Main menu

Corporate profits continue strong

With today's release of Q4 GDP stats, we have our first look at corporate profits for the quarter, and once again they were higher. After tax corporate profits rose 13.7% last year, and now stand at 8.4% of GDP, substantially higher than the 6% average ratio of profits to GDP since the data have been collected. Since 1999, when the S&P 500 first reached its current level of 1320, corporate profits have more than doubled. By that metric stocks have lost half their valuation over the intervening years.

The chart above creates a PE ratio for the S&P 500 by using after tax corporate profits from the National Income and Product Accounts as the earnings. Here we see that PE ratios, currently about 12, are substantially lower than the long-term average of 15.7. All of this suggests that at the very least, equities are not over-priced, inflated, or in bubble territory. Equities are cheap by these historical metrics, which implies that the equity market is priced to some very conservative and/or pessimistic assumptions. Ditto for the bond market, where historically low levels of Treasury yields and expectations for Fed tightening are consistent with a view that the economy will grow very slowly and inflation will remain low for a considerable length of time.

Profits have been very strong in the this recovery, but the market is taking nothing for granted. Equities are essentially priced to the expectation that profits will decline by 25% relative to GDP in coming years, which would take the profits/GDP ratio back to its long-term average of 6%. That could well happen, and it makes sense to think that there is a mean-reversion behavior inherent in profits and GDP. But again, it implies that the market is most definitely not over-priced or artificially inflated.

Claims decline, but slow progress on the jobs front

Fewer and fewer people are getting laid off these days, but the ranks of the unemployed remain large. As the first chart shows, first-time filings for unemployment claims have fallen rather dramatically in the past two years, signaling that U.S. businesses have accomplished the lion's share of the needed adjustments to a slower economy and an eviscerated housing market. This is as it should be during tough times, but we've been waiting for the other shoe to drop, which is a pickup in new hirings. To date there has been some progress, but hardly enough (1% annual jobs growth) to put a dent in the ranks of the unemployed. As the second chart shows, about 8 million people have been receiving unemployment insurance benefits since last summer. Companies are getting leaner and meaner, but what we really need to see is some meaningful expansion. That probably won't come until Congress takes substantive steps to curtail the runaway growth in government spending and entitlement programs. I think it's coming, but businesses understandably need some concrete evidence of federal belt-tightening before making new commitments to expand.

Government needs to step out of the way before business is going to step forward.

Vix update

After a brief Japan-earthquake-tsunami spike, the Vix index has settled back down, and equity markets are breathing a sigh of relief. The equity correction may last a bit longer, but for it to turn nasty would require some new ugly news. Meanwhile, I continue to believe that the market is still priced to a pessimistic view of the world, so that means it has the ability to withstand the occasional bout of nerves or data setback. The fact remains that the economy continues to expand, corporate profits are very strong, monetary policy is nonthreatening, there are plenty of idle resources that can quickly be put to use, and fiscal policy is beginning to reverse the productivity-robbing excesses of the past few years (i.e., if the government can cut back spending this will free up resources that the private sector can deploy more efficiently, thus boosting growth).

Capex has slowed a bit, but still healthy

Capital goods orders declined in January and February, leaving orders about flat for the past six months. But the level of orders in February was still 10% above the level of a year ago. Whether the past two months represent a meaningful decline in business investment, a weather-related blip, or a pause after very strong growth in the second half of last year remains to be seen. With other indicators (e.g., the ISM indices, regional Fed surveys, and manufacturing production measures) pointing to ongoing strength in the production side of the economy, I'm inclined to think this is a temporary slowdown, not unlike others that have occurred in the midst of business cycle expansions.

Gasoline prices and drilling activity

As a public service, I post this chart which shows the average price of regular gasoline in the country, as compiled by the AAA. Gas is getting expensive once again, but I don't think it poses a serious threat to the economy. More likely, high energy prices will act to slow the economy's growth somewhat. Meanwhile, the forces of supply and demand are coming to the rescue, albeit slowly and with a lag. As the next chart (Baker Hughes' total world oil and gas rig count) shows, higher oil prices are having the predictable effect of incentivizing increased oil and gas drilling activity. Higher prices will bring more supplies on line and reduce demand on the margin; that's the way markets work.

Household balance sheets continue to improve

The latest data for this chart came out a few weeks ago, but it's worth highlighting nonetheless. U.S. households' net worth rose by $3.2 trillion last year, thanks mostly to a similar rise in total financial assets. The value of real estate holdings dropped by only $0.5 trillion, while debt fell by $0.1 trillion. Real estate values are now back to the levels of 2003, which is consistent with the decline in the Case Shiller home price index. Financial assets are only $3 trillion shy of their high-water mark set in late 2007.

As with the data in yesterday's posting about household debt burdens, we see that there has been a significant adjustment in relative prices (equities, bonds, and cash holdings are up, while real estate is down) and a significant improvement in households' financial health. Debt burdens are back down to levels the economy has been comfortable with before, and net worth is rising because the economy is growing, households are saving, and corporate profits are strong.

The biggest problem remaining is the substantial decline in homeowner's equity as a percentage of real estate holdings, which currently stands at 38.5%, as compared to 56.5% at the peak of the housing boom in 2006. Lots of folks have lost their homes and many are painfully underwater with their mortgages. But this is a problem that can go away with time: incomes are rising, mortgages can be and have been refinanced at historically low rates, equity rises as debt is paid down, and a stronger economy and easy money can lift home prices in the years to come. Even if more folks default, this does not destroy homes, it merely results in a redistribution of cash flows; some households will be liberated of their mortgage payments, while others will receive less than they had expected. This is not a pleasant prospect, to be sure, but it likely will encourage at least some to work harder.

Households' financial burdens continue to ease

Recently released data for Q4/10 show that households' financial burdens continued to ease. Total financial obligations (auto leases, homeowners' insurance, property tax, mortgage and consumer debt), as a percent of disposable income, have fallen almost 12% from their Sep. '07 high. As the chart shows, debt and financial burdens have on balance been unchanged since 1985, after a rise in the mid-2000s. That equates to some meaningful deleveraging, and as I have pointed out before, this deleveraging occurred during a time of economic recovery. Debt is not essential for a recovery, and reducing debt is not contractionary. Debt facilitates economic activity, but it is not necessary for growth. You can't borrow your way to prosperity, but lending and financial market intermediation can make an economy more efficient. The problem with debt comes when consumers increase their borrowing in the belief that their financial and economic conditions will be unchanged or improved in the future, only to find out that the future did not turn out as expected. This is not a fatal problem, but it does throw a wrench into the economy's gears that can take some time to work out.

In short, I think the reduction in financial burdens is a healthy sign that reflects the fact that people and businesses have been actively adjusting to changing circumstances, and it is this dynamic response to adversity that sets the stage for a new cycle of growth.

The dollar plumbs new lows in real terms

This first chart measures the value of the dollar relative to six major currencies (CAD, EUR, GBP, SEK, CHF, and JPY). According to this measure the dollar currently is trading about 6% above its all-time low which was registered in March, 2008.

This next chart compares the dollar to a large basket (over 100) of trade-weighted currencies. It too shows that the dollar is still a bit higher than its all-time low, but only by a smidge.

The third chart is arguably the best measure of the dollar's value, since it uses a very large basket of trade-weighted currencies and is also adjusted for inflation differentials between the U.S. and all those other countries. Here we see that the dollar (as of the end of January, the latest available datapoint) has now reached a new all-time low. If I were to extrapolate this chart based on trading data since January (during which time the dollar has continued to fall), the dollar would be around 80 on this chart, or about 18% below its long-term average of 97. This is a very sad commentary on the health of our currency, especially when we add to this the fact that the dollar also is at an all-time low relative to gold and most commodities. It's also not something that I expected.

