Corporate Profits – Where Do We Go From Here?
(October 1, 2006)
Before we begin our commentary, let us first take care of some “laundry work.” Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 – giving us a gain of 290 points. In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 – which is now 294.07 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 174.07 points in the black. Real-time “special alert” emails were sent to our subscribers informing them of these changes.
As of Sunday afternoon on October 1st, we are now fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc. Note that, however, both Wal-Mart and Sysco has had a tremendous run lately, so it may be prudent to wait for some kind of correction in these two stocks before buying if you are not already long. We are also very bullish on good-quality, growth stocks – as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). The market action in large caps, retail, and technology have all been very favorable so far – and I expect it to remain favorable at least for the rest of this year. The lack of breadth – as exemplified by the dismal performance of the S&P 400 and S&P 600 is still a cause for concern- but since we are now in a large-cap bull market, I would give the bulls the benefit of the doubt for now. Besides, both the S&P 400 and S&P 600 are still in intermediate up-trends – meaning that this author is willing to give them more time to “confirm” the Dow Industrials and the S&P 100/500 before shifting to a less bullish stance.
Let us now get on with our commentary. In both our commentary from last weekend and from the weekend before last, we discussed that the commodity bull market cannot be officially declared over just yet without the Canadian dollar finally rolling over (confirming the downside moves in the other two popular commodity currencies – the Australian and the New Zealand Dollar). Specifically, we discussed the potential continuing resiliency of the Canadian Dollar by looking at the long position held by small speculators of the Canadian dollar on the CME. As of the Tuesday before last, the net long position held by small speculators was the smallest long position in nearly a year. From a contrarian standpoint, this was bullish for the Canadian dollar. At the very least, it should have provided some kind of support for the Canadian dollar.
As of last Tuesday (the Commitment of Traders reports are compiled at the close on Tuesday and released the following Friday), the net long position held by small speculators ticked up slightly – but it still remains the third smallest long position held by small speculators in over a year. From a contrarian standpoint, the Canadian Dollar is still bullish – but besides the most recent plunges in both oil and natural gas (the latter of which has been occurring since December of last year), there is also one more cause for concern: Declining lumber prices. At any given point in time, lumber exports is nearly always in the top five list of exports in terms of dollar value from Canada to the United States. Following is a weekly chart of cash lumber prices from January 2002 to the present, courtesy of Futuresource.com:
As mentioned on the above chart, lumber prices have also taken a hit this year – declining approximately 36% to its lowest level since June 2003! This is definitely a cause for concern for Canadian dollar investors – especially given that overnight rates in Canada are only 4.25% - or a full 100 basis points below that of the overnight yields of the United States. The Canadian dollar is now very vulnerable – and I believe that the end of the bull market in the Canadian dollar is just a matter of time.
I would like to now reiterate my position of where I believe the stock market and the U.S. economy is heading over the next six to 12 months.
First of all, I have stated in the beginning of this year that the “U.S. Housing Bubble” was bound to pop and that it was going to pop sometime this year. Among other things, the popping of the housing bubble would induce a “mid-cycle slowdown” in the U.S. economy – resulting in below-average GDP growth later this year. At the beginning of this year, this was an out-of-consensus call, and since then, I have stuck to that view. I was also beginning to get bullish on U.S. domestic large caps – and again, I continue to stick to this view. Since the May 10th top in many of the major indices (including international as well as commodities), U.S. large caps have significantly overperformed, and I continue to believe they will continue to overperform for the foreseeable future.
So Henry, why are you unfazed by all this talk of a recession? Especially given the fact that U.S. housing is now mired in a “nuclear winter”?
All our explanations could be found in our MarketThoughts archives, but let me now give you the short version of why we do not believe the U.S. will experience a housing-induced recession:
- First of all, many folks (unlike the late 1990s when everyone thought the market would continue to rise 15% a year) had already been expecting a decline in U.S. housing activity sooner or later. This included many of our subscribers, myself, and I bet many of David's subscribers as well. This is very important, as many of us had already cleaned up our balance sheets just in anticipation of such an event occurring (and there is ample evidence that U.S. households utilized a significant chunk of their “mortgage equity withdrawal” to pay off their higher-yielding debt, such as credit card and auto debts, etc.). In other words, there is now more of a cushion to sustain consumer spending once the “home equity ATM” disappeared – as opposed to the late 1990s when virtually no-one was prepared for a global stock market crash.
