Tuesday, December 4, 2012

Divergence Between Consumer Sentiment and Corporate Sentiment

The guts of most pessimistic on the USA recovery,  and often the main focus of most in the market, is the sentiment reads of corporations.  The most well followed is the ISM manufacturing (NAPM on FRED) which yesterday dipped below 50 and into "contraction" with a read of 49.5.

The ISM Mnf, to older folks remembered and still called NAPM, is as follows:

 The Institute for Supply Management surveys more than 300 manufacturing firms on employment, production, new orders, supplier deliveries, and inventories. A composite diffusion index of national manufacturing conditions is constructed, where readings above (below) 50 percent indicate an expanding (contracting) factory sector. Export orders, import orders, backlog orders and prices paid for raw and unfinished materials are also measured, but these are not included in the overall index. 

Note this is a diffusion index  and is deliberately composed of the "establishment firms" - much as BEA payroll is polled.

In the early 80s this was somewhat a secret - few really followed it and the index was composed with input form seemingly junior line supply managers.  But as the volatility of the economy became front and center from 80s on, especially for fixed income, media and pundits picked up the importance of the index and this fed back to the participants so that a more senior weightier and thoughtful voice gave the view. and in time it became a solid reflection of the senior levels of the firm, not the old Asst VP purchasing manager.   The APM became aware of their importance and hired some economists and a party line was given rather than what a diffusion index seeks.  This still makes it very useful, though, in getting a good handle of de rigor thought from corporate America.  Which, because that is the nature of economic cycles, is reactionary and ex post and empirical, and almost never ex ante, prescient, or Bayesian type forward looking.  That consistency makes it still a must follow economic data point.  It has also been around for a long time so has a long array.  lastly, it is covering an ever shrinking, though slowly, share of GDP - now about 16% of GDP.

(Click on all images to see larger view)

Just eyeballing the above one can see all the cant and popular views of the economy to debt celinings to deficit to Europe to fiscal cliff etc etc; one can also see it is not at all in synch, but for Q2 and Q3 2009, with the SP500 improvement - in fact the correlation is negative.  Though sheer flow across the company warehouse docks insists on creep upwards, the index becomes beaten down and seemingly in two steps in March 11 and April 12.  It is not lost on me that these downward steps are usually when a organized lobbying effort or attack during the election took place.  I suspect it is organized.  The step function is not observed but for this 2 year period leading up to the election. Prior, as far as I can eyeball it moves discreetly. 

On the other side of the coin is consumer sentiment, retail, which is now 71% of GDP.  It was about 67% in 1978 when the U of Michigan started their version of consumer sentiment (UMCSENT on FRED) and has steadily creeped higher. This is a sentiment not a diffusion index so it moves as you would expect any such broadly based poll:

The University of Michigan's Consumer Survey Center questions 500 households each month on their financial conditions and attitudes about the economy. Consumer sentiment is directly related to the strength of consumer spending. Consumer confidence and consumer sentiment are two ways of talking about consumer attitudes

In contrast to the general opinion of corporate America, UMCSENT has reflected the equity market in general:

Obviously the 71% of GDP UMCSENT is at a rather extreme divergence form NAPM considering the last couple of quarters, but how much so?  First, looking at simple xy scatter doesnt seem that extraordinary at all, in fact the current pair is right smack in the middle of the available history to 1978:

Which might explain the complaceny in almost all accepting this divergence as the "norm".  But of course everyone knows scatters aint worth much unless they are of "first differences", so lets replot the xy using rolling annual % change year over year:

And then the divergence is obvious - it is historical wide and extraordinary.  I have the last xy as a red dot above and linked the previous months so the migration can be considered. That also is unique as most divergence develop from a lower value of UMCSENT and also in an clockwise arc towards the N.  They also do not last more than one month before one or the other pulls the pair into the norm.  This has been a very persistent 4 months in this extreme.  It is almost as if US corporations are motivated to be stubbornly dour as a form of communication/lobbying, or they are in a different economy, a different world.