When a currency falls relative to a variety of objective standards (e.g., other currencies, precious metals, and a basket of commodities) then it is very hard to escape the conclusion that it is suffering from rising inflation. Inflation is simply a description of how much a currency is losing purchasing power. Official measures of inflation like the CPI are still registering very low inflation, but they suffer from flaws and are lagging indicators in any event. Prices at the supermarket can lag prices on the commodities exchange markets by many months.

There is no shortage of reasons for the dollar's weakness. For one, the Fed has been overtly and aggressively expanding the availability of dollar liquidity, and when the supply of something increases sharply it is logical to expect its value to decline. Demand for the dollar has been fairly decent in spite of the Fed's efforts to debase the dollar's value—fueled no doubt by evidence that the U.S. economy is gaining strength—but not enough to absorb the additional supply. Second, the world has been rocked by new tensions in the Middle East, and by the devastating Japanese earthquake, but the U.S. has failed to display leadership. Three, Congress is still dithering over the course of fiscal policy, at a time when our budget deficit is near a post-War high, and the federal government's projected unfunded liabilities are clearly on an unsustainable trajectory. President Obama's budget completely ignored these facts, thus contributing to the perception that the U.S. is sorely lacking in leadership.

I remain confident that things will improve before the year ends, but for the time being markets are clearly burdened by a variety of legitimate concerns, with little or no support from the folks in Washington.

Stepping back, I note that the new all-time weakness of the dollar is yet another in a long list of valuation measures that suggest that the market still is priced to a healthy dose of fear, uncertainty and doubt. It's difficult if not impossible to argue that there is any excessive or unwarranted optimism out there when the dollar is at an all-time low, commodities and gold are on fire, credit spreads and the Vix index are still substantially above levels that might be termed healthy, equity earnings yields are higher than PE ratios, and Treasury yields are in the neighborhood of 2-3%.

Thus, to be bearish you have to believe that the market has underestimated the gravity of the problems we face, and you have to believe that the economy will surely falter. You have to ignore the budding signs of recovery, and distrust the economy's proven ability to adapt and overcome adversity. Moreover, you have to believe that the Tea Party will be unable to turn the tide of fiscal policy, and that Republicans also will fail in their attempts to restore sanity to Congressional spending habits. I'm not ready to throw in the towel on this, not by any means.

Fitz Roy

Here's another shot of what is arguably the most beautiful mountain in the world: Fitz Roy, in the southern Patagonia region of Argentina.

Argentina trip notes

After a few days in Buenos Aires and 8 days in the southern Patagonia region of Argentina and Chile, we are now in Tucumán, which is in the northwestern part of Argentina and my wife's home city. Last night we attended the wedding of a favorite niece of ours—a grand affair with some 300 guests, great food, and dancing. It was really impressive, but things here work differently than in the states. The church service was supposed to start at 9:15 pm, but there was another wedding taking place at that time that didn't finish until just before 10. But that didn't matter too much since the bride arrived at 9:55. The reception was scheduled for 10 pm, but didn't get underway until 11. After some drinks and hors d'oeuvres, we sat down to dinner at midnight. Dancing got underway at 2 am and was still going strong when we left at 5:30 am, at which time they began serving delicious little sandwiches for breakfast. This is all perfectly normal here and the sign of a successful event!

I wanted to take this opportunity to provide some details on the places we have stayed, and the person who helped us plan the Patagonian portion of the trip which proved so successful, as this may be of help to others wishing to experience this magnificent part of the world.

To begin with, Francisco (Fran) Shaw, shown here in this photo with the mountains surrounding the Perito Moreno glacier rising above Lago Argentino, was instrumental in helping us plan this trip. He is a Tucumano and a good friend of a good friend, and now lives in El Calafate, which is the gateway to Argentina's glacier district. He's in the tourist service business, like almost everyone in Calafate one way or another, and helps plan trips, suggest hotels, arrange transportation, and points you in the direction of the best activities and hikes. He can be reached at Be sure to tell him I sent you. He is also happy to make arrangements for tours in other parts of Argentina (e.g., Iguazu Falls (one of the great natural wonders of the world) and Bariloche).

