THE BEAR'S
LAIR The
profits bubble By Martin
Hutchinson
With real interest rates having
been negative for nearly four years, you would
expect asset markets to be in a bubble. Debt
markets, with long-term bonds offering yields well
below the expected level of inflation, and
commodities where gold is currently trading at
twice its famous 1980 peak, certainly seem to
exhibit bubble valuation symptoms.
Yet
equity markets in general do not appear
excessively valued in terms of earnings - the
Standard & Poor's 500 Index is trading on only
14.9 times earnings, hardly a frightening level.
When you look more closely however, you see
clearly that the equities bubble rests not on
valuation in terms of earnings, but on earnings
themselves.
Share prices will sometime
correct to a much lower level in real terms (or
inflation will catch up while they remain static,
as in
1966-82). But the
correction will mostly take the form, not of lower
price-earnings ratios, but of a massive squeeze in
earnings (again, subject to inflation probably
doing some of the work). Share prices will decline
only modestly in terms of price-earnings ratios,
but the decline in earnings will cause a massive
overall decline.
It has to be remembered:
the 4,000 that the Dow Jones index hit in February
1995, the day after then Federal Reserve chairman
Alan Greenspan gave his congressional testimony
that loosened monetary policy (as it turned out,
for decades to come), is equivalent to only about
8,100 on the index today, when you adjust for the
last 17 years' increase in nominal US gross
domestic product.
Since 1995's 4,000 was
at worst a middling Dow level, nearly 50% above
the 1987 high, at today's 13,000 the Dow is about
60% overvalued, and has been overvalued ever since
1995, except for a very brief period in
February-March 2009. At the bottom of that
recession, I had a modest crisis of conscience, in
case the Bear outlook was about to become
misguided for a prolonged period. I need not have
worried; it has been appropriate for almost all
the 11-and-a-half years I have been writing the
column, and at least in the short term appears to
be getting righter!
The poster child for
the profits bubble is Apple. Apple's valuation
looks reasonable, at 15.4 times earnings, but the
truth nobody seems willing to address in the
middle of all this mania is that Apple cannot grow
like this forever, or even maintain its current
profits. The problem is not accounting
shenanigans, but Apple's 37.7% sales margin and
91.3% annualized return on equity in the quarter
to December 31.
Those are not just
unsustainable, they are completely unsustainable.
The fourth quarter saw the introduction of a
successful new product, the iPhone 4S, and the
immense outpouring of very justified international
emotion on the death of Steve Jobs.
Jobs
was a unique genius, without question. But, being
unique, he was also irreplaceable. Apple is
perfectly well managed without him, and it has
many good people, but other companies have good
people too. If Apple is no longer led by a supreme
genius, then over time, Apple's sales margins of
37.7% and return on capital of 91.3% are history.
Remember: the company does not have a
unique manufacturing capability. Its products are
manufactured by the Taiwanese Foxconn, which also
manufactures for many other brands. Apple design
is excellent, superior even, but over time, as the
unique fashion value of the Jobs/Apple combination
fade, people will come to pay only modest premiums
for superior design.
At that point, Apple
top management will have two stark choices. The
company can remain within the product categories
in which it has already succeeded. In that case,
profit margins will decline to at most half their
current extraordinary levels, while sales increase
only gradually, with the overall expansion of the
market for those products. If Apple tries to
maintain its price premium, its market share will
erode.
Apple's US$97.5 billion in cash
however gives its management a second option. It
can seek to expand through acquisition, move into
new product categories and expand margins in those
products through applying Apple branding and
design. We might see Apple flat-screen
televisions, Apple digital watches, Apple home
appliances, Apple handbags, Apple SUVs, Apple
restaurants and maybe even Apple apples.
By doing this, Apple management will spend
the cash, but it will find the new acquisitions
contribute little to profits, let alone margins.
Sales will increase, but profitability will become
sluggish, and quality control will suffer both in
the new businesses and in Apple's areas of core
strength, as management is distracted by
acquisition games from running the core business
properly. Apple's share price will decline sharply
and the company will become a sluggish
conglomerate, fit only to be carved up by ruthless
Mitt Romneys.
