U.S. stock futures were higher in pre-market trading yesterday and that upbeat sentiment flowed into the official session.  The major indices held onto almost all of the early-session gains, unlike the past two days in which morning rallies were completely rejected in the afternoon.

A better-than-expected Economic Sentiment reading within the Eurozone and a surprise 4.2% rise in Japanese retail sales drove the day’s relative optimism.  A good spending number for February in the U.S., even though it was not accompanied by an increase in income, kept that momentum going. 

Energy shares led the way as the price of crude rose 3% to close at $82.36/barrel.  Other outperformers were utility, health-care, industrial and basic material shares.  The indexes that track technology and consumer discretionary stocks were the only losers on the session. 

Market Activity for March 29, 2010

Personal Income & Spending

The Commerce Department reported that personal income came in unchanged during February following an upwardly revised 0.3% increase in January.  Economists had expected a 0.1% increase last month, but with the upward revision to the previous month’s reading their estimate was close to accurate. 

The wage & salary component was unchanged in February relative to the month prior and proprietors’ income fell 0.6%.  Basically, what kept the overall income figure from falling was another large increase in the government transfer payments component, which jumped $16.6 billion and offset the $16.5 billion decline within the personal income via assets component – that component was pushed lower by a $15.5 billion slide in dividend income, down $31 billion last two months.  Dividend income is down 30% from its peak in May 2007, and up just 3% from the cycle low touched in June 2009.

On the expenditures side of the report, personal spending rose 0.3% (in line with expectations) after a 0.4% increase in January.  As a result of spending outpacing incomes for six of the past eight months, the cash savings rate has dropped back to 3.1% after hitting a multi-year high of 6.4% in May.  This figure needs to get back to the 6% level and stick there; I believe this is necessary due to the high level of joblessness and $12 trillion hit to household net worth.  The cash savings rate has averaged 6.6% over the past 40 years. 

Here’s the key: if we are engaged in a durable economic expansion, one that lasts for several years and therefore provides sustained profit growth that allows for a multi-year run in stock prices, then a lower cash savings rate will be required – maybe something in the 3% range.  However, if this is not accomplished and we must wait a couple of years to work through several economic challenges before a multi-year expansion ensues, then a cash savings rate of 6% will be necessary.

Government transfer payments continue to account for 20% of total income, a record level, and are allowing for higher spending results than would otherwise be the case. 

How long can it last?   Public-sector spending levels are already leading to other problems (deficit levels and a large-scale misallocation of resources) and cannot continue at this pace.  At which point, consumer activity is likely to show another round of weakness as households must pay down debt and possibly boost cash savings, but without the help of continued increases in government transfer payments.  

Dallas Fed

The Dallas Federal Reserve Bank’s gauge of manufacturing activity within the 11^th Fed district bounced to expansion mode after just slightly slipping to expansion mode in February.  The March reading came in at 7.2 (a number over zero marks expansion) after the -0.1 in February.

New orders, back log of orders, the average workweek and inventories all showed expansion.  Yet the capital expenditure reading (the gauge of business-equipment spending) remained in contraction mode.  The prices paid reading remains high at 39.3, while prices received remains in contraction mode – this doesn’t speak well for profit margins. 

This gauge was introduced in 2004, so not much history there.  I felt it was worth a mention, nonetheless. 

Now Profits are All the Rage

The WSJ ran a story over the weekend touching on the climb in corporate profits over the past couple of quarters.  The measure of profits they are referring to are the corporate profits measured within the GDP report – these profits are the most reliable to watch because they adjust for inventory and capital consumption changes; this means there is no legerdemain involved, these are the figures reported to the IRS. 

While the article I’m referring to focuses on pre-tax profits, I find the best measure to be the after-tax figure; pre-tax profits are about as functional as pre-tax income.  Measuring these profits from the cycle low hit in the fourth-quarter of 2008 (a level that brought the measure back to Q1 2004 levels), they have rebounded by 51.8%. 

That’s pretty good; I hope it is sustainable with the troubles that lie ahead for the financial sector.  But you know, I don’t recall any financial journalists waxing on the beauty of the postwar record run of 20-straight quarters of after-tax corporate profit growth that began in the final quarter of 2001 – this was a profit run that made possible the extraordinary cash levels within corporate America today.  These cash levels didn’t suddenly appear, they’ve been building for years.

What’s more, the current profit increase has been unusually boosted by the financial sector, and as far as I’m concerned insured bank profits are artificially inflated as the Fed is currently subsidizing interest income like never before and banks are not setting aside enough provisions relative to the increase in non-current loans (provisions are an expense, so reduce earnings).  The FDIC’s own coverage ratio, a gauge that tracks the relationship between cash set aside to protect capital against potential losses (provisions) and non-current loan growth, is less than half its historic average.   

As a result, I find it appropriate in this environment to exclude financials from the earnings analysis and when doing so you find profits were much stronger during the initial stages of the previous expansion than they are in this one.  During this current profit rebound, which has been three-quarter now, ex-financial after-tax corporate profits are up 18.6%.  Contrast that to the profit rebound during the first three quarters of the 2001 rebound (the prior cycle) when the figure bounced 34.3% -- nearly double the current increase, yet we heard nothing of this event back then. 

Long-time readings may remember this letter spending much time talking about how financial journalists were derelict in their duty to inform the public, choosing to virtually ignore that previous profit cycle.  Now they celebrate the profit story even as it is likely to be short-lived. 

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900