The biggest obstacle to travel in the Patagonia region is the enormous distances that must be covered between cities and the relative lack of population. That leaves you with only two choices for getting around once you have flown into a gateway city like El Calafate: a bus or private transportation. Private transportation takes long enough (e.g., 7 hours from El Chaltén to Torres del Paine), but the buses can take forever. Fran arranged private transportation for us which, though not cheap, was relatively pain-free.

While in El Calafate we stayed at the Eolo Lodge, which was strongly recommended by Fran. It's located about midway between the town of El Calafate and the Perito Moreno glacier. It's somewhat isolated, but surrounded by beautiful scenery. The hotel is world-class and the food was five-star. It's the sort of place where everyone knows your name within 10 minutes of your arrival. You might also consider Los Notros, which is right across the lake from the Perito Moreno glacier and has a great view, but it's very isolated and relatively small. There are a number of good hotels in town with much more reasonable prices than these two I mention. Everything works as it should and the place is perfectly suited for the international tourists that constitute the bulk of tourism in the area. (My wife was the only Argentine-born guest at the hotels we stayed at.) I would note that the town is a good 45 minutes to one hour by bus from any of the popular tourist destinations, but transportation is readily available.

In El Chaltén we stayed at Los Cerros, the best place in town without question, and not very expensive compared to the alternatives. But there are dozens of smaller hotels and B&Bs, all of which are within easy walking distance of restaurants and the trailheads. We were well advised to take the "easy" trail to the Mirador Torres on the afternoon of our arrival, and the somewhat longer but far more impressive trail to the Mirador Fitz Roy the following morning. Do not miss Fitz Roy!

Our next and final stop was Torres del Paine National Park, which is just across the southern border of Argentina in Chile. You should plan on spending a minimum of two nights here, but preferably at least three, as we did. It's possible to tour most of the park in one very long day via car or bus, but if you want to really appreciate all it has to offer you should also spend at least a day on one of the many trails in the park. We took one of the more difficult trails to the Mirador Torres; it's 22 km roundtrip and about 2400 ft. of elevation gain, most of which occurs in two places—not for the faint of heart. The variety of magnificent scenery around the park (which is quite large, several times the size of Yosemite) is overwhelming. There is no regular telephone service in the park but a few of the hotels offer sporadic internet connections that didn't work while we were there. There are only a half dozen or so hotels in the park, and most are booked for months in advance during the summer season, which starts in November and ends by mid-April. There are numerous campsites however, for the many backpackers that flock to the park. Outside of November-April, you'll find that it is extremely cold and most places simply shut down for the long winter. Ditto for El Calafate and El Chaltén.

Partly because we had no other choice, and partly because of Fran's recommendation, we stayed at Eco Camp, which is considered a "refuge" rather than a hotel. It's an eco-friendly place that gets all its electrical power from a hydroelectric turbine that is fed by water from the mountains above the camp; the turbine is a bit bigger than a garbage disposal. It's a cross between a hotel and a communal camp. Each couple has a separate green geodesic dome (get one with a private bath if you can), and there are three large domes for the store, bar, and eating area. It greatly exceeded our expectations and we had the opportunity to meet quite a few people from all over the world. The price includes all meals and tours/activities. It is situated in a great spot with views of the Torres. Our dome is right behind my head.

If you wanted to create the most efficient travel itinerary, it would probably go like this: fly into Puerto Natales from Santiago, or take a boat from Puerto Montt; transfer by bus or car to Torres del Paine; transfer from there by bus or car to El Calafate; transfer by bus or car to El Chalten; return to El Calafate; fly from El Calafate to Buenos Aires. But no matter how you cut it, you will be spending many hours going by land from one place to another. Let someone like Fran help you figure out what works best for what you want to accomplish.