As of this writing, the equity markets are on a three-day losing streak, caused by less optimism on the “trade war” file. And, while there were some positives in recently released economic data, most major economic indicators continue to show business contraction. The equity market has been driven by “the economy is strong” narrative, FOMO (Fear of Missing Out), momentum, and the injection of huge amounts of liquidity by the Fed (QE4). Unfortunately, strong economic fundamentals are a rare commodity. Early reports from the Black Friday/Cyber Monday buying mania show 6% less foot traffic, but significantly higher online transactions. Too early to draw conclusions.
The NY Fed Beige Book
Comments in the NY Fed’s Beige Book (these come from businesses) regarding metro NYC were nearly all negative; below are some quotes. Generally, NYC is a reliable leading indicator:
- “There has been little or no growth in the Second District economy in the latest reporting period.”
- “Manufacturing activity was essentially flat…”
- “Commercial and real estate markets have weakened, and new commercial construction has slowed.”
- “Contacts in the leisure and hospitality sector… have continued to report steady to declining prices.”
- “Retailers report that sales have been steady to softer since the last report and were lukewarm in their expectations for the near-term outlook.”
- “Businesses across almost all service industries reported some weakening in activity.”
- “The market for retail space has weakened further, even as the holiday shopping season draws near, with rents flat and vacancy rates at multi-year highs.”
- “Financial sector contacts generally reported softer business conditions and expressed concerns about a deteriorating business climate.”
PE Expansion
As of the end of November, almost all the S&P 500’s year-to-date total return has been due to the expansion of the P/E ratio (Price/Earnings). At the turn of the year, the trailing P/E ratio was 16.1, and the forward P/E was 13.6. Those numbers today are at nosebleed levels: 21.0 and 17.9 respectively. November markets continued to make new highs while real economic growth has barely been 2% and likely <1% in the current quarter.
The Bond Market
The bond market tells a completely different story than equities. A year ago, the 10-year U.S. Treasury yield was flirting with 3.40%; today it is 165 basis points (1.65 percentage points) lower, near 1.75%. Bonds are telling us that we are in a period of prolonged slow economic growth and little or no corporate pricing power. Furthermore, in the junk bond market, the spread between such bonds and the Treasury yield curve has widened by 300 basis points (3 percentage points) since May, with 100 of those coming in November. This is risk-averse behavior on the part of bond investors.
Corporate Earnings Recession
At the end of last year, analyst growth expectations for S&P 500 earnings were, by quarter: Q1: +3.5%, Q2: +4.1%, Q3: +4.6%, and Q4: +11.8% (yes, double digits). The actuals have been: Q1: -0.3%, Q2: -0.4%, Q3: -2.2%, and the current analyst composite expectations for Q4: -1.4% (and this looks quite optimistic). Also note that corporate profits are currently at the same level as they were in Q2/14 and that, as a percentage of GDP, profits have fallen to 9.7% from 12.6% in 2012. Such profit contribution to GDP appears to be at a point where one would expect when the economy was entering a recession.
Other Recent Economic Indicators
- The Conference Board’s Leading Economic Indicators fell -0.1% in October, and over the three-month period were down at an annual rate of -1.8%.
- The NY Fed’s current Q4 forecast for real GDP growth is now +0.8%, and the Atlanta Fed’s model is now forecasting +1.3%.
- Auto debt is now at $1.3 trillion with 5% now “seriously” delinquent. In the financial crisis a decade ago, the highest level of “serious” delinquencies was 5.2%. Today, in addition, we have the student debt loan issues.
- On the positive side, Q3 GDP growth was revised up to 2.1% from 1.9%. But, almost all of it was due to inventory, which becomes a drag on Q4 GDP growth.
- “Sales” of new homes hit a 12-year high; cause for celebration? All the growth and then some was in the “not yet started” (i.e., spec) category, with sales of “finished” homes down -8.9%, and sales of “homes under construction” falling -4.4%.
- Also, positive, October durable goods orders rose by an unexpected +0.6%, even with the GM strike (cars & parts -1.9%). Non-defense capital goods orders rose +1.2%.
Rest of the World
The rest of the world is in a worse funk (the U.S. is the least dirty shirt in the laundry basket). Today, 73% of the world’s economies are in a “growth recession” (i.e., GDP growth rates <2%) or in recession itself. Just for comparison, that same number was 74% in Q2/08, 72% in Q3/91, and 73% in Q4/81. Remember what happened next?
- Mexico is now officially in recession;
- Year over year Industrial Production (IP): So. Korea: -1.7%; Japan: -4.2%; Thailand: -8.5%; Taiwan: -2.9%. (The U.S. IP is -1.1% over year earlier levels.)
- China reported a -9.9% year over year contraction in corporate profits, and, according to a Bloomberg report, the PBOC (Peoples Bank of China, the central bank) issued a Stability Report indicating that 4,400 lenders were now classified as “high risk.”
- Europe remains in a funk with Italy, Germany, Finland and the UK in or flirting with recession; France appears to be the only bright spot.
Conclusions
There are few economic fundamentals beneath the equity markets. Plenty of liquidity, to be sure; the Fed has injected nearly $300 billion since September. And there is a lot of optimism. I sure hope it continues. (“Hope,” though, is not a useful investment strategy.)
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU).