The Goldenbar Report

S&P Profits: Carrot on a Stick
16 September 2003

by Ed Bugos

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Today's Highlights:
analysts remain bearish on gold share earnings prospects
falling gold & oil like a rate cut, but they can't fall when USD is weak
bearish supply sentiment drives oil lower this week
markets price future earnings, Wall Street has been waiting a decade...
gold is still cheap on trend to ever growing inflation expectations
the term reflation presumes there wasn't any until recently
Yen gains on Euro rout

It's interesting that gold is the only sector that attracts any quasi-rational thought today. When gold and gold shares go up, Wall Street geniuses say it should be sold.

This week I've read several calls on the gold sector that go something like this: gold shares have gotten ahead of gold prices so they should be sold.

Wow. Pretty shrewd. Buy low sell high, right?

It's just too bad they don't apply this cool & collected thinking to the rest of the market. I wonder why… maybe it's because that's where most of their money is.

Apparently, despite the fact that the broader market remains near record valuations, most shares haven't gotten as far ahead of their "real" earnings prospects, as gold shares have; most analysts are sticking to their conservative forecasts there.

Ah yes, inflation must be low, or non-existent, just like the Fed said today. Right.

A fall in important commodities like oil, gold, or even the grains could be akin to a rate cut.

Weak gold and commodity prices in general support the dollar, and the Fed's yield cap in the process. Weak oil prices in particular tend to boost earnings outlooks and support generally richer profit multiples also.

And of course, falling interest rates tend to boost earnings outlooks and multiples… I'd like to say, when the dollar isn't falling. But it's not always true that way. We seem to live in a world where most everything is still bullish for the stock market.

Indeed, it seems difficult for the stock market at the moment to grasp that a weak currency means rising inflation expectations, rising commodity prices, and ultimately rising yields - exactly what's been happening these days. Hence, a falling dollar is bearish for earnings multiples - though not necessarily for profits themselves, at least not nominal ones.


Because it causes the inflation to manifest in prices more broadly throughout the economy ultimately allowing pricing power to return, which results in two things: a) nominal profits rise, and b) it becomes harder to hide the inflation.

The first part is where you get the bullish headlines; the second part determines their lower value.

Their value is lower because real profits aren't rising nearly as fast as they appear to be on surface, which is why multiples tend to contract in such an environment - as the market discovers this.

Well, if you believe that the CPI or PPI are an accurate barometer of inflation then this is what the data is saying: since the general price level isn't rising that fast, I guess the profit recovery is real; it must be due to all those productivity gains the labor department claims exists.

Heck, that's the conclusion most everyone else seems to be making.

The downside is there's more inflation than productivity, and moreover, there's just plain not enough valuation upside in this stock market to allow it to outperform internationally - which is essentially what's required to support a US$500 (billion) annual trade deficit. Either that or higher rates.

The dollar is going to have to fall until that changes, or until yields rise significantly.

It's been a quiet week in most markets so far.

Traders excused themselves while awaiting the outcome of Tuesday's FOMC. As expected, the committee decided on no change in interest rates:

"The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period" - FRB

They must laugh at anyone who takes this part seriously: "the probability of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level."


I sincerely hope you don't fall for it, because it contradicts the very last sentence (above). Inflation is growing at its fastest rate in a decade to be sure.

The notion that it hasn't yet boosted pricing power is irrelevant. It will. Remember, we're talking about the rate of growth in money supply - an imperfect but far more accurate barometer of inflation than the price gauges. What's more, that last sentence (in the statement) is just another buy signal for gold.

Oil prices drifted lower Tuesday on concerns over the demand side of the Hurricane Isabel story. Oil analysts at Pritchard Capital noted that refineries on the east coast might be shut down, causing a build up of inventories in the weekly DOE figures.

On the other hand, they also pointed out that some nuclear facilities risked shut down, which would boost gas demand.

In our last issue I suggested that oil traders have discounted all the bullish supply news they could for the near future, and that for oil prices to bolt higher we need to see some monetary impetus at this point - i.e. stronger leadership from gold.

However, it seems that the bears are now beginning to discount the nearby bearish supply news as well - meaning the imminent new growth in supplies stemming from improvements in flows from Iraq and Venezuela.

None of the (oil) bears seem to care that demand keeps growing, which means oil is still somewhat cheap. We're still waiting for the drop off in demand the bears called on after 9-11.

Where is it? The fall in demand that is. Nowhere, and it might well remain that way while the Fed sticks to its guns - that inflation is low, and that it will continue to inflate until hell freezes over - which means it will never stop inflating (money and credit). Never is a strong word, but if you look at the historical facts it's more like an understatement.

We're still looking for a bottom in oil this week to upend the fresh fervor on Wall Street.

Another point I'd like to bring up is that the market has priced profits at more than 20 times their trailing levels for the better part of the last twelve years.

When you look at gold stocks today, it is clear they are not a whole lot cheaper than any other stock - if the standard of value is the past.

Clearly, investors are pricing gold shares for much higher gold prices. But most other investors are pricing the rest of the market for much higher real profits. The two propositions contradict each other. If one is going to be right, the other is going to be wrong. They can't both be right for long.

