Corporate Profits and New Orders

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.

Price Dividend and CWI

August 11th, 2013

Last week I wrote about viewing trends in the market through the lens of hard cold cash; that is, the dividends paid by the companies in the SP500.  Today, I’ll revisit that subject in a bit more depth.  Beginning in the last quarter of 2008, reported earnings of companies in the SP500 dropped precipitously, plunging about 90% in the first two quarters of 2009.

The portion of those earnings paid as dividends fell 24% from peak to trough, far less than earnings.

Robert Shiller, a Yale economist and co-developer of the Case-Shiller housing index, uses a smoothing technique for calculating a Price Earnings ratio and graciously makes his data available.  He calculates the 10 year average of real, or inflation-adjusted, earnings and divides the inflation adjusted price of the SP500 by that average.  Because of the low inflation environment for most of the past decade, the difference between the two earnings figures, nominal and real, is slight.

The drop in corporate earnings was extreme, more so than any recession, including the Great Depression of the 1930s.   In the 2001 recession, earnings declined to about half of their prerecession peak.  In the recession of the early nineties, it was about 30%.  In the back to back recessions of the early 1980s, corporate earnings fell about 25%.

While Shiller’s method evens out earnings, it has one drawback, one that no one could have foreseen until 2008 simply because it had never occurred.  The severity of the decline in earnings skewed the ten year average of earnings down over the 2002 – 2012 period.  Since the earnings average is the divisor in the Shiller P/E ratio, it correspondingly makes the ratio of the price of stocks a bit higher than it might otherwise be.

For that reason, I’ll look at a less volatile ten year average of dividends; that is, the inflation adjusted price of the SP500 divided by the ten year average of inflation adjusted dividends.

Today’s market prices are at the twenty year average of the real price dividend ratio, which is about 61.  For a number of factors, market prices as measured by this dividend ratio are higher for the past twenty years than the thirty year average of 51.  The tech and real estate bubbles over-inflated prices but investors have been willing to pay more for stocks as bond yields have declined steadily from their nosebleed levels of thirty years ago.

Let’s crank up the time machine and go back a year.  Here are a few quotes from an October 13, 2012 Reuters article after the market had dropped about 2%:

“Central bank-fueled gains took markets within reach of five year highs in September, but now U.S. stock market participants are shifting their focus back to corporate outlooks, and the picture is not pretty.”

The article quoted the director of investment strategy at E-Trade Financial, Michael Loewengart: “The overall tone is so pessimistic that we may see some upside surprises, but we could still suffer considerable losses if the news is bad.”

“Profits of SP500 companies are seen dropping 3% this quarter from a year ago, the first decline in three years”

It was close to being almost the end of the world.  As you read various comments in the news, keep in mind that these remarks are coming from active traders who see a 5% drop as catastrophic if they have not anticipated it through options and other hedging strategies.  For longer term investors, a 5% drop after a 5% rise over several months is more yawn provoking than cataclysmic.

Through the middle of November 2012, the market would drop another 5%.  Slowing corporate profits and the looming – yes, looming – fiscal cliff spooked investors.  Then, on the hopes that the Fed would do something to offset these negatives, the market regained the 5% lost in the previous month.  In mid-December, the Fed announced that it would double its bond purchasing program and the market has been rising since, gaining 20%.  Has this been a new bubble, one we’ll call the “Fed Bubble?”  Some say yes, some say no.

As we read the daily news, let’s keep in mind that in ten years we will have forgotten most of it.  Some fears will seem silly, some may seem prescient.  Each day there are many predictions, some like this one from December 30, 2001: “By the year 2003, there will be 2 types of businesses, those doing business on the internet and those out of business.” (Sorry, I didn’t write down the attribution).  Some predictions will seem rather silly like the one in March 2009 that the SP500 would be below 500 in a month.

Farmers and businessmen in ancient Rome consulted soothsayers who threw chicken bones and read the pattern in the bones to tell their clients whether there would be rains in the spring and how hot the summer would be.  Sometimes they were right, sometimes they were wrong.

Each day the market goes up – or it goes down.  For the past twenty years it has gone up 54% of the time, down 46% of the time.  Going up seems like an odds on favorite but this is complicated by the fact that the market usually goes down faster than it goes up.  There is also a well documented behavioral phenomenon of risk aversion; people respond more emotionally to loss than we do to gains.

This past Monday came the release of the ISM monthly survey of Non-Manufacturing businesses.  Like the manufacturing survey released a few days earlier, this index also surged upward in July, a welcome relief after the declining numbers in June.  I’ve updated the composite CWI that I introduced a while back and compared it to the SP500 and the Business Activity Index of the Non-Manufacturing Survey.

