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Wednesday, October 2, 2002
Corporate Indebtedness
In his fourth and final revised edition of “The Intelligent Investor,” Ben Graham remarked on the increase of indebtedness of American corporations. In his study of company profits and earnings on capital he wrote, “The most striking figures in our table are those for the growth of corporate debt between 1950-1969. It is surprising how little attention has been paid by economists and by Wall Street to this development. The debt has expanded fivefold while their profits before taxes a little more than doubled.” I think Mr. Graham would be even more surprised, if not shocked, by how much that indebtedness has grown over the last decade. Between the years of 1995-2001, business debt jumped by $2.8 trillion, an increase of 69% over previous debt levels. The money was used to buy other companies, for mergers and increasingly to buy back stock to offset dilution of management’s stock option grants. Instead of investing in new plants, equipment and expanding the capital stock of the country, the money was used in all sorts of malinvestments.
The consequences are now unfolding as corporate defaults keep setting new records. Even more worrisome has been the downward spiral in corporate profits. It is profits and the cash flow from an enterprise that supports those debt payments. With profits in decline bankruptcies are rising. According to the Commerce Department’s latest revision of non-financial business profits, they fell from $504.5 billion in 1997 to $333.7 billion in 2001, a drop of 34%. By the first quarter of this year they fell by 42%. This is an unmitigated profit disaster and goes a long way to explaining the now rising trend in corporate debt defaults. Strangely this is given little attention in the financial press. The media and Wall Street tend to remain fixated on pro forma earnings per share, which are absolutely meaningless. In fact, all of the actual forecasts for a strong economic recovery and the constant blather on what great shape the American economy is in completely ignores this debt phenomenon. The more credit that is created, the more debt that business and consumers take on, which is applauded. The fact that very few analysts or economists pay any attention to this matter is of even greater concern.
Our economy and financial markets have run on debt so long that the consequences of a debt implosion are outside the radar screen of most analysts. Only when you get a spate of defaults, such as what we had at the beginning of the year, does it make front-page news. As quickly as it grabbed attention, it has just as quickly faded away. Yet the growth of debt related to income goes on unabated. For example, in 2001 personal income grew by $386.3 billion while personal debt expanded by $614.6 billion. During the bubble years of 1995-2000 household debts grew by $2,164 billion in comparison to household income, which grew by only $1,675 billion. Personal savings in this country are 0.2% of GDP. Americans don’t save; they just borrow money.
The fact that very few are concerned with this matter is all the more surprising. In policy debates one political pundit after another is calling for more government remedies to keep the economy out of recession. We have just gone on the largest debt and spending spree in this nation’s history. Yet nobody expects there to be a hangover.
The cost of carrying debt has fallen for most households. Rising debt burdens has offset this. In the case of businesses, credit spreads continue to widen and credit default premiums continue to rise. Signs of financial stress are everywhere, but we still hear talk about 3-4% economic growth. The recent downturn in major business indicators is signaling another economic downturn much worse than the previous recession. Consumer retrenchment will be added to business retrenchment to broaden the decline.
Now everyone is calling for the government to take action to keep the economy from falling back into recession. No one wants to experience a hangover. However, the government may be powerless to do anything about it. What can they do but reduce interest rates to zero as in Japan, or to start monetizing debt. The best thing government can do is to stand out of the way and allow the economy to cleanse itself. The government could reduce spending and reduce taxes and allow the private economy to regenerate itself. Initially there would be pain, but eventually a renewed cycle would begin that would be much sounder than the present one which is overburdened with debt. Unfortunately, lower taxes and lower spending are not in the works in a town that makes its living by redistributing wealth and expanding the public trough, so a hard recession now is inevitable.
Today in the Markets
Today’s casino results show stocks headed down again making yesterday’s rise another one-day wonder. John Crudele’s piece in yesterday’s New York Post points out a story that everyone knows on Wall Street but seldom mentions--that these one-day, two-day wonders in the stock market are often contrived affairs. The rise last week was due to hedge fund and money managers trying to drive the markets up so quarterly performance would look a tad better. Those efforts were a monumental exertion by professionals to get prices up in order to make an already embarrassing quarter less embarrassing. These one and two-day wonders, as Crudele has pointed out, are technical blips on a bear market radar screen.
Today’s news was headlined by more charges and arrests in the corporate world. Enron’s former chief financial officer, Andrew Fastow, was charged with masterminding a fraud at Enron that cost investors billions. In other developments, Martha Stewart’s broker at Merrill Lynch pleaded guilty to a misdemeanor and is expected to be singing like a canary. The New York District Attorney’s office is expected to make more announcements of further charges and possible arrests. This may lead to a new TV reality show called, “You’ve got cuffs.” Defendants would be brought before a judge like Judge Judy, plead their case, and to add spice to the show, the sentencing would be left to the audience. Viewers could choose from a list of multiple choices for penalties. The show could assuage investor anger, and in the process lift network ratings. Spin-offs could include, “You’ve got stripes,” “On the rocks,” to “You got nailed.” Other possible choices could include guest appearances of Ana Nicole Smith as a sit-in judge. Guest celebrity judges could also help draw in viewers. In the US the political views of entertainers now carry major political clout. Why not afford them the opportunity to be judges as well.
Markets resumed their downward trek, falling for the third day out of four as more corporate earnings disappointments generated renewed selling. Dow Chemical started things off by warning that Q3 profits would be below forecast. Drug companies got hammered on speculation that Schering- Plough will disappoint on their earnings tomorrow. Confidence is evaporating on earnings. Already this week pro forma profits have been lowered even further this quarter to 6.5%, down form 17% in July. Fourth quarter estimates have also been lowered to 19.1% from 27.7% on July 1st.
Major indexes gave back most of their gains from yesterday on above average volume. Two stocks fell for every one that rose on the NYSE. On the Nasdaq losers outdid winners by a 3 to 2 margin. Volume came in at 1.66 billion shares on the big board. The VIX rose by 3.23 points to close at 43.36. The VXN, up 0.91 points, finished at 58.15.
Overseas Markets
European stocks rose, paced by AstraZeneca and Vodafone Group as some investors judged drugmakers and telephone-service providers can maintain sales growth in a slowing economy. The Dow Jones Stoxx 50 Index added 3.8% to 2458.93. The index has climbed 6.2% since Monday's close, when it ended the worst quarter in almost 15 years. The Stoxx 600 Index rose 2.8% as phone companies and drug shares accounted for about a third of the gain.
Japan's Nikkei 225 Stock Average fell to a 19-year low. Banks including Mizuho Holdings Inc. dropped after Mitsubishi Tokyo Financial Group Inc. said it will post a first-half loss, raising concern other lenders may lower their earnings forecasts. The Nikkei lost 1.2% to 9049.33.
Treasury Markets
Treasuries traded higher after some early downside action as investors bid up fixed-income securities amid declines in the stock market. The 10-year Treasury note rose 10/32 to yield 3.68% while the 30-year government bond was up 18/32 to yield 4.72%. No economic data were due out on Wednesday, but Thursday will see the release of August factory orders, the non-manufacturing ISM index and weekly initial claims.
© Copyright Jim Puplava, October 2, 2002