'Tis Only My Opinion!

August 2003 - Volume 23, Number 8

Is "Muddling through" the best we can do?

Earnings are increasing but future guidance is less than rosy!

As the last week of July comes to a close, companies reported better than expected earnings based upon the downward revisions done at the beginning of the quarter.

At the beginning of this year, earnings for the second quarter were expected to increase by 8% but at the beginning of the 2nd quarter, analysts revised that initial forecast downward to about 5%.  So now, cheers are being heard throughout Wall Street and the Beltway because second quarter earnings are showing an increase of about 6.5%.  Well, gee whiz!

During the first quarter, corporate profits benefited from energy prices and in the second quarter, the falling dollar enabled corporations with extensive foreign operations to show increases as the dollar fell in value.  Since January 2002, the U.S. dollar index has fallen from 121 to 96, or a drop of about 21%.

The real earnings picture may be very different as earnings from operations in the U.S. generated by revenue growth is at best neutral, and probably, slightly negative.  A quick review of Caterpillar and Coke shows the extent to which both of those companies benefited from the fall of the dollar. 

Based upon the abnormally low base from which earnings had fallen, is it any wonder that with all the employee layoffs, benefit reductions, and out-sourcing that earnings increased.  What is troubling is that top-line revenue growth is barely holding even and is falling for many companies.

Merger activity is beginning to increase as companies with connections or strong balance sheets are looking to pick up operations being shed by corporations such as GE that are trying to rediscover their core operations.  The second quarter also saw a slight pickup in venture capital funding but it is still only a pittance of the levels seen in the go-go years.

As we go forward and try to ascertain the outlook for the second half of 2003, there is a disagreement between corporate officers and the analysts and economists on the outside looking in.  Corporations for the most part are very reticent about future sales growth and earnings projections.  On the other hand, the Wall Street crowd and those in the Beltway are trumpeting the effects of the tax cut, the drop in interest rates, and a major increase in liquidity as factors that will interact to move the economy out of the doldrums.

As the chart above shows, corporate profits peaked in 1997.  Even with the current optimistic forecast for the second half of 2003, it is highly unlikely that total corporate profits will exceed $825 Billion.  Yet the market continues trade at valuation highs that are in excess of the levels seen prior to the March 2000 peaks.

At the moment, we only have the revised data for the 1st quarter of 2003.  Per the Bureau of Economic Analysis, the gains in the first quarter were the result of increased interest rate differentials enjoyed by financial corporations.

Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $20.4 billion in the first quarter, according to revised estimates.  In the fourth quarter, profits increased $25.1 billion.  Current-production cash flow (net cash flow with inventory valuation and capital consumption adjustments) -- the internal funds available to corporations for investment -- decreased $4.0 billion in the first quarter, in contrast to an increase of $14.0 billion in the fourth.

Domestic profits of financial corporations increased $15.9 billion in the first quarter, compared with an increase of $0.3 billion in the fourth.

Versus the 4th Quarter of 2002, corporate profits decreased by $4 billion.  At the current rate, it looks like the 2nd Quarter corporate profits might barely exceed last years 4th Quarter. 

Who would you rather believe . . . the people looking at the incoming order book or those trying to guess about it?


Watch out for Monkey Wrenches in the Auto Industry

  The auto industry accounts for about 1.2% of total US GDP.  However, it accounts for about 15% of durable goods manufacturing revenue.

During the next month, the automobile industry will undergo labor negotiations with its union.  Based upon the level of unsold cars and the excess capacity in the industry, contract talks are likely to be prolonged and could result in a strike against one or all three companies.  Ford and General Motors have both indicated that the "guaranteed wage" clause in the existing contract must go and they also expect relief on fringe benefits and pension clauses.  It is highly doubtful if the union will accept these terms willingly.

The following chart shows the share of the U.S. market held in the first 5 months of 2002.  The current numbers are not significantly different.

With the over-capacity of the automobile industry throughout the world, a recent report on the automobile industry suggested that there were at least 19 plants in the U.S. that could be closed if a strike occurs.  Their production could be out-sourced to lower cost plants offshore.

