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April 29, 2002

Belaboring The Point

Economic Rehab...The patient is clearly out of the clinic and functioning as a productive member of global society once again. At least according to the 1Q 2002 GDP report. As you know, we have seen just the first volley in what is sure to be a spate of revisions to this number ahead. Real GDP was up a respectable 5.8% during 1Q. As we have discussed in the past, as opposed to "real" results we prefer to focus on the nominal numbers for obvious reasons. We live in a nominal world of currency, corporate revenues and net income. The last time we checked, corporations were still reporting results in nominal terms. But, who knows, if pro forma corporate reporting is deemed unacceptable by the powers that be, maybe companies will adopt "real" reporting. After all, it works for the BEA (Bureau of Economic Analysis). Quarter over quarter, nominal GDP was up 1.6% in absolute terms.

Maybe more importantly is a look at final sales. Although final sales were up modestly in nominal terms during 1Q, historical year over year change tells a much different story:

Our fearless leader at the Fed has mentioned many a time that he is more concerned with final demand than with reported GDP. On this issue we agree. Without reiterating the obvious, final consumption is what the American economy is all about. Important now possibly more than ever in that the 1Q GDP report reflected yet another decline in capital spending. A sustainable economic recovery will not be built on inventory restocking. It either will or will not be built on the back of the very highly levered US consumer.

As we have suggested for some time now, inventories indeed had a big impact in the academic calculation of GDP for the quarter. Inventories fell roughly $35 billion (annualized) in the quarter compared to an almost $120 billion contraction in 4Q of last year. This change of pace alone accounted for 53% of the reported gain in real GDP for 1Q. As is clear, companies have continued to eat away at inventories, although the rate of decline has slowed dramatically from 4Q. It's pretty clear that second quarter reported real GDP will not receive this type of academic absolute percentage gain boost from declining inventory contraction.

Production numbers for many sectors of the economy have been strong recently as the rate of change in inventory contraction almost certainly hit its lows in the fourth quarter of last year. But, in like manner, it also appears clear that inventories are also being rebuilt via foreign sourced product manufacturing. The recent significant widening in the trade deficit resulted from a very dramatic pickup in dollar based import volume relative to export volume that remained rather stagnant. We consider the spread between dollar based imports and exports one of a number of critical variables that will ultimately shape any potential recovery in US labor markets directly ahead. At the moment, this spread is as wide as anything ever seen in recent history:

As you know, the recent economic downturn has been a chance for many companies to shutter domestic manufacturing and source more product abroad or move more of their own physical production abroad. Despite the wonderful 5.8% 1Q GDP reading, close to a quarter million real jobs were lost during the period. Although consumers have continued to borrow and spend during this ongoing period of contracting employment, we suggest they may face a much different set of circumstances as we move forward. The critical moment of truth for the US consumer lies dead ahead.

Belaboring The Point...Although many recent economic statistics characterize what is the classic beginning of an economic recovery, we are witnessing recent divergence in what we believe to be the key area for potential future economic strength - labor (the consumer). Although this is not without precedent in early recovery cycles, initial jobless claims remain high. As you may know, the recent time extension in jobless benefits entailed those nearing the end of their current benefit period to go through a formal reapplication process. These renewal applications were counted in jobless claims stats some weeks back. It caused a temporary spike that has now dissipated. Although the anomaly spike is now over, initial claims remain high relative to experience of the last few years:

The only other post recessionary period where this elongation in relatively high initial claims experience was seen was during the early 1990's. Job growth was sluggish for more than a year at least. Maybe more importantly this go around is recent "continued" jobless claims experience. Continued claims peaked in late 2001 and began dropping during the first few months of 2002. Completely typical experience for an economic recovery. Unlike historical precedent, recent continued claims have spiked anew to a high beyond what was seen in late 2001. Even adjusting for the estimated benefits extension influence, continued claims are breaking out to a new high. It just so happens that this type of experience is without precedent in an economic recovery period. From our vantage point, this is not good news for the consumer. And by extension, an ill wind for the consumer driven economy.

Anecdotally, we have witnessed many a first quarter corporate earnings report be accompanied by new rounds of announced job cuts. Although GE "made the number", they felt compelled to allow 7,000 folks at GE Capital to soon become untethered from the corporate apron strings. Could it be that in spite of dramatic personnel reductions over the past twelve months that corporations have yet to fully rationalize cost structures relative to what you see in the chart of final sales above? The fact is that it very well could be. As you know, we witnessed clear excess in corporate capital spending during the 1990's. So too did we witness labor markets as tight as anything seen in decades. As we mentioned concerning the 1Q GDP report, capital spending declined in 1Q. Corporations are still smarting from the excess build up of capital equipment in the prior decade. The recent durable goods report clearly represents the fact that for now corporations are afraid to spend. They may have temporarily stopped cutting back on spending, but renewed or accelerated spending is nowhere in sight:

