The World is Economically Lethargic – So Why Are Corporate Earnings at an All-Time Record?
Lance Spicer, Editor, Trident Confidential, 2 May, 2:42 PM
Is there a different “reality”? Has there been some sort of disconnect in the economy where you can have bad (or ordinary) economic news and great earnings from companies?
The answer is yes.
GDP data blinds us. For example, the US economy grew at 2.2 per cent (annualized rate) in the March quarter, which was well short of the average forecasts of economists who had predicted 2.7 per cent. This on the surface was quite bad, but the market kind of ignored it and pushed it’s way higher on the day the news came out and the reason was it wasn’t a bad a figure at all. In fact it was viewed very positively. It was the make up of the GDP number that made the difference. It showed a big drop in government spending (down 5.6 per cent) and a smaller contribution from inventories than expected (0.6 per cent versus 1.8 per cent in the December quarter). More than offsetting this was an increase in personal consumption of 2.9 per cent, which was the biggest gain in more than a year and this was attributed to a big increase in spending on cars and construction.
What this tells us is that the US consumer, who makes up 70% of the US economy, is feeling good and confident enough to buy new cars and build houses, and spend lots of money on other stuff too. Jobs are coming back also so they are confident of keeping their jobs now too, as more and more American businesses start employing more people, particularly in manufacturing and technology.
What makes this recovery so different is that it is unique in that there has been little in the way of government spending support – the private sector is recovering the US economy virtually on it’s own. Government employing people and providing economic incentives assists most recoveries – this one has had just the opposite. If you were to compare this recovery with others, on an apples versus apples basis, and deducted government GDP stimulus from other recoveries, you’ll find this one is one of the most powerful recoveries in the private sector.
That’s why earnings are so high and when you also consider the emergence of China and other emerging economies and how they are buying more technology from the US, as well as very cheap borrowing costs, is it any wonder we are seeing the earnings surprise so much to the upside?
If you were waiting for the backside to fall out of the US economy – you could be waiting a while, as things are only getting stronger and government cutbacks are just about over, so we will see some positive economic input there in coming quarters as tax receipts again start to rise.
The Australian economy however is being strangled by relatively high interest rates and consequently a strong dollar. We heard that the Australian economy grew at a 1.6% annualised rate – yes, slower than the US economy. Can you believe those klutzes from the RBA expected economic growth at 4.25% and we actually have 1.6%? I have been saying they have it all wrong for many months now and the average guy on the street can tell you things aren’t great. I just wonder how smart the RBA board members are or if they tend to avoid the “common people” and their opinions? The bottom line is the RBA got it wrong! Their policy of holding interest rates for so high for so long was a mistake and one that has done considerable damage to the Australian economy. However, I think they have now realized this and we will see at least two rate cuts in coming months and one on Tuesday 1st May (which actually happened at .5 %).
The Australian dollar has been rising this week due to the Bank of Japan adding further stimulus to the Japanese economy. The theory is that this will flow through to higher commodity exports for Australia and therefore push the terms of trade higher. It was also helped by a fall in the US dollar as the lower than expected GDP numbers came through. This, despite the fact that the RBA will need to cut rates. I think this rise will be temporary and it will drift back towards the $1.02-$1.03 range it was trading in a week ago.
The GFC was chaotic and wealth destroying, we all understand that and most of us have never seen anything like it, nor are we ever likely to see something this bad again in our “investing lives”. Not only did it gives us a very unpleasant 2008 and early 2009, but it came back for an encore in the form of the European Debt Crisis in 2011 and numerous other aftershocks.
Most investors are scarred by the experience, but corporations aren’t so easily put off and during the chaos they not only stabilised their businesses, they then set about reducing debt or re-organising debt, restructured their businesses and cut costs and introduced new efficiencies such as technology to increase productivity and profitability… and then waited. Waited for business and consumer confidence to return as either the economy rebounded or product replacement cycles finally meant products and services simply had to be used.
All this has resulted in corporate balance sheets being substantially de-leveraged and carrying more cash than any time in history. The major US and Global corporations have never been more healthy from a cash flow and balance sheet point of view and in terms of fundamental based risk, it hasn’t been this low for decades.
Based on what I can see, it’s absolutely no surprise to me at all (as you well know) that corporate profits this quarter have surprised to the upside to such a high degree – these companies are lean and efficient and are maximizing every slight improvement in economic data. Governments around the world are not in the same situation – in many cases they have never been more vulnerable to public ridicule and tend to err to the side of pessimism, which we all seem to listen to and then seem amazed by the success of corporate earnings. You see, it’s a fact of life, and this is a generalization so it’s not always true, but as US President Ronald Reagan once said "The best minds cannot be found in government. If they could, the private sector would hire them away”. Very true.
When I look at businesses I can buy today, I’m pretty chuffed still at the quality and valuation of these businesses particularly after the 4% pullback in April. Many of the good ones, those with great balance sheets, solid cash flows and fabulous business models are at record sales and profits, yet are nowhere near record highs (a few are, but very justifiably so). There is no better indicator of good value when profits are not only at record highs, but most CEO’s are tipping them to go higher over the next year or two, yet prices remain depressed somewhat.
The reason?
Investor’s attitudes - Many are still waiting for something bad to happen, and the media keeps giving them something to worry about, but how much of it has to do with corporations? No, it’s all about largely ineffective and sometimes incompetent government all around the world.
At some stage, these governments will be replaced and hopefully leaders who have seen the mistakes of the past will learn and improve and the media will choose elsewhere to criticise and in the meantime corporate profits will continue to rise as people just keep going about their business despite government and it’s general lack of “connectedness”.
Of course the average investor scarred by the events of the last few years will remain worried and cautious and will for a very long time be unable to recover losses from 2008 and 2009 due to the fact through fear they remained sidelined, as over the next year or so, stock market indices hit new all time record highs in line with earnings. Last week I quoted investing legend Peter Lynch, “Over the short-term, there may be no correlation between the success of a company’s operations and the success of its stock. Over the long term, there’s a 100% correlation.”
The Bottom Line
For those investors who remain sidelined, they have a choice – start participating in the market again by buying the very best quality stocks or remain where they are and suffer something crueller than losses, missing out on profits when they had the opportunity. Opportunities don’t come “candy-coated”; they are often disguised as a problem, which means most people then miss them.
