Will Corporate Profits Continue to Outperform?

By: Henry To | Wed, Apr 5, 2006
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Dear Subscribers,

With the filing of Delphi's restructuring plan last Friday, the odds of a GM bankruptcy sometime this year has exponentially increased. Prior to Friday, GM had estimated its obligations to Delphi's former and current employees to be in the range of $5.5 billion and $12 billion. Assuming that the sale of GMAC will close in the next couple of months, and assuming the stock market will corporate this year (which will allow GM not to make any cash contributions to its pension plans in 2006), a GM bankruptcy was not inevitable this year - even in the face of a high $65 oil price, a hawkish Fed, a lineup that is still bloated and behind the times, and continued competitive pressures from both Japanese and South Korean auto manufacturers. With the latest restructuring plans filed by Delphi, however, there is now little doubt that many or most of Delphi's plans will strike sometime in early June. Should a general strike occur at Delphi, much of GM's production will be shut down. Estimates of losses at GM range from $500 million to $1 billion on a weekly basis. By definition, a corporate bankruptcy is always preceded by some kind of liquidity crisis. Should a strike at Delphi occur, there is no doubt that it will be quickly followed by a GM Chapter 11 filing.

To paraphrase the Carol Loomis' article on GM, turning around GM is a logistic endeavor which is even more involved than the invasion of Iraq. And finally, make no mistake: With today's $12 billion in market cap, the folks that basically own GM are not the shareholders, but the debt holders, the workers, and the unions. To put this in perspective, the consolidated balance sheet of the company shows over $250 billion in long-term obligations, $70 billion in unfunded pension and healthcare obligations (on a FAS 87 and 106 basis, and hundreds of unhappy GM dealers and thousands of unhappy GM (and Delphi employees). At the end of the day, the $12 billion in GM's common shares is essentially worth zero.

We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,109.32), this position is 239.32 points in the red - but again, given that the market is now showing signs of a classic "blow off" top, this author is betting that this position will ultimately work out. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. This latest signal was sent to all our subscribers on a real-time basis.

In our mid-week commentary three weeks ago, we stated that we will remain 50% short in our DJIA Timing System until at least the March 28th Fed meeting. Whether we were slightly early or not, this was not to be - as we subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. As of Friday evening, this position is 165.68 points in the black. This was also communicated to our readers on a real-time basis. For readers who did not receive this "special alert," please make sure that your filters are set appropriately. We are now 75% short in our DJIA Timing System.

In our mid-week commentary a few days ago, we stated: "Given that the market had every opportunity to decline over the last ten days (especially given the relatively hawkish statement out of the Fed), this author feels that the "window" for the market to decline more from here may be closing. Sure, we know that there will be tax-selling across many of the small and mid caps. We also know that buybacks have turned very quiet over the last few days and that earnings reports will begin to pour out of Wall Street in about two weeks … In light of this, this author is willing to "stay with the course" for just a little bit more of time - but in order to control for risk in our DJIA Timing System, there is a chance that this author will close out our March 20th 25% position in our DJIA Timing System sometime over the next few business days (especially if the market declines to an oversold condition). We will discuss more about this in our upcoming weekend commentary. A 59.70-point gain is really a pittance but we will take it and re-enter our short position once our sentiment indicators get more overbought if we have to."

As of Sunday evening, April 2nd, this author is still looking to get out of our March 20th 25% short position in our DJIA Timing System in order to control our risk and our volatility in our DJIA Timing System. Compared to our 59.70-point gain last Wednesday evening, the current gain of 165.68 points isn't too bad. I apologize to our readers for having to trade so much in our DJIA Timing System recently, but even as this author believes that the market is in the midst of forming a top, I am still not totally convinced that the Dow Industrials has made its final top yet. At this point, a 50% short position in our DJIA Timing System is bearish enough, especially given the short-term (somewhat) oversold conditions in the current stock market. We will reenter on the short side again should the Dow Industrials rally further in the weeks ahead. We will let our readers know on a real-time basis once we have exited our March 20th 25% short position. We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: "A Change in our DJIA Timing System").

