By William White
Published: September 16 2009 19:01 (Financial Times)
[Note: The writer is former economic adviser, head of the monetary and economic department at the Bank for International Settlements.]
Forest fires are judged to be nasty, especially when one’s own house or life is threatened, or when grave harm is being done to tourist attractions. The popular conviction that fires are an unqualified evil reached its zenith after a third of Yellowstone Park in the US was destroyed by fire in 1988. Nevertheless, conventional wisdom among forest managers remains that it is best to let natural forest fires burn themselves out, unless particularly dangerous conditions apply. Burning appears to be part of a natural process of forest rejuvenation. Moreover, intermittent fires burn away the undergrowth that might accumulate and make any eventual fire uncontrollable.
Perhaps modern macroeconomists could learn from the forest managers. For decades, successive economic downturns and even threats of downturns (“pre-emptive easing”) have been met with massive monetary and often fiscal stimuli. This was the case when the global stock market crashed in 1987, and it was repeated when the property boom in many countries collapsed in the early 1990s. Interest rate rises were put on hold during the Asian crisis of 1997, even though traditional indicators said some industrial countries were overheating. Rates were then sharply reduced in 1998, after the collapse of the hedge fund Long-Term Capital Management, and were lowered again when the stock market collapsed in 2001. Today, policy rates in most industrial countries are close to zero, in response to the financial crisis.
What needs reflection, against this backdrop, is whether the policy reaction to each successive set of difficulties laid the foundations for the next one. Worse, the encouragement by lower interest rates of debt accumulation and spending imbalances was the equivalent of undergrowth accumulating in the forest. This undergrowth not only made subsequent downturns more dangerous; it also made the available policy instruments less reliable in response. Looking back over successive cycles, interest rates have had to be reduced with ever more vigour to get the same (and sometimes reduced) response from spending. Most recently, new and untried policies such as quantitative and credit easing have had to be introduced. Logically, the end point of such a dynamic process would seem to be the mother of all fires and few if any means of resistance.
The current Keynesian mindset rightly observes that we have a shortage of aggregate demand. It then concludes that demand stimulus, from whatever quarter, is to be welcomed. However, in addition to the undergrowth problem on the demand side, we can also have an undergrowth problem on the supply side. This was the core of Friedrich Hayek’s position when he debated Keynes in the early 1930s. In response to demand stimulus over recent decades, with investors implicitly assuming that the future would be like the recent past, there has been a massive increase in supply potential in many industries. The upshot is that many of them are now too big and must be wound down. This applies to automobile production, banking services, construction, many parts of the transport and wholesale distribution industries, and often retail distribution as well. Similarly, many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.
In this supply side context, policies such as “cash for clunkers” and value added tax cuts in countries with very low household saving rates and massive trade deficits are clearly suboptimal. So too, in countries with large trade surpluses, is resistance to exchange rate appreciation along with a continuing reliance on export demand. Such policies are equivalent to trying to resuscitate a patient long since dead. Not only will time prove that such attempts are futile, but they also impede the desirable adjustment from declining industries to those that should be expanding. In effect, relying solely on macroeconomic stimulus may well head off a more violent downturn, but only at the expense of a more protracted recession. Maybe this is the principal lesson to be drawn from Japan’s almost two decades of sub-par performance. Indeed, resisting structural adjustment could also imply a decline in the level of “potential growth” in the years ahead. This would bring with it the threat of a stagflationary outcome, if the demand stimulus from Keynesian policies were not to be adjusted downwards in consequence.
Where to go from here? In terms of future crisis management, governments should give more weight to the longer-term implications of their policies. Those that threaten to make future crises more costly, or that impede required structural adjustments, should be moderated. Such inter-temporal trade-offs imply, from time to time, accepting a temporary economic downturn to avoid even bigger future costs. In this sense, good crisis management also contributes to crisis prevention.
