We have made much in the last year of two of the huge increase in earnings that we first expected and now celebrate in corporate America. Part of that huge improvement was simply coming off a very low base. In 2008 and 2009 so many companies went through and wrote-off the kitchen sink (and their bad loans) that we had a decade’s worth of poor decisions recognized in about 18 months. Another part of the huge improvement was driven by good, old fashioned operating leverage as we crammed more revenues through a largely fixed cost structure more leaked out at the bottom line.
The last big hunk of profit improvement can be attributed to high productivity in the workplace. Within this hunk, part of the benefit came from application of technology is large doses. Another chunk comes from ‘right-sizing’ businesses by reducing headcount. Usually companies will let go their least productive workers, the newest or poorest trained. Many firms eliminated a lot of overhead, taking one function after another and hiring an outside firm to do what they do best so you can do what you do best.
Productivity is not likely to get much better at this stage of the recovery and going forward. The benefit of shrinking the cost base can only go so far before you actually forgive more revenues than you make profits. At that point, you have to add-back some workers to make more stuff to sell. We have probably reached that point in this recovery. This is one of the factors that we have been watching closely to see when the higher trend in earnings is about to run out.
We have really enjoyed the 30% gains in earnings for the broad averages in the last couple of years. It has been both fun and profitable to have been on the right side of that trend. It is sad to think that the easy part is over. But, this happens in every cycle and this one is no different. So, where do we go from here?
We still keep going higher, just not on the same trajectory. Instead of 30% year-over-year gains, look forward to 10% gains. It won’t be anywhere near as exciting, but still rewarding. This inevitable slowdown has been included in our thinking all along, so it comes as no surprise. The rapid growth actually went on a little longer than we would have thought which was nice.
What is most important is the gains will no longer be so indiscriminate. It hasn’t really mattered what business you were in up until now for you to make big gains in earnings. From here on out, it will matter a lot. We suspect that some of the darlings of the market in the materials and industrials space will find it hard to continue making large gains. Not only has their revenue growth slowed, due to saturated markets, higher input costs and all the rest, but their cost structures are ballooning. Financial companies have come from near-death experiences back to some semblance of health and now incremental profits will be tough to come by. The steep yield curve, that has helped them immensely, has gotten no steeper. To make more money, they have to make more loans, which means some of those loans will have to go bad. So they will not be able to harvest earnings from reducing their bad debt reserves. There are other examples but we don’t want to bore you more than usual.
The one area we wanted to hit before our time and your attention run out is small caps. One of the distinguishing characteristics of small companies is that they usually have a fairly small geographic footprint. Few small caps have foreign subsidiaries and foreign markets. So, as growth in the US slows, so too will earnings growth in small caps. The one place that 30% growth can still be found is in the emerging markets and big US companies get a lot of their growth from that quarter. Small companies do not. So as big companies enjoy the fruits of being the provider to rapidly growing economies, small companies will be stuck trying to find growth at home. Some of them will manage to take market share from competitors both big and small. Some will have new products that give them a boost. Others will be bought by bigger rivals hoping to gain market share that way. But, the indiscriminate growth in small caps will come to an end, while the indiscriminate growth in large caps will be tempered but not fully stopped.
Issue of the Week
The PIIGS got more ink last week than in a while. Spain was back among the PIIGS since elections there indicate that the Spanish people aren’t going to take a lot of austerity lying down. They voted-out the long-serving Socialist Party in favor of the more conservative Popular Party in regional elections that may indicate the national mood ahead of parliamentary elections next year. The shift may not be tectonic, but the fear is that an incoming administration may take a close look at the books and find a lot more debt than maybe the outgoing party was willing to acknowledge. The risk is that Spain’s credit standing may deteriorate once a lot more debt is toted up.
Spain cannot stand a whole lot more negative press when it comes to their economic standing. Already tarred with the same brush as the other PIIGS, Spain was often considered a much lower risk than Portugal, Greece or Ireland. That may not be the case. The trouble is that Spain’s economy and debt are both larger than the aforementioned states put together. Already, the ECB and the IMF (and probably the NFL) are buckling under the strain of bailing out the PIG group. If Spain is added to the burden, the whole structure may crack. Or maybe not.
