November 2002
The Chicken
or the Egg
| "When we look about us toward external objects, and consider the operation of causes, we are never able, in a single instance, to discover any power or necessary connexion. … We only find, that the one does actually, in fact, follow the other. " |
| -- David Hume |
K, LET'S SEE IF WE CAN FIGURE this out logically: Stock prices follow real -- not inflation-juiced or accounting-created -- earnings growth. Earnings grow when revenues rise, expenses fall, or both. Companies can cut expenses when they have too much capacity or though improvements in efficiency. Revenues rise when firms raise prices or demand increases.
That's all pretty simple, so why's everyone so uncertain about the direction of the market? All we have to do is get a handle on the current environment for corporate earnings.
If you believe the economists, economic conditions have been pretty favorable, at least up until the past several months. Most agree the recession that started in the spring of 2001 ended in the first quarter of 2002. Inflation has been low and the Fed has added liquidity by dramatically reducing short-term rates.
Yet stocks didn't respond positively. After trading downward into the summer, stocks suffered dramatic sell-offs in both July and September. Back at the beginning of the year, the consensus opinion held that the stock market would be making definitive progress by the second half of the year. Now it's still not certain that we've seen the bottom.
In the meantime, the economy is starting to send more negative signals. Rarely do all indicators point in the same direction, but over the past two months, more have turned down.
Mixed Signals
Some economic statistics are more informative than others. Some, like unemployment, are backward-looking in that they confirm conditions of the past without giving much insight into what to expect in the future. More forward-looking indicators are helpful when getting a fix on the upcoming environment for corporate earnings.Perhaps two of the most informative are the Index of Leading Indicators and Consumer Sentiment. The former sheds some light on the business side of the economy while the latter gauges the consumer.
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 Source: Baseline Over the past twenty years, the Index of Leading Indicators has offered little insight into future earnings. With a correlation of -.01, there's virtually no relation between the two. |
Earlier this year the Leading Indicators moved up strongly, fueling the belief that the last year's recession ended in the first quarter of 2002. Since then, however, the index has fallen for the past four months leading some economists to predict a "double-dip" recession.
Of course if there was a recession every time the Leading Indicators fell for a few months, we'd have suffered through a lot more recessions. Take a look at the nearby chart and notice how many times the index fell for consecutive months and how few recessions actually occurred. Like most economic indicators, this one alone is not sufficient to base a valid prediction.
What seems more certain is the lack of relation between the Leading Indicators and corporate profits. As the nearby chart indicates, the two are virtually unrelated. Statistically, no relation exists, but you could have concluded that by just looking at the chart patterns.
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 Source: Baseline Consumer Confidence and corporate earnings are slightly positively correlated. If used as a lagging indicator, the relationship strengthens making it more of a lagging than leading indictor. |
Consumer confidence is equally unpredictive. While there is a mild correlation between the confidence figure and corporate earnings, the relation actually becomes stronger the more it's lagged. The strongest relation occurs when Consumer Confidence is lagged by 8 months. This suggests it's a better lagging than leading indicator.
If you think about it, that makes sense. Folks are more confident about the future when companies are profitable, jobs are secure, and they're making money in the stock market, not when they just hope to.
Oddly enough, Consumer Confidence has remained high throughout the current equity bear market. It only weakened in recent months. That's not the usual patter for an economy emerging from recession.
Then again, home mortgage rates below 6% and new car financing at 0% aren't the norm either. Consumers were able to continue spending despite the recession because they had more money in their pockets. Not only did low interest rates allow them to save on (or even take cash out of) their mortgages, low inflation let them keep more of it. Why not feel confident?
But with interest rates at levels last seen in the Kennedy Administration, with so many homes already refinanced and so many vehicles already purchased at 0%, what's left to be optimistic about? Stocks certainly haven't responded. Corporate malfeasance continues to dominate the news, and when it doesn't, concerns about Iraq and terrorism do.