What is demonstrably true
about Apple is true about US corporations as a
whole. According to the Bureau of Economic
Analysis, corporate profits after tax (roughly,
the E on which P/E ratios are based) in 2011
totaled about 7.5% of gross domestic income (GDI)
- we don't yet have final figures - up from 6.9%
of GDI in 2010.
That's 55% above the
overall average over the period of the BEA's
statistics, 1929-2011. It is 17% above the 1997
and 2006 cyclical peaks of 6.4%, even though the
US economy is currently operating far below
capacity with high unemployment. It is even 6%
above the previous post-World War II peak in the
history of the series, 7.1% in 1965, a year in
which the US economy was overheating in the
Vietnam escalation.
There is however one
year in the BEA's history in which the ratio was
higher than it is today: 1929, when it was 8.8%
(at a pre-tax level, 1929 profits were also higher
than today's, but by a lesser margin, corporate
tax and taxes in general being much lower then).
The driving factor for most companies in
the extraordinary level of corporate profits after
tax becomes evident when you look at the same
statistic's 3.9% average over the decade of the
1980s. That was a period of high real interest
rates that included a recession almost as severe
as the recent unpleasantness, but when overall the
unemployment rate was much lower than today.
Thus in the 1980s, corporate profits were
18% below their long-term average, and barely more
than half their level today. It becomes clear that
the overall level of real interest rates plays a
crucial role in the profit picture.
This
is not surprising, especially in the post-1995 era
when corporations, encouraged by very low real
interest rates, have been more leveraged than at
any time in history. Currently the debt/equity
ratio of non-farm non-financial corporate business
is around 60%, slightly above its 1990s peak and
almost double its average level in 1960-85, before
the new corporate finance revolution of the
Modigliani-Miller Theorem took off.
Since
debt interest is tax-deductible, it represents
very cheap capital in itself, so adding more debt
should allow corporations to use more capital and
thereby increase profits. Further, when debt
represents 60% of equity, a decline of 4% in the
real cost of debt (such as we have seen comparing
its current level from the pre-1995 average) will
add 2.4% to the return on equity.
At some
point therefore, the end of present Fed chairman
Ben Bernanke's misguided monetary policy (probably
triggered by an unpleasant burst of inflation
accompanied by insanely high oil and commodity
prices) will cause corporate earnings to revert to
their long-term average, losing their current 55%
premium and returning stock prices even on their
current fairly elevated P/E ratio to around the
1995-equivalent level of 8,100 on the Dow.
Add to that a decline in the P/E ratio on
the S&P 500 Index to 10 times, and you get a
value on the S&P 500 Index of 589, equivalent
to perhaps 5,500 on the Dow.
That's
without factoring in a renewed recession, which
would presumably drive earnings below their
equilibrium value and possibly drive stock prices
below the 5,000 level on the Dow Jones Index.
In terms of timing, this denouement
depends entirely on the duration of Bernanke's
current monetary policy. Fourth-quarter 2011
earnings for non-financial companies, with
earnings season nearly over, are expected to have
increased by 7.1%, considerably faster than the 4%
rise in nominal GDP - pushing the key ratio of
profits after tax to GDP up to roughly 7.7%, still
further in nosebleed territory. Currently,
estimates for first quarter 2012 earnings are
coming down fairly rapidly, and have just crossed
the zero line at which a decline from
fourth-quarter earnings is expected.
Thus,
even with the economy continuing to expand
modestly, and some few of the unemployed finding
jobs, the short-term prognostications for earnings
are pretty downbeat. If the bubble is not yet
bursting, it may at least be close to maximum
inflation.
It seems likely we are within
months of a precipitous cliff at which interest
rates rise, profits fall sharply and the stock
market collapses. This will be accompanied by
numerous commentators complaining that the stock
market is not at bubble levels, in terms of
valuation. But even in today's recession tail-end,
profits are truly bubble-level - and that is even
more important.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice & Associates.)
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