Where is the Earnings Growth in the Midst of this Mania?
Faltering Profits for Manufacturers, Bankers and Hedge Funds Alike
Wednesday, April 7, 1999
Virtual chaos has come to fully dominate the marketplace, as wild and unpredictable moves are now commonplace for individual stocks, groups and the stock market generally. Certainly, it is anything but the type of trading action one would expect from a healthy market. Instead, the stock market is now almost completely dislocated, with speculation, short covering and both hedge fund and derivative trading having overwhelmed traditional prudent investing. Quite simply, the market has regressed to the point of running completely out of control and, undoubtedly, heading for quite an accident.
So far this week, the Dow has gained 253 points, or 3%. The S&P 500 has also gained 3%, although the Morgan Stanley Consumer index has underperformed, rising just 1% on the back of disappointing earnings news from Gillette. The Transports have risen 1% and the Morgan Stanley Cyclical index has gained 2%. The small cap Russell 2000, once again, performs poorly, trading unchanged for the week. The Utilities, continuing to signal that all is not well, have dropped 1%, as its year-to-date loss now stands at more than 12%. Strong gains, however, have been seen in both the technology and financial sectors. So far this week, the NASDAQ 100 has gained 2%, and has now risen 19% in 1999 and 81% for 52 weeks. The Morgan Stanley High Tech index has surged 4%, bringing its year-to-date gain to 23% and 52-week gain to 101%. So far this week, the semiconductor stocks have increased 5%, and The Street.com Internet index has gained 6%. This Internet index now has a 1999 gain of 72% and a 52-week gain of 201%. The S&P Bank index, so far this week, has gained 4%, of which most came today. The Bloomberg Wall Street index gained 3% today, 8% for the week and 36% year-to-date. Today, it appeared that a significant reversal in technology stocks may have occurred, and that this had potential to lead a market decline. However, the financial stocks came to life at a most opportune time and helped power the Dow to a record close.
Over the past few weeks, a truly historical speculative run has transpired throughout the technology sector, particularly with the Internet stocks. And in this most speculative environment, some of the hottest stocks have been the online brokerages. This week many of these stocks have been in an absolute "meltup". For the week, E*Trade Group has gained almost 40% and Ameritrade 50%. So far this year, these stocks have gained 260% and 500%, respectively. Charles Schwab has gained 24% this week, increasing its year-to-date gain to more than 100%, and its market value to $47 billion. The market values Merrill Lynch at $35 billion.
While it is tempting to lament about the speculative melee that continues to transpire throughout our stock market, we will, instead, focus on the job at hand and, "just stick with the facts." Yesterday, the Commerce Department reported that 4th quarter profits declined 17% for US manufacturing corporations, compared to the forth quarter of 1997. This sharp decline in profits was posted with revenues largely unchanged. After-tax profits at manufacturers averaged 5.1 cents per dollar of sales compared to 6.2 cents during the third quarter and 6.0 cents during 1997's 4th quarter.
Recently, the Federal Deposit Insurance Corporation (FDIC) released fourth quarter earnings results for the US banking industry. Unimpressively, earnings for the 4th quarter declined 1% from the 3rd quarter, the second consecutive decline. In fact, earnings for the quarter were below $15 billion for the first time in five quarters, and were actually 2.5% lower than 1997's 4th quarter. As such, this notable earnings fall came despite bank assets increasing 8.5% for the year. Indeed, earnings suffered as the net interest margin declined to 4.09%, the lowest level since 1991. Quoting the FDIC, "For all of 1998, commercial bank net interest margins declined by 14 basis points, the sharpest year-to-year decline since 1974-75…" Masking the strong deterioration in banks' traditional lending business, noninterest income rose $18.4%. Nonetheless, fully 55% of banks reported lower return on assets. And, importantly, this earnings decline came despite aggressive lending and a booming economy. For the year, commercial bank assets grew $426 billion. Mortgage-backed security holdings grew 22%, real estate construction loans 21%, and commercial and industrial loans surged almost 13%. Furthermore, earnings got a strong boost from a 17% reduction in loan-loss provisions. One thing is for sure, it should be quite alarming that such aggressive efforts translated into only lower earnings. Moreover, the FDIC warned that "asset quality showed signs of weakening in 1998."
