Trumped! A Nation on the Brink of Ruin... And How to Bring It Back

by David Stockman

  But this assumes there is still a functioning government in Washington and that politicians have been 100% cured of their atavistic fears of the public debt.

  Alas, what is going to cause helicopter money to be a giant dud—at least in the U.S.—is that neither of these conditions are extant.

  Regardless of whether the November winner is Hillary or The Donald, there is one thing certain. There will be no functioning government come 2017. Washington will be the site of a political brawl of deafening and paralyzing aspect—like none in U.S. history, or ever.

  At the same time, the existing budget deficit is already reversing, and will end the current year at more than $600 billion. That’s baked into the cake already based on the recent sharp slowdown in revenue collections, and means that the FY 2016 deficit will be one-third higher than last year’s $450 billion.

  Moreover, when the new Congress convenes next February the forward budget projections will make a scary truth suddenly undeniable. As we showed in Chapter 9, the nation is swiftly heading back toward trillion-dollar annual deficits under existing policy and even before the impact of a serious recessionary decline.

  The reality of rapidly swelling deficits even before enactment of a massive helicopter money fiscal stimulus program will scare the wits out of conservative politicians, and much of the electorate, too. And the prospect that the resulting huge issuance of Treasury bonds will be purchased directly by the Fed will only compound the fright.

  What fools like Bernanke haven’t reckoned with is that sheer common sense has not yet been extirpated from the land. In fact, outside of the groupthink of a few dozen Keynesian academics and central bankers, the very idea of helicopter money strikes most sensible people as preposterous, offensive and scary.

  Even if Wall Street talks it up, there will be massive, heated, extended and paralyzing debate in Congress and the White House about it for months on end. There is virtually no chance that anything that even remotely resembles the Bernanke version of helicopter money could be enacted into law and become effective before CY 2018.

  SO NEXT COMES THE CRASH

  Will the boys and girls and robo machines still in the casino after the current election gong show is over patiently wait for their next fix from a Beltway governance process that is likely to be in sheer pandemonium and stalemate?

  We think the odds are between slim and none. As we indicated previously, if Trump is elected the fiscal process will lapse into confrontation and paralysis for an indefinite spell.

  And if Hillary is elected, the Republican House will become a killing field for almost anything she proposes, and most especially the rank Keynesian apostasy of outright and massive debt monetization.

  Yet absent a massive new round of monetary juice like helicopter money, the stock market will not be able to avoid its Wile E. Coyote moment. That’s because the “priced-in” forward earnings on which the casino gamblers are counting are pure fantasy.

  In fact, there is an air pocket below the market even if the U.S. economy stumbles sideways temporarily, and a high speed down-elevator shaft when and as the economy finally rolls over.

  As incredible as it may seem, Wall Street’s sell-side hockey sticks are actually pointing to an out-of-this-world 41% earnings gain for calendar 2017 to $122 per share compared to the $86.94 posted for the 12 months ending in June 2016.

  Obviously, that can’t happen without a massive surge in sales growth or a huge further expansion of profit margins. Neither of these happy outcomes, however, is even remotely on the horizon.

  After hitting a cyclical peak of 10.1% of sales in Q2 2014, the profit margins of the S&P 500 companies have already embarked upon the inexorable process of mean reversion, sliding to 9.3% in Q2 last year and 9.1% in the June 2016 quarter.

  Moreover, that slide is just the beginning. In the event of an actual lapse into recession, current near-peak profit rates would really get slammed. Compared to the peak of 9.4% in Q2 2007, for instance, the S&P 500 operating margin plunged to just 6.2% by the bottom in Q2 2009.

  At the same time, the chance that corporate earnings will be rescued by a surge of sales growth is virtually nonexistent. Indeed, the so-called “incoming” economic data are flashing warnings of a slumping economy, not one that is exhibiting the perennial Wall Street delusion of “escape velocity.”

