Earnings And Recessions

Credit WritedownsBianco: An 1100 S&P would look expensive if we have a recession Economists are telling us that the economy is decelerating rather quickly. What does that mean for stocks, in either a recession or no-recession scenario? Jim Bianco was on Bloomberg Television yesterday with some insightful comments about stock valuations and economic cycles. Bianco told Bloomberg that he believes the likelihood of recession in the US is greater than 50%. To his mind, this means getting defensive. What I found most compelling in his analysis was how he looked at consensus earnings estimates and what impact this could have on valuations.He said:Valuations look very good under one assumption – that the current estimate for earnings is going to become reality. If we have a recession or anything close to recession, history shows us that Wall Street can not only miss earnings when we have a recession, but be way off on earnings; 25%, 30%, 35% is not uncommon of a miss when we have a recession in earnings. So all of a sudden, an 1100 or 1150 S&P that looks cheap now might be expensive if we have a 30% hit on earnings. Credit WritedownsOn recessions and earnings volatility After posting the Jim Bianco article on getting defensive, I traded e-mails with Jim on recessions and earnings volatility. Here’s what he had to say after I showed him the article:
I saw it, the link Tyler had in the comment section from the FT was equally interesting. Mackintosh said the same thing, namely if earnings fall 40% over estimates, like they did in 2008, the market is overvalued. I would finally add that I think the market knows all this. It understands if we miss a recession then stocks are cheap as they can hold the cyclical earnings peak. If we have a recession, then stock are expensive. This is why the major averages gyrate around with huge volatility, the extreme binary outcomes feed into this belief.
The link Jim is referring to was a 5 minute clip from FT investment editor James Mackintosh from late August in which Mackintosh talks about the forward P/E ratio. While I never look at forward P/Es because they are misleading, Mackintosh is on to something in that video. Stocks are not cheap if you use a Shiller P/E which is a rolling average of past earnings. And this has been true since 2009. Comment
We detailed this entire conversation last month:
The first chart below shows S&P operating earnings (red line) and their 12-month forward forecasts  shifted ahead 12 months to the month they are predicted to happen.  The second chart shows the difference between the forecasts and actual releases.  The shaded areas highlight official recessions. Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession. During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%.  Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. During the 2000/2001 recession, top-down forecasters were too optimistic by 25%.  Bottom-up forecasters were too optimistic by 23%. During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%.  Bottom-up forecasters were too optimistic by 40%. Also notice the difference between the top-down and bottom-up forecasts.  Current strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.

What Does This Mean?

If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong. They might be so wrong that one can make the case that the market might be overvalued. We believe this is part of what is bothering the markets, the epiphany that the economy is much weaker than expected and a recession will blow a hole in earnings forecasts to the point that the market might not be cheap anymore.

Source: James Bianco, Chief Executive Officer, Bianco Research, LLC, September 14, 2011

Recessions: Historical Earnings Forecast Errors

Source: Bianco Research (shaded areas = recessions) > Here is a question worth considering: Is Wall Street setting itself up for another huge Earnings miss? Consider the chart above, and the differences between Wall Street forecasts and actual quarterly earnings from 1985-2011. Jim Bianco notes that “Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession.” Consider the prior significant earnings misses:
• 1990/1991 Recession: Top-down forecasters (strategists) were too optimistic by 10%. Bottoms–up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. • 2000/2001 Recession: Top-down forecasters were too optimistic by 25%. Bottom-up forecasters were too optimistic by 23%. • 2007/2009 “Great Recession” top-down forecasters were too optimistic by 39.6%. Bottom-up forecasters were too optimistic by 40%.
Both strategists and Analysts seem to be getting significantly worse at predicting earnings. The significance of this is what might happen if the economy slips into recession: In the event that occurs, present earnings forecasts for 2012 of $112 might too high by as much as 20% to 40%. Hence, why a recession driven earnings contraction supports much lower equity prices. Are markets cheap? The correct answer is it depends on the economy and earnings over the next few quarters . . .

