Housing bubble reincarnated as oil

We took my six-month old grandson to the park this weekend and put him into a baby swing for the first time. He couldn't decide if it was fun or not and took turns crying for a while then laughing for a while. I think of that when I read about the oil bubble.

The Fed has reincarnated the real estate bubble of the early 2000s in the current tsunami of oil. To see how, we need summon the help of the Austrian Business-Cycle Theory (ABCT). The ABCT says that Fed induced interest rates below  the rate that the market would naturally set causes excess borrowing and investment in capital goods industries, not a general over investment, but bad investments in particular industries. The market reveals those excess investments through falling prices that cut into profits, reduce employment and spark a recession in the economy.

Earnings stumble

Despite what mainstream finance and economics teach, the stock market is rational. Two things drive it - profits and risk tolerance, or as they say in finance, the discount rate. Both have advanced the stock market from its lows at the bottom of the latest recession to recent record highs as profit rates and risk tolerance soared so that investors have been willing to pay more for the same profits.

As of the writing of this post, the S&P 500 is down about 3% from its record set on March 2. Some of the selling could have come from profit taking or covering shorts, but much of it is due to concerns about future earnings. Last week I showed that profit rates are at record highs and reasonable investors would assume such rates are unsustainable based on the history. And that seems to be the case as Seeking Alpha's Brian Gilmartin wrote:

Looking at the first half of 2015, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 and Q2 '15, compared to expectations for earnings and revenue growth for both quarters back on December 31 '14.

How high can profits go?

The market set new records this week. Some of the lift came from the European Central Bank printing new Euros. As the ECB buys bonds, the sellers are buying into the US stock market thinking that it is the safest repository. The ECB printing presses will impact stock markets for six months then, like any drug, the effect will begin to wear off. In microeconomics that’s called diminishing marginal returns.

The graph to the left shows profit rates from US domestic only earnings plotted in blue and labeled “Domestic Profit Rates” with the domestic profits that include foreign earnings plotted in red and labeled "National Profit Rates." The data comes the NIPA tables at the Bureau of Economic Analysis. Domestic profit rates are at their highest since 1965, but national rates are at their highest level on record. The high level of profits, and the records in the stock market in spite of a relatively sluggish economy, emphasizes the growing importance of foreign earnings. 

It's not likely that profits can continue to soar and many market watchers are pessimistic about future earnings. The Financial Times columnist Gavyn Davies reported recently that 

Albert Edwards, the market's favourite bear at Societie Generale, wrote last week that the rte of decline in analysts' forward profit expectations in the US is clearly associated with recession. According to MSCI data, profits downgrades are exceeding upgrades by a net 33 percent at present.

Some of the decline in expected earnings comes from falling oil prices and much of the rest from the rising dollar that reduces earnings from overseas. 

Schwab's Liz Ann Sonders estimates that the forward looking price-to-earnings ratio growth rate has actually gone negative:

Bespoke Investment Group (BIG) calculates the “guidance spread” each quarter, which measures the difference between the percentage of companies raising guidance and lowering guidance; so when the number is negative, more companies have lowered guidance than raised guidance. The spread for the most recent quarter came in at a “ridiculously low” -9.4 percentage points. That was the lowest guidance spread since the final two quarters of 2008, at the end of the financial crisis.

Psychologically speaking, pessimism like that coming out of the financial press is good for the market. If predictions turn out wrong and profits surprise by rising the market will soar.  On the other hand, it's hard to see where earnings growth will come from. Eventually, profits will fall as the Ricardo Effect kicks in and when it does the stock market will collapse as it did in 2000 and 2008.