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Waiting for Market Rationality

Equity markets have yet to recognize the fragility and softness of the underlying economy, although they do appear to be somewhat sensitive to geopolitical issues (North Korea). The incoming data continue to confirm:

  • that the consumer has little spending capacity remaining;
  • that inflation’s roar is nowhere to be found (except, perhaps, in hot dogs);
  • that the detail underlying the headline employment number (209,000) show labor market deterioration;
  • that the equity market “rally” is narrowly focused in a small number of stocks while most stocks have shown stagnation since mid-June;
  • that, despite what “Maestro” Greenspan said about bond yields, it is hard to fathom any, much less “rapid” rate increases in the near-term.

Consumer

In my last blog, I observed that we have begun to see credit strains emerge in the form of rising delinquencies at consumer lending institutions.  In June, credit card debt surpassed its 2008 peak and is now above the $1 trillion mark (up from about $800 billion in 2010).  At the same time, the savings rate has plummeted to 3.8% in Q2 from 5.1% a year ago and over 6% two years prior.  It’s a good bet that the 2.8% growth in consumption, reported as part of the initial estimate of Q2 GDP, won’t be repeated in Q3 or Q4.  Clearly, consumer spending has been fueled by both significant borrowing and reduced savings.  Now that delinquencies are on the rise and credit standards are tightening, rapidly rising credit card debt won’t be available to bolster consumption. The savings rate can’t really fall much lower because programmed savings at the earnings source (401ks and pension contributions) account for the bulk of today’s low savings rate.  Going forward, consumption growth will depend on income and wage growth, which, to date, have been the biggest disappointments of this aged expansion.

Equities in the retail sector are getting pummeled (Kohl’s, Macy’s, Dillard’s, and J.C. Penney).  The market’s view is that this is 100% due to the Amazon effect; there is, as of yet, little recognition that the consumer is tapped out.

The hard data tell us that housing has peaked, that auto sales have done the same, and that even the sentiment indexes, as represented by the ISM Manufacturing and Non-Manufacturing indexes, have rolled over.  In fact, the ISM Non-Manufacturing Index, which purports to represent trends in the U.S.’s giant service sector, fell hard in July to an 11 month low!

Based on this data, it appears that Q2 GDP will be revised substantially lower in its first restatement on the last Friday of August, and that Q3 GDP, and, perhaps, Q4’s too, will be sequentially lower.

Student Debt

Also impacting the consumer, especially college graduate Millennials and the parents of returning college students, is the already burdensome student debt load which will again rise substantially as the fall semester begins.  That debt has so constrained the graduate Millennials that:

  • home buying and home ownership for that demographic is 25%-33% lower than for prior generations;
  • that nearly 40% of Millennial college grads move back “home” with their parents;
  • that the age of first marriage for a woman is near 27.5 years (and near 30 years for a man), up from the early 20s as late as the 1970s for both sexes;
  • that family size is significantly lower today (3.1 vs 3.7 in the 70s), much of which is attributable to the younger generations.

This last observation is especially troublesome.  Today’s demographics show a barely growing labor force, and with family formation stagnant and family size falling, that labor force is likely to contract (like Japan’s did beginning in the 1990s).  This threatens future economic growth.  (Remember, today’s bloated PE ratios can only be justified by significant future economic growth!)  It is also noteworthy that student populations are contracting, likely due to the rapid rise in tuition (and the accumulation of student debt) in the post-recession period, as strained state government budgets significantly reduced their support of higher education.

Inflation

The Producer Price Index (PPI) fell -0.1% against the expectation of +0.1%.  This was the first decline in a year, and, more surprising, services prices fell even harder (-0.2%).  Consumer Prices (CPI), too, were benign, rising 0.1%, and bringing the 6-month trend to an annualized rate of -0.1%.  This is so rare that the last time we saw a 6-month decline in the CPI was in 2010, and the time before that was more than 50 years ago!  The only significant price increase in July appears to be in hot dogs (+6% annualized).  I came across this very concise description of where inflation is today.  It is from Wall Street Economist David Rosenberg’s August 11th blog to his subscribers:

At the depths of the Great Recession, the six-month trend in the core CPI got as low as 1.3%… today, 97 months into the third longest economic expansion on record, and in the aftermath of the most profound monetary stimulus ever recorded, the pace [of core CPI (0.9% annual rate)] is fully 40 basis points lower.  Imagine where this trajectory goes once this cycle rolls over…