But still more might be done with crisis prevention. Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the credit-driven expansions that fuel asset bubbles and unsustainable spending patterns. Recent reports from a number of jurisdictions with well-developed financial markets seem to agree that regulatory instruments play an important role in leaning against such phenomena. What is less clear is that central bankers recognise that they might have an even more important role to play. In light of the recent surge in asset prices worldwide, this issue needs urgent attention. Yet another boom-bust cycle could have negative implications, social and political, stretching beyond the sphere of economics.
Thursday, September 17, 2009
Tuesday, September 8, 2009
Why some economists could see the crisis coming
By Dirk Bezemer
Published: September 7 2009 (Financial Times)
(Note: The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands).
From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.
Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.
I undertook a study of the models used by those who did see it coming.* They include Kurt Richebächer, an investment newsletter writer, who wrote in 2001 that “the new housing bubble – together with the bond and stock bubbles – will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn”. Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010”. Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse”. Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it?
Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.
It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.
Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.
Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”.
Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours.
===================
*‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA
Published: September 7 2009 (Financial Times)
(Note: The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands).
From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.
Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.
I undertook a study of the models used by those who did see it coming.* They include Kurt Richebächer, an investment newsletter writer, who wrote in 2001 that “the new housing bubble – together with the bond and stock bubbles – will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn”. Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010”. Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse”. Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it?
Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.
It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.
Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.
Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”.
Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours.
===================
*‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA
Saturday, September 5, 2009
S&P 500: Welcome To Fantansy Island
S&P 500 Statistics (As of August 31, 2009)
Total Market Value ($ Billion) 8,981
Mean Market Value ($ Million) 17,961
Median Market Value ($ Million) 7,494
Weighted Ave. Market Value ($ Million) 72,830
Largest Cos. Market Value ($ Million) 337,432
Smallest Cos. Market Value ($ Million) 700
Median Share Price ($) 31.200
P/E Ratio* 129.19
Indicated Dividend Yield (%) 2.10
*Based on As Reported Earnings.
Total Market Value ($ Billion) 8,981
Mean Market Value ($ Million) 17,961
Median Market Value ($ Million) 7,494
Weighted Ave. Market Value ($ Million) 72,830
Largest Cos. Market Value ($ Million) 337,432
Smallest Cos. Market Value ($ Million) 700
Median Share Price ($) 31.200
P/E Ratio* 129.19
Indicated Dividend Yield (%) 2.10
*Based on As Reported Earnings.
Banks’ Balance Sheets: Getting Worse
Following up on my previous report (http://tinyurl.com/mlxxk8), banks’ balance sheets show no signs of improvements during the Second Quarter of 2009. In fact, key ratios demonstrating bank weaknesses have increased—in some instances they have surpassed all-time highs. All the charts demonstrate an uninterrupted upward trend since 2007. The caveat of my analysis is that the data are backward-looking; that is, we can only extrapolate from the past to give us an adequate assessment of the future. In addition, it takes the St. Louis FED about 6 weeks after the closing of the quarter to publish these figures (this time it took them close to 8). Considering the present condition of commercial real estate, along with the upcoming ARM and Alt-A mortgage resets, there is no light at the end of the tunnel for bankers. Given the information I will present, it is inconceivable that the FED will pull the plug on its intervention in the market any time soon. At the very least, until these figures reverse, all talk about “green shoots” and “economic recovery just around the corner” must be taken with exceeding caution.
Net Loan Charge Offs-to-Total Loans at commercial banks increased to an all-time high of 2.06%, up from 1.76% as of 3/31/09 and up from .96 reported during 4th Quarter 2008. The ratio has more than tripled year-over-year from .64 in 3/31/08. The most recent recorded figure supersedes the prior peak of 1.81% reached in 12/31/91 [see Note 1].
Loan Loss Reserves-to-Total Loans ratio increased to 2.94 from 2.65% reported on 3/31/2009. Year-over-year the recent ratio is up from 1.79% [see Note 2]. In particular to banks whose assets fall between $1 billion to $15 billion, the increase was from 2.10% to the current figure of 2.28% [see Note 3]. For the biggest banks, that is those with assets in excess of $15 billion, the current figure stands at 3.32%, up from 2.96% reported the previous quarter [see Note 4]. Reserves act as a buffer to capital losses resulting from asset deterioration. From a historical perspective, however, reserves at these institutions are low. For example, for the largest banks (assets > $15 billion), reserves reached a high of approximately 4.65% in terms of total loans during the late 1980s. The fact the current trend is up is good news. The bad news is that it’s not growing fast enough.
