Research + Forecast USA Corporate Profits, Dow Jones Index

MARCH 27, 2009 RECOMMENDATION: STAY IN/ STRONG BUY

We recommend to stay invested in the Dow Jones Industrial Average Index (DJIA) until the next quarterly update at the end of May 2009. For those still in cash we suggest a Strong Buy at the current levels.

The Next Quarter’s Outlook

The updated value of our proprietary Business Cycle Index (green line on the charts above) is at the highest level in its 60 years history pointing to a very favorable environment ahead for the USA stock market. We recommend to "Stay In" the market or “Strong Buy” for those who are still out of the market, subject to inherent predictable and unpredictable risks always requiring appropriate risk management.

The Corporate Profits may be lagging the stocks but the foundations of the next big cyclical upswing have been building up. The next market recovery should be a strong V-shape.

Please keep in mind that our quarterly proprietary macroeconomic model does not deal well with sudden man-made stock market crashes that by themselves can cause decline in corporate profits. Stock market crashes are expected and have occurred during almost half of the past ”Out Periods”. This time, the major crash happened during an “In Period” which shows limitation of the model. It is only one of the tools to use when making an investment decision.

The “In Periods” identified by the proprietary formula have been historically characterized by solid and consistent returns underpinned by favorable macroeconomic fundamentals such as stronger Corporate Profits growth.

The “In Periods” delivered annualized 20% ungeared return over 60 years history including the last 5 years of actual results (see Performance record).

The Charts above illustrate recent performance until March 27, 2009. Next quarterly update is planned for the end of May 2009.

Review of the Past Quarter

The Fourth Quarter’s 2008 US NIPA Corporate Profits announced in March 2009 by the USA Government at www.bea.gov Table 6.16.D fell -16.5% on previous quarter, due mainly to drop by -59% in the Financial Sector’s Profits. The Non-Financial Sector’s Corporate Profits fell only by -10.7%. Our earlier optimism was premature.

Dow Jones, S&P500 and all global markets have been extremely depressed reaching new lows from the October 2007 peak and erasing 12 years of gains. No individual stock was safe in such environment; not even the strongest businesses with no debt and growing earnings – everything across the board was hammered. Diversification did not help and spreading equity investments internationally only made things worse. The only safe haven was cash, gold and bonds when interest rates were falling.

In times like this we learn to appreciate that “buy & hold” or “long only” investment strategies, that worked in the falling interest rates environment over the last 25 years, are not suitable for the future.

The chart from http://www.businesscycleinvestor.com/methodology.htm tells the story:

Future will see flat or rising cyclically interest rates that will suppress the average market performance like it did during the 1954-1982 period. Fortunately, the future stock market should still be cyclical and only picking or timing the market should have a chance of delivering superior returns.

Lehman Brothers collapse on September 15, 2008 triggered the second leg of the 2008 Stock Market crash that “we did not have to have” and a global “Great Recession”

Looking back, it becomes clear how critical was the Treasury Secretary Henry Paulson‘s and Fed Chairman Ben Bernanke’s decision to let Lehman Brothers go bankrupt with $613 billion debt - the biggest bankruptcy in history. It led to a global credit shutdown almost overnight, triggered a global “Great Recession” and global stock markets crash. The justification for the decision to let Lehman Brothers go under, while rescuing everybody else at the same time (i.e. AIG, Freddie Mac and Fannie Mae, Merrill Lynch) remain to be analyzed by the research community. Surprising is also the timing of the decision: only two months before the November 2008 USA Presidential Elections which saw the back of the Republicans and President George W. Bush.

Only the rushed $700 billion Paulson’s rescue package approved by Congress on October 3, 2008 stopped the avalanche that was crashing the global financial system. For an insightful analysis of the events watch Frontline’s Program “Inside the Meltdown”.

Bloomberg noted how highly interdependent are the major financial institutions: Bear Stearns refused to contribute to the 1998 bailout of Long-Term Capital Management (LTCM). In turn, Merrill Lynch and Lehman Brothers pulled the plug on Bear Stearns in March 2008. By September 2008, Merrill Lynch was forced to merge with Bank of America and Lehman Brothers was bankrupt.

