August 16, 2012
Mark Twain famously said that he could sum up everything he knows about life in three little words; "it goes on." And so it does. As another earnings season draws to a close what have we learned, what have we confirmed, and where do we go from here?
Any earnings season can be broken down into two elements. The first is the backward-looking quarterly numbers that shed light on recent business results. The second element is the forward-looking guidance that executives provide based on their expectations. For this season there is no doubt that corporate profitability is at historically high levels. However, the rate of earnings growth has been decelerating for three quarters in a row. And although there never is perfect uniformity of opinion the general outlook is cautious for the remainder of the year.
One of the primary factors for such caution is the gridlock in Washington. Although we have not come to any proverbial "fiscal cliff", it's important to understand that behavior can change in anticipation of such events and that the reactions to them are different for business leaders than they are for policy makers. Business leaders and markets proactively anticipate events and take action in advance to defend against potential adverse consequences. Policy makers typically have to be taken right up to the edge and shown the abyss before action becomes possible.
We have learned two important lessons from this earnings season. One is that we are well beyond peak earnings (maximum rate of earnings growth). The second is that business activity has been adversely affected by short-term expectations. Executives from all over the world are reporting customer orders cancelled or delayed, capital investment and hiring decisions pushed out, inventory replenishments forestalled, etc. The threat of the fiscal cliff is suppressing what is already slow economic activity. This is a pattern we've seen before, particularly during the debt ceiling crisis of 2011. For economic actors the anticipation of the event is enough to create real economic headwinds. Damage is being done.
This earnings season has also confirmed similar caution related to the European financial crisis. The time appears near for a climax in the Greek tragedy that is, ironically, Greece. And the similarities to Lehman Brothers are eerie. Both Greece and Lehman espoused confidence that they could make it through and that given enough time a sustainable solution could be found. However, in both situations creditors became averse to lending more money while borrowers remained confident that action was needed to prevent catastrophe. In 2008 when the world got back from its August vacation the hourglass had run out of sand and found Lehman Brothers insolvent. This year it will return and find that Greece remains the same. Will the hourglass have any sand left in it?
Lightening may have struck Lehman Brothers first but the storm proved far from over. As one bad actor was found out the markets turned their attention to the next weakest link. In the Financial Crisis that meant a slew of companies: Wachovia, Merrill Lynch, Fannie & Freddie, Countrywide, Citigroup, among others. In Europe, next on the list is Spain.
A recent article in The Economist summed up Spanish problem with a succinct medical analogy; "Every attempt by local specialists advised by renowned European consultants to treat the sickness brings no more than temporary relief. Even more worrying, the relapses after each dose are happening sooner and sooner. Spain's chances of avoiding intensive care - a full bail-out - are receding to the near vanishing point." As mentioned in my last post, the Spanish government has already borrowed EUR100bln to bail-out their banks and in turn rely on their banks to use these funds to finance their deficits. But as German newspaper Der Spiegel reports, in the last eleven months ending in May capital outflows from the Spanish banking system amounted to roughly EUR162bln, equivalent to 26% of Spain's GDP. Spain recently reported its third straight quarter of economic contraction and has an unemployment rate over 24%. It's hard to imagine how this situation can turn around. What will happen if they do request a full bail-out? Will the market's crosshairs turn towards Italy?
Despite slowing economic activity across the world and a rolling debt crisis in Europe, as of this writing the S&P 500 is within 100 points of its post 2009 highs. More interesting is that yields on Treasuries are near historic lows. The equity and bond markets are thus sending very different messages. Equities are signaling that the worst is behind us. Interest rates suggest that the worse has yet to come. The question then becomes, who do you believe?
The evidence suggests to me that the risk aversion of the bond markets is probably your best bet. In the upside down world we live in, the stock market has tended to rally on bad news under the theory that it is likely to encourage more central bank interventions. Bad news paradoxically becomes good news and markets rise. However, it looks like a charade. A stock market based on hopes of central bank action rather than economic reality is not one that inspires confidence. Further economic deterioration is likely due to the persistent factors discussed previously. It's also a questionable theory that more central bank intervention will provide any economic benefit. All central bank efforts in the past have at best provided temporary and fleeting benefits with huge costs and unpleasant side effects. And each successive effort has had diminished benefits at that. If the thesis of more central bank intervention fails, watch out below.
Brennan R. Redmond, CFA Vice President
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities.)