Here's the thing. The earnings most investors expected, and continue to price into most of the rest of the market have yet to arrive. Forget about the prior discussion of nominal versus real, and let's just look at the nominal picture.

Profits grew in the nineties, but not as fast as the market-implied ratios suggested were expected. From 1990 to 2000, S&P profits grew at a nominal 8% annual rate - compounded. From 1995 to 2000 they grew at a 14% rate. Is this what investors price stocks broadly at 25, 30, or 40 times earnings for??

No. They price stocks like that in anticipation of the kind of earnings growth they've so far never seen. The facts by far suggest that the previous bull market was driven by falling interest rates, and inflation.

Clearly it was not driven by actual profits, headline or otherwise, nor was it really driven by the baby boomer theory postulating ever-greater domestic savings, was it? It was driven by profit "outlooks," much as gold stocks are today.

The best explanation for a situation where profit outlooks grow into a bubble and real profits don't follow is inflation policy. Productivity clearly existed to whatever extent, but in my view, all the real benefits of productivity improvements over the past decade have been offset (and then some) by a profligate monetary policy.

This becomes even clearer if we consider that in only one year (2001), headline S&P 500 profits fell by half - practically to where they were in 1990, and at their fastest pace in half a century.

So we don't even need to think about the CPI to see the prior profits weren't real; they weren't sustainable after all. By the end of 2001, the 10-year growth rate in profits fell to 2%. Even worse, they fell to 25% BELOW their 1995 level.

Thus, in the boom period (1995 to 2001) nominal S&P profits fell 4% per year on average.

Are these the kind of figures we price stocks at 25+ times trailing earnings at? Hell no!

Since 2001 the bulls have been trying to recover back to the profit levels of the late nineties. Up to the end of the last quarter, they recovered earnings up to their 1995 levels, such that instead of falling 4% per year since 1995, they are now flat.

This folks, is garbage, and that's why gold is going up today… because the connection between the Fed's monetary policies and the stock market's general overvaluation is gradually becoming clearer, though still only to a minority of players.

The point is, when the majority of investors figure out the extent to which inflation policy is responsible for the stock market's overvaluation, past and present, gold prices will absolutely soar.

In fact, my hunch is that today's gold share values will look cheap in hindsight - even relative to trailing figures.

Nothing illustrates this developing concept better than the new buzz phrase of the day - reflation. The broadening acceptance and use of this term to describe events underscores the comeback… not of inflation, but of inflation expectations.

To me that means the trend is growing towards the realization of the inflation factor in pricing assets, that the earnings aren't as good as they seem. But this trend has far to go considering the substance of press reports about inflation yet:

"U.S. consumer prices rose less than expected in August despite a surge in energy costs and underlying inflation fell to the slowest annual rate in 37 years, the government said on Tuesday in a report that suggests the economy is not yet safe from the dangers of deflation. That means the Federal Reserve, at its policy meeting on Tuesday, will likely repeat its pledge to keep the federal funds rate, now at a 45-year low of 1 percent, for a "considerable" amount of time, even as economic growth has sped up notably. The core Consumer Price Index, which strips out the impact of volatile food and energy prices and is viewed as a better gauge of inflation trends, dropped to a 1.3 percent annual rate in August from 1.5 percent the prior month, the Bureau of Labor Statistics said" - Reuters

Obviously most reporters couldn't tell inflation from a stock market.

The key thing about inflation is that it precisely does not cause all prices to rise at the same time. Get that through the public's thick collective skull, gold will.

The Fed used to just have to worry about hiding inflation. But today, it seems like it doesn't. Of course, that's probably just a fleeting fact of contemporary life.

The point, however, is not that stocks are expensive relative to their past results. It's that they are expensive relative to future results - the evidence of which lies in both past and current developments.

The earnings have not arrived - to the extent they are expected - and now it is increasingly coming to light that they aren't quite real to begin with. It's still a faint light, but it's been turned on.

So no, we're not contradicting our supposition that gold shares are cheaper than the rest of the market, because it's based on the premise that gold itself is cheap, and the fact that we aren't as bullish on real earnings as everyone else seemingly is. In other words, it simply underscores our outlook for the future earnings of gold companies relative to the future earnings of most other companies.

After all, markets are always looking into the future. The main challenge for investors is to pick the right future.

I have to tell you though; I object to the word "reflation." It's wrong.

Not just because Microsoft's spellchecker doesn't recognize it, but also because it assumes inflation is a recent phenomenon. In fact, the Fed has been in "reflation" mode forever, at least in terms of the inflation data.

Occasionally during Greenspan's tenure the data took a back seat to hawkish rhetoric, disguised by a modest increase in short term interest rates from time to time. The term only shows us that some people are only now figuring out what you and I already knew, and what we discussed in our letter today.

In what's almost commonplace now when the dollar gains, the Yen drove upward against it Tuesday while most other currencies fell against the greenback. Yen bulls have pushed the currency right back up against the 115 to 116 dollar/yen support level.

Overall we view it as bearish for the dollar and bullish for gold.

Edmond J. Bugos


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