For some time now, too many banks and financial institutions have been fighting frenetically to grow and satisfy Wall Street earnings expectations. And with too many lenders chasing a limited number of sound borrowers, lending margins for good credits have contracted sharply, leading growth-hungry lenders to reach out to less creditworthy borrowers. History is certainly replete with such episodes of credit-induced booms and busts, and historians, undoubtedly, will view 1998 as much a watershed year for credit excess. During 1998, total credit growth in the US was more than $2 trillion, with the financial sector increasing its debt growth by a stunning $1.1 trillion, or 70% greater than borrowings from the previous year. For perspective, financial sector debt growth was $456 billion in 1995, $552 billion in 1996, and $653 billion in 1997. 1998 was a record year for junk bond issuance, total mortgage originations, sub-prime mortgage lending and new home equity loans. In sum, it was quite a lending bonanza as the money spigot was opened widely for even the riskiest of borrowers.
Mortgage behemoths Fannie Mae and Freddie Mac also had an extraordinary 1998. These two financial institutions combined to grow their balance sheets by a stunning $220 billion. And, like the banks, such aggressive lending and asset growth failed to translate into big profit gains. As a matter of fact, while Fannie and Freddie assets grew by $220 billion, combined 1998 net income increased by a paltry $655 million. Here again, very aggressive efforts, but not a lot of profits to show for it. And while the bulls today celebrate earnings growth wherever it can be found, it should be disconcerting that profits throughout the lending business are stagnating despite a booming economy and minimal credit losses. This is a most ominous development and portends major problems down the road, come the inevitable downside of the business cycle.
And while such explosive credit growth initially works wonders for financial markets and the economy, as a whole, such excess always have most unfortunate consequences later on. Importantly, last year our financial system moved dangerously, both overleveraging and aggressively extending credit to risky borrowers. And, importantly, it is this combination of excessive leverage and risky credits that almost brought our financial system to its knees last fall and will continue to burden our financial system for years to come. Actually, it is not an issue of if our highly leveraged financial system will have troubles, but when. Today we are again seeing subtle signs that all is not well.
Interestingly, another key sector within our highly leveraged and vulnerable financial system is said to be struggling. Bloomberg news is reporting that many hedge funds are performing poorly so far in 1999. Apparently, George Soros' Quantum Fund has lost 15.5% and Julian Robertson's Tiger Management has lost 7.5%. According to Bloomberg, Quantum assets have declined $2.1 billion so far this year, including $700 million that has been withdrawn by investors. This follows a very difficult 1998 for many hedge funds as huge losses were suffered in the emerging market debacle, the Russian financial meltdown and the crisis that beset US financial markets and the dollar last fall. With this in mind, it is very likely that many hedge funds have been and likely continue to reduce risk by paring positions. And, importantly, it appears reasonable to presume that investors will be pulling money from the hedge fund community in the future, as it is recognized that the global financial environment is no longer conducive to the kind of outsized returns of the past few years. Quickly, the days of perceiving that hedge funds can post huge returns with limited risk appear to be fading into history.
Today hedge fund assets are said to surpass $300 billion. With the significant leverage that many funds use, the hedge fund community controls positions of hundreds of billions of dollars. When times were good and these funds were adding assets through strong returns and inflows, they were able and more than willing to increase the size of their positions, fueling bull markets the world over, especially here in the US through leveraged purchases in the credit markets. Now, with hedge funds losing money and investors apparently beginning to pull money, this group will be buying fewer securities and, in fact, will certainly be forced to liquidate holdings. Indeed, we suspect that an important inflection point has been passed, and the hedge fund community, in aggregate, is now liquidating positions, and this is likely a factor behind the poor performance of the credit markets so far this year. Unfortunately, we also suspect that considerable recent stock market turbulence is related to hedge funds unwinding positions. Clearly, there has been significant short covering that has forced higher the price of many stocks and has been a major factor behind the considerable outperformance of many stocks with weak and questionable fundamentals. When this temporary factor ends, we expect many of these stocks will quickly give up recent gains and some.
Certainly, this has been a very challenging time in the marketplace, as is traditionally the case for major market tops. We continue to work diligently to control risk while also being positioned for a market decline. We definitely view recent chaotic trading as signaling an imminent change in trend and we are ready to capitalize on a great opportunity.
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