All eyes are on the Federal Reverse announcement as the market will quickly parse Bernanke's statements for clues on a reduction of the $85 billion monthly bond buying program that has sent stocks to all-time highs in recent months. As I stated back in February the advance to these new highs was certainly expected as the Fed flooded the financial markets with excess liquidity. The chart below shows the high correlation between the Federal Reserve's balance sheet and the financial markets.
The question is simply this: What happens if the Fed does announce a slowing of their bond buying program?
In theory this is binary answer: "No Taper" - stocks go up. "Taper" - stocks go down. Reality, however, may be more of a singularity for three reasons: overbought conditions, fundamentals and economics.
Overbought Conditions:
There is one truth about the markets, despite Federal Reserve interventions, that remains true: "Stocks do not go in a straight line."
During unfaltering advances in the market investors begin to migrate towards the belief that the stock market will continue its current trajectory indefinitely into the future. This is particularly true near market tops when almost every pundit, analysts and investor is touting why now is the time to "jump in". Of course, history is replete with examples of the disaster that followed such advice.
As we discussed at length in our recent weekly missive "An Initial Sell Signal Approaches" prices can only move so far away from their long term average before "gravity" sucks prices back. The chart below shows the S&P Index on a weekly basis (which smooths out day to day volatility) with a set of Bollinger bands representing 3-standard deviations from the mean.
[Geek Note: In statistics and probability theory, standard deviation shows how much variation or dispersion exists from the average (mean), or expected value. In a normal distribution of data, as shown by the bell curve below, ONE standard deviation from the mean encompasses 68.2% of all data in the distribution (in our case price movement). TWO deviations account for 95.4% of all potential price movement while THREE deviations account for 99.8%. There when prices reach two and three standard deviations above or below their mean the majority of the probable price movement has been achieved.]
With the market trading at 3-standard deviations above the 50-week moving average history suggest that a correction of some magnitude is forthcoming regardless of the Federal Reserve's interventions. This extreme deviation from the long term average combined with record levels of margin debt has the market primed but currently lacking a catalyst to ignite a selling panic.
Fundamentals:
The fundamental underpinnings of the market are also showing signs of strain. While the Federal Reserve interventions, and near zero-interest rate policy, has forced investors to "chase yield" in the financial markets - the current rise in asset prices comes at a time when corporate earnings are hitting a record and showing signs of deterioration as shown in the chart below.
The problem with the peak in earnings is that it negatively impacts the "valuation" story of stocks. If the mainstream analysts are right, and bond yields are set to rise substantially, the valuation story (earnings yield versus interest yield) becomes much less compelling. Ultimately, the weakness that is showing up in the fundamental story will translate into a repricing of "risk" in the markets.
Economics:
Behind the scenes of earnings and price momentum is the economic story. In the long run the markets respond to the strength, weakness, in economic growth. While the market charged ahead in hopes of strengthening economic underpinnings - the problem has been that it has yet to be the case. With the economy "muddling" along at less that a 2% real annual rate - the pickup in employment, above mere population growth, wages and demand have been weak.
The chart below shows real, inflation adjusted, GDP turned into an economic indicator. When the annual growth rate has historically fallen below 2% the economy was either in, or about to be in, a recession. The only time in history that this has not been the case was in 2011 when the economy fell below the 2% threshold for 4 straight quarters. Of course, the bailout of the economy through liquidity programs kept the economy from sliding lower.
The economy is currently pushing a third straight quarter of sub-2% growth with the Federal Reserve discussing taking away a major support for the economy. The extraction of liquidity from the system will stem the forward pull of future consumption, which has come at the expense of higher credit balances and lower personal savings rates for consumers, leading to weaker rates of economic growth.
With corporate earnings dependent on consumer spending (70% of GDP) the gap between economic realities and financial fantasy will likely be filled sooner, if the economy continues to weaken.
The weak economic story, combined with weakening fundamentals and extreme price overvaluation will ultimately lead to a correction of some magnitude in the market. This will occur regardless of whether the Federal Reserve "tapers" their intervention program or not. This leaves investors at the whims of a highly leveraged market that has become much more volatile in recent years. Investors have piled into some of the riskiest assets in the market in their quest for income as their faith has been placed in the Fed that they will prevent a market meltdown. Maybe that is the case, however, history suggests that such blind faith in the markets has rarely worked out well in the long run.
Had a good discussion yesterday with Greg Robb at WSJ Marketwatch discussing various pitfalls that the Fed will face when trying to slow injections of stimulus into the financial markets. The article below is from Greg and he did a nice job coverting the issue. However, one pitfall that I think is missing is the inherent "liquidity trap" that as I discussed previously (see here and here) could wind up being a much larger issue than anticipated in the not so distant future.
It has become fairly clear after all of the talk and turbulence surrounding the Federal Reserve's policy meeting that the central bank wants to pull back on its easy policy stance if it can.
"Market participants have come to accept that the Fed is not going to purchase securities ad infinitum and that the wind-down process will probably be implemented later this year," said Ward McCarthy, chief financial economist at Jefferies & Co.
As the Fed starts its two-day meeting, questions arise over how the Fed should handle tapering its quantitative-easing program and what's in store.
Odds that the Fed would increase the size of its $85 billion-a-month asset purchase plan are now seen as very low. Read preview of Fed's meeting.
But there are a few potential pitfalls that could damage the economy and force the central bank to reverse course, some analysts say. Here are three of them: debt ceiling, deflation and a spooked market.
Debt ceiling
The last stand-off between congressional Republicans and the White House over the debt ceiling in 2011 sent stocks down 20% and pushed down GDP growth by almost a full percentage point, noted Lance Roberts, chief economist of Street Talk Advisors in Houston.
So it is hard to imagine that the Fed will reduce the pace of purchases, "at least not going into" the next debate on the debt ceiling this fall, he said.
Recent good news on the deficit has pushed the timing of this year's debt ceiling clash into October, before a rough deadline in November, said Sean West, head of Eurasia Group's U.S. practice.
Despite some rough talk expected over the summer, the conventional wisdom is that the two sides will avoid a default or a crisis.
"Both parties have signaled that they see little benefit in actually playing chicken with the debt ceiling, though both sides will play hard ball in advance of the deadline, West said.
"This has the lowest potential for a meltdown," West added.
With the conventional wisdom not expecting a show down, any hardening of attitudes as the deadline gets closer could be a "negative surprise," West said. So it would be a "negative surprise" if the risks of no deal rise in September, he noted.
Low inflation
Inflation remains below the Fed's 2% target.
The core consumer price index is up just 1.7% year-on-year in May. The central bank's preferred measure, the index for personal consumption expenditures, is up only 0.7%.
Economists disagree about the causes of the low-inflation trend, which has been in place since the Fed started its latest bond-buying program last September. Some think inflation will bounce back later this year, others are not so sure.
St. Louis Fed President James Bullard has said that low inflation has been a surprise and can allow the Fed to keep up QE3.
McCarthy of Jefferies said that the Fed might actually have to increase the pace of purchases to combat low inflation.
Market correction
One last worry is that the Fed will spook markets with discussion about how fast it might exit from its ultra-easy policy stance.
"Another banana peel is the Fed might tell the market too much and panic the market into a bigger selloff," said Roberts of Street Talk. "The QE rally could come to a quick and sharp end," Roberts said. Consumer confidence would deflate, which could dampen growth, he added.
As of late I have been running counter to the mainstream economists and analysts who have been calling for the end of the "bond bull" market and the "great rotation" from bonds into stocks. This is a topic that I have covered previously when I wrote "Why Bonds Aren't Dead & The Dollar Will Get Weaker" wherein I stated:
"There have been quite a few bold predictions, since the beginning of the year [2013], that the dollar was set to soar and that the great 'bond bull market' was dead. The primary thesis behind these views was that the economy was set to strengthen and inflation would begin to seep its way back into the system. Furthermore, the 'Great Rotation' of bonds into stocks, on the back of said economic strength, would push interest rates substantially higher.
While I have no doubt that at some point down the road that inflation will become an issue, interest will rise and the dollar will strengthen - it just won't be anytime soon. A wave of 'disinflation' is currently engulfing the globe as the Euro-zone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth. Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy. This is a problem that has yet to be recognized by the financial markets."
That wave of disinflation continues to much more prevalent than previously expected. The latest inflation readings (both the Producer and Consumer Price Indices) show deflationary forces still at work. The core reading for PPI declined in May to 1.6% while CPI remained flat at 1.7%. However, PPI and CPI mask the true economic pressures on the consumer as wage growth remains stagnant, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber which indicate weaker levels of economic output both domestically and globally. The battle against the deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis. The problem has been that, much like "Humpty-Dumpty", the broken financial transmission system, as represented by the velocity of money, has not been put back together again.
The chart below shows the Composite Inflation Index (CII) which is an average of both PPI and CPI versus economic growth.
There are two key takeaways from this analysis: 1) Deflationary pressures are more prevalent, at the moment, than inflationary ones; and 2) The CII points to weaker economic growth in the coming quarters which is likely to keep the Fed on hold for a while longer.
Both of these issue point to why the "Great Rotation" has yet to occur. Despite the Federal Reserve's ongoing efforts to inflate asset prices; such inflation is not translating to "Main Street" in the form of higher wages, increased consumption or higher standards of living. The Federal Reserve has often discussed that there are limits to monetary policy and they may have found those limits in its most recent endeavors.
Secondly, the decline in inflationary pressures say much about the actual economy. Historically, declines of this magnitude have been associated with economic weakness and recessions. The current liquidity driven interventions have worked to drag forward future consumption to keep current economic stable but has failed to substantially boost it.
More importantly, if the Fed is truly about to start tapering bond purchases, the historical evidence shows that interest rates fall, rather than rise, following such withdrawals of artificial stimulus. The chart below shows that the recent surge in interest rates is consistent with past liquidity programs from the Fed but the withdrawal of those interventions will likely send rates lower as money rotates back to "safety."
As I stated recently in my discussion on "Interest Rates Vs. The S&P 500":
"However, before you get to excited, look back at that red circle in the lower right corner of the chart [below]. It is important to keep in perspective the recent "surge" in interest rates that has gotten the market's attention as of late. In reality, this is nothing more than a bounce in a very sustained downtrend. Is the bond 'bull market' extremely long in the tooth? You bet. Does that mean that interest rates are set to surge higher in the near future? No."
Reported inflation, or lack thereof, continues to show that there is still not enough economic strength to pull the "life support" from the patient in the short term. While there is not a tremendous amount of downside left for interest rates to go currently - it also doesn't mean that they are going to substantially rise anytime soon as weak economic growth, an aging demographic and rising governmental debt burdens combine to keep inflationary pressures in check.
With this in mind it is highly unlikely the Fed will substantially reduce interventions in the short term. More likely the Fed is likely to try and talk markets down by increasing expectations of future declines in bond purchases. Most importantly, however, the Fed will likely emphasize their "accommodative policy stance" going forward. In a weak economic growth environment the Fed cannot begin a program of boosting overnight lending rates. As the chart below shows, every time the Fed has embarked on such a program to increase borrowing costs it has led to an economic recession or worse.
The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a "soft patch" currently despite the mainstream analysts' rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get themselves out of the "liquidity trap" they have gotten themselves into without cratering the economy, and the financial markets, in the process. As we said recently this is the same question that Japan is trying to figure out as well.
The June release of the New York Federal Reserve regional manufacturing survey posted a much improved print of 7.84 from a negative May reading of -1.43. However, much like "Pandora's box" what you see on the outside and what is inside are two terribly different things. I have compiled a month over month chart of all the current sub-indexes for the survey from May to June which all point to a contraction underway in the region's manufacturing sector.
Econoday did an unusually good summary on the survey stating:
"New orders, at minus 6.69, are down for a second straight month with contraction in backlog orders very deep, at minus 14.52. Shipments are at minus 11.77 with inventories at minus 11.29 in what are also deep rates of monthly contraction. These readings extend what is a very soft run for data out of the manufacturing sector, a run that will support the doves at the Fed.
The headline for the Empire State report, as it is for the Philly Fed report, is not the sum of components, but rather a single reading from a single subjective question on general month-to-month conditions."
While it is a positive that that a number of the respondents were this month, as well as on their outlook six-months forward, it is important to remember that this is a sentiment survey. Sentiment survey's are heavily influenced by current conditions which will change overtime. The problem in the current report is that even thought manufacturer's are "optimistic" currently - the weakness in the underlying data is likely to weigh on that outlook in the reports to come.
The chart below shows what the regions 6-month outlook was in December of 2012 as compared to their current conditions as of June. How accurate was their forecast of conditions six months ago as compared to how they fell today?
As you can see the current conditions that manufacturers are reporting today are markedly weaker than they thought it would be 6-months ago. With expectations by economists for a strong economic rebound through the end of 2013 being a primary support underneath current stock market valuations; the weakness in both the current survey and future outlook doesn't provide much support.
The good news is that the weakness in this report, along with a variety of other data, is likely to keep the Fed engaged for a while longer with the current liquidity programs.
As I stated in recently in "The Economy In Pictures":
"If you are expecting economic recovery and a continuation of the bull market then economic data must begin to improve markedly in the months ahead. If not, the drag of economic growth will ultimately continue to erode corporate earnings, profitability and weigh on the financial markets.
For the Federal Reserve these charts do make it clear that despite continued monetary interventions are not healing the economy but simply keeping it afloat by dragging forward future consumption. The problem is that it leaves a void in the future that must be filled.
In my opinion the economy is far to weak to stand on its own two feet. Therefore, while the Fed may ease off on the current rate of bond purchases, likely not before September, it is highly unlikely that they will remove their 'highly accommodative stance' anytime soon."
The great "bond bull market" is dead.
Interest rates are rising on expectations of stronger economic growth ahead.
The "great rotation" from bonds to stocks is afoot.
These are all statements I have heard being made over the last month as 10-year interest rates went on a surge from deeply oversold levels to grossly overbought levels during that time span. The question, of course, is whether the stock market continue in its current bull market trajectory in the face of higher interest rates? Today's chart of the day is an overlay of the 10-year treasury rate and the S&P 500.
I have noted several things of importance in the chart above:
The vertical dashed lines denote when rising interest rates either led to a correction in asset prices or an economic recession.
I have noted major events for a chronological perspective.
The secular bull market of the 80-90's was spurred by falling interest rates and inflationary pressures which boosted corporate profitability. With the markets valued at roughly 7x earnings with a near 6% dividend yield the markets were primed for credit expansion fueled stock market boom.
I have noted (red circle) the recent "surge" in interest rates for some perspective. While the recent rise has certainly gotten the markets attention as of late; from a historical perspective we are still well within the confines of the current long term downtrend.
I have also noted the similarity between the secular bull market in the 60-70's versus 2000 to present. The breakout to "all time" highs is not necessarily an indication of the beginning of new "secular bull market". With valuations currently 19x earnings on an trailing reported basis, earnings growth peaking for the current economic cycle and sub-par economic growth rates; the fundamental backdrop for a continued bull market from current levels is not available.
The "bull case" for the continued run in equities has been built around the continuation of monetary interventions from the Federal Reserve and a near zero-interest rate policy. However, if interest rates begin do begin to rise in earnest the fundamental backdrop changes dramatically:
People buy "payments" rather than houses. Therefore, the much vaulted support from the sub-3% contribution from housing to the economy will dissipate rapidly as demand slows and prices fall to find buyers.
Mortgage refinancing activity will slow to a stop. (Who refinances to higher mortgage payments)
Higher interest rates make speculative home buying much less attractive.
Personal consumption expenditures (which make up nearly 70% of GDP) will be negatively impacted as the rising costs of variable rate credit lowers discretionary incomes.
Corporate earnings will decline as higher borrowing costs impact profitability.
Corporate capital expenditures will slow as higher borrowing costs reduce the attractiveness of returns on new projects.
Markets will be negatively impacted as higher leverage costs reduce profitability.
Corporate bond issuance will slow sharply as borrowing costs surge.
"Junk Bonds" will come under duress as higher interest rates sap funding for troubled companies leading to defaults and bankruptcies.
Highly indebted municipalities are likely to be "shut out" of the municipal bond markets to obtain funding leading to defaults (i.e. Detroit)
Higher interest rates will blow a massive hole in the CBO's government budget and deficit forecasts.
The list goes on but you get the idea. The impact of substantially higher interest rates are not good for the economy or the financial markets going forward. In the short term consumers, and the financial markets, can withstand small incremental shifts higher in interest rates. There is clear evidence historically to suggest the same. However, sustained higher, and rising, interest rates are another matter entirely.
However, before you get to excited, look back at that red circle in the lower right corner of the chart above. It is important to keep in perspective the recent "surge" in interest rates that has gotten the market's attention as of late. In reality, this is nothing more than a bounce in a very sustained downtrend. Is the bond "bull market" extremely long in the tooth? You bet. Does that mean that interest rates are set to surge higher in the near future? No.
While there is not a tremendous amount of downside left for interest rates to go currently - it also doesn't mean that they are going to substantially rise anytime soon. Weak economic growth, an aging demographic, rising governmental debt burdens and continued deflationary pressures can keep interest rates suppressed for a very long time. Just ask Japan.
I have been writing extensively about the data behind the headline media reports and discussing the importance of the underlying data trends relative to the broader macroeconomic perspectives. However, it is sometimes helpful just to view the various economic indicators and draw your own conclusions outside of someone else's opinion.
With the economy now 48 months into an expansion, which is long by historical standards, the question for you to answer by looking at the charts below is:
"Are we closer to an economic recession or a continued expansion?"
How you answer that question should have a significant impact on your investment outlook as financial markets tend to lose roughly 30% on average during recessionary periods. However, with margin debt at record levels, earnings deteriorating and junk bond yields near all-time lows, this is hardly a normal market environment within which we are currently invested.
Therefore, I present a series of charts which view the overall economy from the same perspective utilizing an annualized rate of change. In some cases, where the data is extremely volatile, I have used a 3-month average to expose the underlying data trend. Any other special data adjustments are noted below.
If you have any questions or comments you can email me or send me tweet: @streettalklive
(Note: The Economic Composite is a weighted index of multiple economic survey and indicators - read more about this indicator)
If you are expecting economic recovery and a continuation of the bull market then economic data must begin to improve markedly in the months ahead. If not, the drag of economic growth will ultimately continue to erode corporate earnings, profitability and weigh on the financial markets.
For the Federal Reserve these charts do make it clear that despite continued monetary interventions are not healing the economy but simply keeping it afloat by dragging forward future consumption. The problem is that it leaves a void in the future that must be filled.
In my opinion the economy is far to weak to stand on its own two feet. Therefore, while the Fed may ease off on the current rate of bond purchases, likely not before September, it is highly unlikely that they will remove their "highly accommodative stance" anytime soon.
In yesterday's post "Gallup: Consumer Spending Is Up - Retail Data Is Down" we discussed sentiment of consumers relative to their actions. Today, the advance monthly retail sales report showed a bump of .06% for May which exceeded economist's estimates. Econoday did a nice summary of the headline data:
"May retail sales surprised and increased 0.6 percent on the month and were up 4.3 percent from a year ago. Retail sales excluding just autos and excluding both autos and gasoline were up 0.3 percent from April pretty much as expected. On the year, they were up 2.8 percent and 4.1 percent respectively.
Most sales sub-categories were up on the month. Auto sales were up 1.8 percent, gaining for a second consecutive month after increasing 0.7 percent in April. Sales at gasoline stations edged down 0.2 percent thanks to declining prices. Elsewhere, furniture and home furnishing stores (down 0.8 percent), electronics & appliances (down 0.4 percent) and clothing & accessories (down 0.2 percent) were down on the month. All other categories advanced with building materials climbing 0.9 percent, food rising 0.7 percent and sporting goods increasing 0.6 percent."
There are some interesting points buried within that analysis. Automobile sales are up as auto manufacturers continue to stuff the dealer network channels, however, incentives for the dealers to actually sell those cars to consumers is now at the highest level in the past two years as margins are squeezed. As we discussed yesterday, with wages on the decline, it is interesting to see the most discretionary goods such as furniture, clothing and electronics falling for the month. The decline in gas prices helped somewhat but the increase in food, which is a much bigger percentage of the family budget rose sharply for the month.
The improvement in consumer confidence, which has been spurred by a surging stock market since the beginning of the year, has helped bolster retail sales currently. However, as always, while the current data point is certainly positive we must view it within the context of the overall trend to give the data meaning. The chart below shows the very defined downtrend in retail sales which clearly peaked in 2011. I have used a 3-month average of the annual rate of change to show rather volatile data more clearly.
(Important note: While the uptick in the retail sales data is a positive note; the volatility of the monthly data makes it very difficult to make any clear assessment about the real strength of the consumer or the economy. This is why I smooth the data to more clearly show the trend.)
It is clear that the sharp increase in consumer attitudes since the beginning of the year has finally translated into a nudge up in retail sales. However, in order for the increase in retail sales to translate to economic growth the advances must be sustainable.
Is The Consumer Really Back?
The question of the sustainability of increasing consumer demand is a key point of the domestic economy. Increased demand, above simple population growth, is the key to spur further employment gains, increased wages and stronger economic growth. This will also lend to increasing inflationary pressures from a cost-push standpoint.
As discussed yesterday wages remain under pressure and increased consumption has come at the expense of personal savings rates and increased consumer debt levels. As I stated:
"While consumers have shown an amazing ability to consume well beyond their means for many years by tapping cheap credit, turning their homes into ATM's and filing for governmental assistance; these sources are finite in nature. Eventually, if wages do not start to rise, full time employment doesn't increase and interest rates rise, consumers may quickly find the end of consumptive capabilities."
From an economic standpoint the increase in retail sales is certainly encouraging as it makes up roughly 40% of the overall Personal Consumption Expenditures (PCE) that feeds directly into the GDP analysis. However, it is also just as important to view the data from the standpoint of where the funds are being derived from. If the increases are a function of increased debt, sales gimmicks and lower personal savings rates - this is not healthy for economic growth longer term. Recent data from MasterCard directly addresses this issue (via Zerohedge):
Since the end of 2009, growth in U.S. consumer spending has been driven largely by luxury goods and consumer staples. The middle class has less disposable income (or access to credit) available for discretionary purchases.
The growth of U.S. retail spending (excluding autos) slowed from an annual average pace of 8 percent in 2011 to 5.1 percent in 2012. In the first five months of 2013, U.S. retail sales have been growing at an annual average pace of just 3.5 percent.
U.S. consumers have been cutting spending on electronics, air travel and gasoline since the beginning of the year. In contrast, sales of necessities such as groceries and baby clothes are robust.
U.S. spending on home furnishings and repairs continues to be robust, which suggests that the housing recovery still has some legs.
On the other hand, the surge in spending on auto maintenance means that people are reluctant to buy new cars, preferring instead to repair what they already own. Similarly, there has been a significant decline in auto parts sales since the end of 2012.
U.S. purchases of high-end jewelry have grown much more slowly than total retail spending. Moreover, high-end jewelry spending hasn't matched its peak in December 2007.
Consumption in Canada has been weaker than in the U.S. for several years despite a much healthier labor market. This might be explained by the slowdown in China and the contraction in commodity demand.
U.K. luxury spending seems to be at least partly driven by the prices of oil and natural gas. That suggests that wealthy Russians and Middle Easterners are a significant source of demand for high-end goods in British stores.
The U.S., U.K. and Canada have all experienced a surge in "staycations" as families avoid expensive travel in favor of simpler -- and cheaper -- pleasures at home.
Perhaps reflecting the global sell-off in commodities, spending on luxury goods in the U.K. has been declining from prior-year periods for the past six months. Growth in U.S. luxury spending has slower than total U.S. retail sales in the first few months of 2013.
MasterCard Advisors estimates that Canadian retail spending has only increased by 0.5 percent in the past 12 months. As recently as March, the 12-month change in consumer spending was actually negative.
While the media quickly proclaimed the May retail sales report as "the most important in years" it will only be important if it is sustainable going forward. For that to happen consumers must begin to see their standard of living really improving through full-time employment and higher wages. Increased demand is the key to push employers to hire and increase wages but they will be slow to act until there is a sustained increase in consumption. What happens over the next few months will be key to the ongoing economic recovery story.
I visited with my friend Mike Iscovitz on Fox 26 to discuss the May jobs report. As I discussed in detail in my recent post "Employment: The Macro Trends" job growth is not keeping up with population growth. Furthermore, and most importantly, as disclosed in the latest NFIB Survey:
"The small business half of GDP is clearly not participating much beyond growth generated by population gains. More businesses are being formed than lost, so there is some boost to job creation there, but too many existing firms have not yet started to replace the workers shed during the recession.
There are many headwinds for growth, the most important being consumer spending. Nothing encourages hiring and inventory and capital investment more than an growth in customers and spending. Consumer sentiment is up some, but not really supported by income growth or new jobs. The savings rate is under 3 percent, so spending is financed by reduced saving (which pays nothing anyway – people who bought 30 year Treasury bonds in 1983 are just now losing those great coupons). The flow of new regulations is very strong (the President promised to use regulatory power to accomplish his goals even if Congress did not cooperate), each agency with its own set of 'victims'.
On top of that, the ACA is about to grip the entire business community in a morass of new taxes, forms to fill out, fines and higher labor costs. Our global customers are experiencing slow growth for the most part and buying less. Monetary policy has become incomprehensible and Fiscal policy is in disarray. Uncertainty is a major impediment to economic progress. With 2014 elections almost upon us, we'll just have to wait and see."
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This past Friday I visited with Bill Griffith, Maria Bartiromo and Rick Santelli on CNBC to discuss my views on the latest employment report. My take is somewhat basic in regards to the data - on a macro level the jobs that are being created are temporary, low paying, jobs that do not create long term sustainabilty for economic growth.
As I stated in "Employment: The Macro Trends":
This problem with part-time employment is that it does not increase economic prosperity. Part-time employment, as discussed in the "Labor Hoarding Effect," has been an aggressively used tool by corporations to suppress wage growth, reduce overhead costs and increase profitability. The problem is that with the Affordable Care Act gearing up to start in 2014 even more businesses will resort to part-time employment to reduce the increased health care tax burden. I stated that:
"The issue of 'labor hoarding' is an important phenomenon that is likely obscuring the real weakness in the underlying economy. Without an increase in the demand part of the equation businesses are likely to continue resorting to further productivity increases to stretch the current labor force farther to protect profitability. However, as we may currently be witnessing, businesses may be reaching the limits of what they can do to continue increasing profits at the bottom line while revenue declines at the top. The implications for the financial markets going forward are clearly negative."
There has been little improvement in the number of people working part-time for economic reasons. However, as I stated, such weak employment leads to dependence of government subsidies which explains the rise in disability claims and food stamp participation as individuals seek to make ends meet.
I also discuss my views on the market and where to invest.
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In an interesting report from Gallup Americans' self-reported daily spending rose to an average of $90 in May, the highest since October 2008 and higher than it has been in May since the $114 found in the same month in 2008. Spending is up from $86 in April and on par with the $89 found in March.
Notice in the chart above that this analysis is based on what consumers are "saying" they are spending money on outside of their home, automobile and normal household bills. The question specifically is "what did you spend, OR CHARGE, yesterday on all other types of purchases you may have made, such as at a store, restaurant, gas station, online, or elsewhere?"
This is a very interesting question from the standpoint that while consumers are "saying" they are spending more the issue is whether they are "actually" doing it. The retail sales data from the Gallup Survey is extremely volatile so in order to smooth the data for comparison I have used a 3-month average of the annual rate of change. The chart below compares the Gallup consumer spending survey data with the actual retail sales data from the ICSC-Goldman Sachs weekly retail sales report and the BEA monthly retail sales report.
As you can see there is a big discrepancy occurring between the Gallup survey and the actual retail sales data. While consumer confidence has definitely increased in recent months, due much to the rise in the asset markets, the question becomes sustainability.
As reported by the NFIB in "NFIB: Optimism Improves But Don't Get Too Excited:"
"There are many headwinds for growth, the most important being consumer spending. Nothing encourages hiring and inventory and capital investment more than an growth in customers and spending. Consumer sentiment is up some, but not really supported by income growth or new jobs. The savings rate is under 3 percent, so spending is financed by reduced saving."
The issues of suppressed wage growth, low personal savings rates and rising credit balances leaves individuals very susceptible to incremental changes in the financial markets and the economy. The chart below shows the annual rate of change in wages compared to outstanding consumer credit as a percentage of personal consumption expenditures (PCE).
As wages have fallen credit has been used to fill the gap. The same can be seen for personal savings rates as shown below.
While consumers have shown an amazing ability to consume well beyond their means for many years by tapping cheap credit, turning their homes into ATM's and filing for governmental assistance; these sources are finite in nature. Eventually, if wages do not start to rise, full time employment doesn't increase and interest rates rise, consumers may quickly find the end of consumptive capabilities.
The disparity between what consumers are "saying" they are doing currently, and what they will "actually" do in the months ahead, will be very important to watch. Historically, there has been a fairly high correlation between consumer confidence surveys and actual retail sales. Currently, that is not the case. Of course, these certainly aren't historically normal times either.
The actual economic data has been much weaker than the "sentiment" data as of late and there is little evidence currently available that is pointing to a strong economic revival in the near future. Of course, the sentiment data has been heavily influenced by an artificially inflated asset prices. The problem is that "sentiment" can turn negative very quickly and with the Euro-zone crisis, the Middle East, and the debt ceiling debate all looming there are more than sufficient catalysts to spook the markets and send consumers running for cover.
It will be interesting to see how the latest stock market volatility has affected consumer sentiment in the upcoming reports. My bet is that we will likely see a little less optimism.
The latest release of the National Federation of Independent Business small business survey showed an improvement in the latest reading to 94.4 up from 92.1 last month. Overall, the readings were positive and this is the second strongest overall reading of the recovery since 2009.
The survey showed that 8 of the 10 internal components posted monthly gains which were led by increases in economic expectations and a gain for sales expectations. The one negative for the month, unfortunately, was hiring plans. As a reminder; the index is still well below its long-term average of 100 and just barely above the post-recession recovery average of 90.7.
However, the opening statement of the survey is the most important for putting the latest data into context:
"For the second consecutive month, small-business owner confidence edged up, according to NFIB's Index of Small Business Optimism, which increased by 2.3 points to a final reading of 94.4 in May.
While May's reading is the second highest since the recession started December 2007, the Index does not signal strong economic growth for the sector. Eight of 10 Index components gained momentum, showing some moderation in pessimism about the economy and future sales, but planned job creation fell 1 point and reported job creation stalled after five months of gains.
'Small business confidence rising is always a good thing, but it's tough to be excited by meager growth in an otherwise tepid economy. Washington remains in a state of policy paralysis, and while the stock market sets records, GDP posts mediocre growth. The unemployment rate remains in the mid-7s and it is departures from the labor force —- not job creation — that is contributing to its decline when it does fall. It's nice to see confidence not shrinking, but there isn't much to hang your hat on in this report. We are back to where we were in May 2012. Two good months don't make a trend, but we can't have a trend without them, so it's a start.' – NFIB chief economist Bill Dunkelberg"
If you take a look at the summary table above can see the real state of small businesses. The big drivers from small business on the overall economy are employment, capital outlays and business expansion. Currently, only a net 5% plan to increase employment, only 23% plan to make capital outlays and just 8% think that this is a good time to expand their business. While the headline of optimism is certainly encouraging - optimism and actions are two very different things.
Employment
As we have discussed previously in regards to "labor hoarding" there is definitely a very tight labor market currently. According to the survey; 47% of business owners hired, or tried to hire, in the last three months while 38% reported few, or no, qualified applicants for open positions. This is why we continue to see a continued fade in employment reductions which is causing "initial jobless claims" to fall (inverted in chart below) but hiring remains weak particularly in the economically important full-time category.
The looming approach of the Affordable Care Act (ACA), which is significantly increasing the cost of health care on businesses, is a huge incentive to increase productivity and the use of temporary and part-time workers. Employment plans fell by 1 point to a net of 5% in the most recent report which is a very weak reading.
Poor Sales
It is hard to plan on increasing employment when concerns over revenue are weighing on your business. One of the top three concerns of small businesses is "poor sales" which directly affects hiring, expansion and capital expenditure plans. The chart below shows three things in this regard: 1) the level of actual sales over the past quarter; 2) firms expectations of sales over the next quarter; and 3) the average of actual and expected sales along with the historic median level.
While much improved from the recessionary trough, the level of sales, both actual and expected, still remain well below levels normally associated with previous recessions.
Capital Expenditures
While "poor sales" impacts the top line of corporate income statements; it has been cost cutting, reduced employment and increases in productivity that have been driving corporate profitability. Capital Expenditures are also economically important as private investment is one of the components of the Gross Domestic Product (GDP) calculation. The chart below shows the increases in "Cap Ex" relative to the fairly stagnant plans to increase employment. I have also noted the very low levels of expectations regarding economic improvement.
While there has certainly been growth on the employment front; it has been the gains in productivity expenditures that have kept hiring and wages suppressed. With the large number of firms with very negative forward expectations of economy strength the hiring and capital expenditure components are not likely to improve until economic confidence increases substantially.
Don't Get Too Excited
While the most recent NFIB survey was certainly a welcome improvement the problem is that mainstream analysts, and economists, tend to take the number out of context. When viewing the data within the longer term trend we do see improvement on many levels but remain mired at levels normally consistent with historic recessions on all levels. This was summed up well by the NFIB:
"The small business half of GDP is clearly not participating much beyond growth generated by population gains. More businesses are being formed than lost, so there is some boost to job creation there, but too many existing firms have not yet started to replace the workers shed during the recession.
The Optimism Index is back to the May 2012 level which are identical to the November 2007 level (the Index fell all through 2007, signaling the oncoming recession). Since then, the Index has been higher in only three months, and by less than 2 points. The low for that period was 81.0 reached in March, 2009. So the Index is 13 points higher now, good news, but 6 points below the pre-2008 average and 13 points below the peak for the expansion, bad news. Until this sector gets in gear, it will be hard to generate meaningful economic growth. GDP growth was 8 percent in 1983, the first year of that recovery period."
"There are many headwinds for growth, the most important being consumer spending. Nothing encourages hiring and inventory and capital investment more than an growth in customers and spending. Consumer sentiment is up some, but not really supported by income growth or new jobs. The savings rate is under 3 percent, so spending is financed by reduced saving (which pays nothing anyway – people who bought 30 year Treasury bonds in 1983 are just now losing those great coupons). The flow of new regulations is very strong (the President promised to use regulatory power to accomplish his goals even if Congress did not cooperate), each agency with its own set of 'victims'.
On top of that, the ACA is about to grip the entire business community in a morass of new taxes, forms to fill out, fines and higher labor costs. Our global customers are experiencing slow growth for the most part and buying less. Monetary policy has become incomprehensible and Fiscal policy is in disarray. Uncertainty is a major impediment to economic progress. With 2014 elections almost upon us, we’ll just have to wait and see."
The chart above shows the top 3 concerns as reported by small business with the red line being average of the three. With the "concern index" still near its highest levels on record it certainly reflects the sentiments from the NFIB above.
As I concluded last time I discussed the NFIB Survey:
"[Those] issues are unlikely going to spur businesses to expand employment, make capital expenditures or increase production other than to maintain current demand levels. Furthermore, the upcoming budget debate is likely to fuel further concerns should there be little, or no, progress made in changing the outlook for the fiscal health of the country.
The bottom line is that the environment in which small businesses operate, which has been confirmed by many of the recent data points, does not seem to be improving as much as would have been hoped this far into an economic 'recovery.'"
I have written in the past that all is not solved in the Euro-zone. In fact, despite the ongoing jawboning from the ECB that they stand ready to "do anything," in reality they have done little to this point other than just talk. While that has worked to a large degree to suppress rising interest rates on debt burdened Euro-zone countries there has been no progress on the "unification" of the Euro-zone or a resolution to its burgeoning debt problems. At the end of February I wrote "Get Ready For A Run To All-Time Highs" wherein I stated:
"My best guess, as I have been discussing for the past four months, is that by the end of the summer the Euro-crisis will be back. The recent elections in Italy, and the subsequent curtailment of austerity, clashes with the goals and plans set forth by the ECB last year. Furthermore, the German elections may also prove disastrous to the ECB plan if Angela Merkel is unseated.
German Finance Minister, Wofgang Schaeuble, just recently stated that:
'Now it is up to those who were elected in Italy on Sunday to form a stable government. The faster they do this, the quicker the uncertainty will be overcome, and by the way, I never said the euro crisis was over. I only said that we have made significant progress. We need to continue on this path, but we will have setbacks.'
His statement was also confirmed previously by Angela Merkel's economic advisor who stated in an interview that:
'The sustainability of Italian public finances is in jeopardy. The euro crisis will therefore return shortly with a vengeance.' Apparently, the Italians were not ready to move on the path of reform that has been taken by Mr. Mario Monti, Field said. 'You cannot expect that Italy's European partners or the ECB will stabilize the Italian economy, when its people are not ready for reform.'"
If we flash back to just one year ago we find the ECB faced with an imminent collapse of the Euro-zone. Borrowing costs are surging, central banks of Greece and Spain are on the verge of default, and economic deterioration is rampant. As stated above, Mario Draghi floated his now famous and historic speech upon the financial markets quelling fears of central bank default through the promise of unlimited outright market transactions (OMT). It was literally the nuclear bomb of monetary interventions. The problem is that the funding from the OMT's was to come from two existing funding programs - the European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM). The EFSF was almost entirely depleted at the time of Draghi's speech which left the bulk of the OMT program based solely on the ESM which has, up until this point, remain not ratified or funded.
This week, however, the German Constitutional Court will conduct a public hearing on the various challenges to the ESM and OMT. It is likely that the ECB will have no choice but to disclose more details about the real terms of the OMT to assure smooth passage and keep from sending the borrowing rates spiking higher on the viability, or lack thereof, of the ESM as the funding source for the ECB to meet its promises of buying debt, as necessary, from struggling Euro-zone countries. The problem, of course, is that Germany is the lynch-pin between the ECB and the Euro-zone as they are the supplier of the money used for the ESM. Unfortunately, Germany is rapidly tiring of bailing out countries that are doing nothing in the way of reforming themselves.
One year later the Euro-zone is still mired in a deep recession, see chart below, and there is no better example showing the lack of progress on governmental reforms than Greece. At the end of 2012 the EU and IMF agreed on Greek Debt/GDP targets and pronounced the nation "fixed." Expectations were that the Greek economy was set to rise sharply from its depression level state and that such an economic surge would set the country back on the path to self-sustainability. Unfortunately, as have so many time in the past, such expectations failed to become reality and now, as Der Spiegel recently reported, the IMF is refusing to participate in further rescue programs for Greece unless financing for the nation is secured for the next 12 months. This explains why interest rates on Greek debt is now surging and it is likely that holders of Greek debt will experience another haircut to cover the €4.6 billion funding shortfall.
Here is the real issue that is most overlooked by market participants currently. As stated above, Angela Merkel is now just a few short months away from the general election with the opposition party gaining some traction given the German populations dissatisfaction with the continued bailouts of the Euro-zone countries. With Germany slipping ever closer to recession and employment showing signs of strain this will not bode well for Merkel at the ballot box. Furthermore, with Germany owed €15 billion in KfW loans and a further €35 billion in contributions to ESM/EFSF mechanisms any agreement on her part would solidify opposition parties' proof that taxpayer money was lost.
Not So Unlimited After All
As with the Federal Reserve's current unlimited Quantitative Easing program which is now seeing talk of ending; the ECB's unlimited OMT program likewise may not be so unlimited after all. As reported by ZeroHedge:
"The first such notable detail comes courtesy of the FAZ this morning, which reports that 'in fear of the judgment of the Federal Constitutional Court, the European Central Bank (ECB) has revealed for the first time the boundaries of their controversial bond buying program... ECB President Mario Draghi announced last year, if necessary, that unlimited government bonds of distressed euro countries would be monetized to save the euro. Meanwhile, however, the central bank has limited this program to a maximum volume of €524 billion and also communicated this to the court.' This is the maximum allowable purchases of Spanish, Italian, Irish and Portuguese bonds.
Why is the ECB revealing that the open-ended program in fact has a very set end now? 'Apparently, to make the program legally less vulnerable the ECB has now said that it has commissioned legal opinions boundaries. Central bankers described the process as "containment.'"
As the chart shows below there is a huge problem for the Euro-zone coming.
While the ECB can only buy bonds with a maturity between 1 and 3 years it is not likely to sufficient in either size, or scope, to bring down the longer end of the interest rate curve which is where the funding problems will occur for the smaller Euro-zone countries. While the ECB continues to talk rates down currently, and may be effective in that regard for a while longer, it will only take a small disruption in the economic system that the ECB can't offset that will unleash the next surge in the financial crisis.
The chart below shows the economic contraction currently underway in the Eurozone. I have overlaid US GDP growth as well for comparison.
With youth unemployment spiraling higher, economic stress rising and government revenue shrinking it is only a function of time until something goes horribly wrong. The timing of such and event, however, is the key. It is also questionable just how long Federal Reserve interventions can continue to keep the divergence between the Euro-zone, which is a major export partner and a big chunk of corporate profitability, and the U.S. from reverting.
Three Problems That Still Exist
There are still three major problems with the Euro-zone that, without fixing, will lead to the next chapter in the ongoing Euro-zone saga.
1) Lack of a constitutional and monetary union.
2) Lack of centralized fiscal and monetary policy controls.
3) Lack of centralized leadership.
The lack of a centralized constitutional and monetary union has led to several years of inaction in the process of unification of the Euro-zone. While it was a "grand experiement" to run the Euro-zone under a single currency the underlying structure to make it effective long term was never achieved. The U.S. is a monetary union under which all state governments act under the central authority of the government and the central bank. The problem for the Euro-zone is that their are 27 leaders and no followers. This is why fiscal reforms remain elusive and each and every promise made by the individual governments to the ECB and IMF for assistance eventually fail.
The problem for the Euro-zone is that without a centralized leadership with the ability to issue its own debt, strong fiscal/monetary policy tools and a central bank with a "printing press" to support it, the survivability of the Euro-zone in the long term is likely doomed. Eventually, smaller countries will want to withdraw from the Euro due to the pressures of austerity requirements or Germany will decide to quit bailing out bad behavior at the own country's expense. The problem then becomes who is going to make good on all the debt held, and guaranteed by, the ECB?
There are currently many promises that have been made to the financial system by the ECB. The question is whether or not they can ultimately "cash the check." While I do not have certain answers as to the where, the who or the when - I am fairly confident that it will be sooner than we currently imagine. I do believe that the ECB will be able to skirt by the ratification of the ESM this coming week and get some limited funding into place, however, I still believe the bigger problem comes at the end of summer when the German voters begin to voice their concerns - after all it is their money that is being wasted.
The May jobs report came in better than expected at 175,000 jobs with the labor force ticking up slightly from the lowest levels since 1979. With the markets deeply oversold on a daily basis the report provide the catalyst necessary for traders to return to the stock market. However, what we need to know from an economic perspective, as well as a long term investment view, is what does 175,000 jobs actually mean? Putting economic data into context gives us a much better picture of where the overall economic trends are and what we should be expecting in the months and quarters ahead.
Population Growth Still Outpacing Employment
As we discussed yesterday in "4 Tools Of Corporate Profitability" the issue of increases in population relate directly to employment growth. As I stated:
"...despite increases in employment in recent months it has been a function of population growth rather than a improved outlooks by businesses. The issue of population growth is ignored by most analysts and economists when discussing employment. However, when businesses are geared for a certain level of demand, increases in population will incrementally increase demand requiring fractional increases in business productivity and output. However, in order to keep costs minimized businesses have resorted to temporary hires rather than full-time employment which incurs additional costs of benefits and health care. The expectation is that temporary workers will eventually become full-time employees, however, with the impending effects of higher health care costs due to the Affordable Care Act - temporary hires may be the new normal. The chart below shows full-time employment relative to the population."
There is little debate that the current labor market is very tight. We know this by looking at the median duration of unemployment, which remains extremely elevated from a historical perspective and the labor force participation rate remains near its lowest levels since 1979.
Within this context we can surmise that businesses are maintaining minimum staffing levels to meet current demand. As stated above increases in population create additional demand which is met with incremental hiring. Unfortunately, many of those jobs are in the low wage paying service based categories which keeps wages and income growth suppressed.
The Real State Of Employment
In order to put perspective on the current employment situation we need to step back and take a look at the long term view of employment in the U.S. The chart below shows the growth in the number of employed persons since 1948 along with a growth trend line.
While growth in the labor force ebbed and flowed over time remained contained within a 5% band above and below the long term trend line. That is until 2008 when the deviation from the previous 60 year trend plunged to over 11%. As of May 2013, despite claims of economic and employment recovery, the deviation of employed persons from the long term growth trend is a negative 11.5%. This is only 0.2% above the historic low of 11.7%.
If we dig a little deeper into the data from 2009 to present we can see the real disparity in hiring trends. The chart below shows the change in full-time versus part-time employment.
While there is no argument that full-time employment has most definitely improved since 2011 it has been part-timers finding a bulk of the jobs. Since 2009 part-time employment is up 1.3 million while full-time is only up 418,000. This goes a long way to explain the surge in food stamp participation rates.
Economic Reports Don't Support Further Gains
One important point to remember is that corporate hiring decisions are grossly affected by the overall strength or weakness of the economy. In the recent post "Economic & Employment Composites Indicate Further Weakness" I specifically addressed the employment issue stating:
"If you strip the employment components out of the EOCI index and weight them into their own composite index we find that the hiring intentions of employers is clearly weakening. The chart below shows the Employment Index smoothed with a 4-month average and compared to the annual rate of change in Total Non-Farm Employees."
"As with the EOCI index above - employment activity clearly peaked in early 2012 and has begun to wane. The recent uptick in the employment index, remember this is a 4-month moving average, is due to the effects from the uptick in economic activity from "Hurricane Sandy." This index will turn down in the next couple of months as the recently monthly data points have declined.
What is clear from the two composite indexes is that the broad economy, and by extension underlying employment, has clearly peaked and has began to weaken. This is well within the context of historical trends and time frames. While the mainstream analysts and economists continue to have optimistic views for a resurgence in economic activity by years end the current data trends, both globally and domestically, suggest otherwise."
Part-Time For Economic Reasons
This problem with part-time employment is that it does not increase economic prosperity. Part-time employment, as discussed in the "Labor Hoarding Effect," has been an aggressively used tool by corporations to suppress wage growth, reduce overhead costs and increase profitability. The problem is that with the Affordable Care Act gearing up to start in 2014 even more businesses will resort to part-time employment to reduce the increased health care tax burden. I stated that:
"The issue of 'labor hoarding' is an important phenomenon that is likely obscuring the real weakness in the underlying economy. Without an increase in the demand part of the equation businesses are likely to continue resorting to further productivity increases to stretch the current labor force farther to protect profitability. However, as we may currently be witnessing, businesses may be reaching the limits of what they can do to continue increasing profits at the bottom line while revenue declines at the top. The implications for the financial markets going forward are clearly negative."
There has been little improvement in the number of people working part-time for economic reasons. However, as I stated, such weak employment leads to dependence of government subsidies which explains the rise in disability claims and food stamp participation as individuals seek to make ends meet.