Considering Net Loan Losses-to-Average Total Loans, there is no evidence of a turnaround in business condition. The most recent figure broke the previous all-time high of 2.03% reported in 1Q2009. Currently, the ratio stands at 2.36%, which is more than doubled on a year-over-year basis [see Note 5]. For banks with average assets of $1 billion to $15 billion, the ratio currently stands at 2.08%, up from 1.63% in the previous quarter. The recent figure is an all-time high, surpassing the mark of about 1.8% in 1991 [see Note 6]. For institutions exceeding the $15 billion average assets threshold, the figures continue to be abysmal: The ratio currently stands at 2.68%, up from 2.35% in the previous quarter. During the last twelve months, this ratio has more than doubled, which indicates a worsening banking condition [see Note 7].
The next key statistic to consider is Non-Performing Loans-to-Total Loans. You may recall that Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. The current figure stands at 2.78%, up from 2.20% reported the previous quarter and up from 1.71% reported on 12/31/08 [see Note 8]. At its peak for all commercial banks, the ratio stood at 4.88%, so the trend is evidence that the figures will continue to deteriorate. The same ominous gap is present for all banks exceeding $1 billion in average assets [see Note 9]
As I stated previously, banks’ balance sheets have deteriorated and will continue to get worse. The trend demonstrates that non-performing loans will continue to increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, are not sufficient to cover the potential losses:
* * * * * * * * * * * * * * * * * * * * * *
(Note 1)
http://research.stlouisfed.org/fred2/series/NCOCMC?cid=93
(Note 2)
http://research.stlouisfed.org/fred2/series/USLLRTL?cid=93
(Note 3)
http://research.stlouisfed.org/fred2/series/US115LLRTL?cid=93
(Note 4)
http://research.stlouisfed.org/fred2/series/USG15LLRTL?cid=93
(Note 5)
http://research.stlouisfed.org/fred2/series/USLSTL?cid=93
(Note 6)
http://research.stlouisfed.org/fred2/series/US115LSTL?cid=93
(Note 7)
http://research.stlouisfed.org/fred2/series/USG15LSTL?cid=93
(Note 8)
http://research.stlouisfed.org/fred2/series/NPCMCM?cid=93
(Note 9)
http://research.stlouisfed.org/fred2/series/NPCMCM3?cid=93
http://research.stlouisfed.org/fred2/series/NPCMCM4?cid=93
http://research.stlouisfed.org/fred2/series/NPCMCM5?cid=93
Net Loan Charge Offs-to-Total Loans at commercial banks increased to an all-time high of 2.06%, up from 1.76% as of 3/31/09 and up from .96 reported during 4th Quarter 2008. The ratio has more than tripled year-over-year from .64 in 3/31/08. The most recent recorded figure supersedes the prior peak of 1.81% reached in 12/31/91 [see Note 1].
Loan Loss Reserves-to-Total Loans ratio increased to 2.94 from 2.65% reported on 3/31/2009. Year-over-year the recent ratio is up from 1.79% [see Note 2]. In particular to banks whose assets fall between $1 billion to $15 billion, the increase was from 2.10% to the current figure of 2.28% [see Note 3]. For the biggest banks, that is those with assets in excess of $15 billion, the current figure stands at 3.32%, up from 2.96% reported the previous quarter [see Note 4]. Reserves act as a buffer to capital losses resulting from asset deterioration. From a historical perspective, however, reserves at these institutions are low. For example, for the largest banks (assets > $15 billion), reserves reached a high of approximately 4.65% in terms of total loans during the late 1980s. The fact the current trend is up is good news. The bad news is that it’s not growing fast enough.
