Adam Hamilton June 22, 2001 2954 Words
As we rapidly approach the long anticipated second half of 2001, the fabled Second Half Recovery the equity bulls have been zealously prophesying must be right around the corner. The mainstream financial media is confidently assuring the investing populace that better things lie dead ahead in the markets and all major US equity indices will be much higher by year end.
The popular party line is well known to investors today. Conventional “wisdom” proclaims because of the Greenspan Fed’s unprecedented series of aggressive rapid-fire interest rate cuts (and more to come), the stock market is bound to rally dramatically because it almost always has in history following interest rate cuts. Because stocks have already fallen far from grace in many cases, the worst is likely behind us. Because US consumers can look forward to a few hundred bucks back from Uncle Sam, consumer spending will dramatically increase in the second half. Because consumer spending will soar, companies will make more money, soon driving up profits and hence stock prices.
The bullish arguments are everywhere one turns and the eternal optimism of the equity bulls is palpable. Watching bubblevision these days is like experiencing a support group created for those who have just survived some tragedy and are bravely convincing themselves all will be fine in the future. Optimism is a wonderful and noble human attribute, but it can be absolutely lethal in the chaotic and unforgiving neo-gladiators’ arena that is the world investment markets.
With consumer spending said to drive 2/3 of the total US economy, the bullish Second Half Recovery fantasy will live or die almost exclusively on the actions of the US consumers. If the US consumers begin to spend gobs of money again and try and relive the gargantuan debt-binge shopping orgy of the 1990s, Wall Street is convinced that we have seen the bottom and the worst is behind us in the US equity markets.
Unfortunately for this hypothesis and those investors who bet their fortunes on it, the legendary US consumer is literally buried under debt. Debt service as a percentage of income is at record highs, personal indebtedness is at frightening record extremes, home equity is plunging as consumers draw on mortgage debt to finance consumption, and usurious credit card debt festers and grows in US households like a medieval plague upon the land. It is hard for consumers to spend money to boost the economy when their aggregate debt load has reached these crushing extremes.
Even with small tax refund checks limping back from the federal government, the net effect on consumption is likely to be trivial. Bush’s tax cut, which he promised to hard-working Americans in order to narrowly edge out big government liberal Al Gore, is dead on arrival, a cruel joke or farce for the taxpayers who pay the bills for our huge government. The spineless tax-and-spend socialist politicians of the US Congress have largely eviscerated the tax cut, leaving few crumbs for the weary American taxpayers. The average refund is expected to be a paltry few hundred dollars.
Although the Wall Street economists are zealously trying to convince investors that a few hundred dollars to a lot of US consumers is a big deal, it is not. Anyone who actually eats, feeds a family, lives under a roof, drives to work, and heats or cools their home KNOWS that a few hundred dollars can be burned in a heartbeat on just the necessities of life. Just taking a family of four out to dinner and a movie can EASILY run $100 after food, fuel, and entertainment are factored in. The cost of living in America is steep and getting steeper all the time as the Federal Reserve creates endless supplies of paper dollars to chase after finite amounts of goods and services. A small token tax refund is unlikely to resurrect the free-spending US consumer of yore.
Back in early April we published an essay titled “Consumers to Rescue Wall Street?” where we discussed the popular Wall Street fairy tale of the US consumer riding to the rescue of equity speculators dressed in suits of shiny armor on mighty white war steeds. We still firmly believe that the US consumer is simply too tapped out to spend the kind of money necessary to rekindle the fire in the belly of the US equity markets. This Wall Street wishful thinking is a straw man, easily knocked down, and many other brilliant analysts have explored this issue from similar and different perspectives and arrived at the same conclusion. The consumer will NOT be able to rescue Wall Street, as debt is a hard master and does have limits.
With the bullish hope of the consumer plunging deeper into record debt territory to bailout the overvalued US equity markets pretty well shot to pieces, we want to take a brief look at the strategic corporate profit picture in this essay. With stock market valuations at stellar levels, it is absolutely critical that profits begin rising, and rising FAST, or else we are staring over the edge of a dark abyss with further painful down-legs in the US equity market highly probable in the second half of 2001.
As every businessman instinctively knows, profits are the ultimate goal of capitalism. Businesses, whether a corner lemonade stand hastily erected by a couple enterprising kids or a monolithic multi-national corporation, exist to make money for their owners. Period. When a business is able to earn profits on the valuable goods or services it provides, it is able to grow and thrive and provide a healthy return to its owners who financed the operation.
On the other hand, if a business is consistently losing money, there is no reason to be in business. Losing money is easy. There is no art to it. ANYBODY can lose money!
