The market, like the Pebble Beach Golf Links, is filled with risk-reward holes that can bury you with the stroke of a pen. Whenever I'm in a funk over whether the market is overbought or oversold, I riffle through my long-term charts on the economy that go back 50 years. What never ceases to amaze me is the symmetry of the charts' peaks and valleys, cycle after cycle after cycle. Aside from charts on market valuation covering price-earnings ratios, book value and yields, corporate profits are the best leading indicator for me--not absolute numbers but profits relative to their long-term earnings trend. Since the early postwar period, the trend line on profits (before taxes) shows a 6.4% rate of growth. The 2009-10 recovery in non-financial corporate profits before taxes shows they've reached their long-term trend line. This is bullish for stock prices because it suggests no excesses like what built up in the 2002-07 business cycle. You could rationalize that the stock market at least isn't overbought relative to the level of corporate profits. My hunch is we're in for a year or more of consolidation around the 1,100 level of the S&P 500 Index. If I'm wrong and the market snaps back above 1,200, I'll deep six these beloved charts and consult my medium in Harlem who dabbles in technical analysis, an oxymoron. When actual profits exceed normalized profits by a big number--say 40%, like in 1998 and 2007--the market shortly thereafter tops out and declines sharply. Earnings drop back to their trend line pattern or below and then we start a new cycle. Over the past decade the earnings cycle for corporations embraced a pattern of at least four years up and four down. From the peak in 1998 profits dropped from 60% above trend to almost 40% below trend. That market cycle covered the technology bubble in 1999, 2000 and then its implosion, which created a mini-recession. From 2002 to 2007 profits recovered in a sharp trajectory, from 40% below trend to 40% above trend by 2007. This cycle covered the tremendous growth in financial sector earnings, largely trading profits from commodities, packaging mortgage-backed securities and other derivatives like credit default swaps. Individuals leveraged themselves to the hilt, buying vacation homes, taking out second mortgages and increasing spending from 66% of disposable income to 70%. Home prices ratcheted up along with the stock market so personal wealth rose and almost everyone felt well off or at least comfortable, even smart if not smug. Alan Greenspan, philosophically, didn't believe in intervening in the stock market by raising stock margin ratios or even tightening credit sufficiently to impact the cost of carry for home mortgages and commercial real estate. The bubble burst, as Lehman Bros., Bear Stearns, The country instinctively choked on Wall Street's bonus orgy. Over the past decade this largesse ballooned from $40 billion to $90 billion while destabilizing the country. The amplitude of the profits swing was comparable with all other deep recessions going back to 1954, including 1969-1970, 1973-74 and 1982: all vicious contractions with horrendous financial markets and gut wrenching upsets in both commercial and residential real estate values. I bought my first co-op apartment in 1974 for $85,000 on Central Park West in the Big Apple. The seller was a partner in a failed boutique brokerage house. The major economic components of GDP need to be examined not only for trend and direction but for amplitude of movement. Many of us overlook amplitude and therefore miss the tops and bottoms of economic and market cycles. Macroeconomic indicators like new orders for durable goods, non defense capital goods, industrial spot prices and the ratio of new orders to inventories all confirm the huge snapback in economic activity since April of 2009. These stats were confirmed by the stock market's recovery and various surveys of consumer confidence and sentiment. Finally, the Value Line stock index, an un-weighted straight arithmetic compilation, recently made a new high. Where am I going with this mumbo jumbo? Well, all my indicators have reached a comparatively high level with other economic cycles. Historically, they adumbrate a business consolidation phase coming as well as a stall in stock market momentum. Other cycles, the Federal Reserve Board stepped in, raising interest rates that cooled down financial markets. Because home building is so depressed and home prices show little recovery the FRB dares not overreact. The bears focus on the depressed housing market as a leading indicator of a double-dip recession in the wings. Maybe yes, maybe no. With the unemployment rate unacceptably high there is no wage inflation to speak of. The entire financial sector still licks its wounds from excesses that went on too long. For the administration, leverage is a dirty word and Congress is still out to get Wall Street for destabilizing the country. Pragmatically, I could turn bullish again, but I need to see confirmation of buoyancy in personal consumption expenditures these coming months. May was flattish for retail sales and blaming it on the weather is a foolish rationalization. I need to see a big recovery in activity and prices for the existing home inventory for sale. So far, nothing to write home about. The home price index shows little late foot as we round the far turn and head into the second half. On new construction, my favorite leading indicators, lots in subdivision and new applications for home mortgages are subdued and suggest an elongated workout period. What is there to like about what's going on? Well, non-financial corporations handled themselves conservatively after the economy topped out in 2007. Employment and capital spending got meat-axed. Free cash flow built up on balance sheets, deleveraging short- and long-term debt ratios. Ford is a much different company than it was in previous cycles. It swims in liquidity today. Transforming acquisitions, like Dow's purchase of Currently, I'm concentrating on growth stocks that should do better in a stop and go economic setting. Visa and even There are plenty of high yields around, hardly mentioned by Wall Street. Citi's preferred stock yields 8.4%. The entire sector of master limited partnerships, particularly in energy, yields over 7%. High yield debentures in the single B and BB ratings category yield between 6.5% and 7.5% with acceptable fundamentals. What I find incongruous is the municipals market remained in a rally phrase these past 18 months despite the moribund condition of California and New York. Everyone who invests is yield starved. How else explain why 10-year Treasuries yielding 3.2% have fallen off my charts dating back to 1946. I like a strong finish. Corporate profits already have recovered to their 2005 level but are by no means seen as excessive relative to GDP. Cash flow for all corporations is in new high ground relative to GDP. The government now is trying to figure out how to tax corporations on their unrepatriated foreign earnings, now standing above 40%. In the '80s and '90s it ran closer to 20% of earnings. I see a saucer-shaped market setting, maybe even a dinner plate, to emphasize longitude. Safe Harbor Statement: Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints. Nothing in this article is, or should be construed as, investment advice. |
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