Weekly Review: Pressure on Corporate Profits
Some little followed and largely ignored economic activity measurements have serious consequences to investing. One such metric is productivity where it was reported that 2Q2011 productivity fell at an annualized rate of 0.3%.
There is a close relationship between corporate profits and productivity that has been developing since 2000 - a New Normal effect.
After the trough of the Great Recession, I estimated that corporate profits would grow beyond most analysts' expectations. A major recession FORCES restructuring for survival - and as the above graph demonstrates, both productivity increases and profits skyrocketed.
Unfortunately, following the Great Recession - the economy did not ignite. What some believed was economic expansion, was the slop of the stimulus. Now the economy is correcting to the underlying dynamics - which are sickly.
Productivity, based on historical evidence, will continue on a downward track, and corporate profits should trend in the same direction. By the end of 2011, there likely will be little growth in corporate profits over 2010.
Another way to look at the potential of corporate profits is a methodology used by my colleague Doug Short who uses the PPI crude-to-finished-goods ratio.
The August 2011 ratio is at the 97th percentile of the 774 data points in this series, down slightly from the 99th percentile in April, but clearly in the danger zone.
As the above chart suggests, there is a inverse (although imperfect) relationship between the PPI ratio and corporate profits. It should be assumed there are many dynamics that influence profits including the aforementioned productivity and costs.
It does not take a quant to see corporate profits are under pressure. Add to this mix a depressionary economy, turmoil in Europe, and a USA political system in pre-election stalemate - is it any wonder any bit of news sets the markets off?
We have been spoiled by the Cinderella investing dynamics of our lifetime. The markets are eager to regain the pre-recession peaks, yet the economy (spelled "demographics") has had a seismic shift - and the underlying debt issues (which will take years to work off) are wallpapered over and will remain a drag indefinitely.
A large determinant of corporate profits is economic expansion. The economy is not only failing to reach pre-Great Recession peaks over two years after the official end of the recession, but some are forecasting a double dip while the rest forecasting extreme low growth.
I cannot identify any major positive dynamic for corporate profits. The markets are considered by many as a forward economic indicator. Could it be the current turmoil in the markets are simply an adjustment to the lower corporate profits outlook?
Economic News this Week:
The Econintersect economic forecast for September 2011 (see first article under author's photo) predicted the economy will contract - but there is an indication that the economy may begin slight growth in the coming months. The majority of the weighted elements were negative, but some key elements were showing positive growth.
This week the Weekly Leading Index (WLI) from ECRI slipped further into negative territory - from a downwardly revised -6.6% to -7.1. A negative number implies the economy six months from today will be worse. This index has been eroding and has been in a four month overall downtrend. Please note that a similar downward trend occurred one year ago and did not result in a recession.
This week, ECRI co-founder and chief research officer Anirvan Banerji told the Economic Times of India:
The [global] slowdown pressure will definitely remain till December across the spectrum. There can only be a rebound early next year but that will largely depend on the policy decisions the large economies take in the next few weeks.The problem is this slowdown is happening within couple of years of huge recession and the world has not recovered fully from the 2008 crisis.
Initial unemployment claims rose 11,000 (from 417,000 which was revised up from a preliminary 412,000 last week) to 428,000. Historically, claims exceeding 400,000 per week usually occur when employment gains are less than the workforce growth, resulting in an increasing unemployment rate. (See second article under author's photo.) The real gauge – the 4 week moving average – rose 4,000 to 419,500 because of the backward revision. Because of the noise (week-to-week movements), the 4-week average remains the reliable gauge.
The data released this week confirms the economic soft spot is continuing. What stood out this week was the contraction of rail traffic.
Bankruptcy this Week: Dallas Stars (the current owner of the Dallas Stars National Hockey League Club)