Is That Recovery We See?

This

week the market seemed to like financial stocks and was buoyed on news that

Pulte Homes would buy Centex to create the largest US homebuilder. And with

banks having some room to adjust their writedowns as mark-to-market is

modified, the market saw significant increases in the financial sector.

Everywhere I keep hearing the old saw that the market predicts a recovery about

six months out, so won't we see a recovery in the fourth quarter of 2009?

If

you look at earnings estimates for 2009, that is what is suggested. Bloomberg

reports that profits at S&P 500 companies probably fell 38% on average in

the first quarter. The stretch of quarterly declines is the longest since at

least the Great Depression, data compiled by S&P and Bloomberg show.

Earnings may drop 31% in the second

quarter and 18% in the next before gaining 74% in the last three months of the

year, analysts predict. Banks are projected to account for all of the rebound in the

final quarter. Without financial companies, the gain turns into a 5%

decline, the data show.

The above estimates are based on

operating earnings, not as-reported earnings. Long-time readers know that

operating earnings are actually earnings before interest and Bad Stuff. As-reported

earnings are what companies actually report on their tax reports, and as a

gauge of profitability they are much more reliable. Before the mid-'90s the

difference between operating and as-reported earnings was typically quite small.

Then companies found they could play the market if they played games with their

operating earnings.

Operating earnings typically do not

take into account one-time, nonrecurring events. The number of items which get

classified as "nonrecurring" has mushroomed to the point where projected

operating earnings for 2009 are more than double the estimates of as-reported

earnings. Operating earnings for 2008 were almost three times actual, or as-reported,

earnings. We certainly seem to have entered an era of really bad one-time

events, which just keep on coming and coming. As recently as 2006, there was

less than a 10% difference between the two. In some quarters it was only 5%. A

far cry from today's 100%-plus.

Those Wild and Crazy Analysts

Analysts, who as a group have been

egregiously bad at predicting earnings of financial stocks for the last two

years, would have us believe they are due for a large rise in the 4th

quarter. Let's visit those assumptions for a few minutes.

They contend that much of the bad

news in the subprime-loan and housing market has been written off. And one

would have to admit that a lot has been; and with the relaxation of

mark-to-market, there may indeed be some truth to that suggestion. But there

are still some issues that remain for housing. Take a look at the graph below.

(Not sure where it is from, as it was sent to me, but I have seen the same data

elsewhere.) Notice that monthly mortgage-rate resets declined markedly in 2009

from 2008, but are expected to rise again in 2010 and 2011. There is still some

heartburn in the mortgage market.

The Shadow Inventory of Homes

And foreclosures keep climbing, though some point to that

fact that they seem to be leveling off. However, a strange thing is happening.

We are seeing what is being called a "shadow inventory" of foreclosed homes.

"We believe there are in the

neighborhood of 600,000 properties nationwide that banks have repossessed but

not put on the market," said Rick Sharga, vice president of RealtyTrac, which

compiles nationwide statistics on foreclosures. "California probably represents

80,000 of those homes. It could be disastrous if the banks suddenly flooded the

market with those distressed properties. You'd have further depreciation and

carnage." (San Francisco Chronicle)

A Realty Trac survey found that

only 30% of foreclosures were listed for sale in real estate listings like the

MLS (Multiple Listing Service). Add in homes that people would like to sell but

simply can't find buyers for, and must either hold or rent, and the unsold

inventory numbers that are public are likely far below actual available homes.

Might some homes in foreclosure be

held off the market because banks eventually want to negotiate with the

homeowner? Possibly, but other surveys show that anywhere from 30-40% of homes

in the foreclosure process in many areas are actually already vacant. There is

no one with whom to negotiate.

Typically a foreclosed home sells

within a few weeks, as banks take the first "reasonable" offer. But it normally

takes about three months from foreclosure to when the home is put on the market

-- it takes a few months to get a home

ready. But surveys show it is taking a lot longer now, and many homes have not

made it onto the market, even as more homes are being foreclosed each month.

The Chronicle suggests

several factors may be at work. First, there is the "pig-in-the-python"

problem. There are just so many homes that it is hard to get them onto the

market and sold. Normally there are about 160,000 homes a year in foreclosure

sales. We are now seeing 80,000 a month, or six times normal levels, and

rising.

Second, lenders could be deferring sales

to put off having to acknowledge the actual extent of their losses. "With

banks in the stress they're in, I don't think they're anxious to show losses in

assets on their balance sheets," one observer said.

Finally, banks may not want to

flood the market with foreclosures, driving prices down even more. They are

simply managing their assets so as to recover the most capital they can.

Given that the graph above says there

will be more mortgage misery as large numbers of mortgages reset in the next

two years, and given the unknowable nature of the losses, it is somewhat

optimistic to think financial profits will rise by 74% in the fourth quarter.

But it gets worse.

Commercial Real Estate Starts a Long, Slow Slide

We are now starting to see some

real deterioration in traditional bank lending. Delinquencies on home equity

loans are rising rapidly. The American Banking

Association released a composite index of eight different types of consumer

loans, and the delinquency rate on this 35-year-old composite jumped to a

record high of 3.22%.

The

above reflects 4th-quarter data. As unemployment is up 2% since then

and is rising, it is more than reasonable to assume that we will see another

record rise in delinquencies this quarter. With unemployment headed to over 10%

and maybe 11% from today's 8.5%, delinquencies are likely to continue to rise

for the entire year.

David

Rosenberg reports that "The National Federation of Independent Business found

in a poll that 28% of small firms said they had a line of credit or credit card

limit cut back in the second half of last year; 69% stated they are facing

worse terms. A new FICO study found that 11% of US consumers -- 22

million people -- have had their credit lines cut or accounts closed even

though they have been paying their bills on time and retain a solid rating."

This is certainly not good news for those who expect a positive 4th

quarter. Cutting credit to small business, the engine of job growth in the US,

is hardly a prescription for a growing economy.

Commercial

mortgages are in trouble. S&P has warned they may cut ratings on $97

billion in commercial-mortgage asset-backed debt. The country's 10

biggest banks have $327.6 billion in commercial mortgages, according to

regulatory filings. A projected tripling in the default rate would result in

losses of about 7% of total unpaid balances, according to estimates from

analysts at research firm Reis Inc. (Bloomberg)

I think, given the track record of

the analysts who project a 74% rise in earnings for financial stocks in the 4th

quarter of this year, that we should remain a tad skeptical. And speaking of

earnings, let's go to the S&P web site and see how things are progressing.

But first, let's look at just how

badly analysts blew it in estimating 2008 earnings. In the table below we see

that as recently as October 15 they were estimating AS-REPORTED earnings to be

$54, down from $92 when I first saw the 2008 estimates. There were only two

months to go in 2008. So, what are the actual 2008 earnings? Down to $14.88!!!

Not exactly a record to inspire

confidence. So, how are we doing in 2009? We see the same pattern. There is a

clear deterioration in earnings estimates. Yet, even with the ever lower estimates,

they are still projecting nearly a doubling from 2008. Care to make a wager as

to what the estimates will look like in a few quarters? Think we will see

earnings rise?

P/E Ratios Go Negative!

When we last visited the S&P

web site a few weeks ago, the P/E ratio for the quarter ending September 30 was

around 181. I must confess that when I looked at it today, as jaded as I am, I

was shocked. You can see the numbers for yourself at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&.

The P/E ratio for the end of the

second quarter is 1944 (not a typo). The losses of the 4th quarter wipe

out almost all earnings for the 12 months ending June 30. But by the end of the

3rd quarter, the estimated P/E ratio has dropped to a (negative)

-467. That has never happened. We have never seen negative earnings over a 12-month

period since WWII. (I don't have data for the Depression era.)

Then as the negative earnings of

the 4th quarter of 2008 drop off, we see the estimated P/E ratio

rise back to 30, which is quite high. However, if actual earnings come in

lower, as I think they will, the P/E ratio will rise and/or the market will

fall as negative earnings surprises just keep on coming.

The Effect of Earnings Surprises

As William Hester of Hussman Funds

writes in a recent article, the rise and fall of the stock market closely

correlates with earnings surprises. Look at the following chart. (You can see

the whole article at http://www.hussmanfunds.com/rsi/econsurprises.htm.

I highly recommend it.)

As Hester writes, "To track the

trends in economic performance, we keep an ongoing tally of how data is

announced relative to expectations -- a method of analysis originally

inspired by Bridgewater Advisors. Economic

data that surpasses expectations gets added to a 3-month running total. Data

that comes in weaker than expected gets subtracted. A rising line means that

economic data is generally coming in above expectations, while a falling line

means that the data has disappointed. A descending line could be the result of

an economy that is not expanding as quickly as economists predict or --

like in 2008 -- it could be the result of an economy that is contracting

at a faster rate than expected.

"... Much of the excitement in the

stock market -- at least that is related to the current performance of the

economy -- seems to be centered on an economy that is performing less

badly than expected. The risks here seem to be that if the trends in data surprises

change, so could investors' attitudes toward stocks that are currently

overbought on a number of measures.

"... If the high correlation between

stock prices and data surprises holds, the recent rally in stocks might be

tested. Even if the economy has bottomed, it's very likely that the eventual

recovery will prove to be uneven, causing the flow of positive surprises to be

uneven. During these periods, the risks to stocks will be greatest when the

market is overbought and investors have priced in high expectations of positive

data surprises continuing."