The critics of government rescues should look at such events carefully as the risks are real and consequences can be harsh. Our News page at www.BusinessCycleInvestor.com/news.htm has a chronology of the September 2008 events. Also Fed has a website tracking The Financial Crisis – A Timeline of Events and Policy Actions.

New Obama Administration commits “all it takes” to rescue the financial system and the economy

The new President Barack Obama and his Treasury Secretary Timothy Geithner together with Fed’s Chairman Ben Bernanke, have demonstrated a total commitment to do “whatever is necessary” to restore the credit markets and to restart the economy. They are certainly taking all the steps and using all tools available to the Government toward that goal in concert with the Federal Reserve Bank and most foreign governments. These are the only entities that can legally create money out of nothing by making an accounting entry in their books and such commitment is what really matters. Even if they get the numbers wrong, they can always stimulate more or reverse the stimulus if necessary. Our News page has details of the main unprecedented stimulus packages announced over the last few months.

The total capital lent/spent/committed/guaranteed by the Government and Federal Reserve Bank during this crisis exceeded by some estimates a staggering $13 trillion - that’s almost 100% of the USA GDP! Interestingly, the total wealth lost by households is also estimated at around $13 trillion including loss in stocks, real estate and other assets values.

To put the $13 trillion rescue into a perspective: it exceeds the Total Assets of all US commercial banks (currently around $12 trillion) and it equals more then ten times the Total Equity of all US commercial banks (currently at $1.2 trillion). Bloomberg also observes that a lesser amount of $10 trillion would pay out 90% of nation’s mortgages.

The elected decision makers are using a mixed approach in applying the newly created funds and that will determine the ownership structure of the assets once the crisis is over. The size of the rescue suggests there is a lot of risk in the parallel shadow financial system outside the more regulated commercial banks.

The stated intention and actual behavior of the US Government and its Central Bank re-affirms our previous report’s view that this 2008-09 recession should not turn into a 1930s style deep depression. In the 1930s, during recessionary times like we are experiencing today, the Government of the day was letting the banks collapse on mass, there was no fiscal stimulus packages and Fed was rising interest rates and not providing liquidity to the financial system. In a word, a total reverse of what is happening now… with the exception of Lehman Brothers bankruptcy.

We are yet to see a full impact of the already approved Obama’s fiscal stimulus package because most of the expenditure will take place later - closer to the next elections. In that regard, President Obama behaves like any other politician preparing for the next term. Economic problems at the beginning of his first term will be attributed to the previous administration while any improvement towards the end of the term will be his achievement helping to win second term in the office.

In the long term, there will be inflationary pressures resulting from the unprecedented spending spree although Fed has tools to cool it down by taking the cash off the market through bonds sales and by tightening monetary policy. Mr Bernanke believes in inflation targeting, even though Congress does not want him to do that, which effectively means he prefers to use much more aggressive monetary policy in both directions. That earned him a nickname “helicopter Ben” meaning he is prepared to drop a large liquidity from a helicopter if necessary. He will try to cool the inflation threat rather quickly when it appears. In the short term, the focus is on avoiding deflation as a result of a massive loss in the value of assets and growing unemployment.

In search for the market bottom – conventional analysis

Let’s look at some indicators that may signal a bottom. Standalone, they are not always reliable because unpredictable psychology plays a significant role in times of panic.

Improving stability of the housing market could signal a bottom and turnaround because this crisis started with the subprime mortgages collapse.

Here are some of the trends to watch - links to the graphs can be found at http://www.businesscycleinvestor.com/resources.htm:

Mortgage Rates (Bernanke is driving them down by buying bonds) are falling – that is a good sign:

Foreclosures show no sign of flattening yet – that is a negative:

Housing Months Supply is falling – this is a positive sign:

House Prices are beginning to stabilize – that is a positive if the trend continues:

Mortgage Purchase Applications Index has not yet bounced back strongly – that is a negative:

Rising Unemployment, while painful to the concerned, at some stage should signal the next economic GDP upswing. It is hard to say if we are there yet:

Recovering financial stocks tend to lead GDP turnaround. It is unclear if the latest bounce is sustainable:

A flattening and beginning of a decline in Cash on the sidelines is also positive for the stock market:

There are many more “soft” signs watched by the economic experts such as for example sentiment of the professional investors. If almost everybody thinks “this is the end of the world” it is probably a good time to call the bottom of the market. Similarly, if the stock market is rising in response to disastrous economic news because “it was not as bad as expected” it could be also a sign of the bottom.

