By David Stockman as originally published on Contra Corner and reprinted here with permission
The casino opened a bit jiggy yesterday (it didn’t last) on month-end window dressing and the alleged “blow-out” earnings of another Dow component. This time it was McDonald’s, which posted a sizzling “adjusted” earnings gain of 22%.
Except there was absolutely nothing to all the ballyhoo. Sales actually decreased by 9%versus the year ago quarter, and save for the dollar’s swoon last year (now reversing rapidly) sales would have been down by 15%.
Never mind say the sell-side numbers wizards. The revenue plunge was due to “strategic repositioning” by the company—-meaning it has sold off company stores to franchisees, thereby shrinking its top line.
Fine. Management claims that was all done to improve operating performance.
But it didn’t.
Operating income was up just 5.0% on a reported basis, but was flat when adjusted for the dollar’s swoon. And pre-tax income was up 4% on a reported basis, but down 1% in constant currencies.
So how did negative pre-tax income growth in constant currencies morph into a 22% adjusted gain per share?
Well, it happened in essentially the same manner which brought about the whole brouhaha about booming Q1 earnings.
To wit, last year McDonald’s tax rate was 32.8% versus 24.4% this year (after the $0.07 carryover adjustment from Q4); its share count last year was also 3.3% higher (825.2 million shares versus 798.7 million) and the dollar was 5.5% stronger. Accordingly, its reported earnings were just $1.47 per share last year.
On a constant currency, constant tax rate, constant share basis, however, McDonald’s earned $1.79 per share this year and $1.80 last year!
In short, Mickey D’s is the poster boy for the Q1 head fake that is being perpetrated by the sell-side and their handmaidens in the financial press. Nearly all the ballyhooed gain is due to currency, share counts and tax rates.
Needless to say, you can’t capitalize those types of gains because they are non-recurring and non-sustainable.
Nevertheless, the questions recurs. When the casino hyper-ventilates about a 22% headline gain which arises from the zero growth economics evident in even the company’s own 2-page press release, you are dealing with some heavy duty mendacity.
Indeed, the Wall Street narrative has been so completely dumbed-down to grotesquely manipulated (“adjusted”), short-term headline deltas that anything which once resembled fundamental analysis was lost long ago.
And the street’s affinity for Keynesian beer goggles has only compounded the financial myopia. That is, it sees close up items (last quarter) in sharp focus, but most time-distant matters (1-10 year back) end up in a complete blur.
No matter. The casino’s day traders and robo-machines are programed by the utterly flawed and unwarranted Keynesian assumption that economies and business profits never stop growing as long as the central bank is “accommodative”. So they really don’t care what the 10-year trend has been because the Fed will keep the party going indefinitely, or succumb to a Wall Street hissy fit if it actually tries to remove the punch bowl.
Needless to say, there could not be a more specious assumption at the present moment. That’s because the current expansion is now in month #106.
That makes it technically the seconded longest cycle ever, having now passed LBJ’s “guns and butter” boom of the 1960s (105 months)—even as it presses hard upon the 119 month record of the 1990s.
But here’s the thing. The current cycle’s stellar old age has been achieved on the back of the weakest business recovery in history; and in the context of an economy that has been starved for productive investment while being freighted down with staggering amounts of public and private debt.
Stated differently, it is always foolish to pay nose-bleed PE multiples at the top of a business cycle because by definition such peak earnings levels are not sustainable and can’t be capitalized as if they are.
For instance, peak S&P 500 earnings of $85 per share for the June 2007 LTM period were capitalized at just 17.6X at the time. Yet that wasn’t cheap or the time to buy the proverbial dip: Within two years, earnings had withered t0 just $7 share, and the stock index had plunged by 55%.
But at 106 months of age, the current cycle is virtually on a respirator. That’s because sustained growth takes investment in productive assets, but there hasn’t been any—as in nichts, nada, nugatory and none.
Accordingly, the US body economic is exceedingly fragile, and not about to grow by the leaps and bounds implicit in current two-year earnings growth rate projections of 54% ($169 per share estimated for 2019 versus $110 per share actual for 2017) .
To wit, real net fixed business (i.e. nonresidential) was $492.4 billion as per the Commerce Department’s freshly minted numbers for Q1 2018. And that means ten years have produced a big fat rounding error: The figure was $492.1 billion way back in Q4 2007!
Needless to say, this isn’t what Steve Liesman tells you on bubble-vision or what the Fed occasionally mentions in its post-meeting economic weather reports.
