It’s The REAL Economy, Stupid

It’s The REAL Economy, Stupid

By Eric Sprott and David Franklin, Sprott Asset Management | 31 July 2009

We are now in the early stages of a depression. The economic indicators we follow to track real economic activity are all signaling a slowdown of massive proportions. You wouldn’t know it from reading the mainstream papers of course— they all focus on the 'relative decline' in the slowdown’s intensity. Reading about the slowdown ‘slowing down’ is not the same as growth however, and does not warrant great excitement in our opinion.

Our Title This Month Paraphrases One Of Bill Clinton’s Presidential Campaign Messages From 1992.

As one of the three key themes in Clinton’s campaign, "The economy, stupid" was printed on a sign in his headquarters in Little Rock to help campaign workers stay on message. This month we’re keeping it simple by focusing on the real economy and its implications for the stock market.

Here is the real economy summarized in numbers:

Industrial Capacity Collapse:
•  US industry used only 68.3% of available capacity in May 2009, according to a monthly report from the Federal Reserve.¹ That represents almost one third of all US industrial capacity sitting idle. Prior to the current recession, the lowest rate recorded since the Fed started this series of records in 1967 was 70.9% in December 1982.²
•  CHART A depicts worldwide industrial production, stock markets, and volume of world trade, then and now, in a comparison from June 1929 and April 2008 on.³ Very similar trajectories. As Eichenberger adds,

"To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The "Great Recession" label may turn out to be too optimistic. This is a Depression-sized event. "That said, we are only [about 20 months] into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline."

CHART A.1 - A.3

Government Tax Revenue Declining:
•  32 of the 46 states whose fiscal year ended midnight July 1, 2009, did not have budgets signed by their Governors. States are grappling with deficits totaling a collective $121 billion, and all states but Vermont require that their budgets be balanced.
•  Personal income tax, which accounts for more than a third of state revenues, dropped by 26% in the first four months of 2009, according to the Albany, New York-based Rockefeller Institute of Government.⁴
•  The US government has spent $2.67 trillion thus far in fiscal 2009, but has only collected $1.59 trillion.
•  The US government collected $685.5 billion in individual income taxes so far this year, a 22% drop from the $877.8 billion the government took in during the first nine months of 2008.
•  US corporate income taxes plunged 57% to $101.9 billion in 2009, down from $236.5 billion in the first nine months of fiscal year 2008.⁵

Retail Sales Slump:
•  The International Council of Shopping Centers (ICSC)/Goldman Sachs same-store sales tally for June was down 5.1% from June 2008, worse than the latest forecast for a 4.5% decline.
•  Privately held luxury department store Neiman Marcus Group Inc. posted a 20.8% drop in same-store sales. Abercrombie & Fitch Co.'s same-store sales fell 32%, even more than the 26.6% decline Wall Street had projected.⁶

Unemployment Catastrophe:
•  The June 2009 jobless rate reached 9.5% (BLS: U3), the highest since 1983. [[But, using the calculation methods for unemployment used in 1983, the current unemployment has now topped 20%! (see John Williams' Shadow Government Statistics) Even the BLS' own U6 statistic shows it to be over 16%.: normxxx]]
•  4 million Americans have been looking for work for more than 26 weeks, representing 29% of the unemployed— the most since records began in 1948.
•  During the last 30 years, Americans who lost their jobs took an average 15.8 weeks to find new positions. In June 2009, the average duration of unemployment was 24.5 weeks, the longest since records began in 1948.
•  The number of people collecting unemployment benefits reached a record 6.88 million in the week ended June 27, 2009.
•  Approximately six people are seeking work for every job opening, the most since the government began keeping such records in 2000. A year ago, the ratio was a little more than two-to-one.⁷

US Housing Market Failure:
•  The annual pace of new home sales is now 342,000, a whopping 32.8% below the rate in May 2008. At the current sales pace, there is 10.2 months worth of inventory overhang sitting on the market, dragging down prices and encouraging potential buyers to wait it out as prices deflate.⁸ [[Plus perhaps another 10 months of delinquent mortgage (over 3 payments in arrears) houses being held by the banks off the market… : normxxx]]
•  New home sales are down 73% from the all time high of 1,283,000 new homes sold in 2005 (mild recession?). See Chart B.⁹

CHART B

Rail Car Loadings Suffering:
•  For the first 26 weeks of 2009, US railroads reported cumulative volume of 6,806,892 carloads, down 19.2% from 2008.¹⁰ An excellent quote included in the June report from the Association of American Railroads stated:

"Whenever Americans grow something, eat something, mine something, make something, turn on a light, or get dressed, freight railroads are probably involved somewhere along the line. Unfortunately, right now there’s not enough mining, manufacturing and buying going on. So railroads, like most other business sectors, are suffering because of it."11

•  Carloads are down 22.5% from the all time high set in the first 26 weeks of 2006.¹²

Dow Jones Industrial Average:
•  Chart C below plots a return comparison of the Dow Jones Industrial Average between 1929 and 2007. Another frightening comparison to 1929.¹³

CHART C

The big question now is what effect all this bad data will ultimately have on the stock market. Stock valuation can often be wonderfully complex— but it ultimately rests on two main foundations: earnings and investor sentiment. The ‘earnings’ component is concrete; it is a stream of profits that companies expect to generate in the future for their shareholders. The ‘investor sentiment’ component, however, is not concrete. It dictates what investors are willing to pay to buy corporate earnings, and can fluctuate widely depending on perceptions of future growth. The relationship between these two components is vital in gauging market direction. The price-earnings (P/E) ratio is the classic investment fraction that combines these two factors into a usable metric. It deserves mention here because its analysis helps to illustrate the point we are trying to make.

In Chart D, we provide a plot of the real, inflation-adjusted P/E ratio of the S&P 500 stock index from 1881 to 2008.¹⁴ As adjusted using Robert Shiller's data, at the end of June 2009, the S&P 500 traded at an inflation adjusted P/E ratio of 16.08, implying that investors were willing to pay an average of 16 times earnings for a share in the S&P 500 index.¹⁵ Sixteen times earnings is well below the all time, inflation-adjusted high of December 1999 (44 times), but also well above the lows of 1932 (5.57) and 1982 (6.64). As it turns out, 16 times is almost exactly at the 109-year monthly average P/E ratio— so stocks are trading at their long-term average P/E level in the current environment. But, are earnings really around $63 as avertised for the last four quarters?

Now that we are into 2Q earnings season, the first quarter earnings are clearer and look to be just above $10. You can see these earnings estimates by clicking on this link You have to add up the four quarters in order to come up with the annual number. As you can see, the "operating" earnings for the first quarter have come up far short of the estimates and the "reported" earnings (the only ones that make any sense at all to us— see the special report "What is the Real P/E?")— have also come up short of expectations. They were expected to be about $9 in March and early April and they came in at $7.53.

Another thing we would like to point out, and that you can find on the S&P website, is the discrepancy between the two advertised 'estimated' sets of "operating" earnings for 2009 and 2010. S&P shows "operating" earning as both "top-down" and "bottom-up". Both of these "operating" earnings exclude 'write-offs' [[i.e., all of the "bad" stuff: normxxx]]. The top down numbers are reflective of the various strategists on Wall Street who look at the macro economic factors as well as profits and profit margins in general. The bottom-up methodology adds up the result for each stock in the S&P 500, as estimated by the Wall Street analysts. [[There seems to be more room for error, as the bottom-up methodology always boasts a higher number than the top down— and both almost always beat actuals (i.e., 'as reported' numbers) by a wide margin! When (as in the second quarter), the estimates are worse than actuals, it is a cause for great celebration on Wall Street.: normxxx]]

The "bottom-up" process is expecting the earnings to be about $56 (we are rounding all the numbers) in 2009 (down from the $63 'estimated' above for the 12 months prior to June, 2009), while the "top-down" methodology would have the earnings for 2009 at about $43. The real surprise, however, are the estimates for 2010. The bottom up approach has an estimate of about $74 while the top down has an estimate of $47. That is a $27 difference!! We believe the top down analysts will still be too high, but closer to reality than the bottoms up analysts. This $47 number would still put the stock market at about a 20 times multiple, and that multiple is associated more with stock market peaks than with the norm or with troughs.

Nevertheless, the only earnings that make any sense are "reported" earnings and the discrepancy there is incredible. Reported earnings were about $15 in 2008 relative to $50 of "operating" (bottom-up) in 2008. And "reported" earnings in 2009 are expected to be $29 and $38 for 2010. This means the difference between "reported" earnings and "operating" (bottom-up) earnings for 2008 was $35, in 2009 it is expected to be $27, and for 2010 it is expected to be $36.

These differences total $98 of "write-offs" and will be excluded from the "operating" (bottom-up) earnings of $180 over the years 2008, 2009, and 2010 that are focused on by almost all of Wall Street. This also means that the $98 of write-offs which should be included in the "operating" earnings (meaning they would be reduced by that amount) over the past year, this year, and next is greater than the total of "reported" earnings of $82 ($15 for 2008, $29 for 2009, and $38 for 2010) over this same period!

