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Today's Market WrapUp |
Circuitous Reasoning
The economy is dependent on consumer spending. The stock market is dependent on corporate profits. Thus goes the reasoning of analysts and economists. Economists and analysts now project a second half recovery for 2003. They have been predicting this same outcome for the last three years and have been wrong on both the stock market and the economy, so their analysis has pushed back the long sought after recovery by another year. Eventually they may end up being right, but ‘eventually’ can be a very long period of time. The problem with the current projections is that it is all based on faulty reasoning.
Let’s begin with corporate profits which peaked back in 1997 and has headed downhill ever since. Companies currently have no pricing power due to deflationary trends, overcapacity and malinvestments made by companies. Many of those high-tech plants that were built during the high tech boom are either idle, for sale, or are operating at below average capacity. Most businesses are plagued with excess capacity, which is limiting their capital spending. Intel has built new plants, yet they can’t keep the old plants running at full steam. This is one of the main reasons why business has been reluctant to spend new money on additional plants and equipment when one out of four factories in this country is not being used. You can forget the capital spending boom which economists have been talking about for the last three years, and now four if you count next year’s second half recovery scenario. Nonresidential investment has fallen by 12 percent from its peak in Q3 of 2000. Everywhere you look there is excess capacity with the exception of energy where it needs to be added.
So with no pricing power, cannibalization of competitors markets, and plenty of excess capacity businesses are cutting costs to improve profitability and conserve cash flow. In addition to excess capacity, businesses are having to provide no cost financing, offer rebates and delay payments on merchandise for years in order to push goods out the door. Sales this year are taking away from sales next year as GM recently announced that it would be forced to cut production by 400,000 units next year. Companies are making sales at the expense of cutting profit margins by offering free financing, rebates, or delayed payments. That explains why profits are down which also explains why analysts are going with pro forma numbers instead of real numbers.
Since labor costs are the biggest expense for most companies, firms are slashing payrolls. This is why unemployment claims are rising along with the unemployment rate. As of Q3 layoffs involving 50 people or more have totaled 1.6 million this year, slightly less than last year at this time. In Wall Street terms, we are doing better than expected. However, we are now in Q4 with companies announcing layoffs almost every day. By year-end layoffs should be close to last year. In addition to these layoffs, many of the jobs being eliminated are highly paid positions. We’re not talking about just the janitor. Investment bankers, analysts, and brokers are losing their jobs and these guys make millions each year. In addition to job layoffs, employees are taking salary cuts and bonuses are being eliminated along with stock options.
A Pertinent & Logical Question
The logical question that should now be asked: how is consumption to be maintained if the consumer is losing his job, taking a salary cut or having his bonuses and stock options eliminated? I’m glad you asked. This brings us to the next line of thinking in the consumption boom forecasted for next year’s second half recovery and booming economic growth rate. The consumer will maintain his spending through borrowing additional equity out of his home at lower interest rates. Borrowing additional equity out of his home assumes that housing will continue to keep rising at double-digit rates and interest rates will keep falling so that the refi game will enable continuous borrowing.
Since the consumer now accounts for two-thirds of our economy, and consumption is now based on a housing and mortgage bubble, what happens if housing falls in value as it most assuredly will when the bubble bursts? When the stock market bubble burst, the Fed created multiple bubbles to take its place in the form of lower mortgages and housing. Unlike stock ownership, which is concentrated at the upper end of society, home ownership is much more broadly based affecting a much broader class of society. What happens to housing when the consumer loses his job or if only one spouse loses their job? How will those housing payments be made? Mortgage debt is much higher today due to lower down payments and the numerous refi’s that extracted additional equity out of housing to maintain consumption.
Full Circle
So we come full circle to the economic line of reasoning that is behind next year’s second half recovery. It goes like this: businesses continue to fire workers in an effort to control costs and drive profits. These fired workers continue to borrow money from their homes that keep appreciating. Interest rates continue to fall so that consumers can continue to refinance their homes taking out additional equity to spend on consumables.