One of the most highly regarded stocks of the NASDAQ bubble era is a perfect example of this, Amazon.com. Amazon represented a great idea of allowing consumers to buy books directly on the Internet and have them shipped to their door rather than fighting traffic on a sortie to the local bookstore. The only problem with the idea is Amazon tried a silly and perpetually faulty strategy to “build market share”. Rather than operating like a normal business and actually making money on operations, Jeff Bezos and crew decided they would compete on price and sell books for less than Amazon’s total cost of supplying those books. Profits? Bah, who needs ‘em? Amazon figured it did not need to make any money since its goal was simply to build market share.
It is certainly a goofy concept, isn’t it? Selling something at a loss for years and years is not a business, it is a subsidy from the suppliers of capital to the retail customers. It is the rough equivalent of you going down to your local bookstore and buying books to resell to your neighbors at prices under what you paid for them. A real business makes money for its owners in the form of profits, not by losing money quarter after quarter year after year. Unfortunately, Wall Street seduced the American populace into believing that it was no big deal if a company was losing money because, after all, the future looked so bright and a “New Era had dawned”.
Lying in the profitability spectrum between companies making money and those losing money are those companies that are making money, but not very much relative to their stock price. These companies that are profitable but WAY overpriced are the most important companies in the American markets and form the lion’s share of the total market capitalization of the US stock market. The names in these ranks include the revered behemoths of the American investing scene including many of the companies in the Dow 30, NASDAQ 100, and S&P 500.
Since businesses are formed in the first place to make money, one of the best ways to value a company is based on the profits it is able to spin off. The simplest and most ubiquitous tool used to quantify profits relative to stock price is the venerable price earnings ratio. P/E ratios divide the stock price by the earnings per share that a particular company is generating in order to provide a quick valuation proxy for the company as a whole.
Throughout market history, on average, stock markets had a P/E of around 13.5. For every $1 of profits earned per share, the stock price of an average company would generally increase $13.50. For instance, a company earning $10 per share might have a stock price around $135, while a company earning $2 per share may see a stock price around $27. During the earlier great bubbles of history, such as the 1929 speculative distortion in the United States, P/E ratios reached stellar extremes, over 25x, roughly twice as expensive as average. Following the great bubbles of history, equally great busts saw stocks fall to dismal valuations following a speculative bubble and trade on average around 7x earnings, half normal value, at the ultimate bottom.
Even though P/E ratios were ridiculed last year during the NASDAQ bubble and continue to be ignored today by many mainstream financial analysts, there is no doubt they are still among the most useful tools available to quickly distill much information into a simple valuation proxy for a profitable company.
Although many claim the bottom has been laid in for our current market situation, the valuations of the major US stock indices as represented by P/E ratios are still at phenomenal extremes compared to historical precedent. They look infinitely more like markets at major tops than markets recovering and beginning to dig out of a sharp slump. In our monthly newsletter Zeal Intelligence, we track market valuations very closely and report on them each month as they are a critical indicator of where the most risk lies in a particular market, to the downside if way overvalued or to the upside if undervalued. We like to use market capitalization weighted average P/E ratios, as they give big market-darling companies a higher weighting in the importance of their P/E ratios in computing the average. It also prevents little companies with ridiculously high P/Es from skewing the data away from a more representative weighted average mean P/E ratio.
The venerable S&P 500, the biggest and best 500 companies in the United States, had a market capitalization weighted average (MCWA) P/E ratio of 39.0 on May 31. This is a staggeringly high number, indicating extreme overvaluation. Everything else being equal and assuming no growth, it would take 39 YEARS for investors who bought the whole S&P 500 index today to break even. A sobering thought, even for the “long-term investors” Wall Street perpetually courts.
The highly speculative NASDAQ 100, the 100 biggest and brightest companies of the modern Wild West of the US equity markets known as the NASDAQ, sported a mind-boggling MCWA P/E of 74.8 a few weeks ago! This number is quite simply terrifying and indicates even at a NASDAQ composite level around 2100 that the big NASDAQ companies are priced many times higher than all historical precedent indicates they should be for the earnings they are able to spin off. An investor who believes the Wall Street hype and buys the NASDAQ 100 today could be looking at nearly 75 YEARS before the underlying companies make back the entire price paid for their shares, assuming no growth or compounding returns. Even if restored growth is assumed, it will still likely take DECADES for NASDAQ 100 investors today to merely break even in profit terms. Ouch!
Alas, even the mighty blue-chip Dow 30, the most important equity index in the world, is not immune from this overvaluation nightmare in the States. The DJIA weighed in at a MCWA P/E of 27.6, twice the historic average and near historical critical levels that signaled bubble tops and impending crashes in the past. Even after the early stages of the NASDAQ bubble implosion, ALL major US equity indices remain at historically obscene valuation levels. Something has to give here.
