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FX Blog - Earnings and Mr. BearEarnings and Mr. Bear
July 25, 2008
Earnings and Mr. Bear
Earnings Before Bad Stuff
How Ugly Can it Get?
A Lean Mean Reversion Machine
Some Thoughts on Energy
Oregon, Maine and a Wedding
By John Mauldin
"The stock market is a voting machine in the short run and a weighing machine in the long run." - Benjamin Graham
voting part of the equation is tempered by fear and greed. It is
largely emotional, although investors like to think of themselves as
rational players. That emotion is driven by views of the future. If you
can be confident of large and growing returns, you are less likely to
be swayed by the erratic movements of a stock. But as confidence wanes?
Well, that is the stuff that bear markets are made of.
the end of the day, what the market weighs is earnings and the ability
of a company to reliably produce them. This week we look at what
earnings are likely to be over the next year and see if we can discern
what that suggests for the markets. We also take a look at the energy
markets, the possibility of a further drop in the price of oil, and
muse on what a sane energy policy for the world would look like. There
is a lot to cover, but it should make for an interesting letter.
first, a quick announcement. I have recently agreed to do a regular
interview each issue with the editors of EQUITIES Magazine, which will
be in the magazine and on their web site. They are also going to
feature me on their web-site home page with my latest writings, under
the title "Guru Blog." I am excited to be associated with a magazine
that has been around for 57 years.
In return, they have agreed to give any reader of mine a free subscription to EQUITIES Magazine. You can go to http://www.equitiesmagazine.com/mwi
and simply register and get the magazine sent to your home. There is
also a link to an interview I did in April with them. They have a lot
of content and free resources like real-time stock quotes and portfolio
managers. Check it out!
Earnings and Mr. Bear
theme in this letter for many years has been that over time markets of
all descriptions revert to the mean. The classic definition of mean
reversion is "the behavior of a variable in which the values for that
variable move towards the long-run average value for that variable."
Prices, indexes, and all types of economic variables tend to fluctuate
around their long-term averages.
Profits as a percentage of
nominal GDP is one of the more significant mean reversion examples.
Last year we saw pre-tax profits as a percentage of nominal GDP climb
to a 55-year high of 14%, which is really rather astounding. Why?
Because over time, profits track nominal GDP. In the post-World War II
era, nominal GDP growth has averaged 7.1%, while profit growth has
averaged 7.4%. Profits over the long term as a percentage of GDP have
not changed significantly for generations. Or put another way, profit
growth has matched GDP growth. We will examine later what might happen
if profits reverted to their long-term average (think ugly).
in the short term, the difference between corporate profits and nominal
GDP can vary wildly. But in the fullness of time, economic pressures
will work to bring corporate profits back to the mean. This can come in
the form of higher or lower wages, changes in productivity, higher or
lower taxes, recessions, or growth booms. All of these and more affect
Let me give you one more way to look at it. If
the economy is growing at 7% (nominal), then corporate profits cannot
continue to grow for more than a few years at 15%. If that growth trend
continued, then at some point in the future the entire GDP would
consist of corporate profits, as each year the percentage of corporate
profits in the GDP would increase. Since trees cannot grow to the sky,
nor can corporate profits become larger than the economy, and so logic
dictates that there will be an adjustment in the future. And we are
beginning to see that logic play out. Let's look at a few numbers.
as-reported 12-month corporate profits on the S&P 500 peaked in the
second quarter of 2007 at $84.95. In March of 2007, S&P forecast
2008 earnings would be $92. Then the economy began to run into trouble
and S&P began to drop their 2008 forecasts, as the table below
shows. (By the way, this is not to pick on S&P. Nearly every major
forecast had similarly optimistic views.)
actually happened? 2007 earnings actually came in at $66.18, following
a lot of ugly write-offs in the last quarter. The estimate for 2008 is
$72.01, as you can see above. Interestingly, they project lower
earnings for 2009, down to $67.66. At today's closing price of 1257,
that projects to a lofty price to earnings (P/E) ratio of 18.55, well
above long-term averages and well above trend for periods of poor or no
growth. For the record, there is no record in history of a bull market
starting at a P/E of 18.
Earnings Before Bad Stuff
other interesting statistic that caught my eye: Reported earnings are
what you pay taxes on. They are what you really made. S&P also
estimates operating earnings, or as I characterize them, Earnings
Before Bad Stuff, or Earnings Before BS. There has been a lot of Bad
Stuff of late. Operating earnings for 2007 were almost 25% higher than
reported (real) earnings, and about 15% (so far) for 2008.
the analysts at S&P must expect a lot of Bad Stuff in 2009, because
they project a difference of almost 45% in 2009. Remember that they
project real earnings to be $67.66 in 2009? Well, they project
operating earnings to be a whopping $108.60. That will be a growth in
earnings of almost 25% in 2009.
