Bubblicious
Jim Puplava
April 9, 2003
The headlines all read the same: Stocks up, Earnings down, The economy is getting weaker. Despite worsening economic and earnings news, stocks have rallied and held up rather well given what has happened to most sectors of the economy. Wall Street is telling themselves that stocks are cheap and investors aren’t listening anymore. According to the latest Wall Street estimates, stocks are now selling at 15 times forward earnings. Given the fact that the S&P 500 is currently selling at around 30 times trailing earnings, we are talking about earnings nearly doubling this year to reach those forward numbers. It goes without saying that this earnings miracle (like the earnings miracles predicted the previous three years that never materialized) will take place in the second half of the year or maybe the last month or week of the year annualized.
I don’t know what these guys are smoking, but it must be one heck of a mind-altering substance. I see nothing, and I do mean absolutely nothing, coming out of companies that would indicate an explosion in earnings is just around the corner.
Shown on the left are a series of graphs depicting global economic indicators that show the world is now in a synchronized downturn. It doesn’t matter what it is you are looking at, whether it is the stock market, the economy, or interest rates -- economic and financial stress are visible everywhere around the globe with the exception of China.
The first set of graphs show that global economic conditions are slumping once again after a brief recovery in 2002. Most importantly is the ISM manufacturing component that shows the U.S. manufacturing sector is once again slipping back into recession. The ISM service sector is also in recession territory again. The graphs of economic activity shows the U.S. economy is clearly heading back into recession if it isn’t in one already.
It Just Isn't Working
Aggressive monetary policy and an over abundance of credit have failed to keep the economic engine running. It is now rumored that the Fed may be considering emergency measures and unconventional policy fixes out of desperation. It is apparent with interest rates at half-century lows that monetary policy has been a dismal failure. The only thing that the Fed has been able to do is recreate new bubbles in mortgages, housing, and consumption, which are now in danger of deflating. It has become the Fed’s own worst nightmare. Monetary policy isn’t working.
Interest rates here in the U.S. and Europe have steadily declined and yet to no avail. Experts now believe the Fed may be forced to cut rates even more at its next meeting in May if not before then if unemployment or the economic weakness continues to accelerate. A 50-basis point rate cut is expected by the next policy meeting in May. The European Central bank is less certain at this time on whether it will cut rates. However, if a serious recession develops in the U.S. European exports, the one bright spot in Europe would be greatly impacted by a slowdown in the American economy. Japan is a basket case where unorthodox measures are now being considered after the failure of monetary and fiscal policy that has failed to keep Japan’s economy out of recession. The Bank of Japan is already buying shares of troubled banks.
Many of the world’s major economic blocks have become far too dependent on exports to the U.S., which is currently running a trade and current account deficit over $500 billion a year. Most of these exports are goods that are being bought by the American consumer who in effect has become the buyer of last resort. How much longer and just exactly how much more debt the U.S. consumer can effectively handle is one of the big questions regarding the economy going forward. Recent evidence at the retail level and a downward drift in the real estate market indicates the long running consumption binge by consumers may be nearing an end.
The only saving grace for consumers at the moment is the mortgage-refinancing boom, which although slowing, still remains strong. Maybe the Fed’s next move will be to offer consumers through banking entities zero-percent loans with no money down and no payments until 2005. Whatever the Fed may now be contemplating it is sure to be unorthodox, because orthodox measures such as lower interest rates and ample credit have failed to create a durable recovery. Now the Fed is not only facing a resurrected stock market bubble but additional bubbles in mortgages and real estate, which are all in danger of deflating. If all three areas deflate the government will have a depression on its hands.
Global Market Melt Down... 3 Years Running
The Bubble is Back
Meanwhile, on Wall Street the bubble has returned. This time the individual investor is not participating. The wild orgy in stock prices is mainly institutionally oriented. It has been fund managers buying the usual suspects such as Internet stocks and technology companies that are leading the rally. In the myopic minds on Wall Street the only thing holding back the economy and earnings is the war. Since early this year one major company after another has warned that earnings and sales are going to be much lower than expected. The chart below shows how earnings expectations have come down dramatically since the beginning of the year. It doesn’t matter where you look, whether it is software, hardware or retail, all sectors within technology are reporting and warning about earnings and sales. Chip equipment manufactures such as Applied Materials have laid-off more workers (14% of workforce). Hardware makers are saying the same thing: orders aren’t coming in, inventory levels are building, and prices are falling reducing margins. Retailers in the electronics sector such as Best Buy, Circuit City, and Tweeters have seen sales fall, inventory levels pile up and as a consequence, they have been rescuing payrolls.
There is a clear inability by Wall Street to recognize that it takes time for a bubble to deflate and for excess capacity to be worked off and cleansed out of the system. It isn’t the war that ails the sector. It is excess capacity left over from the bubble days of the 90’s that really plagues the industry. There is excess capacity in just about everything from cell phones, motor homes and automobiles to computers and video games.
