JOYG Joy Global Inc. (MM)

The attention now shifts to the third quarter earnings picture. We just have 15, or 3.0% of the S&P 500 firms reporting so far, so it is way too early draw any firm conclusions. The year-over-year growth rate for the S&P 500 is 13.9%, way off the 27.9% pace those same 15 firms posted in the second quarter.

Of far more importance are the expectations for the 485 who have yet to report. Growth for them is expected to slow just slightly, to 9.97% over the third quarter of 2010, down from 10.09% year-over-year growth in the second quarter. However, the second quarter was distorted by some big hits to the financial sector.

If we exclude the financials, growth in the third quarter is expected to slow to 12.02% year over year from 19.31%. Then again, at the beginning of earnings second quarter season, growth of 9.7% was expected, 12.2% ex-Financials.

We will need another season where positive earnings surprises far outpace disappointments if we are going to match the second-quarter growth rate. On the top line, growth is also expected to slow sharply, to 5.20% in total from 11.04% in the second quarter, and excluding the financials to 8.95% from 13.21%.

Net Margins Key to Growth

Expanding net margins have been one of the keys to earnings growth. In the second quarter, total net margins were 9.14%, and excluding financials they were 9.13%, up from 9.10% and 7.95 ex-financials in the second quarter of 2010 (all 500). In the third quarter the financials net margins are expected to recover (we will see about that; it depends on the level of net charge-offs at the banks, which are sort of hard to predict). Thus, total net margins are expected (for the 485) to rise to 9.36%, while excluding financials they are expected to drop to 8.94%.

On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.37% in 2009. They hit 8.63% in 2010 and are expected to continue climbing to 9.22% in 2011 and 9.98% in 2012. The pattern is a bit different, particularly during the recession, if the financials are excluded, as margins fell from 7.78% in 2008 to 7.04% in 2009, but have started a robust recovery and rose to 8.25% in 2010. They are expected to rise to 8.76% in 2011 and 9.22% in 2012.

Full-Year Expectations

The expectations for the full year are very healthy, with total net income for 2010 rising to $794.1 billion in 2010, up from $543.4 billion in 2009. In 2011, the total net income for the S&P 500 should be $911.9 billion, or increases of 46.1% and 14.8%, respectively. The expectation is for 2012 to have total net income passing the $1 trillion mark to $1.037 trillion, for growth of 13.7%.

That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $108.72. That is up from $56.96 for 2009, $83.24 for 2010, and $95.56 for 2011. In an environment where the 10-year T-note is yielding 1.83%, a P/E of 13.6x based on 2010 and 11.8x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 10.4x.

Estimate Revisions Near Seasonal Low

Estimate revisions activity is near a seasonal low. What has really been drying up is estimate increases, as those made immediately after the second quarter positive earnings surprise roll off the four-week moving total I track. The number of cuts has also declined, but not nearly as sharply and as a result the ratio of increases to cuts is now at a very bearish level of 0.45 for 2011 and just 0.35 for 2012.

If those ratios stay in that area when total revision activity heats up (as it will dramatically over the next month or so) it will be a reason for very serious concern. The net cuts are very widespread, the ratio of firms with rising mean estimates to falling is down to 0.55 for this year and to 0.42 for next year, and every sector has more cuts than increases for both this year and next.

In light of the generally downbeat economic news, it is not surprising that we are not seeing a lot of estimate increases without the catalyst of positive earnings surprises. During slow revisions periods, the revisions ratio is generally less significant that during periods of high activity, but that does not mean that it should be ignored completely, and it is flashing a yellow caution light pretty brightly now.

The strong earnings performance we have seen, particularly in large multinational company earnings (like most of the S&P 500 I track in this report) is the single most important argument in the bulls favor (along with the low valuations based on those earnings). Thus if that starts to crack in a big way, it is a very big concern.

Recap of Key Data and Events of Last Week

The economic news this week was mostly, but not entirely, on the downbeat side. Housing Starts were down by 5.0% for the month and 5.8% from a year ago. They have been more or less moving sideways at extremely depressed levels (down apx. 75% from peak) for well over two years now. Thus the weakness was not exactly shocking, but it was not very encouraging either.