That’s because in good Keynesian fashion they focus on real gross business investment, which has expanded from $2.0 trillion at the 2007 peak to $2.4 trillion in Q1 2018. Even then, the implied growth rate of 1.9% per annum is nothing to write home about.
Still, that tepid investment growth rate gets whitewashed by the mainstream narrative with the claim that the deep valley in real gross investment during the Great Recession represented some kind of 100-year flood occurrence, and that we are still pulling out of the rut.
Then again, real gross business investment way back at the turn of the century in Q1 2000 posted at$1.6 trillion. This means that during the entirety of this century to date—over two Keynesian booms and one bust—-the trend growth rate has been only 2.3% per annum.
And that get’s us to the skunk in the woodpile. During the same 18 year period, real capital consumption by the business sector rose from $1.09 trillion to $1.91 trillion or by 3.2% per annum.
Stated differently, over the course of the last two business cycles, the growth rate of real capital consumption was far higher than that of real gross investment. The US economy was essentially eating is seed corn.
In fact, real net business investment back in Q1 2000 was $508 billion at an annual rate or about3.3% higher than the $492 billion rate posted for the quarter just ended (Q1 2018).
Moreover, if you look at the three elements that comprise business investment, the story is pretty much the same.
Real net investment in structures printed at $129 billion in Q1 2018, but that represented a negative 2.5% annual growth since Q1 2000 when the number clocked in at $203 billion (all figures in 2009$).
Likewise, real net investment in intellectual property was essentially flat at $104 billion over the period; and real net investment in equipment of $261 billion during the period just ended reflected a growth rate of just 0.95% per annum—and that goes all the way back to the approximate time that Bill Clinton explained to the world what the meaning of “is’ is.
It goes without saying that zero growth in real net investment for 18 years running is something new under the sun, and not in a good way; and not in a way which is remotely compatible with Wall Street’s current 54% earnings growth hockey stick over the next two years.
Indeed, the weakness of the US economy at the 106 month stage of the current cycle could not be more dramatically underscored than by way of comparison with what happened during the 1990s record expansion (119 months).
During that 10-year period, real nest business investment grew from $169 billion (1990) to $526 billion (2000) or by 12.0% per annum.
Even then, the 1990s business cycle did expire in March 2001. Thereupon followed a modest recession over the next several quarters— until Greenspan threw open the monetary spigots and ignited the housing and credit bubble that ended in tears in September 2008.
And that dials us into the other skunk in the woodpile this time around. Namely, record levels of total public and private debt and a national leverage ratio that remains in the nosebleed section of history.
And that, too, contrasts dramatically with the earlier long-lived cycles. Thus, back during the 105 month expansion of the 1960s, the initial debt level during Q3 1960 was $777 billion, which represented 1.42X GDP. When the expansion finally ended in Q4 1969, the total public and private debt level had risen to $1.04 trillion, but was still just 1.48X GDP.
In a word, the debt burden was low and in keeping with the 100-year trend at about 1.5X national income; and the implicit leverage ratio had not increased measurably.
Likewise, during the 1990s boom, the initial debt levels was $13.8 trillion, which represented 2.3XGDP; and the ending level in December 2000 was $29.0 trillion and represented 2.8X GDP.
So the leverage ratio grew materially during the so-called Greenspan tech boom of the 1990s, but it was at least accompanied by a robust rate of net investment growth, which as shown above tripled over the 10-year period.
By contrast, the starting debt in December 2007 was $52.6 trillion. That represented 3.58X GDP and was evidence of the national LBO which occurred after the inauguration of Bubble Finance in October 1987.
Needless to say, the last eight years of so-called recovery have produced virtually no deleveraging, with total public and private debt now at $68.6 trillion or still 3.47X GDP.
In short, the second longest expansion in recorded US history has been accompanied by zero real net investment growth and a $16 trillion increase in nominal debt.
At the same time, as we showed in Part 1, industrial production has also flat-lined as have real median household incomes. In fact, between 1999 and 2016, real median incomes grew by the grand sum of $22 per year.
In other words, the main street economy has essentially gone nowhere during the last decade and one-half and is heading for even weaker results ahead— given the current staggering debt burden and the deep deficiency of real net investment.
Only if you credit Mickey D’s with earnings growth of 22% during the recent quarter could you possibly conclude that now is the time to buy the dip.
In fact, what is actually heading for a dip is the current aging, frail business cycle. And this time the Fed will not be at the ready with firehouse and ladder.
Indeed, the Eccles Building is now hell-bent on administering the bleeding cure of QT; and that’s not the way the other two long expansions ended, either.