“There’s still room for stock markets to rise and worries of an impending recession are premature.” – Mickey Levy, Berenberg Capital Markets
This is a common view of much of the mainstream analysis as common threads still relatively low interest rates, corporate profitability, and low unemployment rates are set to keep the bull market running well into the foreseeable future. But much of the rally since the 2009 recessionary lows has been an influence of outside factors. Interest rates are low because of the Federal Reserve’s actions, corporate profitability is high due to share repurchases, accounting rule changes following the financial crisis, and ongoing wage suppression.
But now, all of that is beginning to change. Interest rates are rising, the yield spread is flattening, and Central Banks globally are “beginning the end” of the “Quantitative Easing” experiment. As I noted recently:
“Combine a ‘trade war’ with a Federal Reserve intent on removing monetary accommodation, both through higher rates and reduction in liquidity, and the market becomes much more exposed to an unexpected exogenous event which sparks a credit-related event. (Of course, it isn’t just the Fed, but also the BOJ and ECB.)”
This is no small matter, although it is being dismissed as such. There has been a direct correlation between the“equity bull market” and the expansion of the Fed’s balance sheet. Yet, much to the Fed’s dismay, little of the asset surge translated into actual economic growth.
But now, that support is being withdrawn and as such the market, unsurprisingly, has run into trouble.
However, such shouldn’t matter if the economy, which ultimately drives earnings, is indeed firing on all cylinders as is commonly stated.
Let’s take a look at a few charts.
Employment is the lifeblood 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 the 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) which shows that when claims fall to current levels, it has generally marked the end of the employment cycle and preceded the onset of a recession.
Question: Does the current level of employment support current asset valuations and the assumption of a continued bull market?
Following through from employment; once individuals receive their paycheck they then must consume goods and services in order to live. Personal Consumption Expenditures (PCE) is a measure of that consumption and comprises roughly 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 businesses fixed investment and employment.
Question: Do the current levels of PCE and Fixed Investment support current valuations or expectations of continued “strong” employment?
As we continue to “follow the money,” as stated, what consumers earn and spend drives revenue growth. As I discussed just recently in “Q1-Earnings Review,” there is evidence which suggests the economy is not a fully robust as it may appear in headline data. To wit:
“Looking back it is interesting to see that much of the rise in “profitability” since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.”
“Furthermore, while the majority of buybacks have been done with ‘repatriated’ cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders.
Ultimately, 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. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs.”
Question: Do weak rates of top-line revenue growth support the current market narrative?
Following the corporate profit story, we can look directly at corporate profits. Over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, expanded share buybacks through increased leverage and continued increases in productivity. However, that profitability has come at the expense of “Main Street” as employment and wages have not risen. As shown, the annual rate of change in personal incomes has been on a decline since the turn of the century. This is a function of both the structural shift in employment (higher productivity = less employment and lower wage growth) and the drive to increase corporate profitability in the midst of weaker consumption. The chart below shows the disparity between corporate profits and employment and wages.
While corporate profitability has surged since the financial crisis, those profits have come at the expense of employees. Since 2009, wages for “non-supervisory employees,” which is roughly 83% of the current workforce, is lower today than at the turn of the century.
The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below shows 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 and economic growth subsequently declined with profits.
Question: How long can corporate profit growth remain detached from slower rates of economic growth?
As stated above, global Central Banks have lulled investors into an expanded sense of complacency. The problem is it has led to a willful blindness and disregard of the underlying fundamentals as asset prices have risen with seemingly reckless abandon. The complete lack of “fear” in the markets combined with a “chase for yield” has driven “risk” assets to record levels. The rise in leverage also supports this idea.
The chart below shows the relationship between margin debt (leverage), stocks and junk bond yields. 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. Central Banks have rushed in every burning building with a “fire hose” of liquidity each time a crisis has presented itself. So far it has worked.
However, the problem is that a crisis, which will be unexpected, inevitably will trigger a reversion back to the fundamentals. What will that catalyst be? I don’t have a clue and neither does anyone else. But disregarding reality in a quest to chase market-based returns has always ended badly when the “herd” inevitability turns.
It has never been, and 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. The question you have to answer, is whether or not such is actually the case?
“Wall Street is a street with a river at one end and a graveyard at the other.” – Fred Schwed, Jr.