SERIOUS MONEY:Data kept since Al Capone's time shows that the last 10 years are the worst on record, writes CHARLIE FELL
THE INFAMOUS St Valentine’s Day Massacre took place during the winter of 1929. Six members of the powerful and notorious Irish criminal gang under “Bugs” Moran were gunned down on Chicago’s north side by an equally illegal and potent Italian rabble that allegedly acted on the instructions of Al Capone. Eight decades later, stock investors could be forgiven for thinking that they’ve been mobbed. The data kept by Standard Poor’s since the time of Capone shows that the 10 years through January of this year are the worst on record, with cumulative losses, including dividend reinvestment, of 40 per cent in real terms.
The law of unintended consequences should never be dismissed and, just as American Prohibition gave rise to organised crime, the idea that financial markets are efficient and self-regulating has contributed to what will ultimately be documented as the deepest and longest downturn since the 1930s.
In an ironic twist of fate, the rise of the gangster under Capone and the flawed economic thinking central to the current malaise both herald from the “Windy City”, Chicago.
The modern-day massacre has long since been evident in stock prices but the knock-on effects are now apparent across the economy and, while the stark reality facing over-indulgent households is well documented, the damage to the supposedly impervious non-financial corporate sector is becoming crystal clear. American business is in the throes of the steepest earnings downturn since the Great Depression and the grim economic background offers no cause for hope.
The numbers speak for themselves. The bottom line on corporate America’s performance during the final three months of 2008 is nothing short of shocking. The quarterly profit figures for companies in the SP 500 show that revenues suffered a double-digit decline year-on-year. Not surprisingly, fanciful operating earnings dropped more than 30 per cent but, disturbingly, the comparable figures based on generally accepted accounting principles (GAAP) showed a loss for the first time on record and there may well be worse to come.
Corporate America’s second-longest earnings expansion in modern history saw return on equity and profit margins soar to levels that are well beyond historical norms. The operating and financial leverage that magnified returns on the upside has become the very same force that will do likewise on the downside.
Serious analysis of the outlook for corporate profits must begin with an understanding of the differences between economic and corporate data. Economic growth is reported quarter-on-quarter at an annualised rate in real terms while corporate earnings are posted year-on-year in nominal terms. The distinction is missed sometimes such that some argued back in 2001 and 2002 that US business performance had somehow disconnected from the general economy when in fact no such observation can be detected from correct comparison of data.
The importance of theoretically correct comparisons is more important than ever today as year-on-year nominal GDP growth dropped below 2 per cent during the fourth quarter of 2008 for the first time since the first three months of 1961. The recessionary data continued through January and suggest that year-on-year growth is set to drop into negative territory during the current three-month period for the first time since 1958. The full-year numbers for 2009 are on course to exhibit negative growth for the first time since 1933.
The outlook for the revenue ambitions of corporate America is hardly inspiring. Top-line revenue growth is clearly under pressure and price discounting is evident from the first negative GDP price deflator quarter-on-quarter in more than half a century. The unintended inventory build apparent in rising stock units suggests that demand has simply disappeared. The pressure on revenues and gross margins thereof is plain for all to see.
The pressure, unfortunately, is not only on the top line but across the entire cost structure. The second-longest profit expansion in modern history was not demand-driven but fuelled by a concerted effort to reduce variable costs and incremental revenue increases which dropped straight to the bottom line. The upside looked great, but the leverage upon which the cycle was built is now moving in the opposite direction.
The bottom line is that earnings are set to collapse so that those who value the market on fantasy numbers will have nowhere to hide.
Those who use one-year forward earnings numbers before all things bad are faced with a number below $40 a share for 2009. The corresponding multiple of 20 times at current prices can hardly be described as cheap compared with single-digit multiples at previous secular bear market lows. Perhaps the disgust apparent among many ill-advised investors will put such flawed analysis to rest.
Stocks do look cheap on trend earnings but secular bear markets don’t end with valuations that are only marginally below long-term averages. They end instead with valuation multiples that subsequently prove ridiculously low and, importantly, are followed by a protracted period of sideways price movement where good old-fashioned dividend stocks outpace all and sundry.
Investors remain confident that the cult of equity will soon return. Astute investors will recognise this fact and put the safety of dividend stocks above glamour for now.
charliefell@sequoia.ie