The P/E on the "reported" earnings of 2008 of $15 is over 61, on estimated "reported" earnings of 2009 of $29 is over 35, and on estimated "reported" earnings of 2010 of $38 is over 24!!

CHART D

Click Here, or on the image, to see a larger, undistorted image.
Note: Red is the P/E ratio; black is the interest rate (Fed: 1913 to June, 2009)

But if 16 times earnings is average— how low is low if investors turn their backs on stocks? There’s the real economy which generates the earnings, and then there’s the investor sentiment/perception which dictates the multiple they are willing to pay for those earnings. We already know that the real economy is in severe decline. What happens if investor sentiment changes? We assess five scenarios below:

1. Earnings stay constant; P/E ratios hit cycle lows: We assume a scenario where investors are nervous, people need to sell stocks to pay for lost wages, or for retirement, but the companies continue to perform as of June 2009. Assuming a P/E of 6, which is close to the all time low, and using an earnings value of $63.04 for the S&P 500 Index, we derive an S&P 500 Index value of 378.¹⁶

2. Earnings get halved; P/E stays constant: Earnings have been half of their current value three times over the last 30 years— so it is entirely within the realm of possibility that they could be halved once again. In the late 1970’s, early 1980’s and early 1990’s the S&P 500 Index generated half the earnings per share that it did this year in 2009 dollars. Using today’s P/E multiple of 16.08 results in an S&P 500 value of 506.

3. Earnings get halved; P/E ratios hit cycle lows: "double trouble".If we combine these cases where earnings are cut in half from today and the P/E ratio drops to a cycle low, it implies an S&P 500 Index value of 189 (depression territory). What about inflation? All three of the above scenarios are calculated using 2009 dollars. Doing so adjusts for the effects of inflationary periods over the last 109 years and allows for the historical comparisons we have discussed. As we mentioned, a stock price is based on pricing the future stream of a company’s profits. Over the long-term, inflation erodes the value of those earnings and with it the multiple that investors are willing to pay for them— ultimately lowering the value of stocks.

4. Glancing at the typical ratio of earnings to dividends, if the index is earning ~$30 (earnings get halved), one should expect dividends to be about $10-$30. There is no record here of another time when dividends were higher than earnings, as they are at present. This says to me that the sustainable yield today is not even 2.5%, but more like 1% to 1.5%, comparable to the peak of the peak dot-com bubble. [[Remember, you can only pay dividends out of reported, i.e., "real" earnings!: normxxx]]

From this level of overvaluation in the face of declining fundamentals, stocks could fall hard for another 18 months to restore value fast (1929-1932 model), in which case the 200-300 level is likely by 2011! Another outcome is to trade in a range for a decade or more and wait and hope for a bout of inflation [[or growth?: normxxx]] to increase the nominal/actual bottom line (1968-1982 model).

5. Finally, there is the Japanese model, where the S&P would get to 200— but over 20+ years! Deflationists and Elliott wavers expect the 1929-1932 outcome, with the most stunning phase of the bear market soon to come.

[ Normxxx Here:       20 Year Annual Average from 1900 thru 1997 There is an important statistic that should be noted. The graph at left shows the Real Stock Market Average Return for every 20-year period ending from 1900 through 1997. Note the incredible symmetry of the pattern. All the peaks and bottoms were approximately 30 years apart. For instance, peaks occurred in 1910, 1940, and 1969 whereas bottoms occurred in 1920, 1950 and 1980. The last real (average annual) return peak occurred in 2000, right on cue, and the next bottom is due around 2010. Thus, the peak in 2000 was slated to usher in a '10 year time of trouble'. (This is just what happened after the three prior peaks, i.e., 1910-1920, 1940-1950 and 1969-1980.) Importantly, note that the twenty year return bottomed near zero in each case. In other words, at each prior bottom, you earned zero real return over the prior twenty years. So, by 2010, expect the real Dow return to be around zero for the preceding 20 years, i.e., back to 1990! Since this is approximately coincidental with the low in P/Es, expect the P/E ratio to decline until around 2010 and then start up again.

Moreover, if we plot the real P/E ratio of the S&P 500 Index fifty months out from 1929 and compare it to the recent real P/E ratio performance from April 2008 to June 2009, we find the similarity between the 2008 economic collapse and the 1929 economic collapse disturbingly close. Don’t get sucked in… the real economy is still struggling and the market has yet to reflect this. In 1932, the Dow Jones Industrial Average bottomed 90% below the September 1929 peak— but not until 1932.

The S&P 500 Index peaked in October 2007 at 1,576, and from our brief analysis above we can easily calculate a drop in the S&P 500 of as much as 88% from that peak using our "double trouble" scenario. At the very least, under all of our scenarios it appears that the S&P 500 Index will test the March 2009 low of 666. Judging by the continued declines we are seeing in the real economy, we expect that test to happen sooner rather than later.

