It's A Mania - Behold The Red Chips And The Big Macs

Submitted by David Stockman via Contra Corner blog,

Zero Hedge recently revealed that $5.3 trillion of government debt trades at subzero interest rates. In today’s fiscally profligate world that is a thundering tell. What it signifies is nothing less than financial regime change. There are no markets left in any meaningful sense of the word - just a raging casino infected with the madness of the crowds and the central bank pied pipers who mesmerize them.

Every day there are new confirmations of the mania. Last night, for instance, the Shanghai stock market closed up another 2.4%, meaning that it is now 114% above its level of just 9 months ago!
^SSEA Chart

^SSEA data by YCharts

And what has transpired in the land of red capitalism during that parabolic move? Why everything has gone virtually straight south because the most fantastic credit bubble in recorded history is beginning to burst. That is, notwithstanding Wall Street’s sell side propaganda, China’s vaunted $10 trillion GDP is not capitalist GDP in any familiar or meaningful sense; nor is it the product of organic market-based economic growth.

Instead, it is “constructed GDP” which has been fabricated out of centrally issued and allocated fiat credit. Over the past two decades the People’s Printing Press of China issued virtually unlimited bank reserves in the process of buying up dollars to peg the RMB exchange rate in support of its national policy of export mercantilism. This, in turn, has enabled China’s total public and private credit outstanding to soar from $2 trillion at the turn of the century to $28 trillion today.

Historical Data Chart

In short, the overlords of red capitalism in Beijing caused the entire nation to borrow itself silly in order to fund a construction and investment mania that has no historical parallel. Indeed, the 14X explosion of debt in 14 years has resulted in not only trillions of artificial “printing press GDP”, but, more importantly, in a stupendous accumulation of over-valued and uneconomic “assets” on both public and private accounts.

There are currently an estimated 70 million empty high rise apartment units in China, for example, because under the baleful influence of unlimited credit these apartments were built for asset appreciation, not occupancy. In fact, most of China’s tens of million of punters who have invested in these units have taken pains to keep them empty and spanking new; like contemporary works of art, appreciation potential can be impaired by marks and scrapes.

Needless to say, there is a huge problem when you turn rebar, concrete and wallboard into tulip bulbs. Namely, when the price mania finally stops not only do the speculators who put their savings into empty apartment units get crushed, but, more importantly, demand for new units quickly evaporates, causing an devastating contraction up and down the building supply chain.

There is no doubt that the sucking sound to the south presently being heard by the suzerains in Beijing is the construction supply chain collapsing—-even as they desperately and almost randomly hop from “tightening” to “loosening” money maneuvers on a daily basis. But housing prices are now heading down for the count and the upstream supply chain is visibly deflating.

China Newly Built House Prices YoY Change

There is no better measure of the true contraction underway in China than the price of iron ore. The Wall Street stock peddlers will tell you not to be troubled by the 70% plunge from the 2012 highs and the 35% drop just in the last nine months. According to them, its all the fault of the big global miners who went overboard opening up massive new iron ore pits and mining infrastructure.

And it is true that cheap debt and roaring stock markets encouraged the likes of BHP, Rio Tinto and Vale to go on a capital spending orgy that is unprecedented. The Big Three alone have added more new iron ore capacity in the last six years than even existed at the turn of the century.

Yet this wasn’t an aberration or a case of one-off exuberance. The over-investment in iron ore capacity was just a mirror image of the same massive over-investment in the waterborne iron ore industry’s principal customer. That is, the Big Three miners were only attempting to stay abreast of the massive over-investment in the steel-making, steel-fabricating and steel-based construction sectors in China.

Iron Ore Spot Price (Any Origin) Chart

Iron Ore Spot Price (Any Origin) data by YCharts

So the collapse in iron ore prices is just the whip-end of a deflationary crisis that is fast overtaking China and the entire world economy for that matter. In that circumstance, why would the Shanghai A-shares market be going parabolic?

Can you say credit-fueled mania? China’s financial markets are populated with tens of millions of speculators, which have recently given-up on the real casinos in Macau and the high rise apartment lottery as well, in order to chase share prices on the belief that Beijing has their backs.

In fact, Beijing is desperately trying to cool the credit boom through clumsy administrative controls, but these efforts only cause China’s rampant credit supply to seek new outlets. During the last six months, for example, the government’s effort to crackdown on trust loans to debt-bloated business has resulted in an explosion of margin debt on the Shanghai and Shenzhen stock exchanges.

In fact, at the most recent level of $264 billion, China’s margin debt as a percent of GDP has been attained only one other time. That would be on Wall Street in September 1929

Yes, 60% of the punters in the Chinese stock market have less than a high school education and thereby constitute the proverbial sheep being led to the slaughter. But that is no consolation because the derangements in the world’s financial markets have nothing to do with education, information or heavy duty securities analysis. This is a mania—–an outbreak of herd irrationality that would make Graham & Dodd and any other true value analyst as welcome as a skunk at a garden party.

Proof of the latter came early this AM when McDonald’s reported another disastrous quarter and its stock promptly shot up by 3%. Within minutes of this anomalous development, however, the house-trained financial press explained it all. Said the USA Today story,

McDonald’s stock rallied more than 2% in premarket trading Wednesday as the company announced a new turnaround plan to be revealed early next month.