The problem is that suppressed wage growth leads to weaker consumer demand which keeps businesses on the defensive to protect profitability. This can be seen by the commercial lending versus job trends chart below.
Depsite historically low borrowing rates for businesses the demand for loans appears to have peaked for the current economic cycle. In turn if businesses are cutting back on borrowing for capital investments the need to hire additional employees will likewise be scaled back.
"Muddle Through" Employment
One thing is for certain -- the job market is very tight as layoffs and discharges have reached the lowest levels since the turn of the century. While this is leading to lower initial jobless claims it is not translating into higher levels of full-time employment relative to the population. This is shown in the chart below.
The "good news" is that for those that are currently employed - job safety is high. Businesses are indeed hiring; but prefer to hire from the "currently employed" labor pool rather than the unemployed masses. Furthermore, the weak state of employment is likely to keep the Fed engaged in its current liquidity programs for longer than previously expected. With the debt ceiling debate just around the corner and weak economic reports it is simply too soon to start taking away the "punch bowl."
It is not surprising that with an economy that is mired at a near 2% economic growth rate that employment is "muddling" right along with it. While the economy is indeed creating jobs, as I previously stated, it is a function of population growth rather than a sign that the economy is on the road to recovery.
What is clear is that current detachment between the financial markets and the real economy continues.
Recently, I wrote an article discussing the "Truth About Wall Street Analysts" and the inherent conflict between Wall Street and individual investors. There is also another group of individuals who are also just as conflicted - corporate executives. Today, more than ever, corporate executives are compensated by stock options, and other stock based compensation, which are tied to rising stock prices. There are billions at stake in many cases and the game of "beat the Wall Street estimate" is critical in keeping corporate stock prices elevated. Unfortunately, this leads to a wide variety of gimmicks to boost bottom line profitability which is not necessarily in the best interest of long term profitability or shareholders. Today we will discuss four tools that have been at the heart of the surge in profitability since 2009 and why such profitability has failed to boost the economy.
One of the primary debates that is currently raging is whether, or not, the economy is currently experiencing a "soft patch" of activity and is set to begin a longer sustained recovery. Such an economic recovery is critical to support the primary thesis of a new secular bull market beginning in the stock market. At the core of all of these arguments is corporate profitability. With the stock market hitting all-time highs in 2013 market valuations have increased considerably. The chart below shows the forward reported P/E ratio change from January of 2012 to present.
The problem is that the price/valuation increases have come at the expense of deteriorating corporate profitability. I discussed this issue earnings at length in my recent report on "Evaluating 3 Bullish Arguments" but importantly was the chart below which showed the deterioration in earnings.
Since 2009 the reported earnings per share of corporations, the bottom line of the income statement, have increased by a total of 175% which is the sharpest, post-recession, increase in reported EPS in history. However, at the same time, reported sales per share, which is what happens at the top line of the income statement, has only increased by a marginal 34% during the same period. This is shown in the chart below.
In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools create a mirage of corporate profitability. Furthermore, as I will discuss below, each have a negative impact on investors and/or the economy.
Stock Buybacks Create An Illusion Of Profitability
One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buy backs. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buy backs.
The problem with this, of course, is that stock buy backs create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding - reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders.
Working For Two
Since the end of the financial crisis corporations have been able to markedly boost profitability through increases in productivity. In any business the highest single expense is the cost of labor. Therefore, increases in productivity can reduce the need for more employees. The first chart below shows non-farm business sector output (ie productivity) as compared to the employment to population ratio.
As productivity increases the need for employment is reduced. Automated answering systems have been used to replace receptionists, automated billing systems, outsourced help desks, etc. have allowed for lower headcounts for businesses while increasing output per person. Higher output, and lower costs, have led to the highest profit per employee in history as shown in the chart below.
What? You Want A Raise?
While increasing productivity will increase profitability - a large and available labor pool, which creates competition for existing jobs, keeps wages suppressed. Suppressed wage growth, combined with increases in productivity have created massive profitability for businesses. The chart below shows real compensation per hour since 2000.
The spike in 2012, see inset, is deceiving because the entirety of the increase came in the 4th quarter as corporations panicked prior to the "Fiscal Cliff." That one time effect is now past but higher tax rates are here to stay. Real compensation has now fallen back to levels previously seen at the beginning of 2012 but higher tax rates have reduced the purchasing power of individual workers. With profitability now under pressure it is unlikely that we will see any significant increases to compensation in the near term particularly as real unemployment remains elevated. This does not support the economic recovery story.
Sorry, We Aren't Hiring Full-Time
The reason that I state the real unemployment remains elevated is that despite increases in employment in recent months it has been a function of population growth rather than a improved outlooks by businesses. The issue of population growth is ignored by most analysts and economists when discussing employment. However, when businesses are geared for a certain level of demand, increases in population will incrementally increase demand requiring fractional increases in business productivity and output. However, in order to keep costs minimized businesses have resorted to temporary hires rather than full-time employment which incurs additional costs of benefits and healthcare. The expectation is that temporary workers will eventually become full-time employees, however, with the impending effects of higher healthcare costs due to the Affordable Care Act - temporary hires may be the new normal. The chart below shows full-time employment relative to the population.
With full-time employment still near the recessionary lows it shows that businesses remain focused on the cheapest cost of labor possible. The chart above also shows jobless claims which have been steadily falling since the peak of the crisis. This is due to "labor hoarding" where businesses have literally run out of employees to terminate or fire. However, just because fewer people are being terminated it does not mean that greater levels of full time employment are being created which is what is needed to create sustainable organic economic growth.
Profit Scraping May Have Reached Its Limit
There is no doubt that corporate profitability has surged from the recessionary lows. However, if I am correct in my assessment, then the recent downturn in corporate profitability may be more than just due to an economic "soft patch." The problem with cost cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. While Goldman Sachs expects profits to surge in the coming years ahead - history suggests something different.
I say this because of something my friend Cullen Roche recently pointed out:
"We’re in the backstretch of the recovery. We’re now into month 47 of the current economic recovery. The average expansion in the post-war period has lasted 63 months. That means we’re probably in the 6th inning of the current expansion so we’re about to pull our starter and make a call to the bullpen. The odds say we’re closer to the beginning of a recession than the beginning of the expansion. That puts the Fed in a really odd position and not likely one where they’re on the verge of tightening any time soon."
This is a very important point. While the Fed's ongoing interventions since 2009 have provided the necessary support to the current economic cycle it will not "repeal" the business cycle completely. The Fed's actions work to pull forward future consumption to support the current economy. This is turn has boosted corporate profitability as the effectiveness of corporate profitability tools were most effective.
However, such actions leave a void in the future that must be filled by organic economic growth. The problem comes when such growth doesn't appear. With the economy continuing to "struggle" at an anaemic rate of growth the effects of businesses profitability tools have become much less effective.
This is not a "bearish" prediction of an impending economic crash but rather just a realization that all economic, and earnings, forecasts, are subject to the overall business cycle. The problem with earnings forecasts, such as Goldman Sachs above, or the CBO's 10 year economic growth forecast, is that they have failed to factor in the probability of normal economic recession. This is a mistake that eventually produces very negative outcomes for investors.
Turn on financial television or pick up a financially related magazine or newspaper and you will hear or read about what some stock analyst from some major Wall Street brokerage has to say about the markets or a particular company. For the average person, and for most financial advisors, this information as taken as "fact" and is used as basis for portfolio investment decisions. But why wouldn't you? After all Carl Gugasian of Dewey, Cheatham & Howe just rated Bianchi Corp. a "Strong Buy." That rating is surely something that you can "take to the bank", right?
Maybe not.
For many years I have been counseling individuals to disregard mainstream analyst and Wall Street recommendations due to the inherent conflict of interest between the major brokerage firms and their "retail" clients. For individuals it is important to understand the relationship between your financial advisor, their firm and you. When you hire a realtor to sell your house there is a clear understanding that the realtor will sell your house for a commission. It is spelled out in advance in a contract and compensation is based on performance. However, when it comes to financial advisors at major Wall Street firms the relationship is not quite as clear.
Major brokerage firms are big business. Really big business. As such they are driven by the needs of increasing corporate profitability on an annual basis regardless of market conditions. This is where the conflict of interest arises. For example, look at the annual EPS of JP Morgan from 1999 to present. Despite two major bear markets, which led to investor losses of 50% each time, JP Morgan never had a year with negative earnings per share. How is that possible?
When it comes to Wall Street profitability the most lucrative transactions are not coming from servicing "Mom and Pop" retail clients trying to work their way towards retirement. Wall Street is not "invested" along with you but rather use you to make income. This is why "buy and hold" investment strategies are so widely promoted. As long as your dollars are invested the mutual funds and brokerage firms collect fees regardless of market conditions. While "buy and hold" strategies are certainly in their best interest - it is not necessarily yours. However, these fees are a byline to the really big money.
In reality, Wall Street is focused on the multi-million, and billion, dollar investment banking transactions, such as public offerings, mergers, acquisitions and bond offerings which generate hundreds of millions to billions of dollars in fees for Wall Street each year.
However, in order for a firm to "win" that business from its major clients the Wall Street firms must cater to those clients. In this regard, it is extremely difficult for the firm to gain investment banking business from a company that they have a "sell" rating on. This is why "hold" is so widely used rather than "sell" as it does not disparage the end client. To see how prevalent the use of the "hold" rating is I have compiled a chart of all the stocks that are ranked by major Wall Street firms and broken them down into the percentages that are ranked "Buy", "Hold" or "Sell." See the problem here.
It is not surprising that there is just 7% of all stocks with a "sell" or "strong sell" rating. It's just not good for business.
However, the conflict doesn't end just at Wall Street's pocketbook. Companies depend on their stock prices rising because it is a huge part of executive compensation packages. Corporations apply pressure on Wall Street firms, and their analysts, to ensure positive research reports on their companies with the threat that they will take their business to another "friendlier" firm. This is also why up to 40% of corporate earnings reports are "fudged" to produce better outcomes.
So, what about the retail investor? If Wall Street is more concerned about big business why do they need the retail investor at all? This is where the conflict of interest becomes more clear. Wall Street needs someone to sell their products to. When Wall Street wants to do a stock offering for a new company they have to sell that stock to someone in order to provide their client, a company, with the funds that they need. The Wall Street firm also makes a very nice commission from the transaction.
Generally, these publically offered shares are sold to the firm's biggest clients such as hedge funds, mutual funds and other institutional clients. But where do those firms get their money? From you. Whether it is the money you invested in your mutual funds, 401k plan, pension fund or insurance annuity - at the bottom of the money grabbing frenzy is you. Much like a pyramid scheme - all the players above you are making their money...from you.
In a recently released study by Lawrence Brown, Andrew Call, Michael Clement and Nathan Sharp it is clear that Wall Street analysts are clearly not that interested in you. The study surveyed analysts from the major Wall Street firms to try and understand what went on behind closed doors when research reports were being put together. In an interview with the researchers John Reeves and Llan Moscovitz wrote:
"Countless studies have shown that the forecasts and stock recommendations of sell-side analysts are of questionable value to investors. As it turns out, Wall Street sell-side analysts aren't primarily interested in making accurate stock picks and earnings forecasts. Despite the attention lavished on their forecasts and recommendations, predictive accuracy just isn't their main job."
The chart below is from the survey conducted by the researchers which shows the main factors that play into analysts compensation. It is quite clear that what analysts are "paid" to do is quite different than what retail investors "think" they do.
"Sharp and Call told us that ordinary investors, who may be relying on analysts' stock recommendations to make decisions, need to know that accuracy in these areas is 'not a priority.' One analyst told the researchers:
'The part to me that's shocking about the industry is that I came into the industry thinking [success] would be based on how well my stock picks do. But a lot of it ends up being "What are your broker votes?"'
A 'broker vote' is an internal process whereby clients of the sell-side analysts' firms assess the value of their research and decide which firms' services they wish to buy. This process is crucial to analysts because good broker votes results in revenue for their firm. One analyst noted that broker votes 'directly impact my compensation and directly impact the compensation of my firm.'"
The question really becomes then "If the retail client is not the focus of the firm then who is?" The survey table below clearly answers that question.
Not surprisingly you are at the bottom of the list. The incestuous relationship between companies, institutional clients and Wall Street is the root cause of the ongoing problems within the financial system. It is a closed loop that is portrayed to be a fair and functional system; however, in reality it has become a "money grab" that has corrupted not only the system but the regulatory agencies that are supposed to oversee it.
The Rise Of Independence
In the past few years there is a change that is occurring which is the rise of independence. Independent, fee only, financial advisors, private investment analysts, research and ratings firms have begun to infiltrate the system. Over the last several years the independent RIA (registered investment advisor) channel is growing faster than overall industry as retail investors are "catching on" to Wall Street's game. The "Occupy Wall Street" movement, while very misguided in its approach, was the first to ring the bell of the wealth gap between "Wall Street" and Main Street.
As more and more "baby boomers" head into retirement the need for high quality, independent, registered investment advisors will continue to grow. The need for firms that do organic research, analysis and make investment decisions free from "conflict," and in the client's best interest, will continue to be in high demand in the years to come as more "boomers" leave the workforce. While the "Wall Street" game is not likely to change anytime soon; the trust of Wall Street is fading and fading fast. The rise of algorithmic, program and high frequency trading, scandals, insider trading and "crony capitalism" with Washington is causing "retail investors" to turn away to seek other alternatives.
Of course, two nasty bear markets certainly have not helped Wall Street. Over the last several years the number of investment advisors has been steadily falling as individuals have taken back control of their own money. While individuals believed that Wall Street was out to take care of them the real truth was markedly different. Wall Street got rich while they got poorer. Now, those same individuals are hiding in bonds to find some return along with safety. The chart below shows the cumulative increase in bond funds versus stock funds as individuals seek safety over return.
Today, probably more than ever, the tide is shifting for retail investors. Those that want to venture into the shark infested waters of Wall Street on their own can certainly find plenty of tools, data and research online. Wall Street has the clear advantage in this game with billions of dollars invested in programs that can manipulate prices, front run trades and move markets to their benefit.
However, an independent advisor can help level the playing field between Wall Street and you. Provided they have the right team, tools and data they can spend the time necessary to manage portfolios, monitor trends, adjust allocations and protect capital through risk management. That expertise, combined with advances in technology, now allows individuals the freedom not to be locked into finding an advisor that lives down the street but to find the best fit for their personal goals and objectives. Today, top quality advisors have clients worldwide and can manage portfolios, communicate and service those clients effectively through technology.
The rise of independence is a good thing. Hopefully, it will continue to take root and grow into a dominant force in the marketplace that can affect regulatory change in the future for a more fair, transparent and less conflicted financial market. In the meantime, it is crucially important to start asking the right questions to figure out who is on your side.
Over this past weekend Russ Koesterich, CFA, who is the iShares Global Chief Investment Strategist, penned an article entitled "The Most Important (And Widely Ignored) Economic Number" wherein he states:
"While economic numbers like GDP or the monthly non-farm payroll report typically garner the headlines, the most useful statistic in my opinion– the Chicago Fed National Activity Index (CFNAI) – often goes ignored by investors and the press."
Russ is correct. The Chicago Fed National Activity Index is a composite index made up of 85 subcomponents which gives a broad overview of overall economic activity in the U.S. As Russ states ignoring the CFNAI could be a mistake:
Markets have run up sharply in recent months partly on the assumption that US economic growth is going to accelerate later this year and translate into faster earnings. But if recent CFNAI readings are any indication, investors may want to alter their growth assumptions for the third and fourth quarters.
Unlike backward-looking statistics like GDP, the CFNAI is a forward looking metric that gives some indication of how the economy is likely to look in the coming months.
The overall index is broken down into four major sub-categories which cover:
To get a better grasp of these four major sub-components I have constructed a 4-panel chart showing each.