Guest Post: Land Of The Setting Sun

Submitted by Jim Quinn of The Burning Platform Land Of The Setting Sun The linear thinkers that dominate the mainstream media and the halls of power in Washington D.C. are assessing the series of disasters in Japan without connecting the dots of history. Their ideological desire to convince people that things will go back to normal in short order flies in the face of the facts. It makes me wonder whether these supposed thought leaders lack true intelligence or whether their ideological biases convince them to lie. At the end of the day it comes down to wealth, power and control. If those in power were to tell the truth about the true consequences of demographics, debt, disasters, and devaluation, their subjects would revolt and toss them out. Before the multiple disasters struck Japan last week, the sun was already setting on this empire. The recent tragic events will accelerate that descent.

Japanese Beetle Meet Windshield

Smart financial minds have been expecting a Japanese economic tsunami for the last few years. John Mauldin described Japan’s predicament in early 2010:

“I refer to Japan as a bug in search of a windshield. I am not so sure about the timing, however, as the economic and fiscal insanity that is Japan may be able to go on for longer than many think possible. But to me it is not a question of whether there will be a crisis, but when there will be one. This year? 2011? 2012? I doubt Japan makes it to the middle of the decade with a very serious and sad day of reckoning.

The downside to the continuation of running massive deficits is that when the break does come, it will be all the more painful and difficult to deal with as the debt mounts. If there is an upside, it is for the rest of the world to see what can happen to a developed country like Japan when massive deficits are allowed to pile up one after another. It will be a morality play writ large upon the walls, which cannot be dismissed.”

Ambrose Evans-Pritchard expected a 9.0 debt earthquake to strike Japan in 2010:

“Weak sovereigns will buckle. The shocker will be Japan, our Weimar-in-waiting. This is the year when Tokyo finds it can no longer borrow at 1% from a captive bond market, and when it must foot the bill for all those fiscal packages that seemed such a good idea at the time. Every auction of JGBs will be a news event as the public debt punches above 225% of GDP. Finance Minister Hirohisa Fujii will become as familiar as a rock star.

Once the dam breaks, debt service costs will tear the budget to pieces. The Bank of Japan will pull the emergency lever on QE. The country will flip from deflation to incipient hyperinflation. The yen will fall out of bed, outdoing China’s yuan in the beggar-thy-neighbor race to the bottom.”

Mr. Pritchard was either wrong or early, depending upon your point of view. JAPAN INTEREST RATES Japan can still borrow for 10 years at 1%. Despite the highest government debt as a percentage of GDP on the planet at 225%, Japan has not felt the wrath of the bond vigilantes. Not only did the Yen not fall out of bed, but it soared to a post-war high against the USD last week after the earthquake/tsunami. Investors drove the value of the yen higher, anticipating a huge rebuilding program in Japan. Japanese financial institutions would need to convert foreign assets into yen to pay for damage claims and construction expenses, a process that would strengthen the currency. In anticipation, investors piled into yen, helping drive up its value. Central banks across the globe intervened and weakened the currency, for the time being. When the world comes to its senses, the Yen will weaken on its own. Japanese Yen (JPY) to 1 US Dollar (USD)

Debt & Demographics

Japan is a one trick pony that just broke two legs and is waiting to be put down. They have experienced a two decade long recession. Their stock market is still 70% below its 1990 peak. They have no natural resources. They allow virtually no immigration. And their population is in a death spiral. The one and only thing they have going for them is their phenomenal ability to manufacture high quality products and export them to the rest of the world. The earthquake and tsunami that struck Japan severely damaged their just in time manufacturing machine. A surging yen would destroy their export machine by making their products more expensive. Hundreds of high tech Toyota, Honda, and Sony factories are shut. Four hundred miles of ports and harbors have been wiped out. There are rolling blackouts, with one million households without electricity. Over 500,000 people are still homeless. The short-term impact of this disaster will push Japan into recession. The rebuilding efforts over the coming years will create a positive GDP figure, but will not do anything to benefit Japan over the long haul. The billions designated to rebuild will be money not invested in a more beneficial manner. The linear thinkers conclude that over the long-term Japan will be OK. These people are ignoring the double D’s – Debt and Demographics. When Japan entered its two decades of recession and experienced the Kobe earthquake in 1995, its government debt stood at 52% of GDP. Today it stands at 225% of GDP. Twenty one years ago, the Japanese population was still relatively young, with only 12% of the population over 65 years old. The population of Japan peaked in 2004 and now is in relentless decline. Over 23% of the population is over 65 and the median age is 45 years old. For comparison, the median age in the U.S. is 37 years old, with only 13% over 65. The projection portion of the chart below paints a picture of death. The population of Japan is aging rapidly and will decline by 4.4 million, or 3.5% in the next ten years. Table 2.2 Trends in Population The question I pose to the mainstream thinkers is, “How can a country with a rapidly aging population and nearly one quarter of its population over 65 years old generate the necessary dynamic enthusiasm for rebuilding a shattered country?” Youthful enthusiasm and hope for a brighter future is essential to any enormous rebuilding effort. Japan does not have it in them. News reports already indicate a lethargic and seemingly insufficient response by emergency workers. The devastation seems to have overwhelmed this aging country. The psychological impact of this type of natural disaster will likely have two phases. Psychology professor Magda Osman describes the expected human response:

“After a disaster, typically small communities become incredibly co-operative and pull together to help each other and start the rebuilding process. There’s an immediate response where people start to take control of the situation, begin to deal with it and assess and respond to the devastation around them. The problem is that we aren’t very good at calculating the long-term effects of disasters. After about two months of re-building and cleaning up we tend to experience a second major slump when we realize the full severity of the situation in the longer term. This is what we need to be wary of because this triggers severe depression.”

This would be the normal response of a traumatized populace. An aged populace is likely to experience worse depression and not bounce back from this tragedy. Japan is still the 10th most populated country on earth, with the 3rd largest economy. China just passed Japan to become the 2nd biggest economy in the world. India will pass Japan by 2012. Table 2.1 Countries with a Large Population (2009) Youthful countries across the world are gaining on Japan. The wisdom of the elderly doesn’t cut it in a global economy. Global competition is cutthroat. China, India and the other emerging Asian countries will take advantage of Japan’s misfortune by filling the hole left by Japanese manufacturers. The short-term issues of power, supply lines, and reconstruction are minor when compared to a mass die off of the Japanese population that will result in a population that is 25% smaller in 2050 than it is today. Demographics are a bitch. Figure 2.4 Proportion of Elderly Population by Country (Aged 65 years and over) With the amount of debt hanging over the Japanese empire, it might be a good strategy to commit hari-kari. The non-thinking pundits on CNBC contend that since Japan hasn’t had any detrimental effects from running their debt to 225% of GDP, running it to 300% won’t be a problem. Reinhart and Rogoff studies concluded that once a country breaches the 90% level, growth slows and a debt crisis is likely to ensue. Japan has been stuck in a 20 year recession, as they chose Keynesian shovel ready projects, quantitative easing, currency manipulation, and covering up the true financial condition of its banks over accepting the consequences of a debt bubble. Remind you of anyone? The result is their real GDP is lower today than it was in 1995. The Paul Krugmans of the world would contend that they just didn’t spend enough. The only reason Japan has not collapsed is due to its homogeneous population willing to buy virtually all of the debt issued by its government for the last twenty years and its prodigious ability to produce high quality products that the rest of the world wants. Japan has maintained a consistent trade surplus, and its government debt has been held mainly by its own people, with 95% of Japanese government bonds in the possession of Japanese, meaning the country was able to finance itself without depending upon fickle foreign investors who might prefer a return greater than 1%. This ain’t 1990. The savings rate of the Japanese population had already declined from 14% in 1990 to 2% by 2008. In a recent article, Mike Shedlock explained the situation prior to the recent devastation:

“The Government Pension Investment Fund, which oversees 117.6 trillion yen ($1.4 trillion), in September forecast that it would sell 4 trillion yen in assets in the business year ending March 31 to fund payouts. Sales by the fund, which helps oversee public pension funds for Japan’s 37 million retirees, come as the first of Japan’s baby boomers is set to turn 65 in 2012, making them eligible for pension payments. Japan choices are to default on its debt, print money to fund interest on the debt, raise taxes effectively robbing savers of their money, or undertake huge spending cuts. The dilemma stems from years of Keynesian and Monetarist stupidity.”

The new tragedy will just accelerate the conversion of Japanese savers into forced spenders. Millions of Japanese savers will be forced to spend their savings on survival, as many have lost their jobs and businesses due to the monumental damage to northern Japan.

