Puny Income Growth Holding Back The Recovery
3/06/14 9:30 PM
The key factor holding the recovery hostage is simply explained
by “Economics 101”. Consumers are still
in the process of deleveraging the massive debts accumulated in the prior boom,
and total income is far too weak to support robust spending. Undoubtedly, weather has been a recent factor,
but that is temporary, and when normal weather returns, economic growth, at
best, is likely to return to its prior mediocre rate, if that.
Consumers may want to spend more, but are restrained by weak
income growth. The only way for
households to step up their spending now is to further reduce savings rates,
which are already not far above the record lows reached during the previous
housing boom. Certainly, after years of
restrained spending, the pent-up demand is there as goods have to be replaced. But labor markets have been weak and gains in
wage income have been limited.
Consumers have increased their spending faster than
income for the last three years. In the
three years ended January 31st, real spending rose 5.4%, compared to
a gain of only 2.9% in real disposable income (DPI). This was accomplished only by reducing the
savings rate from 6.3% of DPI to 4.3%.
Even with the lowered savings rate, consumer spending growth increased
by an annual average of only 1.8% over the last three years compared to 3.5% in
the 40 years between 1956 and 1996. DPI
did even worse, rising at an annual average of 0.9% in the last three years,
compared to its long-term average of 3.4%.
Consumer spending is close to 70% of GDP, and its main
driver is disposable income. In our
view, disposable income growth will continue to remain under pressure, and
will, therefore restrain consumer spending in the period ahead. While employment has been rising, the
year-over-year growth has amounted to only about 1.7% per year over the last two
years, well under historical norms. With
the unemployment rate still historically high and a vast pool of potential job-seekers
not officially in the labor force, employees have little market power, and wage
increases are likely to be limited. The
employment cost index is rising at less than two percent annually, while the
growth in average hourly earnings and hours worked are unusually slow.
In addition, other sources of spending are also
lacking. Borrowing restrictions are
tighter than they were before the recession, and a large portion of the recent
increase in credit is attributable to student loans, which burden young people
with debt that reduces their ability to spend.
Workers worried about future wage increases and job security are more conservative
in their willingness to borrow.
Furthermore they no longer have the enormous gains in home prices to
borrow against as they did prior to the recession.
In our view, therefore, the hopes of investors for an
economic growth rate of more than 2% are too optimistic. If anything, with the Fed gradually
withdrawing stimulus and global economic growth under pressure, growth could
turn out to be much less. Moreover,
corporate profits have soared from under 5% of GDP in 1990 to 10% now, meaning
that any gains from this point could be limited, at best. In sum, we believe that the current market
rally can end badly, as it did in 2000-2002 and 2007-2009.
The Market Is Significantally Overvalued
2/27/14 8:00 PM
One of the bulls’ major reasons for being optimistic on
the stock market is their view that stocks are reasonably valued at 14-to-15
times earnings, well within past norms.
They consistently state this view on financial TV and in print without
ever being challenged by their interviewers.
The far smaller----and shrinking---- number of bears, on the other hand,
contends that the market is substantially overvalued. We believe that the bulls are using a flawed
model that would not have had predictive value in the past, and that the bears
will prove to be correct, as they were in 2000 and 2007.
How can two differing groups look at the same set of
facts and come to such diametrically opposed conclusions? Simply put, the bulls use the current price
of the S&P 500 and divide it by estimated forward-looking operating
earnings to arrive at the current price-to-earnings ratio (P/E). Therefore, based on today’s S&P closing
price of 1854 and consensus estimated 2014 operating earnings of $122, they come
up with a reasonable P/E of 15, or even as low as 13 times if they use the 2015
estimate of $138.
The key words to focus on in the preceding paragraph are “estimated”,
“forward-looking”, and “operating”. The
bears make a similar calculation, but use “actual”, “trailing” and “reported”
earnings----and for good reason. The
problems are as follows. First,
operating earnings usually differ considerably from earnings calculated in
accordance with “generally accepted accounting principles” (GAAP). Operating earnings start with reported
earnings, and then add back a number of expenses considered non-recurring, such
as severance pay, start-ups, inventory write-downs, opening or closing of
facilities and any other number of expenses that corporate managers may choose
at their discretion.
