Will Corporate Profits Continue to Outperform?
(April 2, 2006)
Dear Subscribers and Readers,
With the filing of Delphi's restructuring plan last Friday, the odds of a GM bankruptcy sometime this year has exponentially increased. Prior to Friday, GM had estimated its obligations to Delphi's former and current employees to be in the range of $5.5 billion and $12 billion. Assuming that the sale of GMAC will close in the next couple of months, and assuming the stock market will corporate this year (which will allow GM not to make any cash contributions to its pension plans in 2006), a GM bankruptcy was not inevitable this year – even in the face of a high $65 oil price, a hawkish Fed, a lineup that is still bloated and behind the times, and continued competitive pressures from both Japanese and South Korean auto manufacturers. With the latest restructuring plans filed by Delphi, however, there is now little doubt that many or most of Delphi's plans will strike sometime in early June. Should a general strike occur at Delphi, much of GM's production will be shut down. Estimates of losses at GM range from $500 million to $1 billion on a weekly basis. By definition, a corporate bankruptcy is always preceded by some kind of liquidity crisis. Should a strike at Delphi occur, there is no doubt that it will be quickly followed by a GM Chapter 11 filing.
To paraphrase the Carol Loomis' article on GM, turning around GM is a logistic endeavor which is even more involved than the invasion of Iraq. And finally, make no mistake: With today's $12 billion in market cap, the folks that basically own GM are not the shareholders, but the debt holders, the workers, and the unions. To put this in perspective, the consolidated balance sheet of the company shows over $250 billion in long-term obligations, $70 billion in unfunded pension and healthcare obligations (on a FAS 87 and 106 basis, and hundreds of unhappy GM dealers and thousands of unhappy GM (and Delphi employees). At the end of the day, the $12 billion in GM's common shares is essentially worth zero.
We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,109.32), this position is 239.32 points in the red – but again, given that the market is now showing signs of a classic “blow off” top, this author is betting that this position will ultimately work out. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 – giving us a gain of 89 points. This latest signal was sent to all our subscribers on a real-time basis.
In our mid-week commentary three weeks ago, we stated that we will remain 50% short in our DJIA Timing System until at least the March 28th Fed meeting. Whether we were slightly early or not, this was not to be – as we subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. As of Friday evening, this position is 165.68 points in the black. This was also communicated to our readers on a real-time basis. For readers who did not receive this “special alert,” please make sure that your filters are set appropriately. We are now 75% short in our DJIA Timing System.
In our mid-week commentary a few days ago, we stated: “Given that the market had every opportunity to decline over the last ten days (especially given the relatively hawkish statement out of the Fed), this author feels that the “window” for the market to decline more from here may be closing. Sure, we know that there will be tax-selling across many of the small and mid caps. We also know that buybacks have turned very quiet over the last few days and that earnings reports will begin to pour out of Wall Street in about two weeks … In light of this, this author is willing to “stay with the course” for just a little bit more of time – but in order to control for risk in our DJIA Timing System, there is a chance that this author will close out our March 20th 25% position in our DJIA Timing System sometime over the next few business days (especially if the market declines to an oversold condition). We will discuss more about this in our upcoming weekend commentary. A 59.70-point gain is really a pittance but we will take it and re-enter our short position once our sentiment indicators get more overbought if we have to.”
As of Sunday evening, April 2nd, this author is still looking to get out of our March 20th 25% short position in our DJIA Timing System in order to control our risk and our volatility in our DJIA Timing System. Compared to our 59.70-point gain last Wednesday evening, the current gain of 165.68 points isn't too bad. I apologize to our readers for having to trade so much in our DJIA Timing System recently, but even as this author believes that the market is in the midst of forming a top, I am still not totally convinced that the Dow Industrials has made its final top yet. At this point, a 50% short position in our DJIA Timing System is bearish enough, especially given the short-term (somewhat) oversold conditions in the current stock market. We will reenter on the short side again should the Dow Industrials rally further in the weeks ahead. We will let our readers know on a real-time basis once we have exited our March 20th 25% short position. We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: “A Change in our DJIA Timing System”).