But the problem is not just with the U.S. manufacturers like Ford and General Motors.  Volkswagen has laid off 4,000 workers in Mexico as demand for its Jetta and VW bugs has waned.  European car makers are also reducing production schedules as sales in Europe and elsewhere have fallen.


  • DaimlerChrysler had a 90% drop in second-quarter net profit and operating profit fell 62%
  • Sales of Mercedes luxury cars fell 5% in the quarter
  • Mitsubishi (DaimlerChrysler owns 37%) forecast $674M net loss US sales down 20% in six months to April 30
  • PSA Peugeot Citroen operating profit in auto division down 27% in first half
  • Ford 96% drop in operating profit and $525M loss at Ford of Europe
  • GM Operating profit in auto division fell 87% as US price war gutted North American profit and its European unit lost $3M
  • Renault SA's first-half net profit rose 32%, but only because of its 44% stake in resurgent Nissan Motor Co
  • Renault's underlying operating profit fell 36%
  • Volkswagen reported a 49% drop in net profit during the second quarter and operating profit for the full year will be "significantly" below 2002 earnings
  • In North America, Volkswagen sold 160,000 cars in the second quarter, 10% fewer than a year earlier

Sourced from: The Wall Street Journal, July 25--28, 2003

The auto industry labor negotiations could be a nasty monkey wrench for the economy this fall.


Is the Technology sector going to improve?

Many investors make the fatal mistake of looking in the rear-view mirror when it comes to the world of technology.  In the 1990's, most investors considered technology to be largely information technology or digital driven products.  While the Microsoft's, Cisco's, Intel's, Nortel's, Alcatel, and many others were huge successes, the major growth for these firms is probably over. 

The overcapacity in the telecom industry along with the fast expansion of capability in chipsets has only succeeded in driving prices and profits for many companies in these sectors lower.

Yet, technology encompasses a much wider spectrum.  Battelle Institute has recently released its forecast of the top 10 Technologies in 2005. 

Battelle's  Top Ten strategic technologies by 2005, in order of importance:

  • 1. Human genome mapping and genetic-based personal identification and diagnostics will lead to preventive treatment of diseases and cures for specific cancers.
  • 2. Super materials. Computer-based design and manufacturing of new materials at the molecular level will mean new, high-performance materials for use in transportation, computers, energy, and communications.
  • 3. Compact, long-lasting and highly portable energy sources, including fuel cells and batteries will power electronic devices of the future, such as portable personal computers.
  • 4. Digital high definition television. This important breakthrough for American manufacturers — and major source of revenue — will lead to better advanced computer modeling and imaging.
  • 5. Electronic miniaturization for personal use. Interactive, wireless data centers in a pocket calculator-size will provide users with a fax machine, telephone, and computer capable of storing all the volumes in their local library.
  • 6. Cost-effective "smart systems" will integrate power, sensors, and controls. They eventually will control the manufacturing process from beginning to end.
  • 7. Anti-aging products that rely on genetic information to slow the aging process will include aging creams that really work.
  • 8. Medical treatments will use highly accurate sensors to locate problems, and drug delivery systems will precisely target parts of the body — such as chemotherapy targeted specifically to cancer cells to reduce the side effects of nausea and hair loss.
  • 9. Hybrid fuel vehicles. Smart vehicles, equipped to operate on a variety of fuels, will select the appropriate fuel based on driving conditions.
  • 10. Edutainment. Educational games and computerized simulations will meet the sophisticated tastes of computer-literate student

As one looks at the list, it is obvious that investors' fixation on the technologies that were important in previous years is dangerous.  While those technologies may well be utilized in these arenas, the forward-looking investors will be focusing on stocks that can benefit from developments in Battelle's list.

Even though the forecasts from many technology companies is less than enthusiastic, they do show that many expect some minor improvement in the second half of 2003.  However, from a fundamental point of view, the current rally in the NASDAQ is probably not justified on the basis of earnings valuations. However, as I have stated many times, markets are driven by emotion, not facts.

