Adam Steinberg

financial Research

 Building intuition into the Macro Environment [Type
 and understanding the earnings discrepancy contents
 July/Aug 2009



Introduction Simply put: Where will the company earnings, buying power and credit come from to support our ideas of normal in relation to index averages, asset prices and GDP? To build intuition into a look at the past two decades in the US economy, it’s natural to want to understand a) The conditions that appeared constant, abnormal, and/or correlated (uniquely or otherwise) to the period in question (roughly 1993 to present day 2009). b) The link between those conditions and the corresponding values for assets. And, importantly, eventually to ask what factors in the study would serve as determinants for the future. Plainly, would the gradations between prosperity and despair be dependent or independent of the factors that created them in the past. If credit fueled growth and prosperity for a given era, would credit be needed for the same level of prosperity in the future? If consumer spending has fueled US GDP in the post WWII era, does that mean it’s necessary in the future for the same levels of domestic prosperity? And could said spending levels be possible without generous amounts of leverage offered to the consumer? Think of it this way The growth of the U.S. economy in the last decade was fueled by consumer spending (70% of GDP)—and enabled through the credit expanding phenomenon that increasing demand for Home and Auto loans by individual households, quantitative easing, and the repeal of the Glass-Steagall act (Nov 12 ,1999) created. 2

On the front end of the credit lifecycle was the extension of money to the consumer; the life cycle tapered off with dispersion of those loans as securities globally, and then finally through derivatives and multiple re-distributions as the money flow multiplied to exponentially. This cycle has been irrevocably altered across the socio-economic, as well as macro-economic food chain—with the consumers attitude to home buying irrevocably altered and an inevitable move to the upside in interest rates pending, the overall participation rates will be lower than average. This view is only compounded by the demand dampening occurring through decreasing wages, currency values, and employment. Most simply said, a demand slump in the desire for new homes—and the sheer lack of mortgages to make up CDOs not only serves as a dampening factor in asset prices and GDP but cool off (if not breaks) the consumer credit/spending bubble that the new American prosperity hinged itself on. As the recession/depression seeped into the real economy in 2008, spending began to reflect reality.


Previous to 2008, access to personal lines of credit enabled the consumer to funnel trillions of dollars into industry via equity withdrawals.

Where did that money go? To name a few: Home Depot, Starbucks, Las Vegas, Vacationing, Whole Foods, The high end goods industry boomed with names like Pottery Barn and Apple. As home equity withdrawals peaked between 04’ and 07’ So did the earnings of America’s ruling retail players. This could bring up a conversation surrounding just how good business was at doing business in this period. Pointedly, could anyone make money in this era just by virtue of showing up? 4

Consumer favorite Starbucks’ stock price peaked in unison with the equity withdrawals.

Outspending Prosperity As the amount of wealth in the economy started to peak in 05’ the national savings rate turned negative. The consumer had little discretion in discretionary spending, and obviously felt compelled by aforementioned retail good providers to go into further debt.


As a result, S&P 500 companies, for example, enjoyed relatively easy profits with wasteful systems and un-necessary products. The ERA of the free lunch was in effect, literally. Google’s annual budget for employee meals was 72 million dollars for one recent year. With legions of MBAs on staff and the best resources at their disposal, it would be intuitive to think that American business would be cognizant of the effect two decades of extreme liquidity in the money supply would have on their earnings and hedge accordingly through dynamic planning i.e. forecasting an eventual pullback in spending.


Alas, this wasn’t the case as legions of CEOs cited the “Macro” environment catching them off guard vis-à-vis an exotic and villainous set of rogues from Wall Street. But one look at a free chart available on the FED’s website would have signaled the era’s blatant abnormalities in the quantity of money available.

Without casting an aggregate of American business as incompetent, one could wonder just what they were doing at work?


The S&P 500 (above) also fell in lockstep with the peak in equity withdrawals and the extreme wealth generation of monetary policy. An earnings frenzy led the index to almost 1600, but with the liquidity and leverage available, it had to go to new highs. There weren’t enough mattresses to put the money in. If we isolate the prosperity of the last decade to the result of 1. Monetary Policy 2. Asset inflation 3. Access to credit We can see that gauging an assets’ future performance by the past’s “average” would be foolish in the sense that the conditions that enabled those assets to inflate to those data points are acting, or will be acting, in ways contradictory to growth.


The reality A. Monetary policy will have to get tighter, eventually, which will constrict enterprise and credit lines. B. Asset valuations are deflating. And even if they stabilize, a “normal” year over year appreciation seems unlikely. C. Lines of credit are shrinking drastically, why would “normal” be “normal” (e.g. El Erian’s new normal). What will replace those equity withdrawals? Consumers have no credit and are less willing to spend, so how could a GDP that was 70% driven by consumer spending be a viable model?

Consumer assets have no leveraging ability now. The savings rate is surging, and even the bare necessities are harder to pay for due to job losses.


Analysts predicting a return to the mean on S&P earnings, are shortsightedly missing the idea that prices are a function of demand and utility. Loosely said, "normal" is a long way off. The market can continue to misjudge the future and go higher in the short term, without contradicting the state of decay the economy is in. Obviously demand for borrowing and availability of liquidity are positively linked and in order to have an environment flowing with this liquidity like the previous two decades, a restart of the global market for Loans, MBS and other debt instruments (fueled by a demand for housing) would have to occur. Banking has not started funding business and the demand for money is low, very low. While TARP recapitalized loss provisions it did nothing to motivate lending. What it did do is give large financial institutions more money to trade with. As banks continue to fail on a regional level, the global “too big to fail” banks are increasing their assets as the consolidation of money continues.


While wall street priced in a robust recovery from March to Aug 09’, resulting in earnings multiples of 16 and counting, they discounted the coming CRE and prime loan defaults—and are no longer pricing any considerable risk into stocks or US economy in general. Underestimating the coming impact, overestimating the Governments effectiveness in dealing with the coming issues, and assuming a return to business as usual has lead equity prices too high and too fast. That's one problem: but Wall Street priced these stocks from an Inflation perspective, while all signs (in the shorter term) lead to a deflation or stagflation environment. As asset prices begin to reflect real earnings, top-line sales, and restricted credit conditions, where will the market find optimism and upward pressure? Does American business have any more rabbits in the hat? After the lay-offs, cost cutting, and efficiency measures, will there be demand for their products in the face of worsening macro data? The question, simply, remains: Where will the money come from?


8/2/09 5:06 PM

13 Adam Steinberg, Research 2009

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