On Wall Street there has been a stock market orgy based on the war. Fund managers have been paying extraordinary amounts to own stocks with virtually no growing earnings, if not falling earnings. This is one reason why so many companies are selling at such high P/E multiples. Earnings have fallen; while stock prices have risen. When one manager who was recently interviewed was questioned as to why he was buying and owning such high priced stocks, he responded by saying that it is where the money is going (implying that, in essence, he was part of a mass herd of managers who, like blind sheep, are rushing to buy the very same thing just because everyone else was buying. I listed the trailing P/E multiples for some of these companies below so you can see how absurd valuations are and why I believe these managers are setting up their shareholders or investors to get fleeced again. In some cases where earnings have been negative, such as Sun Micro, forward earnings projections have been used.
With earnings and sales in a downturn and plenty of earnings warnings, Wall Street has been busy lowering estimates as shown in the chart on the right. It is a good thing for investors that the war has provided a distraction for them. Otherwise they would be forced to look at what companies are saying about earnings, which goes hand in hand with layoffs.
I have never bought into the concept that the only thing holding back spending and hiring is the war. The war has simply become the latest excuse as to why the recovery in earnings or the economy has not taken root.
The war is a casualty of the blame game. It is the 90’s bubble and not the war that is the problem. No respected CEO or manager of a business enterprise would be holding back on hiring or spending on new plant and equipment if orders were coming through the front door. If the business were there as Wall Street has projected, companies would be spending, hiring, and expanding. The reason that they haven’t is because the business isn’t there to begin with.
So, Why are They Buying?
This leads one to ask why, given the plethora of evidence of deteriorating fundamentals, fund managers, are buying. Once again the answer to that question comes back to the war. After the war, things get peachy again. In effect the market, according to the theory, is discounting better times ahead. It is really nothing more than a momentum game of money chasing money. There are no usual metrics to follow that would justify such prices or valuations. I find it interesting that many fund managers are ignoring valuations.
Money seems to flow in and out of stocks almost daily depending on the latest war news. One day the coalition forces have killed Saddam Hussein and the next day he is found to be alive. One day they have captured Osama bin Laden or his sons; the next day it turns out to be only a rumor and Osama is missing. Given the fact that the market seems to be moving on any rumor or innuendo on this War on Terror makes this a dangerous market to be investing in unless you are defensive.
The markets seem to rise and fall based the lives of Saddam or Osama. Therefore, perhaps a more useful metric for measuring the markets may be based on the useful lives of both the Iraqi dictator and the Saudi terrorist. I would like to suggest that the financial media and maybe Wall Street may find it useful to quote the markets in terms of Saddam and Osama. It might make more sense to quote closing market prices and valuations based on the number of times both have been killed, bombed, or sighted. For example the media may find it helpful to disclose daily prices in terms of the Dow selling at 28 Osamas or the S&P is trading at 31 Saddams.
Given the haphazard nature of today’s markets, the general bullishness by most institutions and managers, the Osama/Saddam metric may make more sense. I am open to any other metric that may be useful in explaining today’s relapse into irrational exuberance. Main Street is slowly exiting the markets judging by the steady exodus of money flowing out of stock mutual funds. With mutual fund cash levels now approaching 4%, one would have to wonder what drives the markets or what keeps them inflated. It certainly isn’t John Q.
Today's Market
Stock averages headed south again today after it was discovered that Saddam might be alive. Several Wall Street firms downgraded their estimates for companies such as Microsoft and Amazon.com. The focus on earnings is coming back to the forefront and so far the picture doesn’t look promising. There were more layoff announcements today as well with Stanley Works saying it will not only report much lower earnings, but also close down plants and fire more workers after a major drop in earnings. The Dow fell over 100 points for a loss of 1.2%. The S&P 500 lost 12.3 points, a loss of 1.4%, and the NASDAQ dropped close to 2%. Advancing issues led decliners by a 17-14 margin on the NYSE and by 17-12 on the NASDAQ. Volume was light with only 1.27 billion shares trading on the Big Board and 1.29 billion on the NASDAQ. The VIX rose 1.32 to 30.91 and the VXN edged up .53 to 41.45. Both indexes are now at levels that triggered the last major selloff in November and in January of this year.
Overseas Markets
European benchmark stock indexes were little changed after erasing early gains on concern an end to the war in Iraq won't lead to a revival in economic growth. Aegon NV and ING Groep NV declined after their credit ratings were cut amid concern this year's stock market declines have eroded the capital they need to write insurance business. Roche AG, which is expected by analysts to report higher first half sales tomorrow, rose. The Dow Jones Stoxx 50 Index fell 0.2% to 2304.21. The index earlier jumped as much as 1.6% as Iraqis cheered U.S. troops in Baghdad and a statue of Saddam Hussein was toppled. The Stoxx 600 Index lost 0.2%, retreating from a gain of as much as 1.2 percent. Eight of Western Europe's 17 benchmark indexes fell.
Japanese stocks fell 0.9% in U.S. trading, as measured by Bank of New York Co.'s Japan ADR index. June futures on the Nikkei 225 Stock Average fell 85, or 1%, to 8035 on the Chicago Mercantile Exchange, as 924 contracts traded. Futures on the stock-market benchmark closed at 8060 on the Osaka Securities Exchange and at 8090 on the Singapore Exchange.
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