Setting Sun – Race to the Bottom

Traders figured out what must happen over the coming years. A large swath of Japanese insurers and companies will begin repatriating assets held in other currencies to begin the rebuilding effort at home, driving the value of the Yen higher. At a time of crisis a stronger Yen would severely damage Japan’s export based economy even further. Therefore, Central Banks around the world jointly intervened. The Bank of Japan spent Y2 trillion ($25 billion), while central banks across Europe contributed $5 billion and the Federal Reserve spent $600 million to push down the yen on Friday. The Bank of Japan is doing what they do best - printing money. Quantitative easing is an art form perfected by all Central Banks across the globe. Every disaster over the last twenty years, whether man made (wars, internet collapse, housing collapse, debt meltdown) or caused by nature, are met with the exact same solution – PRINT MONEY. This method works until it doesn’t work. Japan’s central bank cannot reverse the demographics. From this point forward the population of Japan will be net sellers of government debt. Japanese insurance companies will be on the hook for $33 billion in claims. They will need to sell government bonds in order to make those payments. The World Bank has estimated the cost of rebuilding to be $235 billion. The government will need to borrow this money. At least 30% of its energy needs are off-line. It already imports 95% of its oil and coal. They will need to increase energy imports to make up for the nuclear energy shortage. Its positive trade balance was already in decline.  The clueless CNBC pundits can drone on about how this natural disaster will be good for the Japanese economy because of the substantial rebuilding program, but they are dead wrong. Japan is trapped, with no way out. They will need to issue hundreds of billions in new debt, which cannot be bought by its citizens, pension funds, or insurance companies. How many foreign investors will buy a 10 Year Japanese government bond paying 1%, knowing that Japan wants to weaken its currency? NONE. The only choices are to raise interest rates to attract buyers or print more money. With an already suffocating level of debt, they can’t allow interest rates to rise. They would choke on the interest. The Bank of Japan will follow the same script as Ben Bernanke. They will print new Yen and buy the newly issued debt. What an original idea. Japan is caught in a debt stranglehold and demographic nightmare. Their currency will ultimately collapse like a nuclear reactor after a tsunami. When Japan defaults on their debt, the pain will be intense, as they will be throwing their own aged population under the bus. America, on the other hand, will throw the whole world under the bus when we default. The Japanese own $886 billion of US Treasuries and have bought $256 billion of our debt since October 2008. Timmy Geithner will need to issue $1.5 trillion of new bonds per year. Japan will no longer be a buyer. They will be a seller. This will put upward pressure on U.S. interest rates. Japan’s reconstruction needs will put pressure on commodity and energy prices. Production and supply problems for Japanese parts and goods are already creating problems for GM and other car companies in the U.S. Lack of supply leads to higher prices. The great earthquake/tsunami/nuclear meltdown of 2011 will result in more quantitative easing in Japan and the U.S. This will result in even more inflation than we are experiencing today. Once the inflation genie is out of the bottle, the race to the bottom will accelerate. Gold will decide who wins the race. It has been a neck and neck race since 2001. I’m not sure it is a race anyone wants to win. But the destination is certain. “The endeavors to expand the quantity of money in circulation either in order to increase the government’s capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation.”Ludwig von Mises

The $4 Trillion Dollar Question

I have been covering the US Real Estate market for decades. I grew up with RE (mom was a RE broker and an investor). I have been a housing bear for about 5 years. I recognized the credit bubble and inevitable bust long before most other analysts/strategists/economists did.

I mention this just to inform readers that it is very rare that I come across any housing analysis that surprises me or adds to my understanding of the real estate landscape in a major way.

Which is why I am so pleased to introduce you to Dhaval Joshi, Chief Strategist at London based hedge fund RAB Capital (and former Societe Generale and J P Morgan Strategist).

Dhaval’s analysis looks a variety of housing data relative to household formation, housing stock, vacancy rates, and inventory is not the typical housing review. It is quite illuminating.

