees who have quit their jobs, referred to as the “JOLTS quit rate.” In the aggregate, it indicates a hive intelligence, the estimation of millions of people about the prospects of getting another job.  Decades ago, researchers asked a number of people to estimate the number of jelly beans in a jar.  Each estimate has very small chances of getting close to the actual number, but the average of all estimates was found to be almost exactly the number of jelly beans in the jar.  I don’t know whether this experiment has been replicated but it is interesting.

After recent months of surging new orders for durable goods, July’s report, released Monday, showed signs of caution and a “return to the mean” of a positive upswing this year.

Although this past month’s data was negative, industrial production shows a clear uptrend.

In an analysis released a few months ago, the Federal Reserve examined data from the 2010 triennial (every 3 years) survey of households and estimated that inflation adjusted net worth per household (green line in the graph) has just climbed back to the level it was almost ten years ago.

 

On the positive side, average net worth is not less than it was ten years ago.  On the negative side for those nearing retirement, it is not more that it was ten years ago.

On Friday, the Personal Consumption and Expenditures (PCE) report showed a 1.4% year over year percent gain, indicating the tepid growth in household spending.  Below I’ve charted the percent gain in PCE vs the percent gain in GDP for the past thirty years.

We are still below the low points of the 1980s, 1990s and early 2000s.  The Federal Reserve is projecting GDP growth of 3 – 3.5% in 2014 but this may be another in a string of rosy forecasts by the Fed, who have repeatedly revised earlier rosy forecasts.  If the Fed were a contractor, it would be out of business due to poor estimating.  A $16 trillion economy is not a kitchen remodel by any means, but it does illustrate how difficult it is for the best minds to make even short term predictions of the economy from the vast amounts of sometimes conflicting data.  Consider then the folly of the Government Accountability Office (GAO), the economic watchdog created by Congress and mandated by Congress to come up with ten year estimates of economic growth and the consequences of existing and proposed legislation.  Those in Congress continue to trot out these fantasy numbers to support or criticize policy and legislation.

Washington continues to vacuum in money and talent from the rest of the country.  Of the richest counties in per capita income in the U.S., the Washington metro area has two of the top three.  The other county in the top three is a stone’s throw from the metro area.  As Washington politicians convince the rest of us that they have the solutions, lobbyists and graduates flock to the concentration of power, jobs, money and influence.
 
Bond yields have increased more than 1% since the spring, meaning that the prices of the bonds themselves have fallen dramatically.  Most of this change has been a reaction to forecasts for stronger growth and a tapering of the Fed’s stimulus program called Quantitative Easing.  Washington is sure to get in the way of stronger growth for the economy as a whole.  Policy out of Washington is designed to promote strong economic growth for Washington.

The market research firm Trim Tabs regularly monitors money flows into and out of the stock and bond markets.  They  reported today that outflows from the stock market in August were half of the record inflows in July.

The blood spilled this year has been in the bond market.  Trim Tabs reports that outflows from bond funds and ETFs have totalled more than $123 billion in the past three months.  Flows into bond funds and ETFs were about $750 billion in 2012, almost a doubling from the $400 billion invested in 2011. (Fed Flow of Funds tables F.120, F.121)

While the prospect of higher rates may have been the trigger that caused a reversal of bond inflows, the underlying current is also an overdue correction of the surge of investment in bonds in 2012.

Households continue to shed debt in one form or another so that total liabilities continue to decline. However, every man, woman and child in this country is carrying, on an inflation adjusted basis, 2-1/2 times the amount of debt they carried thirty years ago.  This level of household liability will continue to put downward pressure on growth.

This next week will kick off with the ISM manufacturing report on Tuesday and finish the week with the monthly employment report.  Year over year percent gains in employment have been steady and guesstimates are for maybe 200,000 net job gains.  150,000 net jobs are needed to keep up with population growth.

The Fed meeting is coming up in mid-September so this employment report will be watched closely to guess the next steps the Fed will take.