This composite index is weighted 70% to non-manufacturing, 30% to manfacturing.  Because this CWI relies on past months’ activity as a predictor of future conditions, it responds with less volatility to a one month surge in survey data.  As we can see, the tepid growth that began appearing this past spring is still showing in this index, although it is a strong 55.5, indicating sure footed, if not surging, growth.  It has been above the neutral mark of 50 since August 2009.

Widgets and Labor

March 9th, 2012

Labor costs are the major share of the expense of producing goods and services.  While the percentages vary by industry, a rule of thumb is that labor is about 70% of the final cost of a product.  The cost of labor to produce one widget should keep rising with inflation.  With the passage of time, widgets sell for more and employees demand more pay to produce those widgets.  Not surprisingly, the Bureau of Labor Statistics keeps track of the labor cost to produce widgets; they call it Unit Labor Cost.  In laymen’s terms we can think of it as the Widget Labor Cost.  The cost is indexed to a particular year year; in this case it is 2005.  If the labor cost of a widget was $2.43 in 2005, we’ll set that to 100.  Indexing makes what might seem like arbitrary numbers more uniform.  If the labor cost of a widget in 2012 is $2.67, then the index would read 110, or 10% more than 2005.

Widget labor costs typically fall or flatten out in a recession.  A graph of the past ten years shows that we still have not reached 2007 levels.

Keynesian economists say that labor costs are “sticky”, i.e. they do not decline in proportion to the downturn in the economy and the reduced demand during a recession.  Wages are the price of labor. Union contracts and employment laws do not allow these prices to fall to what is called the market clearing level.  Labor prices thus become too expensive and employers want less labor, resulting in higher unemployment.

Several decades of data allows us to see some changing growth trends in the labor costs to make widgets.

As I noted earlier, labor costs rise with inflation.  The graph below shows the relationship between the two.

After WW2, the rise in labor costs was just slightly ahead of the rise in inflation, allowing workers a greater standard of living and to put away some money for the future.  During the “stagflation” of the 1970s, this gap widened as workers demanded more pay in response to rising inflation while economic growth stagnated.  When the economy recovered in the mid-1980s, we began to see a narrowing between unit labor costs and the rate of inflation.  Had this narrowing stopped around the year 2000 and labor costs continued rising with inflation we would have a healthier work force and a healthier  economy.  But the gap narrowed further until labor costs were no longer keeping up with inflation.  Dwindling increases in labor costs have resulted in more profits for companies.  Although the labor market has a strong influence on the stock market, it is an indirect influence.  Stock prices are directly influenced by rising corporate profits and the perception that future profits will increase at a faster or slower rate.

Because wages do not rise and fall in proportion to the swings in the business cycle, companies took the only course of action left.  They reduced the labor component cost of their goods and services where they could.  Union contracts offer a company less flexibility in responding to downturns in the economy.  Companies reduced their exposure to union labor by outsourcing production to other countries, or by subbing out production to smaller companies with non-union workforces.  

Many people have been waiting several years for employment to recover.  As the chart above shows, there has been a systemic decrease in labor needed to produce each widget.  There is little indication that this trend will end as the economy continues to recover.  Since this economy is consumer driven, it is dependent on a healthy labor market.  A stumbling labor force will not produce robust gains in the economy. 

That is the background, the context for a look at February’s monthly labor report from the BLS, a better than expected report.  The headline job gain was 236,000, far above the 170,000 anticipated employment gain.  The unemployment rate dropped to 7.7% and the year over year decrease in the unemployment rate indicates little chance of recession.

There were other positive signs in this latest report.  Average hourly earnings of private-sector production and nonsupervisory employees broke above $20, increasing to $20.04.  After rising and stuttering last year, earnings have increased steadily since August 2012.  Despite these gains, hourly earnings of production employees are little changed from 1965 levels.

A slowly improving economy gave some hope that we might see the number of discouraged unemployed workers decline below 800,000 this month.  Instead the number rose from 804,000 to 885,000.

The Labor Force participation rate dropped another .1%.  Fewer and fewer workers are being asked to shoulder the benefits of the retired and unemployed.  The core work force aged 25-54 is still showing no substantial improvement.

