Pushing on a String?

By: Chad Hudson | Wed, Apr 18, 2001
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Well, Greenspan pulled the surprise rate cut yet again. However, the current economic data does little to support Greenspans actions today. Yesterday, industrial production ticked up for the first time since September, led by a strong auto sector. Additionally, home sales came in at an annual rate of 1.613 million units. This was below February's rate, but higher than the total for last year. Looking at the CPI, which was released yesterday, there does seem to be a hint of inflation under the surface. The March CPI came in at 2.9%, which suggests that there is nothing to worry about, except that the biggest decreases came from gasoline (-3.8%), fuel oil (-3.0%), natural gas (-2.1%), and energy (-2.1%). With gasoline spiking this month and continuing concern about the potential of $3.00 gas this summer, the ECB is definitely undertaking a much more responsible approach.

What is happening in the economy is not being picked up in aggregate economic data. The SF Gate discussed the dichotomy of economic views between business owners and the economists. Foote Axle & Forge based in LA provides an excellent example of how higher energy cost can ripple through the economy. Its monthly gas bill has increased from $8,000 to $23,000. Owner Mike Denton had to shut down his second shift and is now reselling axles he purchases from an Asian factory. Mr. Denton touched on something I have been discussing for a long time, "It's now cheaper for me to buy products this company has been making since 1936. If things don't change, this will become a warehouse." This is the part that economists who only look at aggregate data miss until it is way too late. The economists only see the six laid-off employees. They fail to see that higher domestic costs and a strong dollar are eating away our manufacturing base. The one piece of data that proves this is happening, the trade deficit, is explained away by arguing that profligate U.S. consumer, as the bullish spin goes, is merely spending the money foreigners flood into the country to invest in the New Economy. This is, of course, reversing "cause in effect," as it is actually the foreigners that have at this point chosen to recycle the global flood of U.S. dollars back into stock, agency debt and bank deposits. I know it sounds foolish, but it's not my theory. Jack Kyser, chief economist for the LA County Economic Development Corp., understands that "If you're an academic economist, it's very hard. All the evidence is anecdotal." I guess that is why this commentary exists - I feel the same way.

This week we have posted numerous stories about how rising energy prices are driving up costs. Hotels are adding surcharges, laundry mats are increasing the number of quarters required to wash and dry clothes. In the Pacific Northwest, forward prices are already hitting records for energy delivered in August.

Now in addition to soaring energy costs, small business owners are facing increased heath insurance costs. An article in the Milwaukee Journal Sentinel discusses how small employers are coping. Some are dropping coverage, but most are just reducing the quality of coverage and forcing employees to pay more. CalPERS is voting to do just the same. It is accepting lower premium increases for increases in doctor co-payments and prescriptions. It could get worse. Insurance companies typically use investment gains to pay a substantial part of their claims. With the markets down, the industry's statutory surplus dropped 4.5% during 2000. This was the first drop since 1984.

We have reported along with several others that consumers have been leveraging themselves to support the buying binge. What I have feared is that the lower and middle class have been taking on a disproportionate share of the debt. Unfortunately, it appears these fears were well placed. Dismal.com dug into the numbers and discovered some frightening conclusions (Decaying Household Finances). Looking at data from 1998, the lower and middle class have been extending themselves the most. While the data is dated, I would argue that the situation is worse now than two years ago. The article laid the groundwork for why the lower class has increased their debt load so much during the economic boom. The article points out that the lowest economic class enjoyed that highest income gains due to the tight labor markets that the long expansion created. Also, the hot real estate market has increased the perceived value of their house. These are the same forces that lured the middle class as well. These two combined forces are quite powerful and create the illusion of financial prosperity. Unfortunately, it is the lower economic classes that are greatest affected by the marginal changes in the economy. It should also be noted that almost all major banks that reported financial results for the first quarter experienced double digit increases in problem loans.

Also affected on the margin are small businesses. Small business is considered the backbone of the American economy and it is starting to show signs of stress as well, especially in California. The energy crisis in California is starting to take its toll on the manufacturing sector, especially on smaller companies.

Although, Cisco's announced restructuring brings restructuring back into the everyday conversations, there are some obvious points that often get overlooked. Investors always seem to have a sense of relief after a company announces a restructuring. Mostly due to the idea that "Well we got it out of the way, now the company can focus on the future." Unfortunately, that is seldom realistic. One of the greatest restructuring stories out there is IBM during the early 1990s. I think IBM took five restructurings totaling about $20 billion. These charges along with operating losses sank IBM's shareholders equity by over 50% from 1990 to 1993. I know looking at balance sheets is an "old school" way of analysis but I still like it. What is amazing is that over the past seven years IBM's stock has soared 10 times, but shareholders equity is up only 5%. Granted IBM has been buying back stock so on a per share basis it has increased more, a whopping 44%. Remember IBM's stock price has gone up over 10 times since 1993. Even thought investors seem to grasp the idea that a restructuring reduces shareholder equity, since very few look at balance sheets anymore nobody really cares. Investors fail to realize that when a company takes a charge, it is essentially saying that past earnings were overstated. MSNBC published a very good article, S&P 500’s earnings are seen falling, Worst Showing Since 1991, that discusses some of the accounting "tricks" that have become popular during the recent bull market.

Today's 50 basis point cut is not going to help the economic situation the U.S. is experiencing. Correct me if I'm wrong, but the main purpose of lower interest rates is to spur borrowing by consumers and companies. The increased borrowing increases demand for goods and investments, which speeds up the economy. The problem now, is consumer credit is at historic levels and there is excess capacity throughout the manufacturing sector. This makes it highly unlikely that lower interest rates will do much to stimulate the economy. Anyone that it might benefit is in such dire financial position, I doubt they would be about to raise any funds, Lucent, Xerox, and CLECs come to mind. We are at the point where we need a recession. There has been such a misallocation of resources by both the corporations and consumers. Corporations have done everything in their power to try and keep earnings growth up in the short-term without much thought on longer-term strategy. Decisions have been made to build another chip plant so they can get as much business now, and were not concerned what could happen if demand falls off. Companies have also spent the late 90's issuing debt to buy back its own inflated stock. Not only are these financial engineering tricks not going to be feasible going forward, but will cause havoc as analysts start to remember companies file balance sheets along with the income statements.

Selected emailed questions or comments will be addressed on Bears' Chat.


Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis

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