There are a couple of important points to be made in reference to the chart above.
Russ stated that:
"And of all the indicators I've tested, the CFNAI has the best track record of forecasting future GDP. Since 1980 the CFNAI has explained roughly 40% of the variation in the following quarter's GDP, an extremely high proportion for a single indicator."
In order to assess that predictive capability I have created a second 4-panel chart with the four CFNAI subcomponents compared to the four most common economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures. In order to get a comparative base to the construction of the CFNAI I used an annual percentage change for these four components.
The correlation between the CFNAI subcomponents and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy.
Currently, the CFNAI is not confirming the mainstream view of an "economic softpatch" that will give way to a stronger recovery by year end. The latest CFNAI report plunged to -0.52 for April and the index has been negative for the past few months. This is shown in the chart below which shows the CFNAI index as compared to its 3-month average.
Russ goes on to state that:
"While the CFNAI's current level is still consistent with economic growth, it does suggest that growth will sharply decelerate in the second and third quarters of this year, falling to about 1.8%."
This last statement is key to our ongoing premise of weaker than anticipated economic growth despite the Federal Reserve's ongoing liquidity operations. The current trend of the various economic data points on a broad scale are not showing indications of stronger economic growth but rather a continuation of a sub-par "muddle through" scenario of the last three years.
While this is not the end of the world, economically speaking, such weak levels of economic growth do not support stronger employment, higher wages or justify the markets rapidly rising valuations. The weaker level of economic growth will continue to weigh on corporate earnings which, like the economic data, appear to have reached their peak for this current recovery cycle.
The CFNAI, if it is indeed predicting weaker economic growth over the next couple of quarters, also doesn't support the recent rotation out of defensive positions into cyclical stocks that are more closely tied to the economic cycle. The current rotation is based on the premise that economic recovery is here, however, the data hasn't confirmed it as of yet.
The reality is that either the economic data is about to take a sharp turn for the positive or the market is set up for a rather large disappointment when the expected earnings growth in the coming quarters doesn't appear. From all of the research that I have done as of late, it is the latter that seems the most likely of outcomes as there does not seem to be a driver, currently, for the former. Maybe the real question is why we aren't paying closer attention to what this indicator has to tell us?
Howard Marks once wrote:
“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that “being too far ahead of your time is indistinguishable from being wrong.”)
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian."
It is from this viewpoint within which I most often find myself being at odds with the mainstream journalists, economists and analysts. I prefer to look at the data as "it is" rather than as "I hope it will be," for in the long run, it is reality that will win out over fantasy. This was the premise from which I recently wrote "Evaluating 3 Bullish Arguments" wherein I analyzed three of the most common fundamental arguments used to support "bullish outlooks." Those arguments all failed under real scrutiny.
While the average "saver" chases the stock market, salivating at every tick higher, what they often fail to recognize is the mounting risks that will eventually lead to larger than expected losses of investment capital. History is replete with evidence that shows that the longer an up cycle lasts the larger the losses are when it contracts. It ALWAYS contracts eventually. Individuals, despite the television commercials that promote the latest do-it-yourself trading platforms, are not capable of navigating the financial markets over a full cycle.
It is important to understand that I am not "bullish" or "bearish." I have no bias towards the markets other than participating when it is rising and protecting client capital when it isn't. However, I am often given the moniker of a "bear" because I choose to point out the risks to investment capital rather than joining in with the lemmings all merrily marching towards to their eventual demise. My job, as a portfolio manager, is to navigate the markets for the "full cycle" - both the up cycle as well as the down. While the media chastises individuals for not chasing the market to the upside - I have never met an individual yet that was happy with matching market performance during a 20% decline. Losses of investment capital hurt individuals far more than missed opportunities. Lost capital is also far more difficult to recoup.
However, while I have spilt much ink lately pointing out the risks to investors ahead (see here, here and here), it is important that you realize that our portfolio models remain fully invested and that I have been correct in my assessments of the current market trends. Back in February, which now seems like a lifetime ago, I penned an article entitled "Get Ready For The Run To All-Time Highs" in which we discussed the reasons why the stock market would likely push to all-time nominal highs. At that time I stated:
"The bullish trend is supported, at the moment, by excessive bullish optimism and $85 billion a month in liquidity. Market participants, like a marathon runner, are so amped up on endorphins that they lose awareness of their surroundings. Right now, investors see the finish line just ahead as CNBC flashes banners on their screen with countdowns of points to reach a new all-time high.
However, it is important as investors, that we do not simply dismiss the dangers that continue to build in the economy and the markets. To simply assume that there are no excesses being created in various asset classes is short sighted. Asset "bubbles" are never recognized, or acknowledged, until after the fact. Currently the increases being witnessed are primarily due to the inflows of liquidity which is masking the deterioration of fundamental underpinnings. That is an unsustainable trend in the longer term, but, in the short term there is nothing inhibiting further increases as long as complacency remains high."
That analysis, some 160 S&P 500 points later, remains salient. While the risks are definitely mounting (record margin debt levels, low "junk bond" yields, markets at extreme deviations from long term moving averages) there are several reasons why stocks could continue to climb higher in the near term.
The Fed's Liquidity Pump
The most obvious driver of stocks currently is the Federal Reserve's ongoing balance sheet expansion program which pushes liquidity directly into the financial markets. As the chart shows below there is an extremely high correlation, since 2009, between the expansion of the Fed balance sheet and the financial markets.
As long as the Federal Reserve remains committed to its "accommodative strategies" the markets are likely to remain buoyant against weaker fundamental and economic underpinnings. This driver, by all counts, is the sole driver of higher asset prices currently and in the near future.
Complete Complacency
I stated recently that the "lack of fear is what we should fear the most." When investors are the most complacent that is when bad things tend to occur in the financial markets. However, complacency is also a tailwind for stocks as long as there are no exogenous shocks to change the course of the flow of money.
The chart below is the STA Risk Ratio which is a composite index of various sentiment indicators such as the volatility index, AAII bull/bear ratio, Institutional Investor bull/bear ratio, NYSE high/low ratio and others. When this index is rising, as it is currently, markets are on the rise as well. While this index is near historical peaks there is current no "event risk" present, that we are aware of, at the moment to send investors scurrying for cover.
This complete lack of fear, combined with the belief that as long as the Fed is in play there is no downside risk to owning stocks, makes it is very possible for stocks to continue upward trajectory within the context of the current bullish trend. As we will discuss below, there is currently no overhead resistance for stocks from a historical perspective.
Bullish Trend
The laws of physics state that an object in motion will remain in motion until it meets resistance. That is currently the dynamic of the markets. With the breakout of the bullish uptrend, combined with the break of long term overhead resistance, there is nothing to stop asset prices from rising further until the next major correction occurs.
I have drawn three important lines in the chart above. The break of overhead resistance will now become the first level of support for the markets on any correction. If the markets do correct, and find support at 1600 while simulatenously working off the much overbought condition in the process, then the market could rally higher from this level. This same idea goes for the previous two upward trending bullish support lines. However, if the market breaks below 1400 then a different dynamic comes into play. The current bullish cycle will end and a bear market investment strategy will need to be put into play.
However, currently, there is little to stop asset prices from rising higher technically as long as:
1) The Fed remains engaged in their current liquidity programs.
2) Economic and fundamental "bad news" remains "good news" for the markets as it keeps the Federal Reserve in play.
3) The other major Central Banks remain engaged in their liquidity programs.
4) No exogenous events spring up such as a resurgence of the Eurozone crisis.
5) Interest rates remain contained below 2.5%
Risks Remain
While stocks could continue to climb higher that does not mitigate the underlying risks. In fact, it is quite the opposite. It is very likely that we are creating one, or more, asset bubbles once again. However, what is missing currently is the catalyst to spark the next major correction.
That catalyst is likely something that we are not even aware of at the moment. It could be a resurgence of the Eurocrisis, a banking crisis or Japan's grand experiment backfiring. It could also be the upcoming debt ceiling debate, more government spending cuts, or higher tax rates. It could even be just the onset of an economic business cycle recession from the continued drags out of Europe and now the emerging market countries.
Regardless, at some point, and it is only a function of time, reality and fantasy will collide. The reversion of the current extremes will happen devastatingly fast. When this occurs the media will question how such a thing could of happened? Questions will be asked why no one saw it coming. Fingers will be pointed and blame will be laid. While I am absolutely certain this will happen - I just don't know when. It could be later this year or even next year. Timing is always the problem and as Howard Marks stated - being early, even if you are right, is the same as being wrong.
This is why it is more important than ever that you remain aware of the risks and pay attention to exposure that you take on within your portfolio. I point out to you the risks that we are watching, the detail behind the headlines and historical precedents that have led to massive losses of investor capital in the past, so that you can take appropriate risk management actions in your portfolio. There is no prize for beating the market from one year to the next, however, there are severe penalties when things don't go as planned.
Enjoy the ride - just don't forget that our job as investors is to "sell high" so that we can "buy low." This is the one simple rule that is always overlooked by the media, analysts and economists who are chiding you to chase extremely overbought, over extended and excessively bullish markets.
It is interesting to watch mainstream analysts, and journalists, grab for headlines to support the bullish rhetoric without actually doing some underlying research. As we discussed in "5 Questions Every Market Bull Should Answer" the drive by the markets higher is not being driven by fundamental improvements but almost solely by the Federal Reserve interventions. Of course, in the famous words of Jerry Seinfeld, "...not that there is nothing wrong with that" as long as you understand the inherent risks with trying to justify your position by grabbing at half-truths to provide "confirmation."
The release of the consumer confidence report yesterday speaks directly to the issue of "confirmation bias." The following is the front page of USA Today for Wednesday, May 29, 2013.
The paper attributes the markets rise to the release of better than expected consumer confidence and housing reports. However, if the journalist had taken just a few minutes to look at an intraday price chart of the S&P 500 index they would have seen that it was not the case.
As you can see in the chart above the market spiked at the open. What drove that spike was the purchase of bonds by the Federal Reserve of $1.25-1.75 billion which injected liquidity into the markets. The consumer confidence report was not released until 30-minutes later.
More importantly, while the markets did finish positive for the day, they actually finished 50% lower than its early morning peak. This is hardly the sign of strength one should be looking for. Had the economic reports been the driver for the rally - stocks should have finished higher than when the report was released.
Consumers - Sort Of Confident
The consumer confidence report was a good report nonetheless with it rising from 69 in April to 76.2 in May. However, there are still some concerns with the report that should be addressed rather than just dismissed.
As has already been established, by USA Today and many others, consumer confidence has reached its highest level of the past 5-years. Unfortunately, that level is still lower than where recessions are normally setting in.
One of the more important components of the consumer confidence survey is the "expectations index" which speaks to consumers outlook. While that component did improve in the most recent survey - it is still at levels lower than where they stood in 2011. Coincidently, there is a very high correlation between the expectations index and the annual percentage change in economic activity. As shown in the chart below economic activity also peaked in early 2011.
One of the primary goals of the Federal Reserve, as noted by Bernanke in 2010, was to inflate asset prices in order to boost consumer confidence. The theory is that by inflating asset prices consumers will feel more confident about their current situation and will boost economic growth by purchasing more goods and services. The chart below shows that the Fed was indeed able to achieve stronger consumer confidence by inflating asset prices.
The problem is that it is not translating into stronger personal consumption. The chart below shows the improvement in consumer confidence as compared to the annual rate of change in real retail sales.
So, while consumer confidence has indeed improved from the recessionary lows - it is has been weak when compared to historical recoveries. This should not be a surprise when one considers the record number of indiviudals on food stamps and disability claims, quality employment remains elusive, businesses remain on the defensive and wage growth stagnant.
Another reason is that while the Fed focuses on inflating asset prices - the stock market "wealth effect" is primarily located at the top end of wage earners. For the rest of "Main Street" there remains a disconnect between their personal financial situation and "Wall Street."
The next few months will be very important for a "revival" from the current "soft patch" in the economic data. The question, however, remains sustainability.
With the Fed already talking about "tapering" their current program, interest rates on the rise and market risk at extremes there seems to be little more that the Fed can do currently. The question is now whether the consumer is really ready to pick up the slack? The problem is that I am not sure that they actually can.
These are indeed interesting times that we live in. As the markets elevate higher on the back of the global central bank interventions it is important to keep in context the historical tendencies of the markets over time. It is not uncommon at major market peaks to see "irrational exuberance" begin to grip the markets. In March of 2000, as foreign capital inflows drove markets higher, Jim Cramer came out with his 10 must own stocks for the next decade. By the end of 2002, of the few that were still in business, the destruction of capital was enormous.
In 2008, as the markets hit all-time highs from a credit/real estate liquidity push, the justification was a "Goldilocks Economy," valuations were significantly less than in 2008 and "market risk" had been fully diversified through derivatives. Of course, by March of 2009, the bloodshed was enormous.
So, here we are once again with markets, driven by inflows of liquidity from Central Banks, hitting all-time highs. Of course, the chorus of justifications have come to the forefront as to why "this time is different."
“This market is nothing like 2000!”
“You have to realize just how amazing the markets are right now.”
“The ‘Walls of Worry’ have all been knocked down.”
“The next stop for the markets is simply higher.”
“This market is unstoppable.”
“I haven’t seen a market like this in 30 years.”
These were all things that I have either read, or heard, in just the past month. I even read an article as to why “This time is different – really!”
Here is an interesting statistic to think about for a moment.
The current rise in the stock market has gone uninterrupted for more than 190 trading days which is the longest period in the history of the stock market.
Think about that for a moment.
Over the last 113 years of stock market history we are now witnessing the longest rise – ever. Every single time in history, when the markets have gone on extended runs, they have NEVER, not once, lasted as long as the current artificially fueled advance.
There is no doubt that the current advance is quite amazing. However, it is not unstoppable. It will eventually correct. Of course, when it does, these same “book talking jacklegs” that made the statements above will have a litany of excuses has to why such a correction was unexpected. Of course, those excuses won’t replace your lost capital.
In this regard let's review the three most common arguments used to support the current market exuberance.
Valuations Are Cheap
Take a look at the first chart below. First, notice the recent run-up in the market at the far right of the chart. This price action is very similar to what was witnessed at the peak of every previous bull market advance. More on this in moment.
However, and importantly, one the primary “bullish” arguments has been valuations. The argument is that stocks are “fairly valued” because valuations reverted to their long term average during the financial crisis. That is true but also incorrect.
If you take a moment to inspect the chart above you will see several very important points:
1) Never in history have valuations ONLY returned their long term average before setting off into the next secular bull market rise.
2) When P/E reversions begin they continue until valuations have fallen well below the long term average. As denoted by the blue arrows - bull markets begin with valuations around 5-7x earnings with dividend yields between 5-6%. It is not uncommon, however, for there to be continued bounces in markets, and valuations, within the context of the longer term downtrend. Currently, the markets are trading at 23x cyclically adjusted earnings and 19x reported trailing earnings (1666/87.69). Does that sound cheap to you?
(Geek Note: You can NOT use forward operating earnings when comparing to historical valuations which are based on trailing reported earnings. This is the mistake every media outlet consistently makes. Only trailing reported P/E's are relevant.)
3.) When markets are in the process of a long term valuation reversion it is not uncommon for markets to have rallies within the long term decline. This was seen during the run-up from the 2002 lows which were also believed to be the next great secular bull market. This is just part of the long term reversion process and resolution of excesses.
4.) It is not likely that this time is any “different” than what we have witnessed in the past. While the interventions by the Federal Reserve can certainly elevate markets short term – the underlying lack of economic and fundamental strength will continue to put downward pressure on the markets. Bottom line – valuations “ain’t” cheap.
Earnings And Profitability Continue To Rise
Another key "bullish" argument has been the earnings and profitability of corporations. Let's take a close look at reported and operating earnings for corporations since the beginning of 2000.
