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Soc Gen: Meltdown Imminent

Thursday, September 04, 2008 | 04:00 PM

in Earnings | Markets | Trading | Valuation

When people try to figure out what was the cause of today's 344 point whackage, one of the items they will point to will be SocGen's alert today from Albert Edwards:

***Alert****Economic and equity market meltdown imminent****Alert***

Last week saw the publication of Q2 US whole economy profits data. They were shockingly bad. Core measures of profitability are in free-fall and have now reached a tipping point, where corporate activity could easily implode. We have also reached the point where companies give up ‘manipulating’ their profits higher and admit they are actually in free-fall. A combination of economic and reported profits slumping will catalyse the next equity downleg.

I always look askance at such precisely timed alerts -- firstly, because timing markets this precisely is extremely difficult, and second, if memory serves, this is not the first such alert from SocGen.

As to the fundamentals of Edwards argument, he is spot on. Note our prior mention of the SocGen team was back in June (“Appalling” Market Fundamentals, Not Inflation, Is The Problem).

Profits Lead Stocks

chart courtesy of Société Générale

Here's a brief excerpt:

US Q2 whole economy profits were shockingly poor. The headline data (post-tax) were down 6% yoy - bad but not a disaster. But our preferred measure of underlying profits (domestic non-financial economic profits -- full explanation later) is down a surprisingly sharp 17½% yoy. The last 4 quarter's average is down 12% yoy (see chart below). Typically we have now reached the point in the cycle where companies reach the end of the road on earnings manipulation and have to admit to their shareholders how bad things really are, sending reported profits diving. James Montier's recent piece "Cooking the Books" suggests that some companies may indeed be doing what the title implies. But analysts currently see no prospect of a non-financial profits slowdown, let alone recession (see table below). Why? Because companies have not yet owned up to the mess they are in and told the analysts to downgrade their numbers!

We are at a very similar point to the end of 2000, just before corporate capitulation sent
reported profits and the economy diving and the equity market collapsed.

Economists typically model corporate profits as a residual, with it dropping out of their
economic models as a function of what is happening to the economy overall. We have always believed though that corporate profits are a key driver of the economic cycle, rather than just the result of it. Historically, recessions are 'caused' (in an accounting sense) by the corporate sector. As profits decline, after a point companies finally bite the bullet and business investment slumps (see chart below). Historically, the evolution of pre-tax domestic nonfinancial profits proves to be the best explanation for company's domestic spending activity.

Hat tip: Paul Kedrosky

Source:
Global Strategy Weekly
Albert Edwards
4 September 2008