General Motors, the Stock Market and Gold
If the saying "As goes General Motors so goes America" holds true then it doesn't look very good for America or for the stock market.
In a March 16th profit warning GM announced that significant weakness in the North American automotive business would lead to a loss in the first quarter and full year's earnings would amount to just one fifth on the company's December 2004 expectations.
This stunning revelation caught many people by surprise and prompted investors to drive down GM's share price 10% in that one day. GM's share price is down 44% from a 52-week high of US$50.04 to its current low of $29.37. From it's market high of $93, in May 2000, GM shares have lost 69% of their value. This indicates that GM is in serious trouble and may prove to be an important turning point for the entire stock market.
What does GM's financial vulnerabilities tell us about the future of the stock market and the price of gold?
While most people think of GM as a car company 80% of its 2004 earnings came from GMAC, its financial division. While the auto divisions posted losses the finance division provided all of the profits. GMAC doesn't just do auto financing; in fact the majority comes from consumer credit, insurance and mortgage financing. This division provided GM with most of its profitability. Just as with GM, the financial industry was responsible for 50% of corporate profitability in the US. With rising interest rates and the prospect of increasing defaults by overleveraged consumers this is likely to change dramatically in the near future.
This financing activity is clearly masking the problems plaguing its automotive operations. Apart from competitive market factors for car sales, foreign competition, rising commodity and labour costs, and rising oil prices, the areas of greatest concern are GM's underfunded pension liabilities and corporate debt. In 2003, GM faced the largest pension fund shortfall of any US corporation - $25 billion, requiring it to float an extraordinary $17.6 billion bond issue, bringing its long term debt to over $300 billion. This still left GM with a deficit of over $50 billion in its health care fund. The magnitude of this becomes more apparent when you consider that GM's market capitalization is now just $16.6 billion.
GM's pension woes are not likely to improve. In a report for The Detroit News Auto Insider Ed Garsten states that GM currently provides health and income benefits to 461,500 retirees and their surviving spouses. As of October 2004 GM retirees and their dependents outnumbered the company's active workforce by three-to-one. This imbalance will continue to grow as more and more retirees are supported by fewer and fewer workers.
GM's employment and pension woes are not isolated issues restricted to its corporate boardrooms. GM's problems point to and underscore greater systemic issues that could one day choke the life out of tomorrow's capital markets and cause havoc for the West's financial system.
Pension underfunding is a global problem that is particularly pronounced in the US due to the underfunding of Social Security. In 2004, the US Federal government posted the highest budget deficit in history- $412 billion. However, its total indebtedness rose by $11 trillion to $46 trillion largely due to underfunded social security and Medicaid obligations. The magnitude of this liability comes into focus when one considers that the 2004 annual increase is equal to the entire GDP of the whole country. It translates into $350,000 per worker and since both couples work in most families, this represents a $700,000 liability per family.
In 2003, 70% of US corporate pension plans were underfunded by $278 billion with estimates for 2004 exceeding $400 billion. The Pension Benefits Guarantee Corporation, that insures the pensions of over 44 million American workers, incurred a record net loss of $12 billion in 2004 increasing its liabilities to $62 billion on $39 billion in assets, resulting in a deficit of $23.3 billion. The CATO Institute, a policy research group estimates that the agency's shortfall may top $50 billion in the next ten years. If the economy experiences a decline due to rising interest rates or rising oil prices the number of corporate bankruptcies could increase dramatically. Given the precarious financial position of GM, it could be one of them.
During the '90s bull market most pension plans were in surplus. Companies were able to add surpluses to their operating income thereby distorting price/ earnings ratios. After the market decline in 2000 many defined benefits plans became underfunded. Today, the picture is still distorted as pension funding obligations are based on overly optimistic portfolio returns, resulting in a much higher level of underfunding than is being reported.
As an example, prior to its bankruptcy, Bethlehem steel reported that its plan was 84% funded when in fact it was only 45% funded. This resulted in a $4.3 billion liability that the Pension Benefits Guarantee Corporation had to assume. Robert S. Miller, Chairman and CEO of Bethlehem Steel told Bloomberg News: "I hope other companies are ready for this, because many of them, including some automakers, aren't going to be able to outrun their pension liabilities. At some point, the great sucking sound of pension and health care liabilities just overwhelms your ability to raise capital or invest in new plants or equipment."
Like many other members of the S&P 500, GM projects an expected rate of return of 9% on its pension assets. Such exceedingly optimistic assumptions served to increase GM's operating profit by $8.7 billion in 2001 and $8.1 billion in 2002 even though pension assets posted losses of $5.3 billion in 2001 and $5.4 billion in 2002.
These pension liabilities may ultimately cause a decline in the entire stock market. Since 360 of the S&P 500 companies have defined benefits pension plans these obligations will negatively impact earnings as more profits will have to be diverted to pension plans. As lowered profits negatively impact share prices these will, in turn, result in greater pension deficits due to the fact that these company's pension portfolios are invested in each other's stocks. This can become a descending spiral of pension deficits, leading to reduced earnings that in turn lead to lower stock prices, that lead to even greater pension deficits.
With the stock market starting to trend down, long term bonds yielding under 5% and treasury bill yielding 2.7% it is hard to imagine how an assumption for a 9% rate of return can be achieved without adding significant risk. Rather than improve, the situation is likely to get much worse. By 2011 approximately 100 million US workers or roughly the entire population of Japan will have retired from the workforce. Economists agree that this event will have marked consequences for both the US economy and its capital markets. Unfortunately, economists also agree that the effects of this massive retirement wave will be for the most part negative.