  Exhibit number one is total business sales, including manufacturing, wholesale and retail trade. Unlike the virtually useless monthly jobs data which is based on a tiny sample and is egregiously manipulated and modeled by BLS bureaucrats, business sales are the big enchilada. They capture a reasonably accurate picture of the current pace of economic activity.

  Indicative of the comprehensive reach of this series is that during the most recent month (June), the annualized run rate of sales was about $15.7 trillion, representing a huge slice of the GDP. But that figure was down by $550 billion or 3.4% from its peak level two years ago—a sharp deterioration from the 5%-10% annual rates of gain during the initial years of the recovery.

  The chart on the next page provides powerful historical context. Rather than the will-o’-the-wisp of “escape velocity” what it actually indicates is the onset of clear recessionary conditions.

  Moreover, what militates strongly against an imminent reversal of this slumping sales trend is the fact that inventories are piled high throughout all three sectors of the business economy.

  That’s not only a sure sign that end sales have weakened and businesses have over-produced and overstocked; it’s also a classic trigger for cutbacks in production and employment to bring inventories back into alignment with sales. In other words, a recession.

  The chart below is dispositive. After a 15-year march lower owing to new technology and just-in-time management, the inventory to sales ratio exploded during the Great Recession. Business over-produced until the very last minute when confidence in the Fed’s Goldilocks economy was finally shattered by the Lehman bankruptcy on Sept. 15, 2008.

  We are now deep into Goldilocks 2.0, and businesses are again overproducing and overstocking. It will simply take another catalyst—such as a market crash, currency crisis or Trump election victory—to drive the current 1.39X ratio of inventories-to-sales to the 1.45–1.50X zone where the U.S. economy plunged into recession during the fall of 2008.

  In fact, an inventory liquidation driven recession is virtually guaranteed. And that means that retrenchment in production will cause the excess labor being hoarded by businesses at present to be abruptly chucked overboard just as it was after May 2008.

  Even though the Great Recession commenced in the fall of 2007, it was in the 12 month period ending in May 2009 that 6.5 million, or 75% of the recession period jobs losses actually happened.

  In short, the inventory-sales ratio speaks to what happens next. By contrast, the BLS’ monthly headline jobs number is not only a lagging indicator, but its trend-cycle model adjustments make it even worse by significantly overstating the actual excess labor being inventoried at present.

  Yet our Keynesian school marm at the Fed thinks the U.S. economy is expanding nicely because of these useless figures. No wonder the casino gamblers are still at the tables.

  There is plenty of additional evidence for weakening sales, but the 5.9% Y/Y plunge in inbound containers during July at the Port of Long Beach was especially timely and telling. The latter is the nation’s busiest port and point of entry for the vast flow of imports from China and the Far East, and a barometer of the outlook for fall and Christmas sales among U.S. retailer.

  A drop of this magnitude hardly suggests a sales rebound anytime soon—a prospect that is reinforced by the most recent data on freight volumes. For example, intermodal shipments on North American railroads during the second quarter were down by 6.1% versus prior year. This marked the first such decline in the past 25 quarters, and another clear sign of flagging domestic economic momentum.

  Even more significantly, the Cass Freight Index is now back to its 2013 levels.
This index measures freight volumes for all modes of domestic transit and is based on $2 billion per month of actual transactions processed by Cass for hundreds of customers in the packaged-goods, food, automotive, chemical, OEM and heavy-equipment businesses.

  Weakening throughput in these sectors is another sign that the present so-called recovery is getting long in the tooth after 86 months, and especially so in the face of some of the growing headwinds mentioned below.

  We believe these weak business-sales and freight-volume trends are an especial threat to the market’s current lofty valuations. That’s because on a market-cap-to-sales basis, the S&P 500 is now in wholly uncharted waters. In fact at nearly 2.5 standard deviations higher than its historical median, it now towers far above even the peaks reached in 2000 and 2008.