On the plus side, the lack of new building means that we are not adding much to inventory. Of course, that does not help out the employment situation much. Looking forward, there was a 3.2% increase in building permits. No real reason for celebration there, but it offsets the weakness in starts.

Used home sales were better than expected, posting a 7.7% rise on the month and up 18.6% from a year ago. The year-ago number was depressed from the end of the homebuilder tax credit, so I would not be extrapolating that year-over-year gain.

Inventories dropped by 3.0% on the month, causing the months supply to fall to 8.5 from 9.5. Still too high but moving in the right direction. On the commercial real estate front the Architects billing index turned slightly positive after being negative for five months -- a small positive sign for 2012. 

Initial Claims for jobless benefits fell to 423,000. Again -- lousy level, but right direction. We really need to see that number fall below the 400,000 level to indicate the job market is returning to health. Given the severity of the jobs crisis, it will take some time to heal, even after we get below that level. That is the level that would indicate that the economy is producing enough jobs on balance to start to bring down the unemployment rate. Not there yet.

Looking at just the U.S. data for the week, and with very few earnings reports out (and those on balance positive) you would have thought we would have sort of a flat week for the market. Instead, we had the worst one since late 2008. However, it is not just the U.S. economy that affects the market. We got some weak numbers out of both Europe and China as well, and that helped throw the market for a loop.

The Greek saga continued with alternating news about if they would get the next installment of their aid package. I think they will get this one, but the one after that will be a bigger hurdle. I still think the question is when -- not if -- Greece defaults. And the question is days or weeks, not quarters or years.

Twist and Shout

The big news of the week was the Fed coming out with “Operation Twist." It will sell $400 billion of short-term t-bills and notes and buy an equivalent amount of longer-term paper. This is sort of like the Kim Kardashian of monetary policy actions -- it is unexplainably popular, does not do much and is all about the back end.

At the margin it could lower long-term interest rates a little bit, possibly at the expense of higher short-term rates, but given the pledge to keep very short rates under 0.25% through 2013, there will probably be very little effect (even less than on the long end) on short rates. The downside of this is that it flattens the yield curve, which hurts bank net interest margins.

It is not like the real problem in the economy is that interest rates anywhere on the yield curve are too high. Even the 30-year T-bond is yielding only 2.90%, and the 10-year is at 1.83%. Right off the bat it looks like the policy has been very successful in bringing down long-term rates, as long-term treasuries tumbled to even lower historic lows.

So what will bringing them down by another handful of basis points accomplish? Next to nothing.

Just about every market other than the long-end of the bond market did not take kindly the action. I don’t think that it is particularly harmful, just impotent. I suspect this tacit admission of impotence by the Fed is the real reason the market was so weak after the announcement. The other implication is that the bond market is shouting that inflation is not a problem and that the government is not crowding out private investment.

The Fed also moved from saying that the downside risks to the economy are increasing to saying that there are significant downside risks to the economy. In other news, the sun rose in the east today. Many commentators pointed to that statement as the reason for the weakness, but I didn’t think it revealed anything that anyone taking even a cursory glance at the economic numbers has was not already thinking.

What the Fed Could Have Done/Might Still Do

I was, however, disappointed that the Fed did not take a step that I think would have an impact, and which would actually save the government some money. It should have stopped paying interest on excess reserves. In effect the Fed is now paying banks not to lend, which is the exact opposite of what we need them to do. OK, its not that much -- just 0.25% -- but on about $1.7 billion of excess reserves, it adds up to almost $4 billion.

There are two additional options that the Fed has left. One would be to embark on QE3, which would effectively be doing half of Operation Twist -- just the buying part. However, if the Fed did that they would effectively be telling the GOP establishment to go jump in a lake. In light of the explicit warnings not to go down that path, if Chairman Bernanke were to so, the Fed would be painted as being a tool of the Obama administration.

The other step the Fed could take would to be to explicitly target a higher inflation rate. That is a step that would run directly against the grain of any Central Banker. However, if people credibly believed that inflation would be running at, say, 4% for the next five years or so, then the last thing businesses would want to be holding would be cash. Such a step, though, is fraught with the potential for unexpected consequences, and I seriously doubt they will go down that path.

Empty Toolbox

With the Fed now seen as out of ammo, and fiscal policy off the table due to political gridlock (and headed on the wrong path towards austerity) the government is not able to do anything to head off a potential double dip recession. The economy remains extremely fragile and susceptible to outside shocks. The turmoil in Europe -- the destination for about 25% of our exports -- has plenty of potential to be just such a shock.

Passing the American Jobs Act (AJA) would be extremely helpful in heading off a renewed recession, but given the political dynamics right now, that is just not going to happen. If it (or something like it) does not pass, then not only will the economy not get any additional stimulus, but fiscal policy will be leaning heavily towards actively slowing the economy.

The biggest feature of the AJA is an expansion of the payroll tax cut. It would increase the size of the payroll tax cut from 2% of the first $106,800 someone earns to 3% on the individual side, and also introduce cuts in the payroll tax on the employer side, particularly targeted at small businesses. For the median household (including households of one) that would mean about $500 more in after tax income than in 2011.

In contrast, if nothing is done, the 2011 payroll tax cut will expire, and the median household will have $1,000 less to spend. That will be a huge hit to consumer demand (about 70% of the economy) and would result in even more unemployment. While small businesses and their owners are often referred to as the "job creators," that is not really the case.

Yes, historically most new paychecks have been signed by the owners of small businesses. However, no business, large of small, is going to hire people if they don’t think that there are customers for their goods or services. It is customers who are the job creators, not businesses, large or small. It is uncertainty about the number of customers, not about taxes or regulations, which are keeping businesses from hiring.

In 2010, real median income dropped 2.3% from 2009 levels and is now 6.4% below where it was at the start of the Great Recession and 7.1% below its 1999 peak. We also learned that the poverty rate rose to 15.1% in 2010 from 14.3% in 2009, and from 12.5% in 2007 before the start of the Great Recession. People in poverty do not make great customers, and thus are not very good job creators. For more on the poverty report, see this article. 

A Lot Resting on Congress

The thrust of the “American Jobs Act” runs directly counter to the thrust of the debt-ceiling deal. The “Super Committee” of six Democrats and six Republicans that is charged with coming up with $1.5 Trillion in deficit reduction over the next decade is on the road to failure.

If they cannot come up with an agreement by November 23rd, or if Congress does not pass the package by December 23rd, then automatic spending cuts of $1.2 Trillion kick in. Half of those would be to defense, and half to non-defense (mostly discretionary) spending. That is a meat-cleaver approach and will be front-end loaded, with big cuts starting in 2013.

It is clear to me that the Super Committee is going to be deadlocked and/or whatever they come up with will not pass Congress or be signed by President Obama. Thus, the market has to start to price in some of those meat-cleaver cuts.

The other possibility would be that the next Congress decides to cancel the whole thing. That would require a very large shift in Congress in the 2012 elections, and that Congress would not take office until January of 2013, which would be cutting things very close. Any repeal of debt-ceiling deal -- now law -- would be subject to filibuster, and as such would require 60 votes in the Senate. The odds of that happening are extremely low.

Focusing on the Wrong Deficit

Policy makers remain far too focused on the wrong deficit. The trade deficit is a big part of what is ailing the economy. Right now the budget deficit is not (it could well be a problem down the road, but it is not causing big problems now. If it were, the government would not be able to borrow for 30 years at just 2.90%).

Bringing down the trade deficit will require a weaker dollar, but last week, the dollar was just about the only thing that went up in price, along with T-notes. (An energy policy aimed at moving towards using domestic Natural Gas as a transportation fuel replacing imported oil would also go a very long way towards brining down the trade deficit, ad getting the economy moving again.)