Results, though nothing to brag about, were better than expected. The world’s biggest fast-food company said it had a profit of 84 cents per share. Earnings were $1.10 per share, adjusted for non-recurring costs. That beat Wall Street expectations, which were $1.05 per share.


But the big news from the embattled company was the announcement by CEO Steve Easterbrook to reveal a new turnaround plan on May 4.


“As the world’s leading restaurant company, we are evolving to be more responsive to today’s customer,” said Easterbrook, in a statement. “McDonald’s management team is keenly focused on acting more quickly to better address today’s consumer needs, expectations and the competitive marketplace. We are developing a turnaround plan to improve our performance and deliver enduring profitable growth. We look forward to sharing the initial details of this plan.”

Yes, the check’s in the mail, but unlike Richard Nixon’s campaign plan to end the Vietnam War, you can bet that Easterbrook’s plan is not secret at all. The gamblers did not need one iota of detail to bid up the stock because they already know what will be in the May 4 plan. Namely, another round of restructuring charges and a new burst of stock buybacks.

Stated differently, the business model of one of America’s historic blue chip companies is visibly failing (because people are tired of getting fat on its products), and has been for several years. During this time the company has been slowly liquidating itself by feeding the Wall Street’s insatiable appetite for stock buybacks and dividends. And so now that it has promised to accelerate that liquidation—– the gamblers have piled on for another leg higher.

McDonald’s same store sales have been falling since mid-2012. This quarter was no exception and the drop was planet-wide. On a same store basis, the US was down 3.9%, Europe dropped by 2.9% and emerging market sales were off by 7.3%. The pattern of systematic shrinkage thus continues:

The bottom line was worse. Net income of slightly more than $800 million was down a whopping 33% from the $1.2 billion that it earned in the year ago quarter.  So how did that “beat” the street estimates?

That’s easy. MCD’s share count is down 3% from a year ago, and the $1.10 of ex-items earnings cited above versus the street consensus of $1.05 conveniently omitted $250 million of charges, write-offs and foreign currency translation effects.

Of course, all of these hits to net income were duly reported to the SEC on penalty of criminal penalty. Indeed, $87 million of the costs to be ignored were due to the fact that McDonald’s has bragged about spreading the golden arches across the entire planet in pursuit of endless growth……except not to mind its current shrunken level of profits in euros, lira, rubbles and reals.

So, no, these “ex-items” were not exceptional one-time adjustments which will never occur again. In fact, they were just another iteration of the great casino game wherein corporations pretend to be cutting expenses, getting more efficient and tuning up their business models while the Wall Street punters pretend that valuation multiples based on these phony ex-items numbers are “reasonable” and in line with historic averages.

In fact, at today’s closing price of $97.82/ share, McDonald’s valuation is entirely unreasonable—just another confirmation of the mania at hand. Its LTM net income after today’s results was $4.36 billion and its market cap was $94 billion. That means the casino was valuing it at 22X.

Why? The truth is McDonald’s LTM net income is the lowest since 2008 when its net income posted at $4.31 billion. In the interim its bottom line has oscillated around the flat line in a range of $4.5 to $5.5 billion annually.

Stated differently, McDonald’s earnings have been dead in the water for years, and now its first quarter result plummeted by 11% on the top-line and 33% on the bottom line. How does that deserve a “growth” multiple?

At 22X net income McDonald’s is just an integral component of Wall Street’s specious claim that markets are reasonably valued. In this case, the forward looking hockey stick of ex-items analyst projections say McDonald’s will earn 25% more next year and is therefore being valued at a historic PE.

Not really. Apparently people are tired of getting fat and consumers are turning against Big Macs in a big way. Accordingly, it is hard to see how a globe spanning company with $7.5 billion of EBITDA less CapEx can sport a TEV (total enterprise value of equity plus debt) of $104 billion, as MCD did at today’s close.

In fact, there is no way an honest market would ever value a shrinking stream of cash flow generated by a sundown business at 14X.

But in a mania there is no way of telling sundown from sunrise. In fact, the fast money gamblers feast on sundown economics because the latter is precisely the mechanism by which cash is cycled back into the casino.

During the years in which the world’s consumers have been steadily eschewing fatburgers & fries, McDonald’s was putting its own balance sheet on a diet. That is, during the last 10 years it has distributed nearly $51 billion in dividends and share buybacks. Owing to the latter, its share count has shrunk from 1.26 billion to 965 million or by 22%—–all the better to bolster the pretense of earnings growth.

But here’s the thing. During that same decade it only posted $44 billion of net income. That is, it pleasured the casino by disgorging 115% of what it actually earned. And this occurred at a time when what it really needed to do in order to justify its lofty valuation was to undertake a massive investment in re-inventing itself.

At the end of the day, sundown companies like McDonald’s have every right to liquidate themselves. That’s Schumpeter’s “creative destruction” at work, and it goes without saying that the health status of its customers would be all the better for it.

But in an honest free market no one is going to value a liquidating business at 14X free cash flow. Not even close.

So today’s action in the Red Chips and the Big Macs was not about price discovery; it was just the mania bubbling higher yet again.