Before we get into whether such
earnings growth is likely, think about an environment where company
after company keeps reporting large write-downs every quarter. Of
course, they will tell you it is just this once, so don't sell us - now
is a buying opportunity. Long-time readers know that I have written on
several occasions about how continuing earnings disappointments are
what create a bear market. Typically it takes at least three to really
get the attention of analysts and investors, who begin to lower their
projections for both profits and price targets.
How Ugly Can it Get?
Rosenberg, the North American Economist at Merrill Lynch, is one of my
favorite analysts. He is a mainstream economist who is most definitely
not a cheerleader. He can be quite bullish as times, and when he thinks
the times call for it, he can be rather bearish. As we will see below,
he is quite bearish of late. I am going to quote from his opening
remarks in a commentary dated July 25, where he is changing his
forecast. Remove sharp objects from your nearby vicinity.
"Forecast addendum: Adjusting to the new reality
like consumers, who are insulating their windows and making fewer trips
to the malls, we are adjusting our economic forecast to the new
high-oil price reality not to mention the latest round of trauma in the
mortgage markets. Though fiscal stimulus [rebate checks] will provide a
lingering boost to 3Q we expect GDP to plummet 2.5% in 4Q and see a
similar decline in 1Q. In all, we have shaved our 2009 GDP forecast to
-0.5%, a full percentage point lower that where it was previously,
while 2008 is broadly unchanged at 1.5%.
"The scenario we
ran last May, when we shocked the model with higher oil prices, now
appears to be playing out as predicted. With rebate check delivery
winding down, there is now little shielding the consumer from the full
force of $4+ gasoline, deflating real estate and equity markets and
rising unemployment. The new reality means a deeper downturn for
consumers, higher headline inflation, more belt-tightening from
businesses and a mammoth profit squeeze. It also keeps the odds
squarely in favor of more rate cuts from the Fed, in our view.
the last of the rebate money is spent, in either July or August,
consumer spending is expected to roll over, and hard. The oil shock
we're experiencing is on par with the spike in the mid-1970s and
consumer spending will see a similar downturn, in our view. The
unemployment rate will probably crest at about 7.0% in mid-2009, a half
percentage point higher than our previous outlook. We're expecting a
3.0% decline in PCE in 4Q 2008 and 1Q 2009 does not promise to be much
better. We look for savings to rise, as consumers adjust to the tighter
credit environment by building their savings rate up to 2-3/4% by the
end of 2009.
"The deeply disappointing retail sales
report this week only serves to underscore how far behind the curve
consumer is financially and a grim foreshadow of what lies ahead once
the rebate checks are all spent. Flat spending was all consumers could
muster in July with three quarters of the $106 billion total rebate
checks in their bank accounts. We take consolation from the notion that
the folks in the Beltway are doing the same math we are and thus the
drumbeat of another round of stimulus is getting louder all the time.
good news is that we're probably more than half way through the real
estate correction. The bad news is that we've likely still got at least
another 15% down on home prices to go before we reach bottom. Moreover,
housing starts still need to breach the 700,000 mark to deal with the
mountain of new and existing homes with for-sale signs on them. The
supply situation will not be helped by the latest fractures in the
mortgage securitization market, which will only slow the pace that
homes can be sold and inventories can be cleared."
Below is a table with some of his forecasts. You can read the whole report at http://www.realclearmarkets.com/The%2520Market%2520Economist%252007%252018%252008.pdf .
Can you say Muddle Through?
A Lean Mean Reversion Machine
a few pages up when we were talking about the mean-reverting qualities
of corporate earnings? If corporate earnings fell to their long-term
average, that would mean a drop of about 50% from the peak, which would
mean $45 in operating earnings, and even lower for reported earnings.