The technology sector will continue to provide the "juice" in the markets in the next few years. However, the real gains will probably not come from the semi-mature sectors of the previous decade.


The Agribusiness sector is still important.

There are two major trends, besides weather, that continue to affect the profitability of  agribusiness, the nation's largest economic sector and the one most people take for granted.

Ask almost any child in an urban school where milk and eggs come from and the answer is the "grocery store."  In less than a century, we have gone from a society where 80% of the population worked in agribusiness to one where today's farmer feeds about 150 people.  Three factors are primarily responsible for this accomplishment:

  • productivity gains from equipment, 

  • seed genetics, and

  • an improved distribution system.

The first major trend that will affect agriculture in the future is that the average age of the family farmer continues to increase. At the same time, economies of scale require that farms increase in size in order to break-even.  The risk/reward ratio for many farm children is far greater in other fields.  While the burden of estate taxation has been reduced somewhat under the recent tax bill, the family farmer is basically doomed in the next decade as large-scale corporate farming and contract farming takes over.  The limitations on farm payments also will accelerate this trend.  With the estate tax decrease not permanent as well as the lowered capital gains taxes now in effect, many older farmers are in the process of selling out.  This is a trend that should grow in the next two years.

The second major trend is the continued expansion of governmental regulations and reporting requirements.  OSHA and the EPA as well as the USDA have all created a nightmare of regulations that most farmers find to be not only a nuisance but totally idiotic.  Today's bureaucrats often have little comprehension of agriculture. They propose policies to change farm practices to conform to "ivory-tower and green party" advocates who often have never worked on a farm for other than a few summers. 

At a recent meeting, an environmentalist was urging the adoption of a soil-preservation practice that had been discarded 60 years ago as unworkable and wasteful.  The youngster was amazed that his "pet theory" had holes in it. Yet, it was embodied in 40 pages of USDA regulations that thankfully was tabled for further discussion.  To think that farmers would destroy the land on which they lived and from which they made their living is a concept that many environmentalists and today's college graduates unfortunately have.

During the past ten years, the mid-western states have lost many young farmers who have moved to Argentina and Brazil because of the lure of cheap land and less regulation.  They are able to produce products at significantly lower costs to compete with U.S. products.  In fact, the U.S. taxpayer through the World Bank and the Export-Import Bank is making long-term loans to improve the infra-structure of these South American countries to make them even more competitive.  Talk about shooting one's taxpayer in the foot.

The final problem facing agriculture is the old bugaboo of weather.  In many sections of the Corn Belt and elsewhere, weather is beginning to take a toll on crop production this year. The slide of the dollar still has not seen a major increase in agriculture exports.

The following Drought Indicator chart shows the current weather situation.

As the map shows, the west is becoming increasing dry.  This will largely impact the grain and fruit crops in the west, range and forest land, and the crop producing area of Oklahoma, Colorado, Kansas and Nebraska. Cotton and grain crops in West and North Texas may also be impacted.  In parts of Illinois, Indiana and Ohio, as well as the Southeast, the problem is too much rain which is also reducing crop potential.


Are foreigners beginning to bail out of the U.S. Dollar?


While many holders of U.S. debt have a major stake in the value of our currency because they receive that currency as payment for goods shipped here.  If they don't accept our currency, then these countries will find themselves without markets for products which keep many of their citizens employed.

The King report has the following in today's issue:

Reports say Japan has sold a record amount of yen from January to July in an effort to keep the yen from appreciating against the dollar.  Due to China’s dollar peg, Japan cannot afford to allow the yen to appreciate against China’s currency because it would import even more deflation from China.  PS – Reports say Toyota’s Q1 earnings might fall 43.6% because of the stronger yen.

In an earlier report from the Bank of Japan this year, they admitted to spending $40 Billion of U.S. dollars before May in holding down the yen, I wonder what the total is now.  As the King report states, the Japanese and likewise many other Pacific Rim countries have a major problem with the Chinese yuan being pegged to the American dollar.