I think it is both.  I strongly suspect there is an anti-Obama campaign, which  supported  Romney and also to offer a "deal"  to POTUS where support will be given provided the corporate tax rate in the USA is addressed and repatriation of offshore funds allowed.  The US international corporate is tied up in what has become a torquing financial structure that causes great friction to allow the USA corp to follow a swiftly expanding US recovery.  This is from the tax rate policy  they can construct offshore effective tax of 9% (AAPL) to 16%, with the mean roughly around 12%.  Therefore expansion of US capacity has to have a non-tax advantaged return  of about 3% ROI greater versus offshore projects.  This may not seem like much but it is massive when one considers cost of capital is now about 6% - a USA project has to have 16% ROI to the corporation so as to compete against the Ireland based facility generating 12%.  Then if the US corp tax  rate might be even increased - or additional health costs, the corporation is motivated to bet on Europe or China rather than USA domestic demand.  This was especially easy to present to the board when the popular press lurches from bearishly perceiving one event to another that suggests doom and gloom for the USA, especially if unemployment and other key metrics and forward views of respect are suggesting USA GDP will be capped at 2%, if not reenter contraction.  So the dual gain of impeding Obama and working to a position of leverage in terms of possibly gaining a tax deal from POTUS creates strong inertia for CAPEX and corporate investment in  the USA.  The CFO (the person now polled by NAPM) can sagely state that not only are things bad but they are getting worse, irrespective of the fact that the malls parking lots are full as he drove to work, the new cars on the road,  that houses in his town just went up 10%, and the SPX is up to 1410 from 1200 a year ago.  He can defy  his own corporate equity price gains.  But only to a point.

What we saw 4th Q 2011 might be in the making:

Where almost 4% was added in one quarter by corporate America - despite proclaiming to the world via NAPM (around 52 after being around 58 1Q 2011)  that things were still pretty miserable. That 4% represents about 175 billion.  To catch up considering the near "work to rule strike" that corporate USA has applied throughout 2012 - about 300 bil is required for catchup and then about 80 bil per quarter thereafter.  With Boeing taking down 103 bil for 2013 lease financing and autos headed to exceed 16MM sales per year - US corporates will have no choice and a panic will likely begin.  Especially as EU starts to fade and China looks like it will be a disaster.  Likely many new CEOs will appear on the scene as boards respond as this massive error in strategy is mended. You already get a sense of the scrambling and spin control as the likes of CAT and FedEx become a bit strained in blaming Europe and China and everything else under the sun, while companies which either did not make this bet or are also forward looking and honest in mending error as describing a robust US economy - UPS and Ford come to mind.   Irony is the near failure of the US auto industry in 2009, but for Ford, forced a US domestic centric policy and also with lack of much profit, if any, they were not driven by the international tax rate spread and they had no time for Sinophile spiels.

Since the divergence is unprecedented it remains to be seen how much impetus this gives private domestic investment above, or CAPEX but looking at the subsequent annual return of the SP500 to the first difference spread of the two (% ann UMCSENT-NAPM) one gets the near riskless nature of being long SP500 now - unless fo course US retail is completely bonkers and a depression is going to occur Q1 2013.  Seasonal sales blowout and the harsh but very Keynesian boost Sandy has provided already take that possibility off the table.

The above red diamond is the current spread of UMCSENT-NAPM % ann, but the forward looking SP500 return was just chosen out of thin air but the graph does suggest it is very reasonable.  What is obvious is that  the chances of losing money being long SP500, given the 15 tril behemoth with 11 tril of that in the stuff consumer confidence fuels, are very very slim indeed.

It would make sense that given the above, the realities of a a recovery for the largest economic unit in history of mankind,  recovering from a once per century downside event, and the preoccupation on parts of this economy that are near minuscule to its makeup; it would make sense to see SP500 current prospects risk adjusted as life time cheap.  Of course once that view is adopted it has implications on other assets and the correct portfolio construct.