Considering Net Loan Losses-to-Average Total Loans, there is no evidence of a turnaround in business condition. The most recent figure broke the previous all-time high of 2.03% reported in 1Q2009. Currently, the ratio stands at 2.36%, which is more than doubled on a year-over-year basis [see Note 5]. For banks with average assets of $1 billion to $15 billion, the ratio currently stands at 2.08%, up from 1.63% in the previous quarter. The recent figure is an all-time high, surpassing the mark of about 1.8% in 1991 [see Note 6]. For institutions exceeding the $15 billion average assets threshold, the figures continue to be abysmal: The ratio currently stands at 2.68%, up from 2.35% in the previous quarter. During the last twelve months, this ratio has more than doubled, which indicates a worsening banking condition [see Note 7].
The next key statistic to consider is Non-Performing Loans-to-Total Loans. You may recall that Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. The current figure stands at 2.78%, up from 2.20% reported the previous quarter and up from 1.71% reported on 12/31/08 [see Note 8]. At its peak for all commercial banks, the ratio stood at 4.88%, so the trend is evidence that the figures will continue to deteriorate. The same ominous gap is present for all banks exceeding $1 billion in average assets [see Note 9]
As I stated previously, banks’ balance sheets have deteriorated and will continue to get worse. The trend demonstrates that non-performing loans will continue to increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, are not sufficient to cover the potential losses:
* * * * * * * * * * * * * * * * * * * * * *
(Note 1)
http://research.stlouisfed.org/fred2/series/NCOCMC?cid=93
(Note 2)
http://research.stlouisfed.org/fred2/series/USLLRTL?cid=93
(Note 3)
http://research.stlouisfed.org/fred2/series/US115LLRTL?cid=93
(Note 4)
http://research.stlouisfed.org/fred2/series/USG15LLRTL?cid=93
(Note 5)
http://research.stlouisfed.org/fred2/series/USLSTL?cid=93
(Note 6)
http://research.stlouisfed.org/fred2/series/US115LSTL?cid=93
(Note 7)
http://research.stlouisfed.org/fred2/series/USG15LSTL?cid=93
(Note 8)
http://research.stlouisfed.org/fred2/series/NPCMCM?cid=93
(Note 9)
http://research.stlouisfed.org/fred2/series/NPCMCM3?cid=93
http://research.stlouisfed.org/fred2/series/NPCMCM4?cid=93
http://research.stlouisfed.org/fred2/series/NPCMCM5?cid=93
Wednesday, August 26, 2009
Insight: Beware the bubble’s distorted allure
By Tim Price
Published: August 25 2009 (Financial Times)
What kind of a financial crisis are you having? If you are a graduating student, good luck with the job hunt. If you are a banker or an economist still in employment, you are probably keeping your head down while you count the bonus that your fellow taxpayers have so generously if involuntarily gifted you. If an otherwise blameless investor, you are probably wondering why you are being penalised with such derisory deposit rates and whether you should be jumping on to the equity market rally instead.
That might be dangerous. Headline equity index returns, year to date, are desperately misleading. There is, in fact, a two-tier market in operation: speculative (or, more politely, “growth”) stocks, which have done fantastically, and everything else. Industrial metals and mining stocks are one of the best-performing sectors internationally – not a little surprising, given that the global recovery has yet to be sustainably confirmed; energy and utilities sector stocks, along with plenty of other classic defensives, have largely been a washout. (They may yet have their day.)
And an analysis of the Altman Z Score, which assesses the likelihood of corporate insolvency by comparing various balance sheet measures, shows that the frankly flakiest companies have seen their shares hugely outperform the rest of the market even as their capital strength deteriorates. In short, this has been a rally driven by junk.
But then what should we expect, when governments and their nominally independent central bank associates have conspired to manipulate prices throughout the capital asset structure, primarily to bail out banks that are conspicuously unfit for purpose? We are now trapped within a global parody of free markets.
