• The NY Fed’s August regional manufacturing report (Empire Manufacturing) suggests that after the initial backlog-driven rebound, factory activity is running out of steam. To be sure, manufacturing remains in growth mode, but the pace has slowed.
  • The index of new orders is back in negative territory.
  • Hiring is still improving.
  • But factories are cutting back workers’ hours again.
  • Business outlook is less upbeat than it was last month.
  • Homebuilder optimism is near record levels as demand strengthens.

The shift from rentals to homeownership (often from cities to suburbs) is underway. Americans are looking for more room to work and have their children educated at home while reducing exposure to densely populated areas. Homebuilder optimism is near record levels as housing demand soars. Residential construction data confirm this trend, with July figures topping economists’ projections. Housing starts hit a multi-year high (unadjusted).

  • Foreclosures are at record lows due to moratoriums on notices. At some point, this trend will reverse.
  • Rent increases slowed sharply this year
  • The Midwest’s economy is recovering, supported by manufacturing coming back online.
  • However, Midwest consumers are cautious about the future and have curtailed activity, according to CIBC.
  • Improving activity at California ports points to a rebound in US goods imports.
  • The Philly Fed’s regional manufacturing report points to robust factory activity this month.
  • However, the pace of hiring and business outlook pulled back from the July levels.
  • The Conference Board’s US leading index continued to strengthen last month.
  • The Oxford Economics recovery index is showing some improvement.
  • Bloomberg’s monthly economic expectations index and the weekly consumer sentiment index have both turned lower this month. Americans have become more nervous about personal finances.
  • A record percentage of lenders tightened approval standards on credit cards.
  • After four weeks of declines, initial unemployment claims rose last week.
  • Corporate bankruptcies continue to climb.

 

 

Earnings Season Results

 

Here is how it works to get the earnings “beat”.

After cutting earnings estimates drastically following the first quarter, companies reported a record “beat” rate.  That’s the key.

With 90% of companies reporting, we can safely say – “everyone got a trophy.”

Such a high “beat rate” certainly “seems” to suggest companies are firing on all cylinders, and that currently elevated prices are justified.

Earnings Growth: For Q2 2020, the blended earnings decline for the S&P 500 is -33.8%. If -33.8% is the actual decline for the quarter, it will mark the largest year-over-year decline in earnings reported by the index since Q1 2009 (-35.4%).

Earnings Guidance: For Q3 2020, 11 S&P 500 companies have issued negative EPS guidance and 34 S&P 500 companies have issued positive EPS guidance. (Only 10% issued guidance, which leaves analysts guessing at future results)

Valuation: The forward 12-month P/E ratio for the S&P 500 is 22.3. This P/E ratio is above the 5-year average (17.0) and above the 10-year average (15.3).

Let me point out some critical points:

  1. In January and February, investors were bidding up stocks to all-time highs based on REPORTED earnings of $171/share by the end of 2021.
  2. Today investors are paying the same price for 2021 earnings that are $20/share lower.
  3. While earnings revisions did tick HIGHER at the beginning of August, estimates through the end of 2020 hit a new low just 2-weeks later.

During the first six months of CY 2020, analysts lowered earnings estimates for companies in the S&P 500 for the year. The CY 2020 bottom-up EPS estimate (which is an aggregation of the median 2020 EPS estimates for all the companies in the index) declined by 28.7% (to $126.86 from $177.81) during this period.

This marked the largest decrease in the annual EPS estimate for the index over the first six months of the year since FactSet began tracking the annual bottom-up EPS estimate in 1996.

Not surprisingly, given the record-level cuts to EPS estimates during the first half of the year, it resulted in the elevated “beat rate” as noted above. Given the high beat rate, analysts are confident in increasing their estimates for the next quarter.

This is where you should take notice.

During the last TWO years, reported earnings for the S&P 500 have plunged. While analysts are currently hoping for a “V-shaped” economic recovery to provide for the “hockey stick” recovery, risks are high this will not occur.

 

 

The reality is that earnings, and more importantly, revenue (which is where earnings come from) have collapsed.

 

 

Here is a better way to visualize the disparity. The chart below shows the S&P 500 index versus both Operating (fantasy) and Reported (reality) earnings.