The projections of many market

analysts assume that we will have something that will look like a normal

recovery. I have objected that that could be a very bad assumption, since we

are not having a normal recession. This is already a very lengthy recession,

and is just going to get longer. As I will note below, there are reasons to

think we could see a mild recovery late this year, only to dip back into

recession next year.

Corporate Earnings and Recovery in Recessions

Next, let's look at a very

interesting chart sent to me by one of my readers, Chad Starliper of Rather and

Kittrell in Knoxville, Tennessee. It shows all the cumulative drops in earnings

from major peaks, along with the recovery paths. What is interesting is the

divergence between the pre- and post-WWII periods. Our experience since 1945 is

one of rather quick recoveries, averaging about 3-4 years until earnings rise

above the old highs.

The thicker black line shows a drop

of 69.2% from peak earnings since 2007. Prior to World War II, it took 12-20

years for earnings to recover. Earnings are still dropping. As I will point out

in the next few e-letters, we live in a world (not just the US) that is in a

deep recession. There is massive deleveraging and deflation. The recovery is

going to be quite slow, and that portends a slow recovery in earnings, which

suggests protracted churning in the stock market. (By the way, for those of you

who print out this letter, the next graph will be hard to read if it is not in

color.)

Even

ignoring the disastrous 4th quarter of 2008, what if earnings drop

by 80% or more, which is quite possible? That means they have to rise by 400%

to get back to new highs. That could take some time. Even if they could rise at

an unlikely 24% a year, it would take six years to see new highs. Look at what

a mountain corporate earnings must climb.

Consumers are retrenching, and

savings rates are likely to rise for at least 3-4 years, back to 7% or more, leaving

consumer spending not at 70% of US GDP but closer to 63%. That will be a rather

large adjustment, and will mean that a lot of productive capacity will have to

be closed or allowed to lie in disuse for a long time. We just built too many

strip malls and car factories and restaurants. It is going to take some

adjustments.

Further, the Democratic Congress

and the Obama administration are going to enact the largest tax increase in

history in 2010, just as the economy is barely recovering. The Bush tax cuts go

away, because the Republicans could not make them permanent when they had the

chance. We are going to pay for that with a likely dip back into a recession in

2010, or at the very least a prolonged weak economy.

The Implosion in Social Security

And then there is the last piece of

data I want to bring to your attention, which is the most troubling of all.

Everyone knows that the government spends the Social Security surpluses on

current needs, "borrowing" the money and putting it into a "Social Security

Trust Fund," which is basically just US debt we owe to the trust fund. In other

words, there is no trust fund with anything other than paper debt. It is

accounting legerdemain.

Everyone assumed that the real problem

would come sometime later next decade, when there would no longer be surpluses.

In 2008, the Congressional Budget Office (CBO) projected there would be $703

billion in surpluses from 2009-18. Recently, the CBO has revised those

estimates downward. It now projects surpluses to be only $83 billion. Here is a

table that was sent to me from a blog by Chris Martensen.

(http://www.chrismartenson.com)

Writes

Chris, "In the projections for the table above, the CBO has assumed no cost of

living adjustments (COLAs) in 2010, 2011, or 2012 and a return to

economic growth next year. If either of those assumptions proves wrong, the

table above gets smoked to the downside."

Losing

$700 billion (and likely a lot more) out of your budget projections is a huge

blow to the US taxpayer. That money is going to have to be borrowed, or

spending reduced. But the plans are for huge increases in spending.

In

one of the great ironies, the Democrats and the Obama administration are going

to have to deal with the Social Security crisis, and soon. Bush tried to do so,

and he got torpedoed from both sides of the aisle. Politicians just do not want

to be seen doing anything to SS. Given the massive, multi-trillion-dollar

deficits that are projected, the US is going to face some difficulty in

borrowing to meet those deficits in the not-too-distant future. Is it 3 years?

4? 5? No one can say for certain, but that day is coming and it now appears much

closer.

Let's

say that US consumers do save 7%. That's almost a trillion a year. The trade

deficit dropped to $26 billion last month, as imports continued to drop. That's

another $300 billion that foreign central banks could recycle. The Fed could

print a few trillion here or there without really pushing up inflation in

today's deflationary world.

But

there is a limit to continued $2-trillion deficits without the appreciable rise

in interest rates that will be needed to attract buyers of Treasury bonds,

which of course would increase interest-rate payments on the national debt,

while also crowding out corporate and personal borrowing. This is not going to

end well, and the end game is getting a lot closer.

All in all, the next few years are

going to be a very difficult environment for corporate earnings. To think we

are headed back to the halcyon years of 2004-06 is not very realistic. And if

you expect a major bull market to develop in this climate, you are not paying

attention.

The original question was "Is that

recovery we see?" I think the answer is no.