The European Central Bank on July 10th suggested strongly to their members that they reduce substantially their holdings of Fannie Mae and Freddie Mac bonds.  Is this just the start of the avalanche? Perhaps, it was also a partial reason for long-bond rates increasing over 100 basis points since mid-June.  The Fed can control the short-end of the yield curve but the long end is more difficult.

As we have said, when you add the current federal deficit in the range of $500 Billion and a current account deficit of $500 Billion or more this year, the willingness of foreign investors to continue to pile up U.S. Dollars when they have dropped about 20% in value during the last 18 months becomes increasingly doubtful. 

The Fed has basically only one choice . . . "Inflate or Die." 


But what if it doesn't work!

The economic numbers which are coming out today indicate a slight pickup in economic activity.

The good news about GDP growth, initial jobless claims, employment costs, Chicago's PMI manufacturing index and the help wanted index were enough to send the market up to gains close to 2% by 11 a.m. EDT. However, worries about the 10 year bond yield rising to over 4.5% on an intraday basis sent the market cascading lower in heavy volume during the last hour. The 10 year bond closed yielding 4.4% or an increase of about 130 basis points since the middle of June. Bond investors have seen a major downward readjustment of their portfolio values during this period.

The rise in interest rates has caused derivative traders a few sleepless nights.  The credit risk committees in many institutions have to be evaluating the potential damage to the balance sheets and future income statements with concern.

The change in withholding rates, the taxpayer relief checks and the refinancing boom are now in play.  Whether the consumer will continue to carry the economy remains to be seen.

During the past six months, refinancing has been a huge impetus to consumer spending. Yet when all is said and done, GDP only increased 2.4% and the bulk of that increase was accounted for by defense and other governmental spending.

The Fed is walking a high-wire and hoping that the mix of liquidity, tax cuts, consumer spending and government deficit spending will prevent the economy from sliding into a recession, or heaven forbid, a depression.

Of course, they also run the risk of stagflation and/or hyperinflation.  Richard Russell, the old sage of Dow Theory, is so concerned about the ability of the Fed and the Treasury to perform a miracle that he has sold all his bonds and booked his profits.  Maybe you should too. 

In a previous article, we mentioned the possible future deficits facing the American taxpayers which could amount to $44 trillion or more (Social Security, Medicare & Medicaid as well as various other governmental pension programs).  At the moment, our GDP is only $10.5 trillion.  It seems hard for me to fathom how we can meet these obligations in the future without destroying our currency. 

This is what happens when Congress refuses to understand economics and hands out benefits like the current drug benefit being discussed for senior citizens without the tax revenue to pay the bills.  Perhaps, they will buy the votes of our seniors but in the process, they will have destroyed a country.


So what are your alternatives.  It should be obvious that tangible assets rather than paper assets are the preferred investment vehicles in the current environment.  With the money supply continuing to increase at over 7% annually, something is going to give.  Should you place a portion of your portfolio in currencies of other nations like the Euro, the Chinese yuan, or the Singapore dollar, you might be able to protect yourself from a falling U.S. dollar. 

Of course, you might also invest in assets such as farms, another home, commercial property, art and/or jewelry to offset the destruction of paper assets.

Another alternative is gold and silver stocks and/or bullion.  Richard Russell recently said that before this bear market is over, gold and the Dow would meet at around the 3,000 level.  While I don't necessary hold that conviction, Russell's predictions as well as Teddy Butler-Henderson's suggest that the price of gold could rise significantly.

For unlike others, until more facts are in evidence, the economy is still in a "muddling through" mode.  The equity markets are just having another rally in a secular bear market while the bonds are on the path to major losses as interest rates move forward at the long end.


But then - 'Tis Only My Opinion!

Fred Richards
August 2003

Corruptisima republica plurimae leges. [The more corrupt a republic, the more laws.] -- Tacitus, Annals III 27

This issue of 'Tis Only My Opinion was copyrighted by Adrich Corporation in 2003.
All rights reserved. Quotation with attribution is encouraged.
'Tis Only My Opinion is intended to provoke thinking, then dialogue among our readers.

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Last updated - July 6, 2008