Over the last six months or so, we have discussed the concept of "capital vs. labor" - namely the struggles over time between capitalists, unions, and workers. We did not engage in any philosophical or detailed historical discussions (it is really not our job here, as many folks out there can do it better than we can) but even in capitalistic societies, it is notable that just like many things in life, labor/union power also goes through cycles - although trends in labor and union power tend to be very secular in nature and are definitely nowhere near as volatile as the movements in the stock market.

For example, the unionization of the U.S. labor force today is a mere 12.5% (half of which are governmental workers) - declining from slightly over 20% in 1983. Union membership is now at its lowest in the U.S. since 1932. At the same time, we know that the level of real salaries and wages for workers in the United States have not increased very substantially over the last few decades. In fact, the latest "Flow of Funds" data published by the Federal Reserve shows that as a percentage of GDP, wages and salaries paid to workers in the U.S. is now near a 40-year low:

Employees' Compensation & Employees' Compensaiton as a Percentage of GDP (1Q 1980 to 4Q 2005) - Except for a brief dip in 1997, employees' compensation (including supplemental income as well as wages) as a percentage of GDP is now at its lowest level since 1966 - even as employees' compensation continues to rise. The $64-million question is: Will this stage a reversal in the coming months? Or will employees continue to be squeezed out of the picture? In the short-run, this author believes that this 'squeeze' of employees has gotten out-of-hand, but over the long-run, there is no doubt that the U.S. is returning to a more capitalistic economy. Note that the current reading of 56.9% (even though it may be regarded as low) actually only represents the average from 1Q 1948 to 4Q 2005.

As I mentioned on the above chart, employees' compensation as a percentage of GDP - except for a brief period from 1993 to 1997 - is now at its lowest level since 1966. Given the ongoing labor discussions at companies such as Delta, Delphi, GM, and the continuing trend in outsourcing all you can (including investment bank services, and so forth), there is a good chance that this percentage will continue to decline over the next several quarters. Before I go on and discuss the implications of this and other possibilities, let me now show you another chart, courtesy of the folks at Wikipedia:

Income Disparity since World War II - the Gini Index - where 0 is perfect equality, and 100 is perfect inequality (i.e., one person has all the income)

Okay Henry, just what is the "Gini Index?" Readers who are interested in how this index is constructed can read the following page at Wikipedia, but in a nutshell, it is basically a crude and simple way to measure income inequality in a certain economy. While it may be rather crude (for example, non-monetary welfare benefits such as food stamps is not taken into account into household income), the above chart showing the Gini Index over time definitely tells you one thing: Income inequality in the U.S. has generally increased since 1960. That is, the average U.S. worker over the last 45 years has seen his or her relative income levels taken a hit on both sides - those being:

1) The relative decline of the average U.S. worker's salaries and wages as compared to profits either returned to shareholders or retained by the company - as illustrated in the first chart. This trend has also been manifested in the fact that corporate profits as a percentage of GDP in the fourth quarter of 2005 (at 10%) is now at the highest level since the fourth quarter of 1968. Following is a quarterly chart showing the absolute level of corporate profits and corporate profits as a percentage of GDP from the first quarter of 1980 to the fourth quarter of 2005:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 4Q 2005) - Both corporate profits and corporate profits as a % of GDP rose to a new secular high in the fourth quarter of 2005 (with corporate profits rising to an all-time high). Please note that corporate profits as a % of GDP (at 10%) is now at its highest level since the fourth quarter of 1968. Given that the Fed is tightening, and given the rate of ascent in corporate profits in the last three to four years, it seems like the easy money has already been made here. Remember: In the long-run, corporate profits of domestic companies can only grow at the same rate as U.S and world GDP - with periodic over and understatements in between.

2) The relative decline of the median salary and wage level as compared to the pay of executives in the Fortune 1000 companies - as exemplified by the rising Gini Index over the last 40 years and the fact that many CEOs have been rewarded very richly despite the fact that their companies have severely underperformed under their tenures.

More follows for subscribers...


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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