Over the last six months or so, we have discussed the concept of “capital vs. labor” – namely the struggles over time between capitalists, unions, and workers. We did not engage in any philosophical or detailed historical discussions (it is really not our job here, as many folks out there can do it better than we can) but even in capitalistic societies, it is notable that just like many things in life, labor/union power also goes through cycles – although trends in labor and union power tend to be very secular in nature and are definitely nowhere near as volatile as the movements in the stock market.
For example, the unionization of the U.S. labor force today is a mere 12.5% (half of which are governmental workers) – declining from slightly over 20% in 1983. Union membership is now at its lowest in the U.S. since 1932. At the same time, we know that the level of real salaries and wages for workers in the United States have not increased very substantially over the last few decades. In fact, the latest “Flow of Funds” data published by the Federal Reserve shows that as a percentage of GDP, wages and salaries paid to workers in the U.S. is now near a 40-year low:
As I mentioned on the above chart, employees' compensation as a percentage of GDP – except for a brief period from 1993 to 1997 – is now at its lowest level since 1966. Given the ongoing labor discussions at companies such as Delta, Delphi, GM, and the continuing trend in outsourcing all you can (including investment bank services, and so forth), there is a good chance that this percentage will continue to decline over the next several quarters. Before I go on and discuss the implications of this and other possibilities, let me now show you another chart, courtesy of the folks at Wikipedia:
Okay Henry, just what is the “Gini Index?” Readers who are interested in how this index is constructed can read the following page at Wikipedia, but in a nutshell, it is basically a crude and simple way to measure income inequality in a certain economy. While it may be rather crude (for example, non-monetary welfare benefits such as food stamps is not taken into account into household income), the above chart showing the Gini Index over time definitely tells you one thing: Income inequality in the U.S. has generally increased since 1960. That is, the average U.S. worker over the last 45 years has seen his or her relative income levels taken a hit on both sides – those being:
1) The relative decline of the average U.S. worker's salaries and wages as compared to profits either returned to shareholders or retained by the company – as illustrated in the first chart. This trend has also been manifested in the fact that corporate profits as a percentage of GDP in the fourth quarter of 2005 (at 10%) is now at the highest level since the fourth quarter of 1968. Following is a quarterly chart showing the absolute level of corporate profits and corporate profits as a percentage of GDP from the first quarter of 1980 to the fourth quarter of 2005:
2) The relative decline of the median salary and wage level as compared to the pay of executives in the Fortune 1000 companies – as exemplified by the rising Gini Index over the last 40 years and the fact that many CEOs have been rewarded very richly despite the fact that their companies have severely underperformed under their tenures.
In the past, I have raised the possibility that the “annihilation” of the UAW and the pilots' unions may actually signal the turning point of labor power, but given the very secular nature of labor trends, and given that globalization is continuing to bring more educated workers into the mix, probability still favors a declining percentage in employees' compensation relative to GDP, and a rising Gini Index (in the developed countries) going forward. Readers should note that current reading (56.9%) of employees' compensation as a percentage of GDP is actually right the average for the period from 1948 to the present. That is, there is still some more room for this to head down in the years ahead.
Unless protectionist sentiment becomes more prevalent in the U.S. in the months ahead, or unless a world war breaks out, probability still favors a decline in labor power over the long-run, given that both China and India (along with many other countries in Asia) are now strongly favoring capitalism as opposed to other economic ideologies. Politicians in both countries realize that to stay in power, they need both their countries to continue their strong economic growth – growth that they have been enjoying over the last 10 to 15 years.