You could easily see a P/E ratio north of 25 or 30 if the market did
not move down. Quoting from another Rosenberg commentary:
this into perspective, the four-quarter trailing EPS figure in the 2001
recession hit a trough of around $38; in the 1991 recession, the trough
was just over $18. That means that we are not talking about Armageddon
[projecting $45 earnings], but rather offering up some analysis
highlighting the risks to the outlook. We will bottom at levels much
higher than the troughs in the past; that is the good news. The
not-so-good news is that the level of the S&P 500 in the past that
tended to coincide with $45 earnings was right around the 1,000 mark;
and if we were to slap on a typical trough multiple of 10-12x on that
earnings stream, then ... well, you do the calculation."
highlight this analysis because it illustrates the point I have been
making for a long time. Recessions do ugly things to corporate bottom
lines. They savage earnings, and that is what ultimately drives the
stock market lower. For you to be bullish today, you have to believe
that the recession is over and that earnings are going to rise, not
A 15% drop from where we are today would not be out of
historical character. It would be a merely average bear market in an
average recession. Given the extremes to which profits rose in the last
cycle, it would be strange indeed if they did not revert to the mean or
go below. The Dow below 10,000 is not unrealistic, or the S&P below
I clearly do not know the future, and the market does as
much as possible to make me look bad. But I simply believe that the
risk is to the downside. And if Rosenberg is anywhere near right, then
it could get a lot worse. Continued earnings disappointments, combined
with ever increasing write-offs implied by the S&P numbers, is not
the environment for a renewal of the bull market. The current run-up is
a bear market rally, in my opinion. It is a time to lighten up, if you
have not already.
Some Thoughts on Energy Policy
US Geological Survey said the Arctic may contain as much as 90 billion
barrels of untapped crude oil and 1.67 quadrillion (with a "Q"!) cubic
feet of natural gas. This is equal to approximately 13% of the world's
undiscovered oil and 30% (!) of the undiscovered natural gas. There is
yet more offshore oil and gas off the coasts of the US that is not
being utilized. And that is assuming current technological methods. You
have to know technology is going to improve recovery rates.
are debates about energy policy, as to whether we should go to solar,
wind, or bio-fuels, drill for more oil and gas, build 45 nuclear
plants, etc. I don't get it. I would like to check a box that says all
of the above.
The reality is that the world is going to demand
more oil as the developing nations want more cars and energy. Oil
production is declining in Mexico and Russia and other countries where
we get our fuel. While proper drilling and better political climates
could make up for declining production of older fields, it is not the
In the short term, we need to drill in the
Arctic and offshore. Even though I am going to show why oil could go
back to $100 in the near term, in the long term (3-5 years) it could
easily go to $200 and $6 a gallon if we do not do something now, and
maybe even if we do. It will take years for any oil or gas to come from
offshore and Arctic sources. If we are going to have that energy in
five years, we need to drill now.
And it can be done safely. A
large portion of the oil and gas for the US comes from the offshore
fields of Texas and Louisiana. There was a class 5 Hurricane Katrina
which ripped through these offshore rigs a few years ago, and not one
of them had even a minor environmental problem. These rigs are built
solid and safe.
To drill in the Alaskan Natural Wildlife Arctic
Reserve means drilling on a few square miles of land which is basically
wasteland. No beautiful scenery. No tourists. Very few caribou. We have
been drilling in Alaska for a long time without problems, and
technology has improved.
Oil coming online in a few years will
help hold down prices today. That is the way markets work. Every year
we wait will mean higher prices and more money sent outside of the US.
But drilling for oil is not the long-term solution.
Pickens has been running TV ads talking about a plan to divert natural
gas to automobiles and reduce our need for oil. A key point is that we
are sending $700 billion out of the US each year for oil. Over ten
years it could be over $7 trillion. It is the largest transfer of
wealth in history. It is unsustainable. It will be a serious drag on
the dollar, which will make things even worse.
Look at this graph
from my friends at GaveKal. It shows the US trade deficit, but the
black shows the percentage of the deficit that is related to oil. Note
how it has risen in the last few years, even as we have imported less
in non-oil items. We have an oil deficit that is close to 3% of GDP,
when ten years ago it was less than 0.5%. And the gap is rising as oil
is a big proponent of wind power (and is putting his own money into
wind, so he is "talking his book"). But there is a strong logic to what
he says. Slowly converting our power grid to 15-20% wind (or even 5%)
would be useful. You can see a quick presentation at YouTube: http://www.youtube.com/watch?v=Avt8Yo2WE14&feature=user
July 21 has a great article on the rush to build solar power plants in
the deserts of California, Arizona, and Nevada. Applications have been
filed to build plants that would generate a theoretical 60 gigawatts of
electricity. To put that into perspective, California only uses 33
gigawatts. And the biggest and richest firms are lining up to get land
to build solar. These are not small start-ups. And that energy
projection is using current technology, not even assuming what we will
have in 5-10 years.
Note that California has over 10% of the
population of the US, so there are people who actually want to use
their money to build solar plants to provide 20% of the US demand for
electricity. That is not a trivial pursuit.
