|
|
While the prospect of economic recovery
continues to dominate the news, Thunder Capital remains unconvinced of
long-term recovery without the improvement of the single most important
economic factor; corporate profits.
In an effort to make their bottom lines, companies have resorted to cutting
headcounts, reducing capital expenditures, and other cost cutting. While
cutting costs can lift profits when one company cuts on a micro level, it
becomes a real macro issue when many companies are slashing costs. In effect,
they are withholding potential revenues from other businesses as the cutting
snowballs. In addition, accounting methodologies have been increasingly
liberal regarding what to include or exclude on the bottom line resulting in
the highly variable pro-forma earnings.
GDP Increases While Profits Decrease
Profits for companies in the non-financial sector were down to $321 billion
in the third quarter of 2002, compared with profits of $358.7 billion in the
year earlier period, despite what was lauded as a very strong increase in the
GDP figures. We mention this because we believe it is curious that investors
and reporters are so enamored with the growth in the economy, even though it
is at the expense of profits, which make up the foundation necessary to
sustain higher stock prices.
Only the Strong (and the Subsidized?) Survive
The creative destruction aspects of capitalism are no longer allowed to work,
yet they are the natural corrective mechanisms of our capitalistic system. Witness
the planned revival of bankrupt WorldCom. Instead of failing which would
provide profit potential for survivors AT&T and Verizon, WorldCom may now
be able to participate in the marketplace unhampered by its past debts. WorldCom’s
previous mismanagement and misallocation of capital are in essence being
forgiven at the expense of AT&T and Verizon, who did not go bankrupt and
must continue to meet their debt obligations. On a grander scale, every time
the economy was destined to enter a recession the Fed unnaturally cut short
the cleansing process with lower and lower interest rates and higher and
higher levels of credit. This has resulted in a serious and extensive
misallocation of capital that will be painful and time-consuming to reverse.
Savings = Investment: The Forgotten Equation
Businesses do not have the capital for investment because the economic
stimulants to encourage consumption are exactly the same stimulants, which
are discouraging savings. Savings rates in the U.S. have approached zero, so
there is little if any foregone consumption that can be channeled into
investment to kick-start the business cycle. Not only is this lack of
investment likely to continue, as consumption is encouraged, but we are
drastically unequipped as a nation to deal with this deflation in profits. In
Japan, consumers had high savings to benefit from declining prices. Americans
are loaded with debt and have little savings. Our policy makers have flooded
the system with credit and encouraged $130 trillion worth of derivatives. That
could well explain how imbalances have continued on for so long, since we
have never had such massive leverage in our financial system before. What we do
know is it will not help businesses make a profit, which is the most
fundamental factor needed for true economic growth and prosperity.
Trade Imbalance and Profits
There exist some very large and complicated imbalances in the U.S. economy that will be most difficult to unravel. The important point is that this
unraveling process has not started, despite what you would be led to believe
by the media. In fact, imbalances are still being increased. The most glaring
imbalance is the current account deficit, which is approaching a $500 billion
annual shortfall. That translates to almost $1.5 billion of offsetting
investment inflows by foreigners every day and with the dollar breaking to
new lows, seems highly unlikely to continue, if not reverse. One of the
biggest drains of this deficit is that money spent on imports does not
recycle as domestic business revenues. It only benefits the specific country
exporting to us. Economist Dr. Kurt Richebacher, in his November 2002 letter,
describes the trade imbalance as the profits-reducing factor that is least
understood and yet “this leakage has played the single most important
role in ravaging U.S. business profits since 1997.” This growing imbalance has been sustained by the willingness of foreigners to invest in U.S. assets. Foreigners now hold well over $7 trillion in U.S. assets including 13% of
equities, 32% of Treasuries, and 21% of corporate bonds.
Rising Depreciation Costs Hurt Profits
The basic economic maxim that investing in tangible assets such as factories,
which provide jobs, supply, income, and demand, has been lost in the U.S.
Instead our investment has gone into shorter-term, higher-depreciation,
capital investment in technology. With such rapid obsolescence, many times,
the original investment can’t be recouped. Additionally, Dr.
Richebacher notes the government has been fudging its economic statistics
through a process called hedonic pricing. This technique arbitrarily
increases the economic impact of the sale of the computer to account for the
increase in a computer’s power even though the actual price of the
computer has decreased. This results in additions to GDP, which are actually
fictitious, because no one actually paid or received any dollars for that
extra GDP value. Add to this the financial engineering that has provided
little more than goodwill, related to takeovers, and the increasing obsession
with consumerism, and we can view an economy that does not invest in assets
that generate returns. Instead we put money into the purchase of items, which
are simply consumed, with no offsetting return of capital. As a result,
consumption as a percentage of GDP has risen from 62% in the 1970’s, to
66% in the 1980’s, while reaching 70% by the late 1990’s.
Incredibly, as a share of current GDP growth, consumption percentage now
exceeds 90%!
Summary
The credit that has been bestowed upon the remarkable American consumer has
been well deserved. Unfortunately it is this very pronounced shift toward consumption
that has seriously damaged the U.S. economy and it’s historic ability
to generate capital formation. These are the real reasons the outlook for
corporate profits in 2003 are overestimated and frankly, very bleak. The
attempts of the government to revitalize the economy over the past several
years through interest rate cuts, extended unemployment benefits, tax
refunds, etc., have only pushed us further into the already extreme imbalance
toward consumption-based GDP growth. This has come at the expense of a
healthy and balanced economic growth platform encompassing saving and
investment. The point again is that the policies being employed to stimulate
the economy are only pushing us further toward the imbalances, which have
seriously damaged our economy in the first place. The Fed is hoping to
hyper-inflate the impending deflation away but this will do little to boost
profits in a world of overcapacity and ever-higher debt burdens. Every day
the debt burden grows and excess capacity further strains the bottom line for
businesses – PROFITS.
Richard J. Greene
Managing Partner, Portfolio
Manager
Thunder Capital Management
More articles by the author can be accessed by the
"Research Articles" choice at: www.thundercapital.com
| |