(Note: The chart is only through the end of 2012 which is the last complete data set from S&P)
The problem is that the analysts that try and forecast what earnings are going to do in the future are always overly bullish. The chart below shows what analysts were predicting earnings to be for 2012 through 2013 at the beginning of 2012. What actually happened was markedly different.
As you can see in the chart above analysts are once again predicting an exceptionally strong increase in earnings per share over the next four quarters. This is a big part of the "bullish" thesis for the "cheapness" of stocks versus other assets.
This view is contingent on several things going right per Goldman Sachs:
1) That interest rates do not rising quickly collapsing the earnings yield gap. (This is a faulty analysis anyway as we will discuss momentarily.)
2) That economic stagnation ends and organic growth returns. (This hope has been consistent for the last 3 years but has yet to appear.)
3) A continued recovery in labor and housing that is already showing signs of peaking for the current economic cycle. (See recent posts on employment and housing)
4) Continued Federal Reserve interventions. (This one is true as the Fed is now caught in a "liquidity trap.")
5) Expectations that current valuations remain suppressed by rapidly rising earnings per share. (This isn't likely as earnings have likely peaked.)
The chart below shows Goldman Sachs recent forward estimate projections. The red lines represent the same trend of projections that were prominent during the last two earning cycle peaks.
All of these assumptions primarily tie back to a rebound in economic growth. However, as the chart of our economic composite below shows, these estimates are likely to come up fairly short as economic strength wanes.
Earnings Yield Myth
The final “bullish” thesis argument is that earnings yield makes stocks a better investment than bonds. I have written about this particular myth several times in the past and you can read the entire article “The Fallacy Of The Fed Model” on the site.
“The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine "WHAT" to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining 'WHEN' to make an investment. In other words, I can buy fundamentally cheap stock all day long; however, if I am buying at the top of a market cycle then I will still lose money."
"It hasn't been just the last decade either with which the 'Fed Model' has continually misled investors. An analysis of the previous history of the concept shows it to be a very flawed concept and one that should be sent out to pasture sooner rather than later.
During the 50's and 60's the model actually worked pretty well as economic growth was strengthening. Interest rates steadily rose as a stronger economic growth allowed for higher rates which enticed higher personal savings rates. These higher savings rates were lent out by banks into projects that continued further stimulated economic growth. However, following that model would have kept you out of the entire bulk of the 1980-90 secular bull market.
Furthermore, while the model began to work again post the tech-wreck. It kept you in stocks until after the 2008 crash, where you gave up all of your previous gains only to get back at the beginning of 2011.
The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine 'WHAT' to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining 'WHEN' to make an investment. In other words, I can buy fundamentally cheap stock all day long; however, if I am buying at the top of a market cycle then I will still lose money.”
Currently, that "yield spread" is contracting. The problem, as stated above, is that if interest rates rise to 3% or 4% in the near future then the Fed Model will once again signal a move to bonds and out of stocks.
Rising interest rates are potentially a huge problem for the markets and the economy. Rising rates increase borrowing costs, carrying costs, and mortgages while reducing profitability, consumption and production. If the prognosticators of a bond market reversion are “right,” like Bill Gross, it will not be good for stock market investors.
Riding The Bull
The Federal Reserve bond purchases are like a pool of water with only one outlet. The only place for the liquidity to flow is into the equity markets. If you are an adept trader there is likely some money left to be made. However, if you aren’t, you will likely wind up losing a large chunk of your principal balance when prices revert.
The market is currently at extensions that are usually only seen at major market peaks as I discussed recently:
“Market prices are subject to gravity (the long term moving average) and the longer the duration of the moving average the greater the 'gravitational pull' that exists. One way to measure extremes of price movement is through the use of standard deviation. One standard deviation from the mean (average) encompasses 68.2% of potential outcomes within a given distribution of data which, in this case, are market prices. Two standard deviations encompass 95.8% of all potential outcomes while three standard deviations encompass 99.8% of all potential outcomes."
The chart below shows a weekly chart, which is a very slow moving analysis, of the S&P 500 overlaid with Bollinger Bands which represent 3 standard deviations of a very long term (50 Week)) moving average.
“At the peaks of the 'Internet Bubble' and the 'Credit/Housing Bubble' the market never got significantly above 2-standard deviations. Today, we are encroaching well into 3-standard deviation territory. Standard deviation analysis tells us that roughly 99% of the potential movement in prices, from the bottom of the correction in 2011, has been achieved. Furthermore, the extension of the market above the long term moving average is also at levels that have previously been associated with major market tops."
The current level of overbought conditions, combined with extreme complacency, in the market leave unwitting investors in danger of a more severe correction than currently anticipated. A correction to the long term moving average (currently around 1465) would entail an 12.06% correction. A correction to 3-standard deviations below the long term moving average (which is most common within a mean reversion process) would slap investors with 20.1% loss.
If you don't think a 20% loss is possible all you have to do is look back to the summer of 2011 when the "Debt Ceiling Debate" sent investors running for cover under the threat of a government bond default. (Oh, and by the way, that same debate is rapidly approaching in the next month or so.)
There is virtually no “bullish” argument that will withstand real scrutiny. Yield analysis is flawed because of the artificial interest rate suppression. It is the same for equity risk premium analysis which is the subject of an upcoming post. However, because the optimistic analysis supports the underlying psychological greed - all real scrutiny that would reveal evidence to contrary is dismissed. However, it is "willful blindness" that eventually leads to a dislocation in the markets.
Disclosure: It is important to understand that just because I am pointing out potential risks in the market that we currently remain invested in it. However, we are invested with hedges in place along with very tight loss limits. When the current "exuberant" trend ceases to exist so will our participation in the market.
As stated above, this is a dangerous market as the current extension is only seen at major market peaks, however, such extensions can go further, and for longer, than you can imagine. The problem with markets, such as these, are that they resemble a game of "musical chairs” – unfortunately, the major market players will already be seated before the music stops leaving the average investor out of the game.
In several of my recent missives I have made several references to the wave of deflationary pressures that are currently encircling the globe.
In "Japan: A Few Thoughts On The Crash" I stated:
"The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates goes the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return."
Also, in "Bernanke's Link to "Mother Nature"
"How many more natural disasters will come to offset the negative economic impact of a zero interest rate environment coupled with a wave of deflationary pressures is unknown."
But most importantly in "Why Bonds Aren't Dead & The Dollar Will Get Weaker" I stated:
"A wave of 'disinflation' is currently engulfing the globe as the Eurozone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth. Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy. This is a problem that has yet to be recognized by the financial markets.
The recent inflation reports (both the Producer and Consumer Price Indexes) show deflationary forces at work. Wages continue to wane, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber all indicating weaker levels of economic output. The battle against deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis. The problem has been that, much like 'Humpty-Dumpty', the broken financial transmission system, as represented by the velocity of money, can't be put back together again."
The last paragraph above is particularly important. The biggest fear of the Federal Reserve has been the deflationary pressures that have continued to depress the domestic economy. Despite the trillions of dollars of interventions by the Federal Reserve the only real accomplishment has been keeping the economy from slipping back into an outright recession. However, when looking at many of the economic and confidence indicators, there are many that are still at levels normally associated with previous recessionary lows. Despite many claims to the contrary the global economy is far from healed which explains the need for ongoing global central bank interventions. However, even these interventions seem to be having a diminished rate of return in spurring real economic activity despite the inflation of asset prices.
Despite the ongoing rhetoric of those fearing inflation due to the Fed's monetary interventions the reality is that such actions have, so far, failed to overcome the deflationary forces of weak global demand. The chart below is the spot price of copper. Copper, often dubbed "Dr. Copper", is very sensitive to economic growth as copper is used in everything from production, to manufacturing, transportation, housing, etc. So goes copper - so goes the economy. Copper is currently confirming the peak in economic growth for the current cycle.
However, the question remains, do we have inflation or don’t we? Are we experiencing the 1970’s all over again as inflation kills the economy, or in the words of Ben Bernanke, have we entered an era of low inflation and interest rates that will last for some time as the threat of deflation remains a prevalent enemy to the economic recovery?
3 Components Of Inflation
I believe that there are three components required to create a truly inflation environment.
Commodity price inflation is certainly one of them as it does immediately impact the consumptive capability of the average consumer. However, in order to see true pricing pressures across the economy there are two other factors that are critical; 1)the velocity of money, or how fast money is flowing through the system from the banks to small businesses and ultimately consumers, and; 2) wage growth which gives the consumer increased purchasing power.
Why are these two factors so critical to overall inflation question? In the most recent NFIB survey only a small fraction of respondents stated that this was a “good time to expand their business” while the majority of respondents stated that their major concerns were “poor sales, taxes and government regulations”. If you are a small business, who coincidently creates roughly 70% of all new jobs in the economy, and you are worried about poor sales prospects and a weak economic environment, it is highly unlikely that you are going to borrow money to expand your business or extend credit to customers. Businesses in turn choose to hoard cash as a hedge against a weak economic environment instead of making productive investments that will lead to more jobs and higher wages.
Besides the rise and fall of commodity prices, which do indeed contribute to the inflationary backdrop, the demand for money to make productive investments by businesses which leads to higher levels of production, wage growth and, ultimately, consumption is what drives overall inflation. It is important to remember that in economics inflation is:
"...a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy."
It is very difficult to have a "general rise in price levels" amidst a lack of consumer demand driven by suppressed wages, high levels of unemployment and little demand for credit by businesses. The lack of demand exerts downward pressures on the pricing of goods and services keeping businesses on the defensive. This virtual spiral is why deflationary environments are so dangerous and very difficult to break.
I have constructed a composite "High Inflation Index" in an attempt to measure these three legs of inflationary pressures. The purpose, of course, is to visualize the data to determine if inflation is prevalent in the current economic cycle or not. The index is equally weighted of the M2 Velocity of Money, the Year Over Year (YOY) percent change in wages and the YOY percent change in the Consumer Price Index (CPI). The first chart shows the historical levels of each of the three components.
Notice that there is a very tight relationship between the rise and fall of compensation of employees and the velocity of M2 money supply. With M2 velocity plunging to historically low levels this does not bode well for sustained increases in either employment or compensation as the demand for money simply does not exist currently. The next chart is the weighted average of the three components into an index.
The index clearly shows the "high inflationary" pressures that were prevalent in the 1970’s as the economy suffered real inflation and rapidly rising interest rates. Recently, inflationary pressures rose as economic growth surged from the lows of the financial crisis as the economic system was flooded by trillions of dollars of stimulus, bailouts and financial supports. However, that surge, in both the economic growth and the inflationary pressures, peaked in early 2011 and have been on the decline since. This is why the Federal Reserve remains extremely worried about the diminishing rate of return on their monetary experiments as it relates to the economy. Inflating asset prices higher have increased consumer confidence but has had little translation into the creation of underlying economic growth.
With the index clearly warning of rising deflationary pressures in the economy, which has recently been seen in many of the manufacturing reports that have shown downward pricing pressures both on prices paid and received, there is no "exit" currently for the Federal Reserve to reduce its monetary supports. The real concern is that with the index at just 4.88%, which is well below the long term average of 11.63%, that the economy is far to weak to handle much of an exogenous shock.
The risk, as discussed recently with relation to Japan, is that the Fed is now caught within a "liquidity trap." The Fed cannot effectively withdraw from monetary interventions and raise interest rates to more productive levels without pushing the economy back into a recession. The overriding deflationary drag on the economy is forcing the Federal Reserve to remain ultra-accommodative to support the current level of economic activity. What is interesting is that mainstream economists and analysts keep predicting stronger levels of economic growth while all economic indications are indicating just the opposite.
Despite the Fed's recent communications that they are planning to "taper" the current monetary program by the end of this year - the index is suggesting that their interventions, in one form or another, are unlikely to end anytime soon. The threat of "deflation" remains the Fed's primary concern.
CNBC: Global Markets Roiled by Nikkei's 7.3% Slide "Financial markets around the world were roiled Thursday after Japanese stocks suffered their biggest slide since the country was hit by a devastating tsunami more than two years ago. Several reasons have been blamed for the 7.3 percent fall in the Nikkei index to 14,483.98, including a spike in Japanese government bond yields and unexpectedly weak Chinese manufacturing figures."
That was the news that dominated the financial headlines today around the globe this morning. However, while the selloff was certainly large in magnitude, the largest since the nuclear disaster in 2011, it must be put into some sort of context. The chart below shows the Nikkei 225 going back to 1981.
There are numerous points that are worthy of consideration:
1) While the Nikkei has had a parabolic rise since the implementation of "Abe-nomics" the current rally failed at the long term downtrend resistance.
2) As shown in the callout - while the Nikkei did suffer its largest drawdown since 2011 it has hardly registered a blip when compared to the entirety of the recent advance. If this did indeed mark the top in the Nikkei the correction still has a long way to go just to reach the 12-month average.
3) The rise in the Nikkei pushed the markets well beyond 3-standard deviations above the 12-month moving average which is simply unsustainable. As with the U.S. markets - such extensions will ultimately lead to a reversal. However, reversals do not occur without a catalyst. The problem is that by the time you realize what the catalyst is - it will be too late to react.
4) The extreme divergence from the 12-month moving average, as shown at the bottom of the chart, is at levels that have normally been associated with major market tops. While such extreme deviations are important it does not mean that the markets are going to crash immediately. It does mean, generally speaking, that the majority of the advance is already complete and the risks, without a correction first, outweigh the potential for returns.
The Big Picture
While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:
The unanswered question remains as to whether, or not, monetary policy can generate economic recovery. The world's central banks have "bet it all" that it will indeed work. The problem, as is always the case is such monetary experiments, remains the unintended consequences.
The lynch pin to Japan, and the U.S., remains interest rates. If interest rates rise sharply it is effectively "game over" as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support. Japan, like the U.S., is caught in an on-going "liquidity trap" where maintaining ultra-low interest rates is the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go - the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.
The mistake that Japan is likely going to make is believing that if they can generate some inflation for the economy that they will have the ability to cap it at 2%. This is beyond naive and is likely to end very badly. The following video from Christine Hughes sums the entire situation up very well and is worth watching in its entirety.
{youtube} AR3TyfKTeNE {/youtube}
The point here is that the current blip in the Nikkei is likely going to be short lived as liquidity injections continue to artificially inflate assets. However, as in the U.S., parabolic rises in asset prices eventually lead to extreme corrections. If the "grand experiment" in Japan does indeed fail, which is what I suspect will eventually happen, the ramifications on the U.S. markets are likely to be quite severe.
The two charts below show the current extension of the S&P 500 Index. The first chart shows the S&P 500 as compared to its 3-standard deviation range above and below the 50-week moving average. Currently, the index is at levels, much like the Nikkei, that have denoted major market peaks.
The next chart shows the deviation of the S&P 500 price above its 50-week moving average. Here, also, the index is at historically high levels.
So, what does the "crash" in the Nikkei mean? Most likely not much in the near term as long as "Abe" and Bernanke continue to push liquidity into the financial markets. The current bias for assets prices remains to the upside as investors remain completely agnostic towards risk. Despite a threat of war from North Korea, weakening global economics, deterioration in the Eurozone, a slowdown in China or a slowdown in corporate earnings - investors remain solely focused on Central Bank interventions as a driver of asset prices and a complete hedge against investment risk.
"With central banks fully engaged in lifting asset prices through monetary policy - what could possibly go wrong?"
However, in the end, it will be the realization of "fear" that drives volatility substantially higher leading to the rapid deflation in asset prices. In this case Roosevelt was wrong - it is the "lack of fear" that we should fear the most.
Existing home sales for April came in at 4.97 million from an upwardly revised March reading of 4.94 million (originally 4.92 million.) However, the question remains that with rising home prices, and tightening supply, when do potential buyers get priced out of home ownership? Today's chart of the day is actually two charts that may start to give us a clue as to the state of the housing market currently.