Within this parody, governments redirect a waterfall of capital towards the banks. The banks then “invest” this in effect free money in what looks suspiciously like securities speculation and property lending. Meet the new bank: same as the old bank. And while the sums “borrowed” from future taxpayers as economic stimulus have been extraordinary in the west, they are not even the largest. Relative to gross domestic product, as fund managers Eric Sprott and David Franklin point out, China has been busily stimulating its economy more than anyone – injecting the equivalent of fully 64 per cent of its first half 2008 GDP during the first half of 2009. That is the equivalent of buying 122 Ford Class aircraft carriers costing $8.1bn each.
Some questions now deserve to be answered. With credit provision in full-scale withdrawal, does it really make sense to be contemplating bank stocks as investments, not least given the messy governmental scrutiny at work in the sector? And if private sector credit availability is set for broad retreat throughout the Anglo-Saxon economies, how on earth can our nascent economic recovery be described as anything other than pale, sickly and fragile? Equity markets have rallied nicely from their lows, but a degree of realism is surely in order.
The banking sector profits of recent years were never sustainable, inasmuch as they were built on the sandy foundations of leverage. Corporations and households around the world are now urgently paying down debt and rebuilding their balance sheets. They are, in short, battening down the hatches in preparation for a nuclear winter. There is little credit to spare for that diminished crowd with the appetite to take it on. Those are not conditions conducive to a robust recovery, far less to a new boom.
So for those chasing the rally: what, precisely, is your endgame? Perhaps you see extraordinary levels of government indebtedness miraculously evaporating amid new economic expansion, even as taxes rise. Perhaps you see ailing, cash-hoarding banks mysteriously opening the lending taps for the next wave of entrepreneurs. Or perhaps you are looking at the future through the hugely distorting prism of the recent credit bubble. Years of massive misallocation of capital cannot be followed by effortless recovery.
Published: August 25 2009 (Financial Times)
What kind of a financial crisis are you having? If you are a graduating student, good luck with the job hunt. If you are a banker or an economist still in employment, you are probably keeping your head down while you count the bonus that your fellow taxpayers have so generously if involuntarily gifted you. If an otherwise blameless investor, you are probably wondering why you are being penalised with such derisory deposit rates and whether you should be jumping on to the equity market rally instead.
That might be dangerous. Headline equity index returns, year to date, are desperately misleading. There is, in fact, a two-tier market in operation: speculative (or, more politely, “growth”) stocks, which have done fantastically, and everything else. Industrial metals and mining stocks are one of the best-performing sectors internationally – not a little surprising, given that the global recovery has yet to be sustainably confirmed; energy and utilities sector stocks, along with plenty of other classic defensives, have largely been a washout. (They may yet have their day.)
And an analysis of the Altman Z Score, which assesses the likelihood of corporate insolvency by comparing various balance sheet measures, shows that the frankly flakiest companies have seen their shares hugely outperform the rest of the market even as their capital strength deteriorates. In short, this has been a rally driven by junk.
But then what should we expect, when governments and their nominally independent central bank associates have conspired to manipulate prices throughout the capital asset structure, primarily to bail out banks that are conspicuously unfit for purpose? We are now trapped within a global parody of free markets.
Within this parody, governments redirect a waterfall of capital towards the banks. The banks then “invest” this in effect free money in what looks suspiciously like securities speculation and property lending. Meet the new bank: same as the old bank. And while the sums “borrowed” from future taxpayers as economic stimulus have been extraordinary in the west, they are not even the largest. Relative to gross domestic product, as fund managers Eric Sprott and David Franklin point out, China has been busily stimulating its economy more than anyone – injecting the equivalent of fully 64 per cent of its first half 2008 GDP during the first half of 2009. That is the equivalent of buying 122 Ford Class aircraft carriers costing $8.1bn each.
Some questions now deserve to be answered. With credit provision in full-scale withdrawal, does it really make sense to be contemplating bank stocks as investments, not least given the messy governmental scrutiny at work in the sector? And if private sector credit availability is set for broad retreat throughout the Anglo-Saxon economies, how on earth can our nascent economic recovery be described as anything other than pale, sickly and fragile? Equity markets have rallied nicely from their lows, but a degree of realism is surely in order.
