Blowing Bubbles
For now, the earnings narrative dominates the market. All the big-picture items seem not to matter. Unemployment? Who cares? Debt and deficits at every level of government? Whatever. Companies are turning in good profits and the market is uncorking the champagne.
There are reasons to be careful, which I’ll get to.
First, on the face of it, we’ve had a great run. The S&P 500’s fourth-quarter earnings, at the halfway mark, were 17% ahead of last year’s. Importantly, sales were up 9%. So this is no longer a story of cost cutting. Most everyone is doing well, save utilities and health care companies, which have reported declines in profits as a group. Mining and energy companies are doing especially well, with profit growth north of 40%.
The media don’t get how this earnings picture squares with stubbornly high unemployment. I talked to one reporter recently about this very thing. One simple reason for this disconnect is that some of the best sources of profits for many of these firms has been from overseas operations. Many US firms are still cutting jobs, like Boeing and Lowe’s. Profits from emerging markets, meanwhile, grow apace.
There are bright spots in the US, too, of course. US manufacturing is getting a boost. Caterpillar will spend $3 billion this year in capital expenditures to add capacity, more than half in the US. And Emerson said it expects US nonresidential investment to grow 8-9%. Eaton, another US manufacturer, actually said it expects its US sales to grow faster than its overseas operations.
US new vehicle sales were up 17% in January. We’re at a run rate of 12.6 million vehicles, much better than the 10.8 million run rate of a year ago, but well off the 16 million automakers enjoyed pre-crisis.
So it’s a bit of a muddled cherry. As always, you have to pick your spots, which is what we’re all about.
A fly in this whole whiskey sour is inflation.
It’s definitely here and it’s having an impact. Rising costs are squeezing some manufacturers. Whirlpool, for example, said it would boost prices 8-10% to cover rising raw material costs. This sort of thing is rippling across all sectors. Prices are going up everywhere.
Nalco Holding (NYSE:NLC), a world leader in water purification, recently reported disappointing earnings, largely due to rising raw material costs. The stock sold off on the news.
But looking out longer term, the world’s need for clean water only grows more acute. Despite the short-term effects of rising raw material costs, Nalco ought to be able to grow core profits at double-digit percentages for years to come. It is a very strong company that generates a tremendous amount of free cash flow – $185 million last year, to be exact.
So if companies as robust as Nalco are feeling the effects of rising prices, run-of-the-mill companies across the country must also be feeling the effects.
In fact, I was fascinated recently by a story in The Wall Street Journal titled, “Fearing Inflation, Firms Stocking Up.” The story talks about how companies are stockpiling rubber tires, cotton clothing and other goods to insulate themselves from inflation.
Anecdotally, McCormick stockpiled some ingredients for its spices, Anton Sport bought more fabric than it needed, and Monro Muffler bought extra tires and oil.
These purchases are still a small part of overall purchases, but it’s a new trend and something we haven’t seen in years. For most of the last handful of years, companies tried to shed inventory, not carry it.
But what these actions essentially say is that these firms would rather hold real things than cash.
I think we’ll see more of the same. While inflation is here and everyone seems to see it, the central bankers of the US and Europe seem unconcerned. Of course, they have every incentive to continue to let the money presses run.
According to economists Joshua Aizenman and Nancy Marion, inflation did half the work of cutting US government debt from 122% of the economy to 25% from 1945-1973. So with the US government saddled with debts it can never repay, the way out is to debase the currency. Let those printing presses hum and keep interest rates low.
Of course, such money printing also puts in motion great monetary accidents. As the old Austrian economists warned, the new money stimulates investing, but it creates an illusion. It’s like giving off signals that there is plenty of gas in the tank when, in fact, it’s nearly empty.
These easy-money policies helped create the great housing bubble. And the easy-money policies today will create a big bubble somewhere else, which will turn into tomorrow’s bust.
Regards,
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