With these fanciful levels of index valuation running rampant it is really easy to understand why the profit picture is so incredibly important for Wall Street. High valuations can only be rationalized by Wall Street analysts and brokers through very high profit growth rates. With profits SHRINKING for many elite market darlings such as the King Tech Bubble Cisco Systems, valuations will not be sustainable unless there is a massive and rapid growth in profits in the coming second half. Anything less than world-class profit growth will likely spell disaster for these overvalued stocks. A miraculous burst of profitability in the near future is Wall Street’s last hope before it has to face the executioner’s block of the timeless laws of finance and investing and watch huge companies’ stock prices get mercilessly decapitated to more normal valuation levels.
As stock prices hover near very high levels, and earnings continue to plummet in what almost certainly will prove to be a severe recession in the American economy, P/E ratios are ballooning ever larger exerting even more pressure on the stock market to fall to recognize the new reality of a bleak profit picture for the foreseeable future. The early results of this almost unprecedented slowdown are in, and they are not pretty.
As an illustrative example of the severity of the current corporate profit scene, the most important tech stock of Canada, the giant Nortel Networks, recently announced it would be losing over US$19 BILLION dollars this quarter. Yes, BILLION with a “B”! Much of the loss is a writeoff for companies the monolith has acquired in recent years at grossly overvalued prices. It is probably the largest single quarter corporate loss in the history of the universe. Excluding extraordinary items, the company is forecasting an operating loss of $1.5b this quarter on $4.5b of sales. This is extraordinarily bad news for technology in general, as it is estimated that 75% of the Internet traffic in North America passes through Nortel hardware. Nortel has far-reaching tentacles spreading through the whole information economy and is probably a good bellwether for the technology industry as a whole. Decimating its shareholders, the stock has crashed 90% from its peak last year, when it comprised around one third of the total market capitalization of the premier Canadian stock market index, the Toronto Stock Exchange 300.
Now losing a billion dollars is not too hard, as corporations seem to be doing it all the time these days. But a $19b loss in one quarter? Talk about the ultimate “big bath”! Since most of us have not yet been blessed with billionaire status, it is difficult to understand just how staggering this number is. To put $19b in perspective, it is useful to realize that ALL the publicly traded gold mining companies digging for gold all over the planet earth have an estimated total market capitalization of $35b. If this gold stock market cap estimate is correct, then the amount of money Nortel nuked this quarter would have been more than enough to buy controlling interests, more than half, of EVERY publicly traded gold mining company on planet earth! $19b is a staggering loss, one for the record books.
And Nortel is just the tip of the profit iceberg, or perhaps ice age is a better metaphor. As we near the end of the quarter, earnings season looms large and many, many companies will report devastating negative earnings surprises. Thanks to the great bubble boom of the late 1990s, Americans have plenty of virtually everything, and do not need to buy more stuff even if they could. Business inventories are bulging and growing obsolete and need to be written off, production capacity is much higher than demand, price competition is fierce, and the profit picture looks very bleak in the coming months.
Everywhere one turns, there are major profit problems. Airlines report terrible ticket sales, there is a brutal price war underway in personal computers, computer DRAM memory prices have totally collapsed, bellwether companies like Cisco report an unprecedented slide in demand, and the list goes on and on. Every night on the business news, some new company is warning of shriveling profits or growing losses. Every day, we hear of more devastating layoffs indicating fewer consumers will have money to spend as they are cast out of work.
Although it would be nice to be optimistic on the near-term economic prospects of critical American companies, a realistic perspective demanded of prudent investors inevitably leads to great caution and anticipation of very bumpy waters ahead, maybe even “Class 5” whitewater rapids.
With US equity valuations at staggeringly high levels, and crucial corporate profits likely to deteriorate rapidly, P/E ratios will continue to rise until we see a real correction in American equities. The stock market DOES look ahead and is anticipatory in nature, but so far it has dropped the ball and failed to see how bad things are growing month over month in the US economy. With Q3 likely to be fully recessionary and show negative growth in official US GDP stats, we believe the worst lies ahead for the highly overvalued US equity markets. For aggressive speculators, the highest probabilities for awesome returns remain on the short side of the game, betting on collapsing stock prices.
Plummeting profits and stellar valuations are a highly dangerous and volatile combination for equity investors. We believe that extreme caution should be exercised in the months ahead as the probability of significant drops from current levels for all major US stock indices due to plummeting profits is high. Caveat Emptor.
Adam Hamilton, CPA June 22, 2001 Subscribe at www.zealllc.com/subscribe.htm