What all this boils down to is a lack of demand from either the consumer or the business side of the equation. This, along with low inflation, have worked together to deny businesses any sort of pricing power. Without strong demand for their products or the upward drift of inflation, companies can't increase earnings by improving the top line.
Making the Cut
If they can't increase the top line, firms can still grow the bottom by increasing productivity or cutting costs. Over the past few years, this has been where most companies have focused the majority of their efforts.|
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 Source: Baseline Non-farm productivity rose steadily in the '90s, only to fall of a cliff in mid-2000. It quickly reversed course as the economy fell into recession in 2001 and now has returned to the level of the late-90's. |
One of the biggest drivers of the late '90s was the steady increase in productivity. Essentially, when productivity goes up, businesses are able to produce more with the same resources or conversely, maintain output while cutting input costs.
The nearby chart clearly illustrates the increase in non-farm productivity from 1994 into mid-2000. But at that point, it fell sharply as the economy entered recession. On the plus side, since mid-2001, the recovery has been equally pronounced.
With little demand for their products, most firms have used their productivity increase as a way of cutting costs rather than a means of expanding production.
They've also done this by cutting back capital spending. As you'll notice from the chart below, unlike productivity, capital spending didn't recover from its 2000 swoon.
Generally, cutting costs and increasing efficiency is a good thing, but as is often the case, too much of a good thing can end up being a bad thing.
As former Fed Governor Wayne Angell recently stated in The Wall Street Journal, "While attention to cost cutting enables any one company to become more efficient, it can be very destructive whenever most companies attempt to add to profit margins by cutting costs. When all companies reduce capital goods orders, then cost cutting zeal restrains the overall demand in an economy, which is what we are now witnessing."
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 Source: Baseline Capital spending took a sharp drop at the end of 2000. The slide continues into the 4th quarter of 2002. |
A slowing economy and lack of demand is essentially a deflationary scenario. While falling prices may sound attractive in the short run, they're not so appealing when the value of your house and other assets also decline.
Mr. Angell suggests the Fed can avoid deflation by adding liquidity to the economy through additional rate cuts. He argues that would "enhance pricing power with a very minor risk that pricing power would swing so far that companies would forget their cost-cutting zeal."
The Fed complied on November 6th, cutting the Fed Fund rate to 1.25%, a level last seen in the 1950s. But will that be sufficient to spur the economy, corporate earnings, and ultimately stocks?
UCLA's Professor Edward Leamer doesn't think so. Also quoted in The Wall Street Journal, he contends, "The way the Fed influences the economy is through homes and cars." While low interest rates may encourage individuals to build that dream house, refinance their mortgage, or buy a new car, businesses make investment decisions based on demand for their products. Unless the Fed's action can encourage enough consumer activity, capital spending will continue to dwindle.
What Came First?
So it all comes down to one of those "chicken and egg" things: Investors are reluctant to commit to equities until
they feel at least somewhat assured that earnings growth has returned. That won't happen until retail demand goes up or capital spending increases. But consumers have already spent their way through the 2001 recession and now they're pulling in their horns until the economy shows signs of recovery -- something that won't occur without an increase in capital spending. Unfortunately, businesses are holding back capital investment until they can be assured there's a demand for their products.
So what comes first, a pick up in capital spending or an increase in demand? At this point we suspect it's the latter since most businesses are reluctant to invest their dwindling capital to expand capacity without demand.
But what will it take to once again jump-start the consumer? If Mr. Angell is right, perhaps the Fed already did with their recent rate cut. Maybe it will be enough to spur yet another round of refinancings and automobile purchases. Maybe consumers will feel good enough heading into the Christmas shopping season to provide the necessary encouragement to businesses to resume investment.
While that may be a stretch, it may not be as much as you think. Former Fed Chairman Paul Volcker never questioned "the short-term ability of the American consumer to spend all of his income."
Perhaps now more than ever, we're dependent on it.
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