  Consequently, if business sales continue to falter and margins continue to compress, the stock market is vulnerable to a drastic downward re-rating of valuation multiple.

  As indicated by the market’s stunning complacency during the spring-summer melt-up, hope apparently always springs eternal in the Wall Street casino. But we believe that time, trends and events are all finally closing in.

  On the economic front, there is simply no catalyst for a sales-and-growth rebound left, including an exhausted consumer sector that has once again run up record debts to a staggering $14.3 trillion. Even auto sales have rolled over, and understandably so.

  As we indicated earlier, since the rebound began in early 2010, automotive sales have risen by $360 billion and auto debt by $355 billion. That is, anyone who could fog a rearview mirror got a loan and has a car or SUV—even if only on a temporary basis until the repo man arrives.

  Likewise, there are no signs of help coming from business investment or exports. Orders for the former are now down by 12% from their September 2014 peak. Similarly, exports have dropped by 13%—with no signs of a rebound in orders from faltering East Asian, European and EM customers.

  Finally, even the housing rebound is grinding to a halt. Permits for new single-family dwellings during July—a leading indicator of future housing construction—were down 6.1% from 2015, and this compares to 10% to 20% gains during the last several years.

  Moreover, the fact that even the housing “recovery” is reaching exhaustion is especially telling. That’s because it never really recovered from the thundering crash of 2008–10 in the first place. As shown in the chart on the previous page, last month’s single-family permits were lower than they were in 1960!

  That’s right. The housing sector has time traveled backward by half a century. And that’s hardly a confirmation of a stock market trading at 25.2X.

  THE WALL STREET EXCLUDING-ITEMS HOCKEY STICK—2008 REDUX

  So, barring some virtually inconceivable earnings miracle, the market’s nosebleed valuation at 25.2X is an accident waiting to happen. The last time it was near that level outside of outright recession was on May 16, 2008, and the parallels are uncanny.

  At that point, March 2008 LTM (latest 12 months) earnings on a GAAP basis had posted at $60.39 per share. So when the market hit an intraday high of 1,430, the implied multiple was nearly 24X.

  Needless to say, it was a long way down from there. In fact, ten months later the market was 53% lower, and S&P reported earnings actually bottomed that quarter at $6.86 per share, or 90% lower.

  Needless to say, all of this is airily dismissed by Wall Street on the grounds that the earnings figures cited above are based on GAAP. And who would credit GAAP?

  That is, besides the several thousand white-collar “criminals” domiciled in federal hospitality facilities who undoubtedly rue the day they violated it; or the tens of thousands of bureaucrats at the SEC, DOJ and state attorneys general offices who make a living enforcing it; or the far greater numbers of white-collar defense attorneys who make an even better living parsing its fine points.

  Then again, you don’t have to make a fetish of GAAP, even if several billion dollars annually of law enforcement and regulatory intrusion insist upon it. In fact, back in May 2008—at a time that even the White House’s Council of Economic Advisers said there was no recession in sight and Bernanke was preaching mainly blue skies ahead—LTM “operating earnings” had posted at $77 per share.

  So even using Wall Street’s preferred “ex-items” rendition of earnings, the market was trading at a pretty sporty 18.6X.

  Alas, a recession had already been underway for six months, but no one had bothered to tell the Eccles Building and their Wall Street acolytes. The latter mainly peddle stocks, but are otherwise known as “street economists” and “equity strategists.”

  Here’s the thing. Even the LTM “operating earnings” number at the time was down by 16% from its cyclical high of $91.50 per share that had been posted three quarters earlier (June 2007 LTM).

  But like now, the Street insisted that the “earnings bottom” was in, and that 2008 profits would come in at over $100 per share or 30% higher than the March 2008 LTM actual.

  At it happens, the certified operating earnings number for the June 2016 LTM period was $98.36 per share.

  That means that the market was trading at 21.8X Wall Street’s preferred earnings measure at the peak of the August 2016 melt-up. That’s 17% higher than the 18.6X delusion back in May 2008, and also something more.