Ironically, there are
radical environmentalists who are planning to sue to stop this solar
production because some desert animal's habitat might possibly be
disturbed. Seriously? These are the people who think humans should
leave the planet so that animals can live in peace and harmony with
nature. And they are dictating our energy policy. Yes, we are talking
about covering a great deal of uninhabitable desert with solar and
thermal panels. And the government is taking its sweet time processing
the applications. But we need to change the laws so that we can start
the process. Allowing a few radical environmentalists to abuse the laws
to prevent one of the best chances for renewable energy is just crazy.
You can read the well-written article by Todd Woody at http://greenwombat.blogs.fortune.cnn.com/2008/07/15/the-solar-land-rush/.
John McCain wants to build 45 nuclear plants. Yes, that will take some
time, but that means we need to start now. Within 15 years, and
probably 10, our cars will be electric. We need to start building the
power systems to meet increased demand for electric transportation.
let's not forget clean coal technologies. All of the above can be done
and still reduce our carbon footprint. But the point is that whoever
gets elected next November needs to have a plan and put someone in
place to actually lead and stop the bickering. It should not be
either/or. It should be all of the above, because some of the ideas
will not work out as predicted.
Either we are going to see the
economic life sucked out of this country, or we can respond by doing
everything that is in our power. There is not a shortage of energy.
There is a shortage of leadership to produce the energy we need. A real
energy policy would also have the benefit of boosting the beleaguered
T. Boone Pickens may be able to make energy policy the #1
election issue. And with another major effort by Pete Petersen, who is
going to spend $1 billion telling the US how bad our Social Security
and Medicare problems are before the election, maybe we can get enough
people upset enough to demand some action. Maybe. Hopefully.
speaking of the price of oil. It is $123, down from almost $150.
Supplies are building and demand is being destroyed by high prices.
Which of course reminds us that the cure for high prices is high prices.
low could oil go? Data maven, uber trader, and good friend Greg Weldon
recently developed a number of charts showing how supplies of
oil-related products are rising and spreads are tightening. If we are
in a correction, how low could oil go?
I must confess, I do not
understand the fundamental aspect of something called a Fibonacci
retracement, but the pattern keeps repeating itself over and over, so
you have to pay attention. These are numbers based on work done by
Leonardo Fibonacci in the 1200s. Basically, when a market starts to
correct, it tends to go to certain points for support. Traders use them
so much that they become psychologically important, which may be why
they are useful.
Look at the chart below. It shows that if oil
goes to its Fibonacci retracement levels, it could drop to $110 or
below $100. That would not, as Greg notes, violate the longer-term bull
market trend, but it could be seen as a normal correction. Just food
Oregon, Maine, and a Wedding
I fly out for a meeting in Portland, Oregon and back on a ridiculously
early flight Tuesday morning. (What was I thinking?) And then Thursday
I fly to Maine for David Kotok's Annual Shadow Fed Fishing Event. My
youngest son Trey (now 14) and I fly to Bangor and then take a float
plane to Leen's Lodge to meet with 30+ people. There will be several
Fed economists, and some well-known names like Paul McCulley of Pimco,
Martin Barnes of Bank Credit Analyst, Barry Ritholtz, John Silvia of
Wachovia, and some very sharp traders and analysts. Right now, Steve
Leesman of CNBC and a crew are slotted to come in, or so I am told.
Everyone basically ships in a case of their favorite wines, so it is a
very fun event. I can tell you that some of the participants go all out
in their choice of wine, and I look forward to tasting scores of
But the conversation and comradery are the best
part. We get up every morning and go out on the lake with local guides
to fish, then meet for lunch on an island, eat what we caught, talk
shop, tell lies, and drink lots of wine. Then we go out again and come
back for a gourmet dinner, and drink even more wine and maybe some of
Martin's Scotch. Then get up and do it again. And repeat. And the best
part for Trey is that he always seems to catch twice as many fish as I
do, as well as the biggest.
On Saturday night, everyone gathers
in the lodge to place small bets (typically $10) on where the markets
will be one year hence. Last year I asked those of my readers who
wanted to, to also make predictions. We will go back this week and see
how you did, and the best will be sent a copy of some book that I like.
(Besides one of mine. Though I assume you already have those.) And I
already know I have won one bet, so I will be a winner again this year.
It will be interesting to see how close I came in the other bets. I
will write this up in a later letter.
And then I come back for
Wedding Week. The wedding is August 8. I spent Thursday with Tiffani
and Ryan, meeting with wedding planners, musicians, caterers, fireworks
managers (sigh), and a legion of people coordinating an event that has
grown beyond the original vision. But what fun. And to see your
daughter so happy? Priceless.
The weeks seem to go by so fast this summer, and now it is late and time to hit the send button. Have a great week.
Your hoping he can catch more fish this year analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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