Saturday, April 21, 2007

Capital Equipment Recession And Earnings At Risk

Okay, first off this might be the last post for a week or two because I will be traveling. Hey, it's free! Now to the post.

It seems economists and Wall Street prognosticators have finally awoken to the capital equipment malaise. Six months ago nearly everyone was bullish on capex spending stocks. Ditto at the beginning of the year. The thought was that capex spending would save the economy and said earnings growth expectations were ratcheted up to unbelievable 25% for 2007. I warned at the time that those expecting capex spending to materialize would be sadly mistaken. I guess people simply don't understand what is happening and they expect capex to return to ridiculous levels just like they keep betting on Oracle, IBM, GE, EMC, Cisco, SAP and others.

There are very few on Wall Street or in the press who acknowledged the capex problems before the recent panic. The only two I have personally seen are Ed Keon at Prudential and Barry Ritholtz. Amazingly, they couldn't be more opposed in their views with Keon generally being uber bullish on equities and Ritholtz generally bearish. Capex investment is at levels not seen in modern times. That would be negative levels for those who are bullish. The few who have recognized this dilemma have given reasons such as short sightedness of American business and greed of American executives. Others who have come out recently said the capex weakness is unexpected and unexplainable. Well, they may not be able to explain it but that doesn't mean it isn't explainable. None of the reasons I've seen given are accurate. It is not because American companies are losing their competitive edge.

I'm surprised that no one has hit the nail on the head. It might require a little out of box thinking but it isn't that difficult. Maybe it is because I am uniquely positioned since I've spent the better part of my life pumping billions of dollars of capital equipment related goods and services into corporations. Since I prefer to stimulate thought rather than hand everyone all of the answers, all I'll say is ponder it a while and you might come up with some reasonable hypotheses.

A data point I watch quite closely involves capex expenditures. Because I tend to use data points not generally available, I haven't seen anyone talking about it. Fine with me. The bad news is that it had the largest decline since 1973 this past quarter. While I am too young to remember 1973, I'm very well aware of 1973 and the subsequent recession. It was the worst economic slow down since the Great Depression. Many called it a depression at the time. Interestingly enough, as I have written, the early 70s was surprisingly similar to today in many terms; a powerful global expansion, a housing boom, commodity inflation, Americans questioning their competitiveness, a barrage of imports from Asia, economic malaise, an unpopular war, strife in the Middle East, economic catastrophe for American auto companies, etc. That said, as I have written before, we are likely not reliving the 1970s but the 1930s as the "great experiment".

The problem that Wall Street doesn't typically understand is that major capital investment cycles are not tied to the liquidity cycle. That is why so many economists and money managers are caught off guard with their projections. The Fed and government policy can and does incent business investment but they are not primary drivers. So, Democrats praise the 1990s as supporting evidence of their policies and Republicans cite the 1980s. The fact is neither are responsible for the growth in the 1980s or 1990s. Their policies may have assisted in some way by mostly keeping government out of the way and letting free enterprise work its magic. That is why I have stated repeatedly the Fed will not save the economy and those expecting such will be sadly surprised.

So, let's take this capex discussion a little further. What are the other variables we might gain insight into by looking at weak capex? What impact has it created? Well, what's ironic is you need look no further than what the bulls are touting as supporting evidence of their posture. Weak capex spending has resulted in artificially inflated earnings. So, while the bulls tout fantastic earnings, a primary reason is there has been weak capital spending. How great is that? With below trend investment, how sustainable are earnings over the long term? Doh! Instead companies have been investing in stock buybacks which, again is cited by the bulls as supporting evidence of their position. Let's see. Capex or stock buybacks? Which one is most attractive to you as a long term investor? Investment in the future or finding nothing better to spend your money on other than artificially inflated stock prices? Next, if earnings are at cyclical peaks not seen in half a century, how cheap are stocks? Ain't nothing cheap about these markets. Finally, while it is very hard to measure accurately, I'm quite confident corporate research and development spending has been below trend as well. But, hey, with less investment comes a rosy earnings picture. An earnings picture which is so far outside of trend that it will not last. That is not a prediction. That is a fact. Then what?

All of this begs a question. Let's take this to its natural conclusion and talk about something you will never hear from Wall Street. If you are a C-level executive in a large corporation with strong financial controls, you likely have not only heard of it but it is likely part of your finance team's mission to model it. It's called earnings at risk. The topic is too complicated for this blog to go into the detailed analysis of such calculations. But, let's take a real world result we just recently experienced. How far might broad market earnings fall in a recession and what areas are most vulnerable? Let's answer the second question first. For various reasons, commodity stocks, utility stocks, consumer discretionary stocks and financial stocks amongst others. Commodity earnings as an example are many standard deviations above trend and given the disproportionate makeup of finance industry earnings in the markets, both have a high exposure of risk. What have I constantly harped about? Highly inflated commodity related stocks, small cap stocks, consumer discretionary stocks and financials. Given the minor recession on 2000, we saw earnings fall approximately 40% in the S&P. With this cycle's imbalances would earnings at risk be 50% across the board for equity markets? In other words, without going into lengthy analysis are market earnings of commodities, financials, etc at risk comparable or worse than technology in 2000? I don't believe that is unreasonable without grinding through calculations. If so, the S&P PE at risk is higher than 1929 and the small cap index PE at risk puts it higher than technology in 2000. What I'm saying is earnings at risk is a much better data point in this cycle than current price to earnings ratios or projected ratios which are simply trend following calculations any twelve year old could calculate.
posted by TimingLogic at 3:20 PM