Now that I have stated my position, let me “contradict” my thoughts and suggest what may entail over the short-run. In our January 12, 2006 commentary, I discussed this concept by asking a bunch of what I think are some important questions for both U.S. investors and salary earners over the next two to three years. In that commentary, I stated:
I now want to take this issue further and ask our readers a few questions. At this point, the situation is very much in flux - but this is very important to keep in mind going forward. Historically - even in a relatively capitalistic country like the United States - there has been a cycle between labor empowerment and labor disempowerment. While the disempowerment of labor due to the "influx" of labor from China and India in recent years is most likely a structural change, it is crucial to keep in mind that this is by no means a "linear change." That is - at various points - labor should fight back, whether it is through unions, government lobbying, or labor strikes or even violence. Moreover, the most talented and educated of the U.S. labor force will always be in high demand, and once companies find out that offshoring may not necessarily solve all their cost problems (for example, replacing IBM's North American and European programmers with programmers from India), it will be time for U.S. labor to again be in control. Let me now cut to the chase and ask a few questions:
- On the strength of outsourcing, offshoring, declining union power, automation, low borrowing costs, etc., corporate profits as a percentage of GDP are now (second quarter of 2005) [the fourth quarter of 2005 has now broken this previous record] at a 35-year high. Can this get any higher?
- Expanding on point number one above - all these are generally OK in a period of general economic prosperity. That is, it is OK for your neighbor to be laid off - but when it comes time for you to be laid off, it is not as OK - especially if one has to settle for a lower-paying job at Wal-Mart. Reforms only work when unemployment is going down, and not up (that is why this author believes that reforms in Germany will ultimately not work).
- Given a period of rising stock prices or rising wages, which one will labor choose? Are we all capitalists now as many have stated in the last few years? Sure, rising home prices have made us feel good (and have provided many jobs since September 11th) but what happens if housing prices stop going up? Given that 40% of all jobs created since 2001 is real estate related, it is also not difficult to envision a vicious cycle occurring in the United States (slowing housing market leading to higher unemployment which again leads to a weaker housing market, etc.).
- Are we going to see a labor backlash in 2006? Will there be protectionist policies in some of our declining industries, such as in the form of more tariffs, quotas, or another call for a higher Chinese Yuan? For example, China became a net exporter of steel for the first time in 2005. At the end of last year, the premium for "Hot Rolled Coil" in the United States was US$270 per tonne over the price in China (US$310 per tonne), and US$130 per tonne over the price in Korea. Production in China is expected to increase 15% in 2006 - bringing the number to 390 million tonnes - a significant amount of which will be undoubtedly exported. Given that total U.S. demand of steel is "only" 115 million tonnes, there is no doubt in mind that the premium will decline very swiftly during 2006 and beyond in the absence of government intervention. Will the steel companies once again lobby for tariffs, as they have done again recently but without success? Also, as I am writing this, two major Chinese auto companies are set to export their automobiles to the United States starting in 2007 and 2008, respectively, while another Chinese company is in talks to buy parts of Delphi. Given that many men and women in Congress are already hotly debating the trade deficit issues, my guess is that unless the Chinese government intervenes in curbing overcapacity in both the steel and in the automobile sector, it is virtually a given that there will be some protectionist measures enacted sometime this year or 2007. Ironically, GM or Ford going bankrupt may mark the "peak" of the power of the capitalists and shift power back to labor going forward possibly for the rest of this decade.
- And finally, what will happen to corporate profits if there is a labor backlash? Subsequently, what will happen to stock prices if there is a labor backlash? As companies are discouraged to continue to offshore their operations, the more-educated segment of the U.S. labor force will again be able to demand a higher premium for their services. Wages and benefits will generally rise after inflation and wage inequalities between executives and the technical workers will also decrease - for the first time in a long time. Of course, all this will serve to decrease corporate profits. At the same time, readers should keep in mind that nothing happens in a vacuum, and that if the United States does try to implement quotas or tariffs in either the steel or the auto industries, there will most likely be retaliatory actions - not just from China but from other Asian countries as well. All this will serve to adversely impact international trade activity - and ultimately global economic growth. Such a scenario will not be pretty for corporate profits going forward.