The banking sector profits of recent years were never sustainable, inasmuch as they were built on the sandy foundations of leverage. Corporations and households around the world are now urgently paying down debt and rebuilding their balance sheets. They are, in short, battening down the hatches in preparation for a nuclear winter. There is little credit to spare for that diminished crowd with the appetite to take it on. Those are not conditions conducive to a robust recovery, far less to a new boom.
So for those chasing the rally: what, precisely, is your endgame? Perhaps you see extraordinary levels of government indebtedness miraculously evaporating amid new economic expansion, even as taxes rise. Perhaps you see ailing, cash-hoarding banks mysteriously opening the lending taps for the next wave of entrepreneurs. Or perhaps you are looking at the future through the hugely distorting prism of the recent credit bubble. Years of massive misallocation of capital cannot be followed by effortless recovery.
Thursday, August 13, 2009
Alternative yardsticks for US earnings tell different stories
Paul Marson is chief investment officer of Lombard Odier. He wrote the following article in today's Financial Times (8/13/2009). It is worth the read because it explains the irrationality behind the financial markets these days. Make no mistake, the upward turn in the market since early March has been propelled by factious perceptions. "Green shoots" are nothing more than code words by politicians and other central economic planners to replace the reality of our situation. The "green shoots" they talk about are merely the consequence of massive fiscal and monetary inflation; they are temporary. In this environment, of course firms are going to report "earnings." Yet, few recognize that these numbers have been massaged and twisted in such a way that value estimates are difficult to ascertain. Against this backdrop, Mr. Marson provides some insigthful comments. Here it is...enjoy.
======================================
The US second-quarter earnings season is now ending, apparently on a good note as nearly three-quarters of US companies have beaten consensus expectations. But a closer look at these earnings shows there is cause to be more cautious about the health of corporate America than the headline numbers would suggest. The cloud of euphoria that followed recent results had more to do with extraordinarily low expectations than to any meaningful and lasting improvement in prospects, which still require a rapid recovery in economic activity. This suggests the recent equity rally off the back of these results is overdone.
Every quarter, US companies publish their results under the defined US GAAP accounting rules. These results are labelled "reported earnings". However, the most commonly looked at form of earnings are adjusted "operating earnings" on which companies prefer to focus as they consider these better capture the underlying trend in activity. Adjusted operating earnings exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill right downs and other write-offs. While reported earnings are based on strict accounting rules, adjusted operating earnings are at the discretion of companies because there is no defined set of exclusions. Neither measure is perfect but with adjusted operating earnings, exclusions are currently so large that information about the true state of companies (and therefore the market as a whole) is being excluded.
These exclusions have reached the level where the gap between adjusted operating earnings and reported earnings is so wide that they deliver different messages on the state of US corporates.
There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.
Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak. This $54 gap is a record.
How has this come about? Much of the difference between adjusted operating earnings and reported earnings is caused by massive writedowns in the financial sector. However, outside the financial sectors write-offs are also at record highs as corporates are eager to toss out impaired assets during periods of stress.
Furthermore, when looking at adjusted operating earnings, it seems that most US corporates managed to beat their analyst estimates thanks to production and job cuts.
There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.
Those assessing the health of corporate America seem to be assuming a substantial, and above normal, recovery in reported earnings, alongside a return to above-trend GDP growth over the next 12 months. They are in danger of looking at the prospects for economic recovery, revising earnings expectations higher, but without considering how this might happen. In the meantime, the elephantine gap between adjusted operating earnings and reported earnings sits quietly in the room.
======================================
The US second-quarter earnings season is now ending, apparently on a good note as nearly three-quarters of US companies have beaten consensus expectations. But a closer look at these earnings shows there is cause to be more cautious about the health of corporate America than the headline numbers would suggest. The cloud of euphoria that followed recent results had more to do with extraordinarily low expectations than to any meaningful and lasting improvement in prospects, which still require a rapid recovery in economic activity. This suggests the recent equity rally off the back of these results is overdone.