The first chart shows existing home sales as compared to the average year-over-year change in wages. As home prices rise, regardless of the current interest rate, the monthly mortgage payment increases. It is important to remember that families buy "payments" rather than "houses" so with wage growth stagnant, or decline, the ability to buy a home becomes much more of an issue.
The second chart shows that this may be happening currently. The chart below is the annual percentage change in real estate loans at all commercial banks.
There are two important points to take notice of. First, the rate of loans for real estate has turned down in recent months which is coinciding with the decline in mortgage applications and a stagnation in existing home sales. Secondly, loan growth, as shown in the chart inlay, has been virtually flat since the middle of 2011 which does not really support the whole housing recovery meme.
I have made these points in the past and Doug Kass' recent post reiterates my ongoing concerns:
"Hedge funds and other corporate and institutional investors have gobbled up homes for investment, creating the appearance of a more vibrant residential market than might actually exist. This has served to prop up home prices, which, in turn, could serve to turn away first-time homebuyers (who continue to be haunted by little wage improvement and a still relatively sluggish labor market). I have argued that construction only represents about 3% of U.S. GDP, and, as such, I didn't think (and still don't think that) the housing market could provide enough leverage to get U.S. real GDP growth to exceed a tepid 2% rate. I continue to expect a pause in an anticipated durable multiyear recovery in housing."
However, this becomes even more of an issue if the "bond bubble" breaks and interest rates do rise. For potential homeowners the cost of "buying" will increase significantly and the profit margins for investors will decrease. Just recently as mortgage rates ticked up only slightly there was an almost immediate falloff in mortgage applications.
Currently, there are still more than 25% of homeowners underwater which limits their ability to move, refinance or sell their homes. However, as prices rise, there are two issues that begin to attack the housing story: 1) As prices reach levels where underwater homeowners can sell they will likely do so out of a psychology need to escape the "trap," which will bring a large supply of homes back onto the market, and; 2) rising prices will eventually erode the profitability of buying homes for rentals which will bring the speculative frenzy that has been the driver of the recent recovery to a halt.
The housing recovery is ultimately a story of the "real" unemployment situation which still shows that roughly a quarter of the home buying cohort are unemployed and living at home with their parents. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. Also, we should not discount the psychology of home ownership has dramatically changed since the crash as many of the "millennials" saw the financial damage their parents suffered and are opting out of taking such a perceived risk.
As I stated recently the optimism over the housing recovery has gotten well ahead of the underlying fundamentals. The overarching problem is that the housing market that is almost exclusively dependent on the continued push to artificially suppress interest rates combined with massive amounts of direct stimulus, and incentives, to bailout current homeowners and banks. This intervention is causing an artificial supply suppression which is likely to create a backlash in the future as the current supply/demand conditions are unsustainable.
While the belief was that the Government, and Fed's, interventions would ignite the housing market creating an self-perpetuating recovery in the economy - it did not turn out that way. Today, these repeated intrusions are having a diminished rate of return and the risk now is that interest rates rise shutting potential homebuyers out of the market. It is likely that in 2013 housing will begin to stabilize at historically low levels and the economic contribution will remain fairly weak.
The downside risk to that view is the impact of higher taxes, stagnant wage growth, re-defaults of the 6-million modifications and workouts, elevated defaults of underwater homeowners and a slowdown of speculative investment due to reduced profit margins. This story will continue to unfold in the months ahead and the keys to watch for will be the level of interest rates, real employment and wages, and the effects of any fiscal drags from policy changes relating to reductions in spending and potentially additional taxes.
Yesterday, after I updated my economic and employment composites and discussed that they were pointing to weakening economic trends, a two mile wide tornado ripped through Oklahoma causing a massive amount of destruction. The video below is a 10x time-lapse video of what is potentially one of the worst tornadoes in modern history.
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What does this tornado have to do with the economic analysis from yesterday? That is a very interesting question.
Over the last two years the economy has twice ground towards much slower rates of growth. Each time Bernanke would make the pitch that it was just an "economic soft patch" and that the economy would strengthen later on in the year. Each time he was correct. However, the reason by which he was correct is what is most interesting. I call it the "Mother Nature Effect."
If we take a look back at history you will see what I mean.
In early 2011 - Japan suffered a massive disaster of an earthquake and tsunami which devastated the country and shut down much of their production. This production break impacted the domestic economy causing weakness in economic growth. However, that issue was compounded by the "debt ceiling debate" in the summer which pushed consumers to the sideline as fears of a "debt default" swept the country. By the end of the summer economic growth had waxed rather sharply and the stock market had plunged nearly 20%.
As the Federal Reserve launched its second round of Quantitative Easing, which began the process of supporting asset prices, the strangest combination of events occurred to boost economic growth. First, Japan had struggled back onto its feet and began returning to manufacturing and production which in turned opened exports back up to the U.S. Pent up demand for products by the U.S. consumer boosted spending. Simultaneously, energy prices plunged providing a roughly $60 billion tax credit to consumers at the time which supported consumption even while wage growth weakened.
Then "Mother Nature" answered the call by providing Bernanke with the warmest winter on record in 65 years. This allowed construction and manufacturing to continue during a period of the year when much of the Northern part of the U.S. is "shut in" due to inclement weather. Lower needs for heating oil, and natural gas, led to a further massive tax credit for consumers which boosted consumption. The abnormally warm weather skewed the economic data higher due to the effect of the seasonal adjustments that are normally accounting for much colder weather. All in all - the boost to growth was quite substantial and came just when it was needed the most.
In 2012 we witnessed the same thing occur once again as the economy began to show signs of deterioration. As the effect of the seasonal data skews, due to the warmer than normal winter, faded and the "Fiscal Cliff" fears pushed consumers and businesses into a defensive posture the economy slid towards much slower growth. However, once again "Mother Nature" stepped in with "Hurricane Sandy" which rocked the North East. Congress responded with a $60 billion aid bill that led to a rush of economic activity of rebuilding homes, replacing flooded cars, fleets of taxis, and funded the repair of massive amounts of infrastructure. However, that effect faded quickly as life returned to normal in a very short period of time.
As I watched the news last night, and started to assess the damage caused by the numerous tornadoes in the Mid-West including the "super twister" shown above, it occurred to me that once again we are witnessing "Mother Nature" answer Bernanke's "economic soft-patch" call.
The chart below is my Manufacturing Composite Index. It is a derivative of the EOCI index discussed yesterday except it strips out the Leading Economic Indicators to focus solely on the broad nationwide manufacturing activity. You can see the ebb and flow of activity as it was affected by "Mother Nature."
This, of course, is the "broken window" theory in action, and while in the long term "smashing windows" does not promote sustainable organic growth, it does provide short term bursts of economic activity.
Note: The "broken window" theory suggests that if a window is broken it must be repaired creating economic opportunity for the person repairing the window who then uses the compensation for the repair to buy shoes which creates economic recovery. However, the fallacy of that theory is that you are replacing things which were already purchased and therefore capital that would be used for future purchases is being diverted into replacement of something which was already paid for.
The chart below is a close up of the Economic Output Composite Index (EOCI) that I discussed yesterday. I have added (dashed black line) the potential impact from the forthcoming surge in activity from the rebuilding of the destruction from the recent tornado's. This is strictly an assumption at this point as while the damage was significant it will be far lower than what we saw from "Hurricane Sandy."
While I knew that the Federal Reserve wielded significant power - I didn't realize that the position of Chairman came with a direct line to "Mother Nature." Maybe there is more than just conspiracy theories when it comes to government experiments to control the weather?
I jest, of course, but what is relevant is that the effect of "Mother Nature" has provided the short term boosts to economic growth which kept a struggling economy above the water line. How many more natural disasters will come to offset the negative economic impact of a zero interest rate environment coupled with a wave of deflationary pressures is unknown. However, you do have to admit that the "Mother Nature" effect is quite interesting nonetheless and wonder, if even for just a moment, if Bernanke has her on speed dial.
KIPLINGER.COM(Click Here For Original Article)
Shares have recovered modestly from their autumn swoon. But future gains won't come easy.
The stock market may be the world's most ruthless headmaster, teaching investors costly lessons on a daily basis. But few lessons are more instructive — or more costly — than those provided by the meteoric rise and fall of the shares of Apple (symbol AAPL).
In case you missed it, here's the CliffsNotes version. Until last fall, Apple was one of the decade's most compelling success stories, with its shares rising 100-fold from September 2002 through September 2012.
With the iPhone and iPad breaking sales records, analysts contended that even though Apple was trading at a record high of $705, the stock still had room to run. Many analysts published price targets for the next 12 months of $750 or $800 per share. (In September 2012, Kiplinger's Personal Finance columnist Andrew Feinberg proclaimed "Apple is still cheap" at $606 a share.)
But Wall Street's love affair with Apple began to cool when company officials hinted in a conference call last October that profits in the October-December quarter might be flat and that revenues weren't going to be as robust as analysts had predicted. Apple shares sank below $400, rallied 18% in late April and early May, then retreated again to around $430. Meanwhile, many of the analysts who had predicted an $800-a-share price a year ago are now hoping the stock will bounce back to the $500-$560 range.
What lessons can this sad story teach?
Watch the innovation cycle. Apple's growth was based on the popularity of its innovative products — from phones that talk back to reading devices that play songs and take pictures. But the first iPhone was introduced six years ago, and the iPad is three years old. Although both have since been refined, the dearth of uniquely new products gave competitors a chance to catch up and develop similar devices. Increasing head-to-head competition makes it tough to sustain the high prices that have made Apple so profitable. In fact, the company's latest earnings reports show that its wide profit margins are narrowing.
Exponential growth becomes harder with size. It's easy for investors to think that if a stock has doubled in price, it could triple or quadruple — as Apple has several times in the past. However, stock prices tend to track earnings and revenue, and every time a company's earnings and revenues double, it becomes harder for them to double again, says David Tan, assistant professor of strategy at Georgetown University's McDonough School of Business. After all, a company with $1 million in revenue has to sell only $2 million worth of products or services to double in size. But a company with $172 billion in annual sales, which is what analysts estimate that Apple will ring up in its current fiscal year, has to add another $172 billion in sales to grow twice as large.
To put it another way, for Apple to maintain the 40% to 50% pace at which it grew in the past, it would have to buy or build a business the size of the Walt Disney Co. every 12 months.
Winners take chips off the table. Unless every stock in your portfolio doubles each year (in which case Warren Buffett would like to hire you), Apple's rise over the past 12 months likely caused it to become a disproportionately large share of your assets.
That makes your portfolio riskier and less balanced and is a signal that it's time to sell a portion of that stock, says Lance Roberts, chief executive of Streettalk Advisors, a Houston money-management firm. If a stock doubles, sell half your shares, Roberts advises. That takes your profits off the table, securing a gain and reducing the risk that one stock could jeopardize your overall wealth.
The market loves and hates with equal intensity. Wall Street is a lot like Taylor Swift, Roberts adds. It falls head-over-heels in love and will forgive many a transgression with a well-adored company. But one too many slips and the market can turn as unforgiving as a jilted lover, singing "we are never, ever, ever getting back together."
Will investors ever love Apple again with as much ardor as they once did? Perhaps, but spurned investors may require twice as much coaxing as they would with a stock that hadn't jilted them in the past.
Things may not be as bad as they seem. When Apple hit its nadir, dipping to $390 a share in mid April, all the news was bad news. Facts that investors already knew were used as justification to dump the stock: The company lost its creative genius, Steve Jobs; no one is sure whether Apple has sufficient products in its pipeline to fuel the double-digit growth rates of the past; Samsung usually sells more smart phones than Apple; and competition in the tablet market is just starting to heat up.
All of that spells tough sledding for Apple. And yet Apple products are highly coveted, its iTunes site is the most popular online music portal in the world and the company is a cash cow, with a pristine balance sheet and vast financial reserves. In short, news of the technology titan's demise were apparently premature. The stock has since bounced back to the mid $400s and market pundits are once again cautiously optimistic.
Kathy Kristof owns 40 shares of Apple in her Practical Investing portfolio.
"The economy is amazing right now - employment is recovering, innovation is going and housing is reviving. What's not to love?" This was a statement I heard in the media to justify the recent rise in the stock market. In this past weekend's newsletter I went into significant detail in dismantling the bullish arguments with one point being the consistent weakness in the economic data.
The most recent release of the Chicago Fed National Activity Index (CFNAI) is the last of the components released each month that comprises the Economic and Employment Composite indexes. The April data for the CFNAI was not good with the manufacturing component confirming what we had already seen in most of the regional Federal Reserve manufacturing surveys. The overall CFNAI index plunged from to a negative 0.53 from a negative 0.23 in March. In both months, manufacturing production fell, down 0.4 percent in April following a 0.3 percent decline in March.
However, as opposed to recent media headlines boasting of the strength of consumer spending and housing, the consumer & housing sector was the second largest drag on national activity in April dropping from negative 0.15 in March to negative 0.17 in April. Employment also did not confirm the recent BLS report, which we suspected would be the case, as the employment component has fallen from a positive 0.35 in February to a positive 0.1 in March to ZERO in April. This is certainly not a trend that supports the much hoped for job growth in the near future.
Let's take a look at the two composite indexes to see what they are telling us about the economy and the most likely direction of the data in the months ahead. Both indexes are weighted average of the CFNAI, ISM, several Federal Reserve manufacturing surveys, the NFIB Small Business survey, Chicago ISM and the Leading Economic Indicators. The only difference between the two indices is that the employment composite is comprised of the employment components of the above as opposed to the overall activity components.
STA Economic Output Composite Index (EOCI)
The EOCI index fell sharply to 26.08 in April from 30.35 in March as the brief surge in activity from "Hurricane Sandy" finished working its way through the system. The chart below compares the EOCI index to real, inflation adjusted, GDP on a quarterly basis.
There are a couple of important takeaways with this index. The first is that both positive and negative trends in the EOCI index track very closely to the ebb and flow of GDP. The second is that historically when the EOCI index was below 30 the economy was either in, or about to be in, a recession. Currently, the economy is not running in recessionary territory, as of yet, but the trend of weakness in the macro economic data is somewhat concerning.
The chart below shows these corollary trends a bit better with the EOCI index, smoothed with a 3-month average, compared to the annual rate of change in nominal GDP.
What is most concerning is that while the asset prices are inflated with artificial interventions that trend of economic data has clearly peaked for the current cycle. Either the mainstream economists and analysts are correct and the economy is about to turn substantially stronger and play catch up with asset prices or asset prices will revert to catch up with the fundamentals of the economy. The latter is much more likely the case from a historical perspective.
STA Employment Composite
If you strip the employment components out of the EOCI index and weight them into their own composite index we find that the hiring intentions of employers is clearly weakening. The chart below shows the Employment Index smoothed with a 4-month average and compared to the annual rate of change in Total Non-Farm Employees.
As with the EOCI index above - employment activity clearly peaked in early 2012 and has begun to wane. The recent uptick in the employment index, remember this is a 4-month moving average, is due to the effects from the uptick in economic activity from "Hurricane Sandy." This index will turn down in the next couple of months as the recently monthly data points have declined.
What is clear from the two composite indexes is that the broad economy, and by extension underlying employment, has clearly peaked and has began to weaken. This is well within the context of historical trends and time frames. While the mainstream analysts and economists continue to have optimistic views for a resurgence in economic activity by years end the current data trends, both globally and domestically, suggest otherwise.
As we discussed recently:
"A wave of "disinflation" is currently engulfing the globe as the Eurozone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth. Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy. This is a problem that has yet to be recognized by the financial markets.
The recent inflation reports (both the Producer and Consumer Price Indexes) show deflationary forces at work. Wages continue to wane, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber all indicating weaker levels of economic output. The battle against deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis. The problem has been that, much like "Humpty-Dumpty", the broken financial transmission system, as represented by the velocity of money, can't be put back together again."
The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a "soft patch" currently despite the mainstream analysts rhetoric to the contrary. There is clearly something amiss within the economic landscape and the recent decline in the economic, employment and inflation data are telling us just that.