The newest bail-out packages for Ireland, Greece and Portugal set a really high price tag on stability within the Euro-zone. But, Spain would more than double the total cost of bail-outs if it is in as bad shape as the others. Spain had its own housing boom, which endangered its housing finance segment. It also has the usual generous public segment pay, pensions and benefits that scalp a large percentage off the top for public services. Spain has 20% unemployment, little job growth and few native industries. With all the same problems, the same solution may be in the offing. Anyway, that’s what had the Euro on the ropes for most of the last several weeks and this will likely only get worse.
The simple solution is to beat-up the bondholders. But, in the case of much Euro-zone debt, the bondholders are the banks. So, bail-out the nation states or bail-out the banks, you say tomayto, we say tomahto (some of these things just don’t work out in print). The best solution is to undo the currency union before everyone has to get bailed-out. It may not be all that important to have one currency, when all you get is trouble (no inflation, but lots of trouble). Debasing their currencies and making the bondholders take the hit via inflation is the classic way for democracies to cut their debt. There is a message in there for holders of US debt, too.
Economic News
1Q GDP remained at 1.8% growth rather than having that guess raised somewhat as expected by most economists. GDP suffered from less consumer spending than originally thought, but higher business investment and rising inventories. Recall that in the first quarter we had some fits of bad weather on the Eastern Seaboard and also across the Midwest which likely hampered consumer spending. Since the first estimate had a lot of data on January, but limited data on February and even less on March, it was widely expected that the level of activity would actually be higher than that projected from January. So, this report comes as a negative surprise.
New homes sales rose in April by 7.3%. This was surprisingly good as many forecasters had presumed a decline in sales. The pace, 323,000 at an annual rate is still 23% below the level of a year ago. The construction industry is limping along at extremely low levels of activity. Only 78,000 homes were under construction nationwide in April that is a record low going back at least to the late 50s.
The Federal Housing Finance Agency reported that home prices fell by 0.3% in March. The decline means that over the first quarter of the year house prices dropped by 2.5%. The drop may reflect the number of foreclosed homes hitting the market across the country. As more motivated sellers show up and few anxious buyers meet them, the pressure on prices mounts. The FHFA only looks at mortgages purchased by Fannie Mae and Freddie Mac and thus sees only ‘conforming’ mortgages. This limits the insight of this survey into higher prices urban areas.
Weekly Stuff
So, it wasn’t all that bad, really. Okay, so US stocks slipped a little last week. Most other markets gained. That’s why we have diversified portfolios, so when one market doesn’t do well, others might. And, last week others might.
US stocks sank early last week and then just didn’t get back up enough by the end of the week. It wasn’t all that bad, just not good. Kind of like when your gravy has lumps, it might taste okay, but it isn’t a thing of beauty. Small stocks managed to turn in a gain, despite the declines in the large cap indexes.
Foreign stocks didn’t do any better, but a falling dollar helped their returns look better to US investors, like us. Most developed markets fell 1% give or take, but London did much better with hardly any loss at all. The developing markets were generally stronger with the notable exception of China, which was down.
Bonds did reasonably well if you limit your discussion to US Treasury securities, most other areas just collected their coupons. Foreign bonds were helped by the declining dollar.
Real estate securities continued their winning ways. It seems that when financial stocks aren’t winning, real estate securities try to find something else that is winning and hitch their wagon to that instead. The winning side now is inflation hedges and REITs have been trumpeting their inflation hedge credentials lately. The fact that real estate is rather expensive on Wall Street versus Main Street doesn’t seem to bother anybody.
Commodities had a very wild week. Energy prices were up, down and mostly sideways. Precious metals had a similar chart pattern. The grains were all over the place with winners and losers side by side. Industrial metals were generally higher. A real mishmash, but the indexes found more positives than negatives by the time the week ended.
We would like to add our thanks to the millions of veterans for their service to our nation over the years. The whole point of Memorial Day is to honor those who have died defending America from our enemies both foreign and domestic. If you know any veterans, just a quick thank you will be appreciated.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services
480-895-0611