Bloomberg Global Confidence Index measures sentiment of the professional investors: value above 50 means more than half of the investors expect rising market ahead. The index is low although it has been slightly rising since November 2008 when less than 5% of the professional investors were optimistic:

Of course, the above is not a complete list of indicators to watch.

Whatever is the timing of the recovery, we should anticipate a V-shape not a U-shape upturn, if history is any guide. On the Fed’s chart below USA Payrolls are falling (blue line) during GDP (red line) slowdown (shaded areas), followed by always sharp V-shape GDP recovery at the end of each recession. Stocks usually anticipate the GDP recovery earlier by 3 to 12 months.

The Credit Derivatives Swaps (CDS) Systemic Risk Analysis

President Obama has a good chance of succeeding in reviving the USA economy as long there is commitment to do so. However, there are three major risks:

1. Inadequate coordinated fiscal & monetary policy response to the crisis by foreign Governments and Central Banks,

2. Foreign bond buyers may limit purchases of the US debt that would drive long interest rates higher undermining the stimulus,

3. Underestimated systemic risk related to the highly leveraged Derivatives – Credit Default Swaps (CDS)

The first and second concern does not require much discussion. People make decisions at the end of the day and they can make wrong decisions for whatever reasons. In the interconnected world, the USA efforts need to be supported by synchronized response from major economies to sustain the positive momentum in credit/debt flow, to stabilize exchange rates and the financial system at large.

The third risk is the most serious. Derivatives have been our ongoing concern because the exposures are really large. Yet Derivatives are relatively less regulated, not necessarily properly reported and valued. They are exposed to the risk of counterparty default that even the Governments and their Central Banks may not be able to handle should one of the major banks fail.

An analysis of the Derivatives exposure illustrates the scale of risks involved:

Data from Comptroller of the Currency (OCC) estimates that five banks controlled 97 percent of the total industry amounting to $184 trillion in notional derivatives. That is more than 12 times the USA GDP or almost 6 times the total capitalization of the global stock markets!

Majority 99% of the Credit Derivatives are Credit Default Swaps (CDS). These are highly leveraged debt insurance instruments that relay on stability or better yet growth in the underlying assets values and maintenance of the good credit ratings by the insurers (this 2-part video explains how it works and what makes it risky). One major crack has a potential to take down the whole global financial pyramid like a house of cards. AIG was rescued because it had large exposure to the CDS.

One player, JPMorgan Chase Bank NA, controls $91 trillion, or 49.4% of the Derivatives market - see table below:

The OCC has developed a measure of the total credit exposure of major derivatives players:

The above chart estimates what percentage of bank’s capital is exposed in case of a possible default of its derivatives trading partners. Only Wachovia is exposed to less than 100% of its capital. All other major banks risk exceeds their capital base; in case of HSBC the exposure is 664% of its capital. JPMorgan, holding half of the market share is exposed 400% of its capital base, Citibank 259% and Bank of America 177%.

A collapse of any of the major banks would bankrupt the whole financial system and its current ownership structure although some of their creditors would still survive. That is why bankrupting Lehman Brothers, the fourth largest investment bank and heavy player in Derivatives, was risky and could have wiped out the whole financial system. The situation was only stabilized by the $700 billion rescue package rushed through the Congress in September 2008.

If the credit default swaps are to stay on such a large scale, the only way to avoid a major systemic collapse is through promoting economic growth and continuous appreciation of the underlying assets. The cyclical nature of the markets will always make it a challenge… and an opportunity for market timing investors.

Business Cycle Investor
March 27, 2009

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More information about the research methodology can be found at www.businesscycleinvestor.com/methodology.htm

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USA Corporate Profits & Dow Jones Forecast

Business Cycle Investor