Enzio's Clock

Background

1. What must happen to U.S. profits

According to The Economist of 8^th December 2007, the average guesstimate of total U.S. operating earnings during 3Q07 was down by six percent over 3Q06.

However, overseas profits of US corporates were up by 32%. As these overseas earnings constitute 20% of total US profits, the domestic profits of U.S. corporates must have fallen by an annual 12% in 3Q07. These were operating earnings, i.e. they do not include sub-prime write-downs. Were these to be included, David Rosenberg of Merrill Lynch reckons that reported earnings numbers tanked by a whopping 28% in 3Q07.

In America herself, particularly the profits of “consumer discretionary” companies were depressed the most. This sector includes makers of cars, consumer durables like furniture, and retailers. And more recently, even the sellers of luxury goods begun whimpering; their sales are not as oblivious to declining incomes as you might wish to believe, either.

As The Economist of 17^th November 2007 saliently points-out: America is about to embark on its first consumption-led downturn in two decades. Why so? Let's re-cast this into the framework of The Economic Clock and see what the logical consequences for profits have to be.

Amazingly, U.S. analysts reckon that in this 2008, profits will rebound by 14%. In addition, they are forecasting that profits in each and every sector will rebound. We think that these analysts are out of their trees.

Here are our reasons for skepticism. More recent visitors might want to learn to earn more about the framework of The Economic Time. Below, we discuss what will happen to companies' turnovers as well as margins.

First, as The Economist explains, “Going by experience, profits start to fall when the annual rate of economic growth falls below 1.5%”. Subscribers know that for many moons I have been forecasting American stagflation.

• The "stag” bit is that America just does not grow this year. That is because its Economic Time must worsen:

· Excess demand for money. The sub-prime mess means that the excess demand for money (credit, in this case) must intensify. The Economic Clock teaches us that only when there is an excess supply of money can asset markets flourish. So the opposite holds, too: asset markets have to wilt whenever there is an excess demand for money. In simple talk: people don’t have the spare cash with which to buy assets such as stocks, bonds and houses):

1. Credit crunch. As we pointed out in our first Collateral Damage mini-series: banks just don’t want to lend to each other. Any Central Bank actions to alleviate such fear are mere drops on hot stones. So if banks cannot fund themselves, how, possibly, can they lend?

2. Consumer confidence. Falling asset values must hurt consumer confidence and thus consumption itself. Indeed, in The Economist of 17^th November 2007 (p. 72),

a. Housing dump. Nouriel Roubini and Christian Menegatti, of Roubini Global Economics (RGE), suggest that “…the seven other housing recessions since 1960 lasted an average of 32 months and saw housing starts fall by 51%.” Already, housing starts are down by 47% from their peak, so the “pattern prediction” identified by RGE above is holding – already at this early stage of the downturn!, and

b. Housing crunch. “Richard Berner, of Morgan Stanley, expects a further 25% decline, taking the pace of housing starts in 2008 to below 1 million, the slowest since records began in 1959.”

· Excess supply of goods. On the real side of the economy, watch this excess demand for money alter Americans’ current excess demand for goods into an excess supply thereof:

1. Less consumer confidence. Falling asset values cause an erosion of consumer confidence - which consequently curtails spending. Said Economist quantifies the impact of declining house prices on consumer spending as follows: “The most recent research implies that changes in Americans’ housing wealth affects their spending more than similar changes in their financial wealth, although the effect takes longer to emerge. A$100 fall in financial wealth is traditionally associated with a $3-$5 decline in spending. An equivalent falling in housing wealth…eventually reduces spending by between $4 -$9.” In other words, falling house prices depress consumption about two thirds more strongly than falling financial wealth does; besides, the consumption-dampening effects of lower house prices last longer than those of “mere” financial implosions. For me, this has everything to do with psychology. Robert Maslow years ago created the Maslow pyramid of needs. At its most basic, each of us needs food, sex and shelter. Out uppermost need is the desire to be important. But, notice that “shelter” is a very basic, subconscious need: once its fulfillment is threatened, people really get scared – and thus tighten their belts;