In like manner, it may very well be that we enter a new period of continued labor weakness ahead. We have seen temp employment pick up recently, but it has not yet translated into permanent employment gains. At the moment, help wanted advertising lies all of one point above a 38 year low:

Reading Between The Lines...Many of the recent batch of corporate earnings reports are being "made" on the back of continued cost cutting, not on nominal revenue and operating earnings gains. In terms of the importance of nominal numbers, we have constructed the following table that is a little peak at nominal year over year sales growth over the last five years for a cross-section of well known household names. We've simply picked these at random. No hidden or devious rationales. Have a look:

What stands out to us is that although revenue growth has certainly slowed, especially during 2000 and 2001, the fall off is nowhere near what has been seen as the rate of change decimation in actual corporate earnings. As you know, we just lived through one of the mildest "real" recessions in many a decade, yet simultaneously experienced one of the greatest year over year implosions in nominal corporate earnings in half a century. So let's get this straight. Mild recession in terms of revenue softness, but a nightmare in terms of translation to the bottom line.

In reading between the lines (the top and bottom lines), it appears that the mismatch in rate of change between revenues and profits in 2001 suggests that costs were not cut quickly enough to match the downturn in revenue related change to preserve bottom line performance in a more stable manner than was experienced.

Implication for the future? Nominal revenues in the form of increased final sales better materialize, and soon, or it would seem highly likely that corporate cost cutting is about to click up a notch or two. As you can see in the table, we have included S,G&A (selling, general and administrative) expenses as a percentage of revenues for each company across each year. Although a number of companies such as Emerson have done a simply fantastic job of matching S,G&A against revenues (holding S,G&A as a percentage of revenues constant), others such as CAT, KRI, MSFT, etc. have allowed S,G&A to creep much higher as a percentage of slowing revenue growth in recent years. As a quick tangent, the year over year change in advertising spending in this country last year was the greatest decline in more than half a century. Ad spending was being cut drastically. Certainly the other key component of S,G&A is human bodies and their coincident salaries. If nominal final sales do not pick up ahead, there is an excellent chance that further S,G&A rationalization relative to revenues will take place. Not a good omen for the current labor situation. Of course ultimately influencing consumer behavior in terms of final sales.

Waging The Battle For Recovery...In addition to the current trends in labor stats and the potential for additional labor related S,G,&A rationalization ahead, it just so happens that history teaches us that wage growth in early stage economic recoveries is not exactly vibrant. In fact, quite the opposite. In early stage economic recoveries throughout the last three decades, average hourly earnings growth has fallen to a new post recessionary low. And this is across all industry segments. The following historical charts tell the story for themselves:

In deference to rejuvenating corporate profits, moderation in wage gains post an economic slowdown has been a real shot in the arm. As you can see in the charts, in many cases it is multiple years after a dark side economic interlude when year over year wage gains again reaccelerate. At the moment, current wages take on possibly a multi decade peak level of importance in that existing consumer leverage is at record levels. In the following chart we take a look at personal consumption expenditures and household leverage, both relative to disposable personal income over the prior four decades. Although there has been some acceleration during the 1990's, consumption relative to disposable income has been relatively stable:

Household leverage, though, has been a different story entirely. From the perspective of the consumer and his/her ability to power the economy forward ahead, we find ourselves in currently unique circumstances. We find a consumer being called upon to serve two masters - the need for continued consumption of real goods to stimulate macro economic expansion and the simultaneous mandate to fund existing principal and interest payments in terms of servicing household leverage. At the same time we would suggest that the consumer will be deprived of one of the most essential gifts that drove personal consumption over the last twenty years - the ability to refinance all forms of household debt during a secularly declining interest rate environment. We may be at a point where the ability of the consumer to refinance household debt ahead has hit a secular peak (inverse to interest rates). A peak that may be in existence for a good while to come.

Of course the ultimate irony of the moment is that the year over year growth rate in both final sales and personal income is near a four decade low.

Certainly where the economy heads over a period of months is anyone's guess. What is clearly of singular importance over the intermediate term to the macro US economy is continued expansion in personal consumption. We suggest a consumption crossroads lies ahead directly related to continued labor market softness, the need for corporations to further reconcile cost structures unless final sales (revenues) accelerate significantly, historical precedent of early cycle recovery softness in wage gains, and the fact that consumers heavily levered relative to historical experience have little, if any, opportunity to refinance household debt ahead.

Before signing off, we'll leave you with one last chart to ponder. It goes without saying that the consumer will make or break the US economy ahead. But, is this issue, in terms of the meaning of the US consumer to global consumption and economic growth, really much bigger than that? (Answer: You better believe it is.)

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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