All these are very important questions, so let me further expand on these. Expanding on point number three, it is again essential to ask: Are you basically a capitalist or a wage-earner? Would you like to see a 10% rise in your salary as opposed to a 10% rise in your 401(k) portfolio? Do you have sympathy for the workers at Delphi or GM? How happy are you when housing prices in your neighborhood appreciate by 15%? Can you even afford to buy a house in your neighborhood and pay off your mortgage in 30 years? Or do you see yourself as being a virtual slave to your local bank or credit union? It is also interesting to see that there tend to be many more capitalists near the peak of the stock or housing market than at the bottom – when everyone is having a grand old time and when one is more concerned with rising asset prices than income levels.
I am raising all these issues since this author now believes we are in a Catch-22 from the standpoint of the U.S. investor. That is, I believe corporate profits (as a percentage of GDP) will decline no matter what happens over the next two to three years. In the short-run, this author believes that there will be some kind of “backlash” coming from labor – whether it is an outburst of protectionist sentiment or just the fact that every last penny has been squeezed from employees' salaries and benefits. This latter scenario may be more plausible than you think – given the tightness in the job markets among college graduates and among the information economy. In the alternative scenario (the absence of a labor backlash), the weakness in corporate profits will be caused by a combination of two things: The continuing weakness in the growth of employees' compensation (on a year-over-year basis, the growth in employees' compensation in the fourth quarter of 2005 was only 5.3% - the lowest since the second quarter of 2004 and which is definitely below the growth of nominal GDP) and a dramatic slowdown in the U.S. housing boom (and subsequently, mortgage equity withdrawal). Given the relatively weak growth in workers' compensation over the last few years, the growth in asset prices is more important than ever. Such a conjecture makes perfect sense when one takes a look at the following chart:
Okay, we know that given the financial know-how of Americans and given the many online budgeting and “financial optimization” tools we have today, borrowing money and leveraging yourself like a U.S. corporation is now much more streamlined and is a strategy which makes perfect sense (in theory). We also know that absolute total net worth of American households continues on a secular upward trend. At the same time – as the U.S. economy switches to a service-based economy which requires a lot of formal education but is much more flexible, the business cycle has gotten less volatile. Today, our financial system is also much less vulnerable to shocks (such as the relatively muted reactions to Enron, Refco, Delphi, Delta, and GM, and so on) than 20 years ago, for example, given securitization and given the ability for financial corporations to diversify much of their sources of risks.
However, all these tools and systems do not change the fundamental fact that American households are as financially leveraged as ever – and continues to remain so given that the asset-to-liability ratio of American households is now down to 5.4 - from a level of slightly over 14 in 1952. This ratio suffered its biggest plunge in recent years with the bursting of the technology bubble in 2000, and while household net worth started taking off again in 2003, it should be noted that it has taken a lot of debt to finance the most recent “asset boom.” In a credit-based and financially-leveraged society such as America, one needs to tread very carefully if you are a central banker. Like I mentioned in the above chart, the last thing that the Fed wants is a declining net worth of American households. That is why both Alan Greenspan and Ben Bernanke were so fearful of a deflationary scenario back in 2002. Given the fact that Americans are so financially leveraged today, given the continuing rise in both short-term and long-term interest rates, and given the slowdown in the U.S. housing boom, we will be lucky to avoid a recession sometime in 2007 (for now, my mid-cycle slowdown scenario in 2006 still holds). But in order to avoid any kind of debt liquidation, we will most probably need the Fed to start lowering rates later this year, as well as a sustainable rise in workers' compensation relative to GDP. Either scenario would not be a happy scenario for corporate profits going forward – especially in light of the fact that corporate profits as a percentage of GDP is now at its highest level since the fourth quarter of 1968.