Every quarter, US companies publish their results under the defined US GAAP accounting rules. These results are labelled "reported earnings". However, the most commonly looked at form of earnings are adjusted "operating earnings" on which companies prefer to focus as they consider these better capture the underlying trend in activity. Adjusted operating earnings exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill right downs and other write-offs. While reported earnings are based on strict accounting rules, adjusted operating earnings are at the discretion of companies because there is no defined set of exclusions. Neither measure is perfect but with adjusted operating earnings, exclusions are currently so large that information about the true state of companies (and therefore the market as a whole) is being excluded.
These exclusions have reached the level where the gap between adjusted operating earnings and reported earnings is so wide that they deliver different messages on the state of US corporates.
There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.
Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak. This $54 gap is a record.
How has this come about? Much of the difference between adjusted operating earnings and reported earnings is caused by massive writedowns in the financial sector. However, outside the financial sectors write-offs are also at record highs as corporates are eager to toss out impaired assets during periods of stress.
Furthermore, when looking at adjusted operating earnings, it seems that most US corporates managed to beat their analyst estimates thanks to production and job cuts.
There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.
Those assessing the health of corporate America seem to be assuming a substantial, and above normal, recovery in reported earnings, alongside a return to above-trend GDP growth over the next 12 months. They are in danger of looking at the prospects for economic recovery, revising earnings expectations higher, but without considering how this might happen. In the meantime, the elephantine gap between adjusted operating earnings and reported earnings sits quietly in the room.
Monday, August 3, 2009
Read between the lines and know the real facts, or risk being deceived
By Marty Chenard
It is now August. Many are guessing that the 4th. Quarter will see a positive GDP number this year. The market appears to be factoring in that possibility. Will it really be possible to generate a positive GDP?
Second Quarter earnings results can now be given some thought. Here is what happened on the S&P 500:- Almost 61% of the S&P 500 beat their estimates. - 35.5% did better than last year's earnings per share.- Almost 25% had sales ahead of last year's.- 75% reported lower sales.
It is hard to find fault with the improvement in earnings per share ... but the fine print says: "75% had lower sales, but 61% beat their estimates."
So ... 60 out of every 100 companies beat their estimates ... but 75 out of every 100 had lower sales? How does one have lower sales but beat estimates?
You could do it by under estimating future expectations. In this way, what would normally be a bad result, looks good because you did better than the worse result that you reported "could happen".
Okay, so how could you have lower sales, but better earnings? You would have to cut costs ... cut inventories, layoff, reduce expenses, etc. That works the first time around ... the second time around is very difficult to cut as much on a percentage basis. So, the salvation will have to be an increase in sales during the current and future quarters.
That's the rub. The economy needs an increase in spending by consumer and business end users. We are getting some increases due to government stimulus programs. That can't go on forever without the consumer taking back the spending reins ... or our government will go bankrupt, the Dollar will fall, and interest rates will go up.
So, now we need the real thing ... increased spending by the consumer. We need an increase in demand because people can afford it, not because the government gave a consumer a $4,500 credit so he could buy a car. Christmas is not that far away, and the government will not be giving any consumer subsidies out for buying clothes, appliances, pots & pans.
So, as an investor, that's what you want to be watching for: Reports that indicate consumers and businesses are increasing their spending levels. Recent earning estimates are turning up slightly ... that's a good thing. It would be nice if "lots of increased spending" could happen without big increases in debt levels, because all of the excess debt and leverage has not been wrung out of the system yet.
If all goes well, and positive expectations bear fruit, then we will see forward economic progress. But, if GDP remains negative in Q4 along with weak consumer spending appears during the holidays, then the market will have a confidence retraction bringing things back to where the true balance is.
Although some earning estimates have turned slightly up, sales have not moved from declining to "increasing". The progress we are making is one of "getting less worse", and granted ... that has to happen first before we get to where things are "good". For now, don't mix the two ... getting less worse is different than getting better, and less worse is economically a lot different than getting better.
Be open minded and consider the real "comparative conditions" relative to time ... sometimes the media tries to "headline" the news to make things look better than they really are.