In addition to the pension and health care liabilities GM's debt is also of concern and is symptomatic of the high consumer, corporate and government debt levels. US corporate debt grew to new highs of over $9 trillion, representing 84 percent of GDP. These high debt levels are significant when you consider that the Federal Reserve has stated it intends to continue to raise interest rates, and that equity markets are overvalued by all traditional measures. The combination of decreasing consumer spending and increased debt service costs will ultimately translate into slower growth, a contraction in earnings and reduced profit margins. This will all translate into declines in stock prices.
GM's total consolidated debt was $301 billion on December 31, 2004. To put this into perspective this is almost as large as Canada's entire Federal Debt of about $363 billion. It is larger than the value of the US gold reserves of 512 million ounces, worth about $217 billion at $425/ounce gold.
GM is a benchmark bond issuer, being the world's third largest corporate borrower with $114 billion in outstanding bonds. Much of that debt may soon fall below investment grade status among the most influential credit rating agencies, relegating the once venerable GM to "junk bond" status. Since the recent announcement the yield on GM's euro denominated bonds have soared to 9.59%. Fitch Ratings recently lowered its ranking on GM to one step above junk, while Moody's said that it may lower its rating to one step above junk or high yield status. Dominion Bond Rating service had lowered its rating on GM last week to two levels above junk status with a negative bias. What will happen to global bond markets if GM's bonds go into default?
With borrowing costs surging to their highest level in almost two years, increasing pension shortfalls, declining auto sales, reduced credit demand and increasing default risk the earnings picture looks bleak for both the auto and financing divisions. Instead of a $2 billion positive cash flow for 2005 GM now projects a $2 billion cash shortfall.
GM's troubles have immediate ramifications for today's stock markets. This is due to the size of GM, its role in the North American economy and the place it enjoys on its representative index. General Motors Corporation is one of the 30 "blue chip" companies that comprise the Dow Jones industrial Average. These 30 companies represent just two percent of all listings on the stock exchange, but account for 25% of the daily trading volume of the New York Stock Exchange.
The popular belief that a diversified portfolio of stocks and bonds will provide long-term capital preservation and growth is simply not true during bear markets or during periods of rising interest rates. For full diversification, portfolios need an allocation to tangible assets, including precious metals in order to provide negative correlation to financial assets, and to offset any declines. While North American investors have participated in the longest and highest equity bull market ever during the past twenty years, it is important to understand that this period was not the norm - nor is it likely to be repeated over the next twenty years. Today, most investment portfolios are not fully diversified and are at risk of capital loss.
A secular bear market could last for a decade and wipe out any gains achieved during the bull market. The 1920s bull market took the Dow from 66 in 1921 to 381 by September 1929, and the ensuing decline took it down 89% to 41. The current bull market started in 1982 at 777 and reached a peak of 11,750 in January 2000. The rally in 2003 is typical of a bear market rally similar to the 1930 rally in the US, and the 1980 rally in the Japanese Nikkei Index. Will this bear market repeat what previous secular bear markets have done? Will the ensuing decline take the Dow below 777?
If a secular bear market is coupled with rising interest rates then GM's pension problems, as well as the pension problems of many of the S&P 500 corporations, could lead to insolvency. GM's pension plan has a traditional split of 55%-60% equities, 30%-35% bonds and 10%-15% other assets. There is no mention of any allocation to precious metals to provide portfolio insurance and to help offset losses that these assets may suffer.
While many retail investors and pension fund managers believe in the buy-and-hold strategy, it does not work during a bear market. Many of the baby-boom generation will not live long enough to even break even on their investments during the coming bear market. Many corporations with underfunded pension liabilities may face bankruptcy long before this strategy delivers the necessary returns to fund their pension obligations. Investors in the Dow of 1929 had to wait 30 years just to break even in inflation-adjusted terms. Japanese investors who held stocks in the Nikkei are still down 71 percent, 15 years after the 1990 high.
Rather than buying and holding, investors need to consider the benefits of reallocating portfolio holdings during cyclical trend changes. Apart from the fundamental vulnerabilities for traditional financial assets, it is important to understand the cyclical nature of markets. As asset classes move through individual bull and bear phases, investors should adjust portfolio allocations in order to maximize long-term growth. A portfolio overweight in a bear-phase asset class can result in huge losses requiring decades to recover from.
With respect to equities and precious metals, an important indicator for portfolio adjustments is the Dow:gold ratio. An increasing ratio, such as that experienced from 1921 to 1929, from 1933 to 1968 and from 1982 to 2000, indicate that portfolios should be overweight in equities. Declining ratios, such as those experienced from 1929 to 1933, 1971 to 1980 and 2000 onward, indicate that portfolios should be overweight in gold. In 1933 and 1980 the ratio came close to 1:1, while in 2000 it reached its highest level of 43:1. Since then, it has declined to 25:1 and is trending lower. This indicator suggests that since March 2000 investors should have been allocating higher percentages to precious metals and smaller percentages to equities. Will this ratio again be 1:1, as the bear market in equities continues and the value of gold increases?
As the outlook for financial assets deteriorates, the importance of a fully diversified portfolio with an overweight position in precious metals will become increasingly more critical. Although no one knows for certain the impact of rising oil prices, the risks posed by derivatives and high debt levels, and the threats posed by overvalued equity and real estate markets, there is more than enough justification to consider an overweight position in bullion. Apart from a portfolio allocation of 5 percent in bullion during all market conditions, an overweight position of at least 10 percent is essential today.