Earnings Aren't What They Used to Be

As Wall Street’s big money players return from the Hamptons in the coming weeks, they will have to reassess the earnings power of their portfolio companies. Last week, Staples confirmed the message we heard from Office Depot and Office Max: the small business sector as a whole isn’t very healthy. Disappointing earnings from Dell dampen the mood even further.

The recent economic data adds to the case that the economy is slowing rapidly. It turns out that Obama stimulus plans didn’t stimulate much of anything except the budget deficit.

Yet despite all we’ve been through, most policymakers and commentators remain confused and frustrated because they’ve misdiagnosed the root causes of the financial crisis. The seeds of today’s economy were sown in the credit bubble of 2000s, which, thanks to government policies and central banks, grew far bigger than it ever could have grown if a free market truly existed.

We’ll hear a lot more from policymakers about how the economy is approaching “stall speed,” implying that it needs another shot of stimulus fuel. They haven’t taken the time to consider how the original stimulus plan might have undermined the economy’s foundational strength. The economy is not a machine to be tinkered with, but a complex, uncontrollable entity that seeks to allocate capital to its most needed uses.

The endless stream of Washington’s tone-deaf policies makes it almost impossible to plan. Growing regulatory burdens for small businesses is a huge problem for the labor market. I’ve heard from a half dozen sources in the past few weeks about soaring premiums as health insurance plans come up for renewal. Thanks to the mandates in the newly signed healthcare law, premiums will keep rising. The law had the effect of increasing the cost of hiring new employees, so we shouldn’t be surprised that layoffs still exceeding new hiring – even this far into “the recovery.”

As much as I’d prefer a return to smaller government – for the sake of our economy’s long-run health and competitiveness – here’s what I expect to happen: further weakness in GDP, employment, and the stock market will reduce the political momentum behind fiscal responsibility, and sometime in 2011, we’ll have another stimulus plan. Maybe it’ll come in the form of extension of the Bush tax cuts, with a political compromise resulting in rebate checks or payroll tax holidays for working class voters who aren’t paying much, if any tax as it is.

Perhaps, as a flanking maneuver in its war on deflation, the Fed will finance these checks with the printing press. Further quantitative easing in the bond markets to suppress the long end of the yield curve is nothing but a giveaway to the big banks’ trading desks and a subsidy for government borrowing costs. So the Fed is probably thinking about ways to more effectively get newly printed money into the hands of consumers. But the Fed needs to be very careful about such novel, creative ways to steal from savers. It could spark a crash in confidence in the US dollar. It’s a giant game of chicken, and it’s dangerous.

But I doubt there will be much political support for these tactics until conditions in risk assets – stocks, corporate bonds, and housing prices – get much worse. I doubt that the average voter realizes what the economy would look like without the federal deficit running continuously at 10% of GDP, like it will this year. On the other hand, a slashed deficit would be extremely painful for every single household and business – even those that have behaved responsibly – because it would translate into less business sales, less desire to hire, and lower household income.

This is why you shouldn’t get the economy addicted to harebrained schemes cooked up by economics professors in the first place. The professors espousing Keynesian stimulus are like street corner drug dealers, and they have the economy hooked to their product: stimulus injections.

As a result, the economy is still unable to produce legitimate economic growth or sustainable job creation. US stocks remain a very risky asset.

Dan Amoss
for The Daily Reckoning

The Daily Reckoning