The fact that nobody sees a flaw in this kind of thinking surprises me. To put it simply, it is based on debt and contraction of employment, which doesn’t spell prosperity. If one company fires workers it is another thing. When all companies within an industry fire workers the economy contracts. That nobody questions this line of reasoning shows the flaw of present-day economic thinking. Only the Austrian school of economics would question this reasoning and see it as fatally flawed. We are basing our prosperity on even higher mountains of debt. To give you the size of that debt since 1998 the U.S. credit system has generated $9.7 trillion of debt taking our outstanding debt to $30.4 trillion.
Not to worry, argue our brilliant economists and analysts. The Fed is now on top of things expanding the money supply at an annual rate of over 20 percent. The current money supply is increasing at an annual rate of $1.75 trillion. M3 currently stands at $8.55 trillion. Given the huge increase in the supply of money and the economy’s inability to generate above average growth rates, or the stock market’s inability to recover should be a warning that this policy is flawed if not fatal. In my opinion, it is one reason why commodity prices are rising, gold prices are hitting new records, and the dollar is falling. Gold and commodity prices and a falling dollar all bring into question these flawed policies. It should at least make people think as to how they will protect themselves from the insane policies of government to inflate away the value of paper money. Which do you think will hold its value and protect you from the storms that are building in force as the financial barometer drops--gold, silver, and “things” or paper money and tech stocks?
Today’s Headlines
On the scandal front, former Tyco director Frank Walsh pleaded guilty and agreed to pay $22.5 million to settle charges that he took secret payments for brokering the acquisition of CIT Group. WorldCom’s new CEO accepts the resignation of six board members. And it is suggested that former Andersen lawyer Temple should be investigated for perjury.
On the earnings front, McDonald’s posted its first-ever loss and eight consecutive quarters of declining earnings. Micron Technology’s losses widen to $315.9 million as the price of memory chips drops. FAO will file for bankruptcy unless its lenders ease terms of its loans. Best Buy reduces its forecast because of a slump at Musicland; and Circuit City posts a third quarter loss as a result of price cuts and the sale of fewer high margin items. Target said its December sales are well below expectations.
In the financial markets the dollar drops for the fourth day out of five. The major indexes all lost ground, down double-digits this year. The Dow would have to rise close to 1,600 points to break even this year. The Nasdaq would have to rise like a phoenix and gain 645 points and the S&P would need to make up close to 260 points. Santa will have to be extra special this year if this lost ground is to be made up.
All three major averages headed down after a brief morning rally. Fears over the upcoming war on Iraq and the terrorist attacks that might follow it here in the U.S. weighed in on the market. Colin Powell said the U.S. government is skeptical that Iraq will comply with UN demands necessary to avert war. The retail sales reports coming out are giving fresh evidence that the consumer may be retrenching--tapped out may be more accurate. Normally the market rallies the last ten trading days of the year, so traders are expecting the Santa Claus rally to begin as soon as tomorrow.
While stocks, long-term bonds and the dollar headed down, gold prices rose again as the price shot up as high as $343, their highest price in five years as tensions build up over war and geopolitical disturbances around the globe from the Middle east to North Korea. Gold also got a favorable lift from Weiss Research out of Florida. Weiss Research analyst Kevin Kerr said he could see the possibility in which bullion banks with huge short positions in gold could get squeezed in the worst possible way. The gold that they have sold short is now jewelry worn by women around the world. In effect the women have become the longs while the investment banks have become the shorts. Who do you think will win this battle? I’m going with my wife who has become an avid gold bug, especially the kind that can be worn rather then stored.
Volume came in at 1.24 billion on the NYSE and 1.3 billion on the Nasdaq. Market breadth was negative by 19-12 on the NYSE and by 20-14 on the Nasdaq. The VIX edged up slightly by .18 to 30.16 and the VXN dropped 1.70 to 48.14.