While employment gains in the 25 – 54 age group have stagnated, the larger group aged 25+ continues to show improvement.  The unemployment rate for this larger group declined another .2% and now stands at a respectable 6.3%.  The employment picture for new entrants into the labor force, those aged 16 – 19, remains bleak.  This past month, the rate of the unemployed in this group increased and now stands at 25%.  Hispanics have seen a 10% decrease in unemployment during the past year but there are still almost 10% unemployed.  The minority group that has suffered the most through this recession has been African-Americans, whose unemployment rate has stayed subbornly high.  There have some small declines in unemployment over the past year, but almost 14% of this group is unemployed.

However, a group that has had persistently high unemployment, those without a high school diploma, saw a significant decline from 12% to 11.2%.

A significant contributor to that decrease is the steady rise in construction employment.

Perhaps not so widely followed is the “Craigslist indicator of construction activity.”  No, you won’t find this one charted anywhere but it does give a clue to what it going on in your area.  Search for “work van”, “work truck”, “step van” or “cube van” in your local Craigslist.  If there are a lot of listings, it means things are not good.  A few years ago, the Denver area used to have pages of work vehicles for sale by both owners and dealers.  This month there are few listings.

Other positives were the increase in the weekly hours worked to 34.5, in the pre-recession range.  Health care enjoyed strong gains as usual.  Professional and business services enjoyed strong gains, offsetting the unusually flat gains of January.  A rise in retail hiring was a nice surprise.

A bit of a head scratcher was the revision of January’s job gains, erasing 25% of the 160,000 job gains that month.  Revisions of that size leads to doubts about the winter seasonal adjustments that the BLS makes to the raw data. 

There are still 3 million fewer people working than in January 2008, when the BLS reported employment of 138 million.

In the past week the Dow Jones Industrial average crossed above the high mark of 2007.  On an inflation adjusted basis, the Dow is still well below the level it attained in 2000 and has still not passed 2007 price levels.  Some argue that the average 2.2% in stock dividends paid out each year partially compensates for the 3% loss in purchasing power.  Others argue that the dividend is compensation for the risks the investor assumes in the stock market and should not be taken into account.  If we disregard dividends, the inflation adjusted SP500 index is – well, it’s better than it was in 1990.

If a buy and hold investor has been in the market since 1990, she has gained 4% per year after inflation.  Adding in a dividend yield of about 2.5% over that time results in a total gain of 6.5%.  Had she bought a 30 year Treasury note in 1990, she would have been making about 8% per year for the past 23 years.  There are three lessons to be learned from this:  Diversify, diversify, diversify.

Predictions and Indicators

January 20th, 2013

I was talking with someone this week who thought that, this year or next, the financial world would melt down.  This week someone else asked what I thought was going to happen this year.  The S&P 500 index is approaching the highs of 2007.  Is this a good time to invest in stocks?

I don’t know.  In the early 1970s, Alan Greenspan, who would become head of the Federal Reserve in the late 80s, called for a bull market just a few months before the market imploded and lost almost half its value.  Recently released minutes of meetings of the Federal Reserve in 2007 showed that some members were worried about contagion from the decline of the housing market to the rest of the economy but the overall sentiment was that housing and employment weakness was a needed and normal correction to an economy that had gotten a bit too frothy.  No melt down anticipated there.

All any of us can know is what has happened and even that knowledge is imperfect.  Regulators who are privy to information that might spook the markets often conceal that information and hope to contain the damage.  Brokers and managers at large investment houses actually help build bubbles, skimming off fees and derivatives profits in the process.

With an imperfect assessment of the recent events, and a non-existent knowledge of the future, investors face the choice of putting their savings under the mattress or sending out their vulnerable savings into the economic fog.

Over the past few years, I’ve looked at several indicators that have been fairly reliable foreshadowings of coming recessions.  Before I look at those, let’s look at the big daddy indicator: the stock market.  Over the course of a week, millions of buyers and sellers try to anticipate the direction of the economy and corporate profits.  The majority of the time the market does anticipate these downturns but we need to look beyond the main index, the S&P500.  Instead we look at the year-over-year percent change in the index.  Below is a monthly chart of that percentage change.

The percent change drops below zero when the majority of investors do not believe that the market will increase over the next year.  You may also notice that it is a good time to buy the market when the y-o-y percent change declines 15-20%.

When we look at the past twenty years, the lack of confidence has been a reliable indicator of the past two recessions.  The graph below is the y-o-y percent change in a quarterly average of the S&P500.

These charts are easily available at the Federal Reserve database, FRED.  Just type in “Fred SP500” into your search engine and the top result will probably be a link to a chart of the index.  (Link here ) Click the “Edit Graph” button below the chart, then change the Frequency under the resulting graph to Monthly or Quarterly to smooth out the graph.  Just below the Frequency field is a drop down list of what you want to chart.  Select “Percent Change from Year Ago”, then click “Redraw Graph”.  Fred does all the work for you.