  Like eight years ago, the March operating earnings number is down 14% from its peak of $114.50 posted for September 2014. And also like back in 2008, expected forward year earnings of $133 per share are 35% above current levels.

  WALL STREET’S QUARTER-TRILLION-DOLLAR ACCOUNTING FIB

  In truth, all of this is worse than déjà vu. That’s because the casino’s financial narrative has been so corrupted by recency bias and accounting promiscuity that it has no idea what the profits picture really is or where it is going.

  So it is worth documenting just how far the “earnings” narrative has departed from GAAP. Near the end of a cycle, in fact, this “GAAP gap” becomes egregiously wide.

  As the Wall Street Journal recently documented, Wall Street’s ex-items or pro forma version of S&P 500 earnings came in at $1.040 trillion in CY 2015 compared to GAAP earnings of $787 billion. It would appear that CEOs and CFO’s who filed their SEC statements on penalty of prison time, averred that their actual profits were exactly $256 billion smaller than what they told their investors.

  As it happens, that quarter-trillion-dollar fib is exactly the size of the ex-items charade back in 2007. It seems as if companies actually need a periodic recession so that they can toss into the kitchen sink the write-offs for all the dumb deals and investment mistakes they made while the bubble was still inflating.

  And despite Wall Street protestations that these “ex-items” charges against profits are “nonrecurring” the truth of the matter is that they do consume cash or capital, and they do permanently weaken the balance sheet of companies that take these charges.

  To wit, goodwill write-offs for failed M&A deals result in losses on the cash or stock originally paid to the seller. Likewise, equipment and property write-offs for closed plants and stores dissipate corporate resources, as do massive severance expenses for fired employees. And surely the tens of billions of stock options issued to executives are a real charge to income, not an “ex-items” expense to be ignored.

  There is a reason why all of these so-called nonrecurring or ex-items expenses are strictly included in GAAP income statements, and the fact that they can be lumpy on a quarterly basis at the individual company level is hardly a reason to disappear them.

  The rather obvious solution would be to smooth or amortize them into income at the company level. But for the S&P 500 as a whole there is not excuse at all. Operating charges and so-called nonrecurring charges are all averaged into one giant pot representing upward of $10 trillion in annual sales, anyway.

  In short, the one and only purpose of the “GAAP gap” is to make the market seem far less expensive than it actually is. And on that score, Wall S
treet has been corrupted beyond repair.

  WALL STREET’S GREAT SHRINKING HOCKEY STICK

  In any event, not only are Wall Street’s hockey sticks extremely crooked from an accounting point of view, but they are also egregiously predictable in the magnitude by which they deflate as one-year forward estimates are eventually overtaken by reality.

  To wit, in March 2014, the one-year forward estimate for CY 2015 came in at $135 per share of “operating earnings” for the S&P 500. At length, CY 2015 unfolded—bringing with it a collapse of oil and materials prices and a sharp slowdown of global growth that came as a big surprise to Wall Street.

  Accordingly, the S&P scorekeepers now certify that actual operating earnings for CY 2015 came in at $100.45 per share. Apparently, in a world where “one-timers” don’t count, that gigantic 26% miss doesn’t count, either.

  That’s because in March 2015, the Street “bottoms up” consensus for 2016 was pegged at, yes, $135 per share, again.

  The problem is that the 2016 hockey stick had already been rolled-down to just $111 per share as of June. Yet even if there is no further earnings decline in Q3 and Q4, earnings will total just $100 per share for 2016. That would be another 25% miss.

  Never fear. The Street consensus estimate for 2017 as of this past March was $136 per share for the third year in a row.

  But that has already been walked down to $130 per share and there are still six more quarters of downgrades to go. Yet this is not the least bit surprising. Walking the hockey stick back is what Wall Street equity analysts do.

  WHY THE NEXT STOCK MARKET CRASH IS NEAR