Employment

The headline employment number for July looked solid enough, but upon closer scrutiny, the data turn mushy.  In the past, I have commented on BLS’s use of the “birth/death” model.  Because they only survey large and mid-sized employers (via Unemployment insurance roles – approximately 634,000 businesses), the “birth/death” model represents their assumption of how many net new jobs (i.e., job births minus job deaths) small business created.  Nothing has actually been counted.  This is just a plugged-in number. In July, this plug number was 158,000.  The problem here is that this estimate is completely insensitive to changes in underlying growth.  If the economy is slowing, this number causes the headline number to be overestimated.  Conversely, if economic growth is accelerating, the number may be too low.

Layoffs, too, further undermine the “strong” labor market myth.  What is of particular interest is that layoffs are occurring not only in the usual suspect sectors, but also in heretofore bastions of growth.  The usual suspects, of course include apparel, retail, publishing, etc.  What is surprising is that we are now seeing layoffs in aerospace, auto manufacturing, financials, healthcare, and, most amazing, in mega-cap tech.  Energy companies, too, have stopped hiring as the run-up in rig counts has ended with the stagnation of oil prices in the $45-$50 range.

Equity Markets – Waiting for Rationality

By any historic measure, the U.S. equity market is significantly overvalued.  One of the market’s legendary investment gurus, Bob Farrell, had a series of investment rules, one of which was that overvalued markets never correct by moving sideways (until fundamentals catch-up); they correct by going south!

The ominous signs today include:

  • Only a handful of stocks are propelling market indexes to new highs; the value of the median S&P 500 stock is off 8% from is 52-week high, while the average stock is off closer to 12%;
  • There are more decliners than advancers even while the indexes go higher (the indexes are market-cap weighted, meaning that the larger companies have more weight in the index than do smaller companies and a few of the larger companies can move indexes up even if the prices of the majority of the smaller companies are going down);
  • The value of the transportation and small cap stocks have fallen, a sign that risk aversion has begun.

Interest Rates

In early August, former Fed Chairman Greenspan opined that the bond market (not the stock market!) was in a bubble.  My reaction: WOW!

  • In a bubble, asset prices rise to astronomical heights, and when the bubble bursts, the prices of the assets fall and may not recover their bubble peaks for years, decades, or ever! If an investor purchases a U.S. Treasury Note, for example, that investor receives the yield return he/she bargained for when the bond matures.  How is this a bubble?
  • Let’s give Greenspan the benefit of the doubt and assume he meant that, since interest rates are low, they are soon going to rise. Consider that there are been five long periods of low interest rates in U.S. history. The last episode was in the 1930s (through 1953).  The other four began in 1837, 1873, 1908, and the current episode which began in 2008).  If history is any guide, the current episode of low rates may be far from over;
  • For historical context, and to show Mr. Greenspan’s forecasting ability, he said the same thing about bonds in his Congressional testimony in early 2005. At that time, he said bonds were in a “conundrum;” Greenspeak for “overvalued,” and that yields had to rise (while bond prices had to fall).  At that time, 10 year T-Notes were yielding 4.15%. It is now 12.5 years later with the 10 year yielding 2.2%!

Conclusions

Credit strains are appearing.  The savings rate is falling.  Without the significant credit growth of the recent past, consumption growth would have stagnated.  The hard data imply that Q2 consumption (and therefore GDP) growth will be revised downward at August’s end, and that Q3 and Q4 consumption growth will disappoint.  In addition, despite a very good-looking headline employment number for July, a deeper dive reveals concerns over small business job creation in a slow growth economy.  Full-time employment actually fell, and rising part-time jobs means either strained household budgets, or the unavailability of full time employment.

Demographics point to slow growth, and now we see an exhausted consumer.  Equity market internals tell us that not all is well.  The least I can say is that valuations will have a hard time rising from here.  Given the economic fundamentals, I see nothing in the near-term that would cause interest rates to permanently rise to higher levels, and any such bounce up should be viewed as a buying opportunity.  That the Fed continues in a tightening mode in the face of growing economic weakness makes the future look even more murky.

Robert Barone, Ph.D.

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