As of right now, the majority of investors are somewhat hopeful that there will be an increase in the index in the coming months. 

Another indicator I look at is the y-o-y percent change in the unemployment rate (UNRATE).  This is the headline number that comes out each month.  When the percentage change goes above 0, it’s probably not the best time to putting more money to work in the market.

Although the unemployment rate is still high, the yearly percent change is healthy.  As someone quipped, “It’s not the fall that kills ya, it’s the change in speed when ya hit the pavement.”  The change in each of these indicators is the key aspect to focus on.

Entering “Fred Unemployment” into a search engine should bring up as the top result a link to the unemployment chart.  Follow the instructions I gave for the SP500 and Mr. Fred will do all the number crunching.

Looking at a broader index of unemployment, the U-6 rate, gives no indication of near term economic decline.  Below is the percent change in that index.

Another indicator is New Orders in Nondefense Capital Goods Excluding Aircraft.  As I noted the past few months, this has been worrisome.  We don’t have sixty years of data for this indicator but a decline in the y-o-y percent change in new orders has foreshadowed the past two recessions.  Recent monthly gains give some hope but the decline in equipment investment shows a lack of business confidence for the near term future.

The last index I look at is a composite indicator put together by the National Bureau of Economic Research, NBER, the agency that makes the official calls on the start and end of recessions.  The Coincident Economic Index combines employment, personal income, industrial production, and manufacturing and trade sales.   In a healthy or at least muddling along economy, the percent change should stay above 2.5%.

You can access this by typing “Fred Coincident” into a search engine and the top result should be the graph for this indicator.  Follow the same instructions as above to show the percent change.

Except for New Orders there does not appear to be anything immediately worrisome.  According to Standard and Poors, (the S&P in the name of the S&P500 index), estimated operating earnings for 2013 are about $112 (Source).  At a 15.0 P/E ratio, that would put fair value of the SP500 at 1680, or 13% above its current level of 1486.  The problem is that the estimates of 2013 earnings have been drifting down from $118 last March.

For the past few years there has been a pattern of declining earnings estimates.  Something seems to be getting the way of early optimistic forecasts.  However, even if operating earnings were to actually come in at $100 for 2013, an investor with a ten year or more time horizon couldn’t say that she had overpaid at current market levels.

A favorite theme of 1950s sci-fi movies was the underwater creatures who had been turned by nuclear radiation into a gigantic monsters lurking on the seabed.  The tranquil calm surface of the water gave no hint of the monster swimming beneath the surface.  Then came an upswelling of water seen from the shore, a crashing crest of wave and the creature erupted from the liquid depths. For many investors, there may be that same sense of foreboding.  European banks loaded up on government debt; the Federal Reserve buying the majority of newly issued U.S. debt this past year; trillion dollar U.S. deficits; persistently high unemployment;  perhaps that is why there is so much cash floating around. 

The MZM money stock includes cash, checking accounts, savings accounts and other demand type accounts, money market funds and traveler’s checks; in short, it is money that people can demand now.  The percentage change has moderated recently and shows neither confidence or fear, of investors not knowing whether to step left or right.

For the long term investor, a showdown over raising the debt ceiling in the next few months may present another buying opportunity before the April 15th deadline to make IRA contributions for the 2012 year.

Earnings 2011

Over 80% of S&P500 companies have reported earnings for the 3rd quarter.  80% have beat earnings estimates that were previously lowered, an indication of how well companies are managing the estimates of the analysts who cover them.  In the third quarter of 2009, how many companies beat estimates?  79% (source) – pretty close to this year’s third quarter.

In September of this year, Standard and Poors reported that 2011 earnings estimates for the S&P500 fell below $100 after peaking at about $105 in early August.  2012 earnings estimates have been lowered from $111 to $108.  The S&P index closed about $1250 this past Friday, giving a forward P/E ratio of almost 12, a fairly conservative ratio.  These estimates, however, do not take into account any debt contagion from Europe. In a recent interview Nick Raich, Director of Research at Key Private Bank, projected an estimate of $85 in 2012 if there are no solutions found to the debt crisis in Europe.

Investors Friend has an article summarizing past S&P500 earnings and the difficulty of estimating earnings as there are several versions of earnings – GAAP and operating being two of the most frequently cited.

Yesterday Standard and Poors issued an update of third quarter earnings results.  Pay particular attention to the downward revisions for next year’s earnings in each sector.