Currency values are always relative, and a weak Dollar requires a strong Euro, the second-most important currency in the world (with a huge gap between it and number three, which would either be the Yen or the Pound). The current mess in Europe is not conducive to a strong Euro.

The end result was an extremely weak market last week, the worst one we have had since the 2008 crisis was in full bloom. Against the very poor macro-backdrop, one has to look at the valuations that stocks are currently have. Those to me look wildly attractive, particularly if the current earnings expectations (or anything close to them) can be achieved.

Market Pricing in a New Recession?

At these levels, it is clear to me that the market is pricing in not just slower growth, but an outright recession -- either underway or just about to get underway. If it turns out that we avoid an outright recession, and the decline in profits that usually comes with one, then the market should rally from here.

As I noted above, the expectations are starting to come down, particularly for 2012, but the vast majority of stocks, and every economic sector is expected to earn more in 2012 than in 2011. The decline in the revisions ratio is mostly driven right now by the drying up of new estimate increases, rather than a flood of new estimate cuts. It is entirely normal at this point seasonally for overall revisions activity to slow down dramatically.

Not only were stocks down hard, commodities got hit even harder -- including gold and silver. More importantly, oil prices fell sharply, which acts as a tax cut for the developed world (not just the U.S. but also Europe and Japan as well). That should help to offset some, but certainly not even close to all, of the current economic headwinds.

In the Great Recession oil prices plunged from almost $150 per barrel to the mid $30’s. That helped cushion the blow, but far from prevented the Great Recession from happening. The cliff that commodities fell off of this week makes it even clearer that inflation is not a big problem. If anything, deflation is a bigger risk right now (another reason for more monetary easing by the Fed).

I found the decline in copper prices particularly alarming. Copper is sometimes referred to as the metal with a Ph.D. in economics. It tumbled to just $3.28 per pound, down an incredible 16% on the week, and off from a record high of $4.55 back in February. The good doctor is shouting about a coming economic slowdown. Commodity related stocks such as Freeport McMoRan (FCX), Joy Global (JOYG) and Cliffs Natural Resources (CLF) were among the hardest-hit this week.

Bullishness Fading, Bearishness Advancing

Sentiment has turned overwhelmingly bearish. The American Association of Individual Investors poll now has just 25.3% bulls, down 5.2% for the week. That is 1.3 standard deviations below the historical average of 39.0%. Meanwhile, bearish sentiment is at 48.0%, 1.8 standard deviations above the historical norm of 30.0%.

Valuations on stocks look very compelling, with the S&P trading from just 11.8x 2011, and 10.4x 2012 earnings. Put in terms of earnings yields, we are looking at 8.46% and 9.62%, while 10-year T-notes are only at 1.83%.

The old “Fed Model” suggested that the forward earnings yield (call it 8.45%) should be in line with the 10-year note. Instead we have the dividend yield on the S&P 500 higher than the 10-year note. If we exclude the companies that pay no dividend (and thus yield 0% regardless of where they trade) then 90% of all S&P 500 stocks yield more than the five year, 70% yield more than the 10-year, and 40% yield more than the 30-year Treasury.

With the possible exception of the very depths of the 2008-09 crisis, such valuations have not occurred in my lifetime. P/E's were low in the 1970’s, but that was in the context of very high inflation and interest rates. From a long-term perspective, stocks look extremely undervalued to me.

Valuations Compelling

Long-term investors should start to take advantage of the current valuations. However, I would not be shooting for the stars. Look for those companies with solid dividends (say over 2.5%), low payout ratios, solid balance sheets, and a history of rising dividends, which are still seeing analysts raise their estimates for 2012, or are at least not cutting them aggressively. I don’t know if you will be happy doing so next week or even next month, but I am pretty sure that you will be quite satisfied five years from now if you do so.

Doing so will take a lot of intestinal fortitude. However, the time to double-up is when you feel like getting sick. Looking at the world economic situation and the action of the markets last week, my stomach is feeling more than a little bit queasy.
 
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