Take Financials for example. Some media sources have excitedly reported that " Financials are up 273% from the Second Quarter of 2008". Well, the 2nd. quarter of 2008 was negative, so what did the media really mean? Did that 273% improvement mean that things were in the positive ... or almost positive, or in the negative?
Here is what they could have said, if the media had wanted to use a different time-frame for the same result: They could have said that, "Financials were down 83% from the 2nd. quarter of 2007".
Was it misleading to make things appear as if they were wonderful? Or, was it a good thing to show the optimistic side? Our thinking is that "enough of the numbers should be reported so that someone really understands what is going on". If a person gains 30 pounds, is that good or bad? To answer the question you need to know what their ideal weight should be and how much they weighted before losing 30 pounds. Depending on the answer, they could be grossly over weight, underweight, or just right.
It is now August. Many are guessing that the 4th. Quarter will see a positive GDP number this year. The market appears to be factoring in that possibility. Will it really be possible to generate a positive GDP?
Second Quarter earnings results can now be given some thought. Here is what happened on the S&P 500:- Almost 61% of the S&P 500 beat their estimates. - 35.5% did better than last year's earnings per share.- Almost 25% had sales ahead of last year's.- 75% reported lower sales.
It is hard to find fault with the improvement in earnings per share ... but the fine print says: "75% had lower sales, but 61% beat their estimates."
So ... 60 out of every 100 companies beat their estimates ... but 75 out of every 100 had lower sales? How does one have lower sales but beat estimates?
You could do it by under estimating future expectations. In this way, what would normally be a bad result, looks good because you did better than the worse result that you reported "could happen".
Okay, so how could you have lower sales, but better earnings? You would have to cut costs ... cut inventories, layoff, reduce expenses, etc. That works the first time around ... the second time around is very difficult to cut as much on a percentage basis. So, the salvation will have to be an increase in sales during the current and future quarters.
That's the rub. The economy needs an increase in spending by consumer and business end users. We are getting some increases due to government stimulus programs. That can't go on forever without the consumer taking back the spending reins ... or our government will go bankrupt, the Dollar will fall, and interest rates will go up.
So, now we need the real thing ... increased spending by the consumer. We need an increase in demand because people can afford it, not because the government gave a consumer a $4,500 credit so he could buy a car. Christmas is not that far away, and the government will not be giving any consumer subsidies out for buying clothes, appliances, pots & pans.
So, as an investor, that's what you want to be watching for: Reports that indicate consumers and businesses are increasing their spending levels. Recent earning estimates are turning up slightly ... that's a good thing. It would be nice if "lots of increased spending" could happen without big increases in debt levels, because all of the excess debt and leverage has not been wrung out of the system yet.
If all goes well, and positive expectations bear fruit, then we will see forward economic progress. But, if GDP remains negative in Q4 along with weak consumer spending appears during the holidays, then the market will have a confidence retraction bringing things back to where the true balance is.
Although some earning estimates have turned slightly up, sales have not moved from declining to "increasing". The progress we are making is one of "getting less worse", and granted ... that has to happen first before we get to where things are "good". For now, don't mix the two ... getting less worse is different than getting better, and less worse is economically a lot different than getting better.
Be open minded and consider the real "comparative conditions" relative to time ... sometimes the media tries to "headline" the news to make things look better than they really are.
Take Financials for example. Some media sources have excitedly reported that " Financials are up 273% from the Second Quarter of 2008". Well, the 2nd. quarter of 2008 was negative, so what did the media really mean? Did that 273% improvement mean that things were in the positive ... or almost positive, or in the negative?
Here is what they could have said, if the media had wanted to use a different time-frame for the same result: They could have said that, "Financials were down 83% from the 2nd. quarter of 2007".
Was it misleading to make things appear as if they were wonderful? Or, was it a good thing to show the optimistic side? Our thinking is that "enough of the numbers should be reported so that someone really understands what is going on". If a person gains 30 pounds, is that good or bad? To answer the question you need to know what their ideal weight should be and how much they weighted before losing 30 pounds. Depending on the answer, they could be grossly over weight, underweight, or just right.
Subscribe to:
Posts (Atom)
Posts
