The Daily Reckoning PRESENTS: It's nearing Fall 2003... and
economic indicators are promising. Will this year usher in
the fabled second-half recovery, after all? Alas, the devil
is in the detail.
WAITING FOR GODOT
by Kurt Richebacher
"There is no means of avoiding the final collapse of a boom
brought about by credit expansion. The alternative is only
whether the crisis should come sooner as a result of the
voluntary abandonment of further credit expansion, or later
as a final and total catastrophe of the currency system
involved."
Ludwig von Mises,
Human Action, A Treatise of Economics,
Yale University Press, 1949
Once again, we are treated to the vaunted "second-half
recovery" mantra from the mainstream financial press. Could
it be that this year we will finally have our cake and eat
it, too? For the benefit of long-time Daily Reckoning
readers, we will cut to the chase and dispense with all
illusions of suspense: in reality, the U.S. economy is in
recession, as reflected in the dismal employment
performance.
Pointing to the various statistical adjustments in the
price indices that substantially boost America's real GDP
growth, we have argued ad nauseum that the reported U.S.
growth rates grossly overstate the reality in comparison to
other countries.
Of course, it is nevertheless always possible that the
economy is embarking on a strong, solid recovery, as
predicted and widely expected. The bullish consensus draws
its optimistic assessment largely from the belief that a
sufficiently strong policy stimulus is now in place and
partly from some better-looking indicators.
As to the first assumption about policy stimulus, we can
only express our utter amazement. It flatly ignores the
extremely poor economic effects of the even more prodigious
monetary and fiscal stimulus of the past two-and-a-half
years. To us, this recent experience really forbids any
optimism in this respect about the future.
Assessing the U.S. economy's prospects essentially begins
with two crucial questions: first, will businesses start
hiring and investing again pretty soon? And second, will the
consumer be willing and able to keep up his borrowing and
spending binge? Please consider that one month of the second
half of the year is already behind us.
Looking for the recovery, it strikes us in the first place
that the second quarter was no better than the first
quarter, if not weaker. Production posted gains of 0.1% in
May and June. But it decreased at an annual rate of 3.2% in
comparison to the first quarter.
The central assumption behind the consensus' U.S. recovery
forecasts is an incipient, strong revival in business capital
spending. In actual fact, it is absolutely indispensable that
it materialize very quickly.
Since any sign of higher investment spending or even of
higher production is so far completely missing, we have to
look for early indicators. There are modest improvements in
survey indexes, generally considered as leading indicators,
but there is no trace of it in the hard data, reflecting
current facts.
Capital goods orders and shipments, in our view the best
proxy for investment spending, remain stuck in virtual
stagnation. In fact, 'core' orders for capital goods
excluding defense and aircraft dropped 0.4% in May,
following a 2.8% decline in the month before. New orders for
machinery were 4.3% below their level a year ago, and among
those, orders for computers and electronic products were down by
9.6%.
However, the bullish consensus argues that the necessary
conditions for the investment revival - above all, higher
profits, higher cash flow and stronger balance sheets - are
developing.
It is generally agreed that a strong rebound in profits is
the key condition for a solid and sustained investment
recovery. Aggregate after-tax profits of nonfinancial
corporate business, as measured by NIPA, were $197 billion
in 2002, even lower than the $205.3 billion in the
recession year before. Yet they improved in the course of
the year. But as it is so often, the devil is in the
detail.
The fact is that profits have been and continue to be
heavily inflated by special factors. We note: first, big
'inventory profits' deriving from rising oil and commodity
prices; second, big gains from financial activity and
speculation; third, big currency gains by foreign
subsidiaries of U.S. firms; fourth, an unusually large rise
in the profits of foreign firms in the United States; and
fifth, continuous, heavy underfunding of pension fund
obligations.
If the poor profit performance needs any further proof, it
is in the unfaltering 'earnings-management game.' Despite
the condemnation of past accounting tricks, the familiar
tricks to make profit numbers look better than they are
have remained in rampant use. A common ploy is to report
fictive 'pro forma' profits; another is to measure them
against deliberately reduced 'expected' profit. For
example: the reported profits of Apple Computer topped
expected profits by a whopping 67%. In actual fact, they
had fallen 41%.
Whenever we read of better-than-expected profits, we
presume cheating. Such reports often lead to the systematic
delusion of investors. Yet no one protests; instead, they
follow after the delusion in the hope that it will mean
higher stock prices. Economic reality is too unpleasant to
be faced with open eyes. But for people with a bit of
common sense, this method of comparison is completely
arbitrary and meaningless.
It seems, of course, a fair assumption that a solid second-
half economic recovery will not fail to buoy profits. But
first of all, we do not believe in this recovery, and
second, we fail to see the micro and macro adjustments that
are necessary to improve profits.
As we have stressed many times, our own assessment of
profit prospects is strictly determined by focusing on the
particular flows of business revenues and expenses that
generate business profits. Based on this analysis, we see
nothing that speaks for substantially higher profits. There
is a great risk to profits in a probable, prolonged rise in
personal saving from current income. A possible boost may
come from the rising budget deficit.
Regards,
Kurt Richebacher,
for The Daily Reckoning
P.S. Poor profit prospects are not the only reason we are
unable to see a solid, sustained investment recovery in the
United States. General financial viability, measured by
various financial indicators, is another indispensable
condition.
How robust are American company finances? The short answer
is that balance sheets are not a picture of health. What's
more, whether they are improving or deteriorating remains
an open question. We believe in the latter eventuality; at
best, there has been very little recent improvement.
In the frantic pursuit of higher stock prices, American
managers in the past few years have systematically
devastated the balance sheets of their companies. Financial
damage that took several years to build up cannot be
corrected in several quarters.