Even with the recent upward revisions to earnings, operating earnings are still 33% lower, with reported earnings down 46%.

 

 

Despite the rise in the S&P 500 index, earnings have fallen despite substantially lower tax rates and massive corporate share repurchases. (Share repurchases reduce the denominator of the EPS calculation.)

This is no small thing. The issue of share repurchases previously has been two-fold. Primarily, it was the distortion of bottom-line earnings per share.

We have discussed the issue of “share buybacks” numerous times and the distortion caused by the use of corporate cash to lower shares outstanding to increase earnings per share.

‘The reason companies spend billions on buybacks is to increase bottom-line earnings per share, which provides the ‘illusion’ of increasing profitability to support higher share prices. Since revenue growth has remained extremely weak since the financial crisis, companies have become dependent on inflating earnings on a ‘per share’ basis by reducing the denominator. “

At the end of 2019, reported EPS was boosted by $3.21/share by share buybacks. That support has now collapsed to just $1.51 per share.

 

 

Had it not been for the share repurchases, the EPS decline would have been worse. Nearly 75% of earnings reported are from “accounting gimmickry” versus actual “revenue” growth. 

Think about that for a moment.

However, for investors, the real issue is that almost 100% of the net purchases of equities has come from corporations.

 

 

Today, buybacks have fallen sharply as corporations move to conserve cash amidst a recessionary economy.

 

 

As noted, since the “Financial Crisis” lows, much of the rise in “profitability” has come from cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks, revenue growth, which is connected to a consumption-based economy, remained muted. Now, the “economic shutdown” has crushed revenue growth entirely.

Since 2009, the operating earnings per share of corporations has risen by just 158%. However, the increase in earnings did not come from an increase in revenue. During the period, sales (which is boosted due share reductions) grew by a marginal 41%.

However, investors have bid up the market more than 365% from the financial crisis lows of 666.

 

 

The market is currently trading at absurd valuation levels. There is little to support the idea of a “V-shaped” recovery at this point.

 

U.S. Savings

 

Many Americans have also been handed a big pile of cash from the government through the stimulus checks mailed out earlier this year and from extra unemployment payments.

As a result, more Americans are tucking that money away. We’re now near an all-time high for savings deposits, recently passing the $11 trillion mark.

 

 

This raises a couple of possibilities.

Either a lot of folks are being smart and saving their money for a rainy day… or a lot of bills are about to come due in the form of rent or other debt payments that had been temporarily suspended during the height of the pandemic-related shutdowns.

We lean toward the latter option.

 

The Fed

 

The Fed balance sheet we thought was outsized at $4 trillion is now $7 trillion—and I believe it’s on the way to $14 trillion. In the end there will be inflation. Call it three to five years from now. We’ll one day look back and wonder what in the world were we thinking.

 

 

The measures taken to ameliorate the recession, in terms of trying to help people in distress, while they’re popular and humane, they’ve resulted in a massive increase in the debt overhang. The pandemic will eventually go away, but the debt will remain. It’s been my view that over-indebtedness ebbs economic growth. Debt is a double-edged sword: It’s increasing current spending in exchange for a decline in future spending unless it generates an income stream to repay principal and interest.

We had four secular peaks in total debt to GDP. The 1870s, 1920s and 30s, 2008-09, and we’re going to set a new peak this year, which will take out the peak in 2008-09. The debt surge reflects both a rising debt and a decline in GDP. In the three earlier instances, the inflation rate fell very dramatically. We now have a new secular peak in debt to GDP occurring within 12 years of the prior secular peak, whereas before they were decades apart. That’s massively disinflationary.

When debt goes up, growth goes down. In other words, if you incur more debt, you can spend today, but you have to pay it back tomorrow. Your personal economy eventually slows because you have less money left over to spend on things.

When the Fed initiated QE1, QE2 and QE3, folks said those policies were very inflationary. There is a liquidity effect of what the Fed is doing, and the liquidity effect can be very powerful over the short term. But ultimately the increase in the money supply did not follow through after the rounds of Fed purchases of government securities because the banks couldn’t utilize the reserves, they didn’t have the capital base to make the loans, they had to charge a risk premium in an environment in which the risk premium was rising very dramatically and the borrowers couldn’t pay the risk premium. There was no secondary follow-through in terms of money supply growth, and the velocity of money fell, and the growth rate fell back after a transitory rise. And I don’t really see this as any different.