2. Triple dipper: combine a crack in housing starts with further dumps in the stock market, and you may wonder why employers would be in the mood to hire anybody – or, indeed, to keep employees who are “surplus to requirement”. Cueing from our point one above: if a $100 drop in financial wealth erodes about $4 in consumption, and if a $100 drop in housing wealth erodes a further $7 in consumption, then the combined double meltdown equates to $11 less in private consumption – equating to an 11% drop on our original $100 worth of spending….Given that consumption equates to two thirds of any economy, watch that $100 wealth erosion obliterates private consumption by 7 1/4 % (this is two thirds of the 11% decline in private consumption). Add another harpoon to weaker home prices and a wilting stock market: what happens to all of that non-housing related consumer credit? Do cash-hungry and asset-strapped banks just sit back and allow their "assets", their consumer credits, to melt? Hardly! They start to call-in the loans, further intensfying the downward spiral of an excess supply of goods.

3. Slower job creation. In said Economist article, we read that “History suggests that a turn in the profit cycles has a big effect on earnings. This is because of many companies’ ‘operating leverage’: they have high fixed costs, so …when revenues start to fall, companies can be slow to cut costs in response.” Thus, one of the more flexible cost-cutting domains is in the number of people employed. Once peoples’ jobs are at risk, they tighten their belts. So, if people spend less – why on earth should companies invest more in jobs and in other investment? Already, according to said Economist, the pace of job creation in 2007 was about two thirds that of 2006…

4. ARMs explode. As we suggested recently, this year, the interest portion of adjustable rate mortgages will explode. That further obliterates any “feel-good” consumer factor.

5. Slower exports. With The Economic Time worsening in Japan and in Europe, too, expect less U.S. exports to these places – and less profits for U.S. multinationals operating in these markets.

6. Stagflation. We have been braying-on about the effects of higher commodity prices AND a weaker dollar for a long time. Not only do consumers have to pay higher “taxes” on oil and gas, but they also have to pay higher “taxes” on goods that are not priced in US dollars. According to said Economist, Goldman Sachs’ Jan Hatzius reckons that “…a rise in petrol prices of once cent reduces consumers’ overall disposable income by about $1.2 billion and tends to drag consumer spending down by $600 million.”

• Thus, the bottom line is that turnover is set to wilt.

• The “flation” bit arises from more cost-push inflation.
• Not only is the ever-weaker dollar driving up import costs, but U.S. productivity is waning, thus boosting unit labor costs.
• Thus, the bottom line is that margins get squeezed: companies cannot pass-on higher costs if there is an excess supply of goods, now can they?

The bottom line is that things are not so different this time…cycles, by definition, repeat themselves, albeit with different characteristics.

3. How to Make Money Off This Idea

• Always consult your financial adviser first.
• Short the US stock market, for instance by buying
  
• UltraShort S&P 500 ProShares (SDS:US)
• Short the U.S. real estate sector, particularly residential property. Here are some overall real estate ETFs worth exploring:
• iShares Dow Jones Real Estate Index Fund (IYR:US), or
• SPDR S&P Homebuilders ETF (XHB:US)
• Short U.S. materials companies that are directly hooked into the property downturn, for instance
• Material Select Sector SPDR Fund (XLB:US)
• Short the US financial sector. Consider shorting, for instance
• Financial Select Sector SPDR Fund (XLF:US)
• KBW Regional Banking ETF (KRE:US), or
• Regional Bank HOLDRS Trust (RKH:US)
  
• Short U.S. consumer discretionary stocks, for instance via this ETF:
  
• Consumer Discretionary Select SPDR Fund (XLY:US).
  
• Particularly avoid luxury good makers such as Louis Vuitton Moet Hennessy (MC:FP is the code for the LVMH share quoted in France): while their sales in China and other prospering emerging markets may be booming, the bulk of their sales are in “first world” markets where The Economic Time clearly is worsening.