I have often spoken of the disconnect between Wall Street and Main Street. While asset prices are inflated by continued interventions of monetary policy from the Federal Reserve, boosting Wall Street profits and widening the wealth gap between the top 20% of Americans and the rest, "Main Street" continues to suffer a from a rising cost of living and falling wage growth. Just recently Gallup released the following survey:
"The federal poverty threshold for a family of four is just under $24,000; however, Americans believe such a family unit living in their community needs more than double that -- $58,000, on average -- just to 'get by.' That estimate reflects 29% of Americans saying these families need up to $50,000 in annual income, 47% saying they need between $50,000 and $99,999, and 10% saying they need $100,000 or more."
The problem is that as the cost of living rises over time due to the effects of inflation - median household incomes have fallen. The following chart shows the seasonally adjusted median household income through March of 2013 as compared to Gallup's poll of family living needs.
The shortfall is quite evident. The obvious question that follows is:
"Where does the money come from to fill the gap between living standards and incomes?"
The chart below answers that question. The chart shows the difference between the $58,000 need for a family unit and median incomes, defined as the "income gap," and then compared to household credit.
Besides the very brief forced deleveraging of balance sheets during the financial crisis, as households defaulted on debt and financial institutions cut credit lines, consumers have returned to credit to supplement incomes with a vengeance since 2011.
Ample Evidence
There is considerable evidence behind the current dislocation between Corporate America and Main Street. Real unemployment remains extremely elevated as witnessed by the labor force participation rate and employment-to-population ratio at levels not seen since the early 1980's.
I recently published a piece on the "5 Questions That Every Market Bull Should Answer" discussing the disconnect between the "have's" and the "have not's" stating:
"Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates - there is nowhere left to generate further sales gains from in excess of population growth."
This is why the gap between corporate profits and the number of working employees is the highest level on record. Fewer workers, higher productivity and longer hours for the same pay, or less, equals higher corporate profits. This is great for executives, primarily the top 10% of wage of earners, who are compensated from rising share prices, bonuses and other performance related compensation. However, for the "working stiff," there is little reward for their labor.
"Welfaring Of America"
At $58,000, Americans' perceptions of the amount it takes just to get by in their community is substantially higher that the national median household income. This level is also well out of reach for a bulk of the lower 30% of American households.
However, this gap between incomes and living standards goes a long way to explaining the "welfaring" of America. As incomes have waned against a rising cost of living - it is not surprising to see more individuals receiving income supplements in the mail either from "food stamps", social security benefits or disability claims. All of which are currently at record levels. The chart below shows the level of social security benefits as a percentage of disposable personal incomes which is currently near the highest level on record.
"How long can the disconnect last between Wall Street and Main Street? "
There is no clear answer for that as consumers have shown a willingness to draw down savings rates to historically low levels while quickly returning to cheap credit forgetting the disaster that it caused them not so long ago. However, in reality, when you have a family to feed, clothe and house - it really doesn't matter what is logical, but what is necessary, regardless of the consequences down the road. Of course, for many American's today, the only real difference between now and the "bread lines" of the 30's is that the "bread" is delivered in the mail rather than at the "soup kitchen" on the corner.
There have been quite a few bold predictions, since the beginning of the year, that the dollar was set to soar and that the great "bond bull market" was dead. The primary thesis behind these views was that the economy was set to strengthen and inflation would begin to seep its way back into the system. Furthermore, the "Great Rotation" of bonds into stocks, on the back of said economic strength, would push interest rates substantially higher.
While I have no doubt that at some point down the road that inflation will become an issue, interest will rise and the dollar will strengthen - it just won't be anytime soon. A wave of "disinflation" is currently engulfing the globe as the Eurozone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth. Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy. This is a problem that has yet to be recognized by the financial markets.
The recent inflation reports (both the Producer and Consumer Price Indexes) show deflationary forces at work. Wages continue to wane, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber all indicating weaker levels of economic output. The battle against deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis. The problem has been that, much like "Humpty-Dumpty", the broken financial transmission system, as represented by the velocity of money, can't be put back together again.
The weak level of economic growth, global deflationary pressures, demographic trends and excess indebtedness which derails productive investment are keeping inflationary pressures suppressed. The chart below shows the Composite Inflation Index (CII), an average of the consumer and producer price indexes, versus interest rates. With inflationary pressures turning lower it is highly unlikely that we will see interest rates rising anytime soon
Our long term view on the 10-year Treasury remains at 1%. Despite the Federal Reserve's ongoing efforts to inflate asset prices; such inflation is not translating to "Main Street" in the form of higher wages, increased consumption or higher standards of living. The Federal Reserve has often discussed that there are limits to monetary policy and they may have found those limits in its most recent endeavors.
The same goes with the U.S. dollar. With Japan engaged, on a relative basis, in a Quantitative Easing program twice as large as the U.S. on an economy just one-third the size, the suppression of the Yen has boosted the Dollar higher in recent months. However, the deflationary pressures globally are likely to create a feedback loop on Japan's effort to create inflation leading to a economic decoupling that creates a potential disaster in Japan. This is the bet that Kyle Bass has made and anticipates happening in the next 24 months.
The chart above shows the U.S. Dollar versus the CII. Historically, downturns in the composite inflation gauge lead to, not surprisingly, declines in the dollar. Currently, the economic data is confirming that we are likely to see dollar weakness sooner rather than later.
The bottom line is that the "bond bull market" likely still has a bit of life left in it. The deflationary pressures that weigh on the consumer and the economy are likely going to keep downward pressure on rates for some time to come as the Fed comes to realize that they have been caught in the same "liquidity trap" that has plagued Japan for a generation. Those same pressures will also temper any "dollar bull market" for the foreseeable future as well.
The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a "soft patch" currently despite the mainstream analysts rhetoric to the contrary. There is clearly something amiss within the economic landscape and the recent decline in rates, the dollar and inflation are telling us that.
Recently I have been discussing the direct connection between the Federal Reserve's Q.E. program and the market as well as putting you, my dear reader, to the task of answering the inherent questions regarding the sustainability of the current rally.
Today's chart of the day looks at the market from a technical perspective. While there are a plethora of Wall Street analysts calling for much higher levels for the S&P 500; most of these calls are based simply on the belief that the current trajectory must continue indefinitely. While you certainly cannot "fight the Fed" the underlying fundamentals and economics that support the markets long term are not present for the party. What is very important to understand, and can be clearly seen in the chart below, is that despite repeated calls for "ever rising" stock markets in the past eventually left investors devastated. Markets do not, and cannot, continue indefinitely in one direction.
Market prices are subject to gravity (the long term moving average) and the longer the duration of the moving average the greater the "gravitational pull" that exists. One way to measure extremes of price movement is through the use of standard deviation. One standard deviation from the mean (average) encompasses 68.2% of potential outcomes within a given distribution of data which, in this case, are market prices. Two standard deviations encompass 95.8% of all potential outcomes while three standard deviations encompass 99.8% of all potential outcomes.
The chart below shows a MONTHLY chart, which is a very slow moving analysis, of the S&P 500 overlaid with Bollinger Bands which represent 2 and 3 standard deviations of a very long term (34 month) moving average.
At the peaks of the "Internet Bubble" and the "Credit/Housing Bubble" the market never got significantly above 2-standard deviations. Today, we are encroaching well into 3-standard deviation territory. Standard deviation analysis tells us that roughly 99% of the potential movement in prices, from the bottom of the correction in 2011, has been achieved. Furthermore, the extension of the market above the long term moving average is also at levels that have previously been associated with major market tops.
The top graph is a very long term (150 month) measure of overbought and oversold conditions. It is also warning that the current market environment is stretched very far and that further gains are likely to be limited without a correction first.
However, therein lies the potential problem. Looking back at the markets during a bullish trend the market is usually contained between the long term moving average and 2-standard deviations above the mean. However, when the extension is above the long term mean subsequent corrections are generally more associated with mean reversions. A mean reversion is where prices fall an equal distance in the opposite direction or well below the long term moving average.
The current level of overbought conditions combined with extreme complacency in the market leave unwitting investors in danger of a more severe correction than currently anticipated. A correction to the long term moving average (currently around 1350) would entail an 18.5% correction. A correction to 2-standard deviations below the long term moving average (which is most common within a mean reversion process) would slap investors with 33% loss.
If you don't think a 33% loss is possible you should be aware that that is about the average draw down of the markets during a normal recessionary cycle. Not only is such an event possible - it is probable when, not if, the economy slips into an eventual recession.
IMPORTANT: We are currently invested n the market and I am not suggesting that you sell everything and move to cash. What I am saying is that the market is very extended and the risk of a correction of some magnitude has increased significantly this year. Therefore, if you are close to retirement, or simply just can't afford the risk of a major market correction, then you may want to start reducing some of your portfolio risk and begin to build in some hedges against an unexpected event. Whatever eventually trips up the market will be "unexpected."
Currently, it seems that most of the world's concerns have been put behind us due to the massive injections of liquidity being injected by the Federal Reserve, BOJ, ECB and China. The Eurozone crisis has disappeared, recessions in the Eurozone and weak US economic data are of little concern, declining revenue and earnings are readily dismissed as the primary driving force for investors is Fed interventions. However, it is within this complacency, that an unexpected turn of events can pull the rug from beneath the markets and send money racing for the sidelines. Unfortunately, for most individuals, by the time they realize what is happening it will likely be far too late to act.
BLOOMBERGMay 15 (Bloomberg) -- Bernanke, other Fed officials will probably drop hints about tapering QE before June meeting, then start reducing purchases behind scenes before formal announcement is made in Sept., said Lance Roberts, chief strategist at Streettalk Advisors.
"If I was Ben Bernanke, there would be two things I've got to be concerned about," Roberts said in phone interview today "One is creating asset bubbles: If you look at yields on junk bonds, they are at historic lows. The other is the margin on NYSE stocks, which is the amount of leverage investors have taken on. Markets have gone virtually parabolic"
"What the Fed has got to figure out is if it's solely because of what it is doing or because of the economy and underlying fundamentals"
"At the next meeting, I would start to put out language that says, 'At some point in the future we're going to see some tapering,' and see how the market reacts. If the market
reaction is fine, I would start doing that behind the scenes and announce it later"
"It's very possible we'll see hints come before the next meeting. It wouldn't surprise me to see more articles and more Fed officials talking about Fed tapering before June so there won't be a shock to markets"
"If you look at financial markets, they are extremely susceptible to a sharp, rapid correction. It would kill everything the Fed has put together. Bernanke will condition markets long before he takes action. We may see tapering occur prior to the Sept. meeting"
"I'm predicting nothing specific in the next few months. But in Sept., around the Fed's Jackson Hole event, we could get specific numbers"
Roberts said he expects Fed to announce in Sept. tapering of QE to ~$65b/mo. from $85b/mo., with $10b taken off MBS and Treasuries each, followed by another similar reduction later.
"Here's the problem. Some of the economic data is not improving. If you taper off now and we don't have economic strength, the economy is likely to start to slip into a recession quickly. There are also questions of whether the Fed has reached the limit of its abilities to purchase bonds, and why the boost to asset prices hasn't translated into the real economy. Clearly, there's a broken transmission system."
There have been a litany of articles written recently discussing how the stock market is set for a continued bull rally. The are some primary points that are common threads among each of these articles which are that interest rates are low, corporate profitability is high and the Fed's monetary programs continue to put a floor under stocks. The problem is that while I do not disagree with any of those points - they are all artificially influenced by outside factors. Interest rates are low because of the Federal Reserve's actions, corporate profitability is high due to accounting rule changes following the financial crisis and the Fed is pumping money directly into the stock market as I discussed yesterday:
The stock market has rallied sharply in direct correlation to the expansion of the Fed's balance sheet yet economic growth has floundered much to the dismay of the Federal Reserve. As I discussed recently:
"The increases in excess reserves, which the banks can borrow for effectively zero, have been funneled directly into risky assets in order to create returns. This is why there is such a high correlation, roughly 85%, between the increases in the Fed's balance sheet and the return of the stock market."
With this in mind I do have a few questions that would like to ask in order to stimulate your thinking?
Employment
Employment is the life blood of the economy. Individuals cannot consume goods and services if they do not have a job from which they can derive income. Therefore, in order for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must be employed at a level that provides a sustainable living wage above poverty level. This means full-time employment that provides benefits and a livable wage. The chart below shows the number of full-time employees relative to the population. I have also overlaid jobless claims (inverted scale) that shows despite media headlines to the contrary - falling jobless claims does not mean improving employment.
Question: Does the current level of employment support the current rise in asset prices?
Personal Consumption Expenditures (PCE)
Following through from employment; once individuals receive their paycheck they then must consume goods and services in order to live. Personal Consumption Expenditures is a measure of that consumption and comprises more than 70% of GDP currently.
PCE is also the direct contributor to the sales of corporations which generates their gross revenue. So goes personal consumption - so goes revenue. The lower the revenue that comes into companies the more inclined businesses are to cut costs, including employment, to maintain profit margins.
The chart below is a comparison of the annualized change in PCE to the S&P 500 index. Notice the current divergence of the index from PCE.
Question: Does the current weakness in PCE support the current rise in asset prices?
Import / Export Prices
As we continue to "follow the money" it is important to review what corporations are receiving for the goods and services that are being exported as well as what they are paying for goods and services being imported. More than 40% of corporate profits today come from the exports of goods and services. Therefore, declines in prices received from exported goods directly affect profit margins. However, declines in prices of imported goods and services are a positive for profitability. The chart below looks as the difference between export and import prices. When net prices are rising that is a positive for profitability, again at the top line of the income statement, and a negative when they are falling.
Question: Are very negative net export prices supportive of the current market?
Corporate Profits As % Of GDP
Following the corporate profit story we can look directly at corporate profits. Companies are currently at the highest level of profitability in history and is one of the key stories behind the "ongoing bull market" premise. However, that profitability has come at the expense of "Main Street" as employment and wages have not risen. I have discussed this recently stating:
"Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates - there is nowhere left to generate further sales gains from in excess of population growth."
The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below show corporate profits as a percentage of GDP relative to the annual change in GDP. As you will see the last time that corporate profits diverged from GDP it was unable to sustain that divergence for long.
Question: How long can corporate profits remain diverged from weakening economic growth?
Margin Debt Vs. Junk Bond Yields
As stated above the Federal Reserve's expansion of the balance sheet has investors ignoring the underlying fundamentals as asset prices rise with reckless abandon. The complete lack of "fear" in the markets combined with a "chase for yield" has driven "risk" assets to record levels with stocks at all-time highs and junk bonds sporting record low yields. This has been amplified as investors have taken on ever increasing levels of leverage. The chart below shows the relationship between margin debt (leverage) and junk bond yields. Margin on stocks is at levels last seen at the peak of the market in 2008 with yields on junk bonds at levels at levels never before witnessed. This didn't end well last time as the reversion in the assets triggered repeated margin calls leading to a cycle of forced liquidations.
Question: What is the possibility of this divergence being maintained indefinitely?
Being bullish on the market in the short term is fine - you should be. The expansion of the Fed's balance sheet will continue to push stocks higher as long as no other crisis presents itself. However, the problem is that a crisis, which is ALWAYS unexpected, inevitably will trigger a reversion back to the fundamentals.
As I stated in "Clues To Watch For The End Of QE Infinity":
"...with margin debt at historically high levels when the 'herd' begins to turn it will not be a slow and methodical process but rather a stampede with little regard to valuation or fundamental measures. As prices decline it will trigger margin calls which will induce more indiscriminate selling. The vicious cycle will repeat until margin levels are cleared and selling is exhausted.
The reality is that the stock market is extremely vulnerable to a sharp correction. Currently, complacency is near record levels and no one sees a severe market retracement as a possibility. The common belief is that there is 'no bubble' in assets and the Federal Reserve has everything under control."
Take a moment to compare what you have heard, and read, with the questions presented here. Draw your own conclusions and invest appropriately.