No Joy in Greenspan's Wonderland!
The other day, a fast talking lady - a US stock market bull - was debating my friend David Tice - a well informed bear - on CNBC. The lady whose name escapes me kept on talking about how healthy the US economy was, in what a great shape the US consumer was, and how corporate profits were today not only higher but of far "higher quality" than in 2000, when the S&P sold at its high for 1527. She, therefore, concluded that the stock market was based on a sound economy, rising corporate earnings and their "high quality" a bargain.
Bridgewater Associates recently published an excellent piece entitled, "The Money Shuffler's Vig", in which they showed that, in the US, money made from manufacturing is "a pittance in comparison to the amount of money made from shuffling money around: 44% of all corporate profits in the US come from the financial sector compared with only 10% from the manufacturing sector" (see figure 1).
Declining Manufacturing and Rising Financial Profits, 1948-2004
Source: Bridgewater Associates.
From the above figure we can see that whereas manufacturing accounted for more than 40% of corporate profits until the early 1980s, today manufacturing profits have shrunk to 10% of corporate earnings, while financial earnings, which in the past only made up for 10% of profits have surged to over 40%. I may add that this number understates the full contribution of the "money shufflers" to corporate profits, since industrial companies such as GE and GM, which derive either all or a large portion of their profits from financial activities (consumer loans, etc) are not included in the above number, which only captures financial companies' profits. Moreover, another large profit contributor to corporate earnings is the retailing sector whose earnings were just about 20% of manufacturing earnings until the early 1980s but whose profits are now almost as large as profits derived from manufacturing. I leave it up to our readers to judge how "healthy" and of what kind of "quality" current corporate profits are in the US!
In any event the stock market seems to have slightly different views about the quality of earnings the above lady was referring to on CNBC. As can bee seen from figure 2, one money shuffler - until recently the by the investment community beloved AIG - has come under severe pressure and is approaching its March 2003 lows. But it is not only AIG that has been weak recently. Fannie Mae, sub-prime lenders, and banks (including Citicorp) have also broken down - certainly not a positive indicator for the entire stock market. In fact, we would use any strength in financials including mortgage, credit card and sub prime lenders, and providers of financial guarantee products such as Capital One Financial (COF), Countrywide Financial (CFC), Accredited Home Lenders (LEND), New Century Financial Corp (NEW), MBIA Inc (MBI), MBNA (KRB) and banks as a selling or shorting opportunity.
In addition, as far as the great shape the US consumer finds himself in, the stock market seems to have a different view than the "bullish lady" that appeared on CNBC. Retail stocks have been weak and just recently Best Buy (BBY) and Wal-Mart (WMT) broke down (see figure 3). I may add that Wal-Mart is now also approaching its March 2003 low.
At the expense of boring our regular readers, I have once again mentioned the persistent weakness in financial stocks and retailers because of the implication their poor performance could have on the housing market. Weakness in financial stocks indicates that money is getting tighter and that the ability of finance companies to extend loans at negative real interest rates may be coming to an end. Obviously a slowdown in loan growth to the real estate sector would have negative implications for the housing market and the homebuilders whose stocks have risen by almost ten-times since 2000 (see figure 4 in March report). Moreover, weakness in both financial and retailing shares suggests an imminent slowdown in US consumption. Why?
Over the last twelve months, about 25% of consumption growth in the US was driven by households, which drew down their home equity lines of credit by an unprecedented US$ 110 billion. Please note that, according to Merrill Lynch, the 37% increase in revolving home-equity loans over the last twelve months has exceeded growth in wage-based income by a factor of six. So, if the housing market begins to weaken as a result of financial companies diminished ability to extend loans an important pillar of consumption growth - increasing revolving home equity loans - will be absent and weight on the consumer ability to keep up his lavish spending habits.
I have to admit that I am somewhat surprised that the stocks of homebuilding companies have so far failed to decisively break down. This especially in view of the weakness in financial stocks and retailers! But then again, if the NASDAQ could reach 5000 in year 2000 nothing should surprise us. For the bulls no price has ever been too high. But for value oriented investors such as Warren Buffett there appears to be little value in the asset markets. From figure 4, we can see that at Berkshire Hathaway's, cash as a percentage of book value now exceeds stock holdings.
Berkshire Hathaway's cash holdings as a percentage of book value, 1994 - 2004
Source: Eric Fry, The Rude Awakening
Needless to add that it appears that Warren Buffett - not exactly a beginner at the money shufflers' game - does not share the optimism about the US economy and the stock market the "bullish lady" expressed on CNBC.
I have pointed out in previous comments that a strong dollar (tighter money) is bad for asset markets. This seems to have been confirmed by recent market action. Each time the dollar strengthens stock and commodity markets stumble. This is particularly true of emerging markets. While fundamentally most emerging economies are far sounder than the US emerging economies' stock markets are vulnerable in an environment of tighter money and a rising US dollar. After their out-performance since 2001, I would expect a more challenging environment for the next six months or so (see figure 5).
Relative Performance of Emerging Markets, 2001 - 2005
Source: Gavekal Research
April tends to be a month of seasonal strength. This coupled with the very near term oversold condition of stock markets around the world and the likelihood that oil prices could decline somewhat following Goldman Sachs' call for $ 105 oil should support stock prices and lead to some rebound in stock markets in the period directly ahead. I do not recommend playing this short term rally from the long side but using this strength to reduce positions and to initiate some short sales.