In our view, the only thing propping this market up is investor sentiment. [[And Wall Street hype!: normxxx]] Earnings have not improved. Keep it simple, stupid— investing is and has always been about the real economy [[eventually, anyways: normxxx]], and this market is so far ignoring the hard data. You can invest in sentiment if you want to, but as we have said before, we prefer to invest in real things.

In the short run, the market is a voting machine. In the long run, it's a weighing machine. — Benjamin Graham

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¹ Federal Reserve Statistical Release, Industrial Production and Capacity Utilization— G.17 (June 16, 2009). Retrieved on July 10, 2009 from: http://www.federalreserve.gov/releases/G17/Current/default.htm

² Gallagher, Thomas (June 16, 2009). Industrial Capacity Use Hits Record Low. Retrieved on July 10, 2009 from: http://www.joc.com/node/411908

³ Eichengreen, Barry and O’Rourke (June 4, 2009) A Tale of Two Depressions. Retrieved on July 10, 2009 from: http://www.voxeu.org/index.php?q=node/3421

⁴ Randall, Kate (July 1, 2009). US states budget crisis fuel massive spending cuts. Retrieved on July 10, 2009 from: http://www.wsws.org/articles/2009/jul2009/budg-j01.shtml

⁵ Clifford, Catherine (July 13, 2009). Uncle Sam is $1 trillion in the hole. Retrieved on July 13, 2009 from: http://money.cnn.com/2009/07/13/news/economy/treasury_budget/?postversion=2009071315

⁶ D'Innocenzio, Anne (July 10, 2009). Weak retail sales in June raise worries. Retrieved on July 11, 2009 from:http://www.google.com/hostednews/ap/article/ALeqM5jEUOBuLQexhEw6Sbb1sU7mSLR6iAD99B0MO01

⁷ Miller, Rich (July 10, 2009). Obama’s Jobless Safety Net Torn by Rebecca Alvarez (Update1). Retrieved on July 11, 2009 from: http://www.bloomberg.com/apps/news?pid=20601109&sid=atnjG1uvDprY

⁸ New Home Sales Stagnate. April Revisions Mitigate May Decline. Retrieved on July 10, 2009 from: http://www.mortgagenewsdaily.com/06242009_new_home_sales_stagnate_april_revisions_mitigate_may_decline.asp A Look at Case-Shiller Numbers, by Metro Area http://blogs.wsj.com/economics/2009/06/30/a-look-at-case-shiller-numbers-by-metro-area-april-2009-update/

⁹ US Census Bureau— New Residential Sales. Retrieved on July 13, 2009 from: http://www.census.gov/const/soldann.pdf

¹⁰ American Association of Railroads (July 9, 2009). Rail Freight Traffic Remains Down During Holiday Week. Retrieved July 10, 2009 from: http://www.aar.org/NewsAndEvents/PressReleases/2009/07_WTR/070909_Traffic.aspx

¹¹ American Association of Railroads (July 2, 2009). Rail Freight Traffic Down in June. Retrieved on July 10, 2009 from: http://www.aar.org/NewsAndEvents/PressReleases/2009/07_WTR/070209_Traffic.aspx

¹² American Association of Railroads (July 6, 2006). Led by Coal and Intermodal, U.S. Rail Traffic Up in June. Retrieved on July 14, 2009 from: http://www.aar.org/NewsAndEvents/PressReleases/2006/07/Led%20by%20Coal%20and%20Intermodal%20U,-d-,S,-d-,%20Rail%20Traffic%20Up%20in%20June.aspx

¹³ Lundeen, Mark J. (July 3, 2009). Bear Markets and Horror Movies. Retrieved on July 10, 2009 from: http://www.gold-eagle.com/editorials_08/lundeen070509.html

¹⁴ Shiller, Robert J (2005) Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]. See also Shiller's site. Data set downloaded on July 3, 2009 from: http://www.econ.yale.edu/~shiller/data.htm

¹⁵ Bloomberg reports the P/E for the S&P 500 Index in June 2009 as 14.58. The discrepancy with Shiller’s data is for several reasons:
a) Shiller reports using a June 10 closing data
b) Shiller uses a rolling average value for Real Earnings when calculating the P/E ratio
c) Shiller uses extrapolation for estimates of the CPI data when calculating real earnings for June 2009.
Despite these minor variances, we found this publicly available data set to be the most complete comprehensive historical review of P/E ratios.

¹⁶ Bloomberg S&P 500 earnings per share for June 2009 not included in Shiller dataset.

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