Keep in mind, when the Fed comes in barrels open like this, the program initially looks successful because it unblocks what problems existed in the markets. But it’s the job of the economist to understand the unintended consequences. When the Fed comes in and they have this tremendous success, which gives the appearance that the inflation process is starting, they thwart a couple of important mechanisms that make the free enterprise system work: creative destruction and moral hazard. The first-round effects of the Fed look effective, and they’re widely hailed, but they make the economy even more overleveraged than it was before, and credit is allocated to those who are not really in a position to generate economic growth from it. We’ve seen numerous similar programs in Japan and Europe, and it looks like the central bank has the capability to do whatever it takes. They certainly have the ability to calm and re-liquify markets, but those actions then compound the underlying problem, which is the extreme over-indebtedness. You get a transitory boost, you get a liquidity effect, but that liquidity effect runs out very quickly.

 

The U.S. Dollar

 

To me, it is a measure of confidence in U.S. authorities. I could be wrong, but I do believe that when confidence in the dollar is lost, that’s when rates rise, and inflation gets out of control. I think the price movement in the dollar will signal to us the shift from deflation to inflation. Therefore, the trend in the dollar is important.

A study by Hirschman Capital shows that out of 51 cases of government debt breaking above 130% of GDP since 1800, fifty governments have defaulted. The only exception, so far, is Japan. We mention this because the IMF expects US Government Debt to hit 141% by the end of this year.

I think we are following the Japanese path, and thus it may be years before we experience a default.

Defaults can come in different forms: The most likely is a currency debasement that would probably lead to rising inflation. And it could come in outright debt defaults: something I think is most probable in Europe (due to their flawed political structure). If that occurs, we will see a rush of money to the U.S., further extending the dollar’s reserve status.

But when you look at 50 of the 51 cases, free money (MMT) has usually led to hyperinflation. Then, the system breaks and a new one is formed. Debts are reset and we move forward. That’s the path we are on and my best guess is we’ll figure it out this decade.

But now, we see an increasing number of industrialized nations running into the same problem, including the US. The US is extremely important as it still provides the world with the most important reserve currency. Once faith in that currency declines and the US dollar enters a decisive multi-year bear cycle, hell could break loose. It would remove any potential discipline from many central banks around the world and they would simply follow that path of reckless liquidity creation. Thus, the world runs the risk of a major monetary crisis, massive currency debasements and currency reforms in the coming years, which would be expressed in rising prices of real assets (expressed in such debasing currencies).

Martin Armstrong sees a monetary crisis cycle starting in 2021 and a sovereign debt crisis in 2022.

The point at which confidence is lost will show up in the dollar. Money will flee and seek its best opportunity. Again, let’s keep an eye on the dollar. The current monthly trend is pointing lower (red arrow, lower section, right hand side). A double top appears to be in place (2018 and 2020). A break below the 2008 low would be a major warning.

 

 

Real assets are the beneficiary. Commodities, agriculture, real estate, and precious metals.

Gold may already be telling us something.

 

 

COVID Update

 

COVID hospitalization trends:

 

 

Market Data

 

  • Tech giants Facebook (FB), Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), and Alphabet (GOOGL), by market cap, make up roughly 25% of the S&P 500 Index today. That’s up from about 17% in January.
  • Only about 6% of the S&P 500 members are making new 52-week highs.
  • Nasdaq 100 breadth has been deteriorating.

 

 

The speed of this market recovery has been remarkable.

 

 

We’ve had the shortest bear market in recent history.

 

 

  • The stock market is increasingly pricing in higher corporate taxes as the US elections approach. The underperformance of companies with the highest median tax rates has accelerated.
  • Short sellers have capitulated. S&P 500 short interest is the lowest in 15 years.
  • Small and mid-cap stocks haven’t participated in the S&P 500’s run to new highs.

 

 

 

All content is the opinion of Brian J. Decker