Let's now discuss the most recent action in the stock market. Despite the recent highs made by many of the popular indices last week, this author is still witnessing weakening breadth across the board – such as the number of new highs vs. new lows, and the declining tops in the NYSE McClellan Summation Index. At the same time, the Philadelphia Semiconductor Index is still under the 500 level – after testing the 550 level as recently as late February and early March. The Dow Utilities also closed at yet another low – declining by over 10 points from 399.74 to 389.01 for the week – representing the lowest close since November 15, 2005. Given the current divergences and given the fact that the Fed is still tightening (like I said before, the Fed will not stop until either the stock market or the commodity market cracks) – and based on history, this author believes that the current cyclical bull market has only a few more months to go at the most. The last thing any central bank wants is a parabolic move in gold prices, and just like Alan Greenspan in 1987, Ben Bernanke is also facing a parabolic rise in gold prices (along with a plunge in bond prices although that hasn't really occurred yet at this point). Given this, I do not think that Bernanke still stop at 5.0% unless gold plunges back to below $500 by June 28th. However, this author does not really see the Fed raising the Fed Funds rate beyond 5.25%, as Chairman Bernanke and all the other Fed governors are also definitely watching the asset-to-liability ratio of American households with great interest.
Let's now go ahead and discuss the most recent action in our two popular Dow indices, that of the Dow Industrials vs. the Dow Transports. For the week ending March 31st, the Dow Industrials rose 170 points while the Dow Transports declined 40 points:
As I mentioned last week, “the recent daily action of both the Dow Industrials and the Dow Transports continue to look good on the surface. Underneath the surface, however, there has been significant deterioration in the internals, as we are seeing cyclical issues such as BA, CAT, and the airlines “blowing off” while the rest of the list continues to languish. It is even more interesting when one notes that both BA and CAT make up two of the three components with the highest weightings in the Dow Industrials (since the Dow is a price-weighted index).” Our position on this does not change in the latest week – but given that the market can do anything in the short-run, we will continue to look for an exit point in our March 20th 25% short position in our DJIA Timing System over the coming days. Over the next couple of weeks, however, probability continues to favor the downside.
I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. As I mentioned in last week's commentary: “Ever since we seriously started writing our twice-a-week commentaries in August 2004, following these individual weekly sentiment indicators every week has been a ritual for us. That being said, while this was a very profitable game to following in a range-bound market (similar to what we have been experiencing since January 2004), this author is not so sure going forward – as weekly sentiment readings (unless they were very oversold or overbought) is pretty much useless once the market starts trending in a big way. Since this author believes we are now in the midst of forming a top, following these weekly sentiment indicators may not be as much of a ritual for us going forward. As a result, we will – for the first time in a long time – stop featuring these indicators in our commentaries on a weekly basis starting this week. Instead, we will continue to follow the AAII, the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys in a more condensed format – by looking at the four-week moving average of these three popular sentiment indicators and reporting back to you if we are seeing some kind of divergence or extremely overbought or oversold readings.”
Readers who want us to periodically show you the individual weekly charts should let me know – but in the meantime, I will only report to you a condensed format of our three popular sentiment indicators. As I mentioned previously, there are still many bullish folks out there who cite the latest weekly oversold readings in either the AAII or the Investors Intelligence Survey, but what they are ignoring, however, is the fact that the most accurate of these sentiment indicators thus far in this bull market is the Market Vane's Bullish Consensus. If one takes the average of bulls-bears% differential of these three surveys (and smoothed them on a four-week basis), readers may be surprised that we are still getting readings that are at the high end of their historical trading range. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week (note that I have redid the scales and shortened the time period by changing the starting month from July 1987 to January 1997):
As indicated by the above chart, even though the four-week moving average is now getting slightly oversold (at 20.9%), it is still pretty overbought relative to the readings since January 1997. In the short-run, this author is still looking for a more oversold reading before we will pare down our 75% short position in our DJIA Timing System. Should this indicator get to more oversold levels (such as those we witnessed during October 2005), then we may even pare down our short position back to 25% or even to a completely neutral position – and re-enter our short position from a high level in the Dow Industrials. Most importantly, the average of these three popular sentiment indicators is telling us that over the last two years, bullish sentiment has actually been trading near record high levels – suggesting that a sustainable uptrend from current levels is not very likely. Again, this author would argue that at this point, the cyclical bull market that began in October 2002 is “long in the tooth” and is in the midst of topping out. For now, we will remain 75% short in our DJIA Timing System – looking to pare down our short position back to a 50% level in the days ahead.
Henry K. To, CFA