In an attempt to not steal too much thunder from Gary Shilling's thought-provoking interview with Bloomberg TV, his view of the S&P 500 hitting 800, as operating earnings compress to $80 per share, is founded in more than just a perma-bear's perspective of the real state of the US economy. As he points out "The analysts have been cranking their numbers down. They started off north of 110 then 105. They are now 102. They are moving in my direction." The combination of a hard landing in China, a recession in Europe, and a stronger USD will weigh on earnings and inevitably the US consumer (who's recent spending spree has considerably outpaced income growth) with the end result a moderate recession in the US. The story is "there is nothing else except consumers that can really hype the U.S. economy" and that is supported by employment but last week's employment report throws cold water in that. "Consumers have a lot of reasons to save as opposed to spend. They need to rebuild their assets, save for retirement. A lot of reasons suggest that they should be saving to work down debt as opposed to going the other way, which they have done in recent months. So if consumers retrench, there is not really anything else in the U.S. economy that can hold things up." While the argument that the US is the best of a bad lot was summarily dismissed as Shilling prefers the 'best horse in the glue factory' analogy and does not believe investors will flock to US equities - instead preferring US Treasuries noting that "everyone has said, rates cannot go lower, they will go up, they will go up. They have been saying that for 30 years."
Links to the three-part series that Shilling (and his hosts) describe can be found here (these are notes from the longer discussions):
Part 1 - Shilling Describes the key factors behind his recession call:
Consumers Are the Linchpin: The U.S. economy is being fueled these days by strong consumer spending, which increased in February by 0.8 percent, its best showing in seven months, after rising 0.4 percent in January. Retail sales rose 1.1 percent in February -- the fastest pace in five months -- while same-store sales advanced 4.7 percent. These numbers correlate with recent gains in consumer confidence and sentiment.
Spending, Saving and Debt: The support that consumer spending has received from less saving and more debt appears temporary. Household debt -- including mortgages, student loans, and auto and credit-card loans -- has fallen relative to disposable personal income, though. In my analysis, this is largely because of write-offs of troubled mortgages. Nevertheless, revolving consumer credit, mostly on credit cards, is no longer being liquidated.
Consumer Retrenchment: The data so far aren’t conclusive, but evidence of U.S. consumer retrenchment is emerging. Consumer confidence has moved up recently but remains far below the levels of early 2007 before the collapse in subprime mortgages set off the Great Recession. Real personal consumption expenditures growth has been volatile in recent months and falling on a year-on-year basis. Voluntary departures from jobs, another measure of confidence, may be decreasing. And consumer spending will no doubt have a big slide if my forecast of another 20 percent drop in house prices pans out.
Housing activity remains depressed, with the only signs of life coming from the multifamily component, which is being driven by the appetite for rental apartments as homeownership declines. Homeowners are losing their abodes to foreclosures; many can’t meet stringent mortgage-lending standards; some worry about homeownership responsibilities in the face of job uncertainty; and many have no desire to buy an asset that continues to fall in price.
What Oil Threat?: Recently, there has been great concern about $4 per gallon gasoline and whether, as in 2008, those high prices will act as a tax on consumer incomes and force drastic cutbacks in other purchases.
Part 2 - Shilling focuses specifically on the employment picture
Job openings were up 16 percent in February compared with a year earlier, but in a survey by the National Federation of Independent Business, a net zero percent of small-business owners said they planned to hire over the next three months. Furthermore, would-be entrepreneurs aren’t all that enthusiastic: Only 2.7 percent of job seekers started new businesses in the last quarter, down from 12 percent in the third quarter of 2009.
Job openings: The U.S. has a lot of job openings, but having endured huge layoffs in recent years, employers are being very picky in new hiring. Contrary to Federal Reserve Board Chairman Ben S. Bernanke’s assertion that high unemployment is mainly a cyclical concern that will be solved by economic growth, I believe that a big part of the problem is structural.
Business Cost-Cutting: During the sluggish business recovery that began in mid-2009, sales-volume increases for U.S. business have been tiny, and the ability to raise prices was very limited even as commodity and other input prices climbed until about a year ago. As a result, profit margins were threatened. Meanwhile, foreign competition has been fierce.
Manufacturing productivity: Labor-intensive factories producing items such as textiles or shoes have long departed American shores for low-cost venues abroad and may never return. Those that remain -- and the type of manufacturing that is coming back to the U.S. in the much ballyhooed “reshoring” -- is robot-intensive, highly automated production that requires limited labor. Manufacturing output has recovered from its recessionary low, though not to the previous peak. Yet output per person, a measure of productivity, after the usual recessionary decline, has resumed its robust upward trend.
Jobs up, profits down: As in the past, the large share of national income accounted for by high corporate profits is unlikely to last for long. In a democracy, neither capital nor labor keeps the upper hand indefinitely. Quite apart from the Obama administration’s determined effort to redistribute income in favor of lower-income households, the seeds of narrower profit margins have already been sown. In recent quarters, productivity growth has been tiny. Have we reached bottom in terms of cost-cutting? Industrial leaders say productivity- enhancing opportunities are never exhausted, but it is possible that the low-hanging fruit has all been picked, at least for now.
Corporate earnings implications: More jobs are about the only spur to household incomes, and consumer spending is the only source of strength in the economy this year. If new employees spend their paychecks freely, they could create more consumer demand, additional corporate revenues and profits, more jobs, and so on, in a self-feeding cycle. But, as I discussed in Part 1, new and old employees are more likely to retrench and precipitate a recession.
That would cause great disappointment for corporate profits. In conjunction with a major recession in Europe, a hard landing in China and foreign-earnings translation losses caused by a rising dollar, the operating earnings of S&P 500 companies could drop to $80 per share this year, compared with Wall Street analysts’ expectations of $104. That would almost guarantee a major bear market with a likely price-earnings ratio low of about 10. This implies that the S&P 500 index (SPX) would be around 800, a 43 percent drop from its recent level.
In Part 3, I’ll examine why the Fed may embark on a third round of quantitative easing if the economy weakens this year and whether Congress will be tempted to enact policies of its own to address a huge fiscal drag in 2013 as payroll and income taxes rise and unemployment benefits plunge.