- As I discussed in our August 20th commentary, many bears would cite the “fact” that the stock market has nearly always experienced a decline after a pause in the Fed rate hike campaign. Well, this will depend on which time period you study. If one focuses strictly on the late 1950s to 1981 period, then this will be a resounding “yes.” However, if one had studied the time periods after 1981, then the tables would have be turned (with the exception of the rate hike cycle ending May 2000). Moreover, I would argue that both Greenspan and Bernanke had been pre-emptive in their current rate hike campaign – raising the Fed Funds rate as early as June 2004. The current rate hike campaign was also very well communicated (with the possible exception of this year but overall, this has been a very transparent Fed especially compared to the Fed of the 1960s and 1970s) – thus significantly decreasing any chances of a hedge fund blowup, sovereign default, or companies making relatively bad economic decisions. In other words, this current rate hike campaign has been truly unique. Not only does there not have to be a decline after the end of the rate hike cycle (see periods before 1981), but there does not have to be a 10% correction in the stock market during the rate hike campaign either (unlike the 1994 to 1995 hike cycle when Orange County and many other hedge funds blew up). One piece of evidence showing that the Fed has been pre-emptive is the fact that the P/E ratio on the S&P 500 has now contracted three years in a row – representing only the ninth time this has occurred in the history of the S&P 500 dating back to the beginning of the 20th century. If the P/E ratio of the S&P 500 declines four years in a row, this will be only the third time it has occurred – with the first two being the 1934 to 1937 and the 1975 to 1979 periods.
- The Federal Reserve has also been pre-emptive in popping the housing bubble. As I have mentioned before, the housing bubble was due to pop sooner or later. What really mattered was at what level it would take to pop the housing bubble. Would it be 5.25%, 5.5% or even higher at 6.0%? The jury is now out, and it is 5.25%. The fact that it only took a 5.25% Fed Funds rate to pop the housing bubble is actually a bullish sign for both the economy and the stock market, as a Fed Funds rate higher than 5.25% would have made the curve significantly more inverted and would have “choked off” many parts of the “non-housing” economy.
- As for the often-mentioned chart “showing” that the NAHB Housing Index has actually been a 12-month leading indicator of the S&P 500, there could not be another analysis out there that could contain as many flaws, as I discussed in our August 24th commentary. The classic chart from Birinyi Associates shows a 79% correlation going back to 1996, but if one extends the history of the NAHB Index going back until 1985, then one can clearly see that the NAHB Index has not always been a leading indicator of the stock market. Moreover, to suggest that the topping out of the NAHB HMI in early 1999 foretold the end of the technology and telecom bubble a year later is naïve – as the latter was mostly driven by easy credit, unprecedented optimism and greed, and a mass bullish psychology that have never been seen since the late 1920s. The bubble ended once it exhausted itself. The fact that the NAHB HMI topped out a year early was accidental – and it should not be given more weight than say, the NYSE A/D line which actually topped out in April 1998 (the latter of which is infinitely more useful as a leading indicator of the stock market).
- As for famed economist Nouriel Roubini (of www.rgemonitor.com) openly calling that a recession, perhaps he is correct this time but his August 2004 paper calling for a significant slowdown even though oil was still below $50 a barrel at the time suggests that his record has not been perfect. Moreover, he is now also on the record stating that the latest rally in the S&P 500 is a “sucker's rally.” My response to this: This cannot be any further from the truth, as according to the ICI, U.S. equity mutual funds actually experienced an outflow of $3.7 billion in August. Moreover, from May to August of this year, the outflow of U.S. equity funds was $23.1 billion – representing the highest four-month outflow since a $71.4 billion outflow from July 2002 to October 2002. In other words, the folks that have been propping up this stock market has been the private equity investors and the hedge funds (not retail investors) – and most likely, the suckers that Mr. Roubini is referring to were the folks selling stocks (similar to the folks who sold during July to October 2002), not the folks buying stocks!
Let us now take a look at U.S. corporate profits. The latest GDP and corporate profits data for the second quarter was just released. U.S. real GDP grew 2.6% in the second quarter while U.S. corporate profits again hit an all-time high. Corporate profits as a percentage of GDP, however, declined slightly from the first quarter from 10.3% to 10.2% - but is nonetheless still close to a new secular high and the highest percentage since the fourth quarter of 1968. Following is a quarterly chart of corporate profits and corporate profits as a percentage of GDP from 1Q 1980 to 2Q 2006:
As mentioned in the above chart, current corporate profits as a percentage of GDP is – for practice purposes – at its highest level since the fourth quarter of 1968. Obviously, the $64 trillion question is: Can corporate profits continue to rise at the same pace as it had since 2002? It will be ludicrous to think that it can – given that corporate profits simply cannot grow more quickly than GDP over a sustained period of time. That being said, we are now living in a world that is the most globalized since the beginning of World War I. And given that many U.S. corporations are now both hiring and selling in many different countries, this has two important implications: 1) Employment costs can and will continue to be squeezed as many U.S. corporations “offshore” a significant amount of their operations to lower-cost countries such as India, the Philippines, Vietnam, and China; 2) While many US-headquartered corporations continue to derive half or most of their revenues from sales in the U.S., this is no longer the only significant source of revenue – and most likely, U.S.-derived sales will continue to decline in significance going forward. That means that while U.S. corporations are only seeing 3% to 5% revenue growth in their own domestic market, they are most likely going to see double or even triple that in other markets such as India and China. In other words, corporate profits are no longer tied to U.S. GDP as it has in the past, but most probably some kind of measurement that resembles world GDP. If that is indeed the case, then corporate profits could conceivably continue to grow much faster than U.S. GDP – at least until the next global recession.
