Increasingly elusive earnings

The Bear's Lair: Increasingly elusive earnings [¹]

By Martin Hutchinson | 20 October 2007

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)— details can be found on the Web site www.greatconservatives.com

As the earnings season in the US stock market gets into full swing, the Dow Jones and Standard and Poors indices go from strength to strength, setting records about every other day. Yet their exuberance has failed to focus on one important factor: corporate earnings have peaked for this cycle and are set to decline substantially in the quarters ahead.

The reasons for the peaking are pretty obvious. The credit squeeze in August may have eased, but there is now no doubt that it was a primarily US-led event, centered on the home mortgage industry. That is leading to earnings disasters throughout the financial services sector, with the notable and surprising [[questionable?: normxxx]] exception of Goldman Sachs. (It is also bringing into question current risk management techniques; the Morgan Stanley "quant" operation lost $390 million on a single day in August, far more than the theoretical "value at risk" that was the centerpiece of their risk management calculation.)

Losses from subprime mortgages are not going away, and they will be recorded in earnings over the next several quarters [[if not years: normxxx]]. As subprime mortgages default, more housing is brought onto the market, and house price declines accelerate. That process causes more previously sound mortgages to become delinquent, either because the homeowner loses his job or simply because the homeowner needs to move [[or refinance: normxxx]] but is trapped by a mortgage that is now underwater. Any mortgage made at a higher loan to value ratio than the traditional 80% is endangered by a house price decline extending into the 15-20% range, with more than that on the coasts, as now seems likely.

In the mortgage market that existed before 1980, there would have been a stabilizing factor, in that the great majority of mortgages had been taken out several years earlier, when house prices were much lower, and so would remain sound. However the extraordinary volume of mortgage refinancing that took place in 2002-2006, each of which refinancings resulted in a 2-4% fee for some hyped-up mortgage broker/salesman, has destroyed that comforting but old-fashioned thought.

In today’s market, a high percentage of consumers refinanced their mortgages using a valuation close to the peak, and have subsequently spent the money raised on vulgar ostentation. They are now busily re-filling their credit card balances to continue enjoying the excessive consumption that they have come to regard as their due. The arrival of reality on their front doormats, in the form of a credit card bill they can’t pay, including atrocious increases in interest charges due to their lowered credit standing, will not only produce losses for the lenders, it will also decimate those consumers’ consumption.

[ Normxxx Here:  In any other endeavor than the credit business, this notion of hitting delinquents with increased interest rates and fees on all their debt, is known as "piling on." It does not enjoy a good reputation.  ]

The home mortgage sector, the housing sector and real estate brokerage were the largest job creators in 2001-05, accounting for 40% of the jobs created during that period, with the second largest engine of job creation being the inexorable increase in the size of governments at all levels. The rest of the economy has since 2000 proved weak at job creation, as evidenced by the anemic employment figures we have seen in 2007, even while consumption has held up and the overall economy has been alleged to grow at 3% per annum.

The real estate market has nowhere near bottomed; new home sales are still running at close to 800,000 per annum, compared to the 400,000 per annum at which they bottomed in the last four housing downturns, all of them milder than this one is proving. Since employment tends to lag activity, with layoffs occurring only after a considerable delay when business turns down, it’s likely that there is a considerable further employment squeeze in the construction, real estate brokerage and mortgage banking sectors still to come, as the market adjusts to a world in which house prices barely cover the cost of construction, a large overhang of properties causes each home sale to take an average of 8-9 months, and tight lending standards and a shortage of investors make mortgage origination very difficult.

As housing and credit card woes affect consumption, that will damage the rest of the economy. If household consumption, the great engine of US economic growth for several decades, is due to fall back in real terms, capacity levels in consumer-related manufacturing and profit levels in consumer-related industries will also be squeezed.

The only offset will be profit increases in export industries, buoyed by the decline in the dollar and increase in US firms’ competitiveness. Here however a reality has to be recognized: operations that have been outsourced since 1990, and are now producing goods and services from low wage countries in the Third World, are not coming back. The initial costs of restructuring a production and distribution chain are immense; there is thus a gigantic "hysteresis" in the global economic system.

If a firm requires a 20% operating cost advantage to outsource, taking account of all the up-front expenses and disruptions involved, it will also require a 15-20% cost differential to bring production back onshore, because almost all the upfront costs and disruptions of production transfer would have to be incurred a second time. That would mean the dollar would have to decline around 40% in real terms against the currency in the offshore centre before the production concerned was repatriated. Measuring from the dollar’s recent levels, that won’t happen (the decline from 2002-06 was merely a reversal of the over-exuberant 1995-2002 rise) or, if it did, the effects on the financial markets, in terms of collapsing bond prices as foreign investors fled, would cause massive further disruption.

There are thus a number of factors likely to cause profit levels in the US economy to decline. That would not be surprising; even by the conservative government measurement, corporate profits are currently at record levels in terms of Gross Domestic Product. You would expect that; monetary policy has been extremely loose since 1995, so the share of capital in the economy has steadily increased and the returns to that capital have caused profit levels to soar. As real interest rates revert to their norms, probably now accompanied by a rapid increase in inflation rates from their current alleged 2% per annum (actually, 5% per annum) towards or even beyond the 10% level— causing a collapse in bond markets— profits will be squeezed back towards their historic levels and decline as a percentage of GDP.

Profits reported to shareholders, those taken in calculations of price-earnings levels, are likely to decline further than the economic profits used in government statistical calculations. The gap between the Bureau of Economic Analysis measurement of corporate profits and Wall Street’s reported profits has soared in the last few years, as it did in the late 1990s. That is almost certainly a reflection of lax accounting standards. In the late 1990s, that laxity took the form partly of not expensing stock options, transferring huge sums from shareholders to corporate management without disclosing the fact. It also included playing games whereby the costs of corporate churn were transferred "below the line" and expensed directly against equity, allowing reported profits to maintain a steady upward trend. The ratio of "extraordinary items" to reported earnings, which averaged around 5% in the 1980s has been much higher since the middle 1990s, peaking at over 100% in 2002, the year in which the corporate sector wrote off its 1999 excesses. It has been climbing again recently, and is likely to climb further in 2007’s results, as losses from misguided financial experimentation are deemed no longer part of ongoing operations and hidden from view.

Asset valuation has been a particular area of profit inflation in recent years, and should be a fruitful source of disasters in the forthcoming downturn. One particular sector to watch will be the investment banks, which normally benefit as the stock markets worldwide climb, as they have in 2007. As the most active participants in financial markets, they have the highest exposures to financial market chicanery.

Goldman Sachs, for example, reported this week that the "Level 3" assets in its books, those for which liquidity is lowest and valuation most difficult, had jumped by a third in the quarter to $72.05 billion. These "Level 3" assets presumably don’t include Goldman’s multi-billion dollar holding of the Industrial and Commercial Bank of China, quoted daily on a stock exchange, however over-inflated its share price and illiquid its trading market. Instead, they appear to represent mostly derivatives and securitization assets linked distantly to mortgage loans and leveraged buyout deals, whose valuation is carried out by the operating unit itself, based on the price at which it would have to sell the asset to preserve its bonus pool from unexpected losses.

Set against Goldman’s capital of $36 billion, that $72 billion is a frightening figure. At some point, probably in a downturn, the real value of those "Level 3" assets will have to be recognized. No doubt the resulting losses will be written off against capital but even Goldman’s brilliant and gloriously paid accountants will find it difficult to write off $72 billion of losses against $36 billion of capital.

Corporate profits are Wall Street’s main justification for the current over-inflated level of the US stock market; they have been increasing in every quarter since 2002 and are held to justify an S&P500 earnings multiple of "only" 18. However, Thomson Financial reported Thursday that third quarter earnings, those currently being reported, were likely to come in fractionally below second quarter earnings, for the first time since 2002.

If that prediction is fulfilled, and we have now passed the peak of earnings in this cycle, then unexpected losses and the need to return corporate accounting to a reasonably conservative basis will make the downward slope in earnings long and steep, so that even if 18 times earnings were an appropriate level, it would imply a massive drop in the stock market. Such a drop in the stock market, particularly if accompanied by an inflation-caused drop in bond markets, will decimate Wall Street’s profits, throwing overpaid bankers out of work and further pressuring consumer spending. It is a vicious circle, spiraling ever more rapidly into an almost (but not quite) bottomless pit.

It might be time to speculate in a few long term put options— or move your money overseas, but where?