Enjoy:

~~~

Can the US economy really return to “business as usual” when it has 4 million houses surplus to requirement, when 1 out of 4 mortgages are in negative equity, and when by our calculation, it is burdened with $4 trillion of excess mortgage debt, equivalent to 30% of GDP?

For many years, total mortgage debt consistently and reliably equalled 0.4 times the value of the US housing stock. Intuitively, this average of 0.4 makes perfect sense as every property usually has a mortgage ranging from 0 to 0.9 times its value. So in 1990, $6 trillion of housing collateral could support $2.5 trillion of mortgages, and by 2006, $23 trillion of housing collateral could support $10 trillion of mortgages. But since then, the US housing stock’s value has slumped to $16 trillion which means the amount of mortgage lending supportable by the collateral has plunged to $6 trillion. However, actual mortgage debt has remained at $10 trillion – $4 trillion too high.

The fact that mortgage debt has barely declined suggests that relatively few homeowners have defaulted on their mortgages or paid off debt yet. Instead, a quarter of all borrowers are sitting on negative equity. That’s just as well – because were mortgage debt to shrink by even half of $4 trillion, the US economy would slump.

Perhaps homeowners are patiently expecting house prices to rise again. But if so, they may be in for a long wait. Prices are likely to be weighed down by a massive oversupply of homes relative to underlying demographic demand. Whether you look at the houses to population ratio, the houses to household ratio or vacant houses ratio, the conclusion is the same – there is a 3% surplus of properties, equivalent to 4 million homes. And with household formation running at just 0.9 million while the US is still building 0.6 million new homes annually, only 0.3 million of the oversupply will be absorbed per year (see page 5).

Ultra low rates to stay

A recent study by the Federal Reserve (The Depth of Negative Equity and Mortgage Default Decisions by Bhutta, Dokko and Shan) investigated the question: at what point do underwater homeowners “strategically default” on their mortgages? Surprisingly, it found that the average borrower doesn’t walk away from his home until negative equity reaches a very high level, -62%. But the fascinating thing was that there was something that could trigger underwater borrowers to default much, much earlier – and that something was an interest rate rise.

With a quarter of US mortgages underwater, and likely to stay that way for some time, the Fed must follow its own research if it wants to prevent a cascade of defaults. Hence, expect US interest rates to stay ultra low for an ultra long time.

>

>

For many years, total mortgage debt consistently and reliably equalled 0.4 times the value of the US housing stock. Intuitively, this average of 0.4 makes perfect sense as every property usually has a mortgage ranging from 0 to 0.9 times its value. So in 1990, $6 trillion of housing collateral could support $2.5 trillion of mortgages, and by 2006, $23 trillion of housing collateral could support $10 trillion of mortgages. But since then, the US housing stock’s value has slumped to $16 trillion which means the amount of mortgage lending supportable by the collateral has plunged to $6 trillion. However, actual mortgage debt has remained at $10 trillion – $4 trillion too high.

>

Loan to value ratio is 1.5 times too high

>

To put it another way, the loan to value ratio of total mortgages outstanding to housing stock value is currently 1.5 times too high.

>

24% of US mortgages are underwater

>

The fact that mortgage debt has barely declined suggests that relatively few homeowners have defaulted on their mortgages or paid off debt yet. Instead, a quarter of all borrowers are sitting on negative equity.

>

Higher interest rates may trigger cascade of defaults

>

A recent study by the Federal Reserve investigated the central question: at what point do underwater homeowners “strategically default” on their mortgages? Surprisingly, it found that when the decision is based on negative equity alone, the average borrower doesn’t walk away from his home until it is very underwater (negative equity of 62%). But the fascinating thing was that there was something that could trigger underwater borrowers to default much, much earlier – and that something was an interest rate rise. In fact, higher interest rates were even more significant in triggering defaults than higher unemployment.

With a quarter of US mortgages underwater, the Fed must heed the advice of its own research if it wants to prevent a cascade of defaults and the consequent repercussions on the financial system and the economy. Hence, expect US interest rates to stay ultra low until millions of mortgages escape out of negative equity.

>

The US has built far too many houses

>

Perhaps homeowners suffering negative equity are patiently expecting house prices to rise again. But they may be in for a long wait. Prices are likely to be weighed down by a massive oversupply of homes relative to underlying demographic demand.

Between 2002 and 2006, US homebuilders went on a construction binge, building 12 million new homes while the number of households went up by just 7 million. The painful legacy is a massive oversupply of houses relative to the number of households.

>

The oversupply will take years to clear

>

With household formation running at just 0.9 million while the US is still building 0.6 million new homes annually, only 0.3 million of the oversupply will be absorbed per year. As there are currently 4 million too many homes, it may take years to mop up the huge oversupply of houses.