However, even should corporate profits decline going forward, the market (the S&P 500) does not have to decline from current levels, as exemplified by the fact that the last peak in corporate profits occurred during the third quarter of 1997 – even as the market continued to roar ahead for more than two years. For a more systematic look at the relationship between corporate profits/earnings surprises and the subsequent performance of the S&P 500, readers can go back and refresh their collective memory by reading our September 4th commentary. As illustrated by a study conducted by Morgan Stanley, contrary to public belief, there is no correlation between earnings growth (or revisions from earnings estimates) and the subsequent performance of the S&P 500. This was also "proven" by a study done by Victor Niedorhoffer – who actually found a slight negative correlation (i.e. when earnings growth declines, the stock market actually outperforms). In our September 4th commentary, I stated:
In fact, if Victor Niedorhoffer's findings hold true for this cycle, then the S&P 500 could conceivably outperform going forward in the next 12 to 18 months. So Henry, why do you think this lack of correlation has held true in the past, and does it make sense?
Subscribers should first take this into account – that individual stock outperformance after better-than-expected earnings do not translate well when one looks at the S&P 500 as a whole. As I have mentioned before, I would not be surprised if this negative correlation occurs again this cycle, for the following reasons:
- A significant chunk of the outperformance in earnings has been due to the energy and the materials sector. Should earnings surprised on the downside in these sectors going forward, this should increase margins in more productive sectors of the economy, such as technology, consumer discretionary, and real estate. While this may cause a downward adjustment in S&P 500 earnings, such a weakness in the energy and materials sector should be a boon for the rest of the sector – thus causing the S&P 500 to outperform.
- Interestingly, the 2004, 2005, and 2006 YTD points are all clustered towards the upper middle section of the chart [editor's note: please see our September 4th commentary for the chart] – suggesting that the return of the S&P 500 has not been all that great over the last three years despite a successive string of earnings surprises. In other words, this negative correlation has held true over the last three years, so why can't it continue to hold for the rest of 2006 and into 2007? If that is indeed the case, then the S&P 500 should outperform even as earnings are ratcheted down going forward.
The following chart showing the profits of various industries as a percentage of total corporate profits from 1998 to 2Q 2006 is a perfect illustration, as it shows that that the profits of both the petroleum and coal products and the chemical products industry as a percentage of total profits have been rising and are now at new secular highs:
Going forward – even should corporate profits or corporate profits as a percentage of GDP decline, chances are that this may “come out” of the petroleum, coal products, and the chemical products industry – while sparing the retail trade, durable goods industry, etc. Given that energy costs, and hence, energy profits are collectively a drag on the global economy, such a scenario is potentially bullish for the S&P 500 and for stock markets around the developed world, even should total corporate profits decline.
Let us now discuss the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:
For the week ending September 29, 2006, the Dow Industrials rose 171 points while the Dow Transports rose 126 points. While the “big news” was the Dow Industrials' failure to close above its all-time January 14, 2000 high of 11,722.98, it is encouraging to see the Dow Transports closing above its September 13th closing high of 4,451.45 last Thursday when it closed at 4,466.54. This minor confirmation on the upside by the Dow Transports suggests that the most recent uptrend in the two popular Dow indices remains intact. And while the failure of the Dow Industrials to best its all-time high may cause some “disappointment selling” early this week, this author still believes that the surpassing of its all-time high is inevitable, and occur sometime over the next few weeks. We remain 100% long in our DJIA Timing System. Readers please stay tuned.
I will now continue our 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. The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 21.4% in the latest week. 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:
Given that the four-week moving average of our popular sentiment indicators have reversed to the upside and is still not at a very overbought level, there is a good chance that the market will maintain its most recent trend of higher prices at least until this indicator gets overbought. Again, chances are that the Dow Industrials will close above its all-time high of 11,722.98 in the weeks ahead.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
As one can see from the above chart, the 20-day moving average of the ISE Sentiment has plunged from 108.7 to 101.5 in the latest week – a level not seen since October 2002. Meanwhile, the 50-day moving average is again at a level not seen since the recording of this indicator – declining yet further from 112.4 to 111.2. This suggests that the market has already bottomed and is preparing itself for a further up move over the next few months.
Conclusion: While the breadth of the stock market continues to be a red flag, my overall view of the market and the sectors we like does not change from what we have already discussed over the last three to four weeks. That conclusion is: U.S. large caps and growth stocks continue to be the most attractive asset class in the world today – and while some conservative investors would opt for sitting in cash today (which makes sense since it is yielding at over 5%), I believe that that “parking in cash” mentality will start to change once the Fed starts cutting the Fed Funds rate – perhaps as early as January 31st of next year. As for the chances of a recession in the U.S., I do not believe it will occur – barring a major terrorist attack on U.S. soil or an oil embargo from Iran (the chances of the latter happening is next to nil as well). As for the Canadian dollar, it is now fundamentally very vulnerable – and for our Canadian readers – I strongly urge you to consider hedging your buying power going forward by either purchasing U.S. stocks or even letting some of your money sit in a U.S. CD.
Henry To, CFA