In the past 15 years or so, companies have gotten a lot
more creative about what items they can write off, and now a large number of
expenses that used to be considered a normal cost of doing business are called “unusual”,
even when these write-offs are taken year after year. In other words, in too many cases what is
called operating earnings is pure fiction, and not calculated in accordance with
generally accepted accounting principles.
Second, the long-term average P/E ratio of 15 is based on
actual trailing reported earnings, not on estimated forward-looking operating
earnings. Prior to the last 15 years of
sequential bubbles, the 71-year average of
P/E on this basis was 14.5
(rounded by us to 15). Operating earnings
as they are calculated today, did not even exist until after the mid-1980s, when
they began coming into vogue, partly as a means of making earnings look better than
they would under accepted accounting rules.
Since operating earnings always exceed reported earnings, often by
significant amounts, the P/E on operating earnings has averaged about three multiples
below the P/E on reported earnings.
Therefore, it is likely that if operating earnings had a long history,
the average P/E would have been only about 12, rather than the 15 on reported
Third, estimates of year-ahead operating earnings are notoriously
unreliable. In the last 28 years,
estimates were too high about 76% of the time, often by ridiculously high
amounts, particularly prior to turning points in the economic cycle. In May 2008 the estimate for the year was
$89, and eventually came in at $50. At
the same time, the 2009 estimate was as high as $110. The final number was $57.
In sum, the use of forward-looking operating earnings to
determine the current value of the market and to estimate future market levels
can be highly misleading. Currently, the
market is selling at 20.8 times our calculation of cyclically-smoothed reported
earnings of $89, about 39% higher than the historical average of 15. This is higher than at any point in the post-war
period until 1996, and about at the same level reached at the top in 1929.
At present levels the market is discounting a highly optimistic outlook
that leaves it increasingly vulnerable to the serious U.S. and global economic
and political risks that can come to the fore at any time.
Looking Beyond The Weather
2/20/14 7:30 PM
In our view the economy is disappointing, even allowing
for the bad weather. We’ve been saying for some time that, following major
credit crises, economic growth is sub-par for many years to follow, and that
is, indeed, what has been happening. For
the last few years growth has generally trended at about 2% annualized,
sometimes a bit more and other times a bit less. Every time growth exceeded 2% the pundits
believed that the economy was achieving “escape velocity” only to see it drop
back into renewed weakness.
Before the bad weather hit, the economy was already
sputtering. Real disposable income was
increasing at only a 0.6% annual rate, and consumers were able to increase
spending only by reducing their savings rate to the lowest point of the recovery. Second half GDP was goosed by a jump in
unwanted inventories that had to be worked off in coming periods. The year-over-year increase in payroll employment was within the same range it had been in for the prior three years. The housing industry had also turned down. Existing home sales for November were down
year-over-year for the first time in three years, and the mortgage purchase
index was declining----all before the bad weather settled in.
Granted, the weather has been a factor and has slowed the
economy down even more. When conditions
return to normal, it is logical to believe that there will be some
snapback. However, when that happens
growth is likely to return only to the same tepid pace it was on before the
Let’s take payroll employment as an example. Employment in November, prior to the poor
results in December and January, increased 1.82% year-to-year, compared to recovery peak of 1.88% in March 2012. In January the rate dropped to 1.65%. In order for the year-to-year growth rate in
March to return to the November level, the economy would have to add 652,000
jobs, an average of 326,000 for each of the next two months. And if February is also disappointing, we
could actually see a big catch-up in March on the order of 400,000 or 500,000
jobs. Even then, however, that would
only be enough to return to the November annual rate, which is in the
inadequate range of the last two years.
Keep in mind, too, that in prior post-war recoveries, employment
typically rose by 3.5%-to-5% annualized for many months, far above anything
seen in the current cycle.
In addition, the global economy is faltering as
well. The IMF has stated that the world
economy is still weak and that “significant downside risks still remain”. Europe is barely growing while China is
showing signs of slackening growth even by the government’s suspect official
numbers. Even more disturbing are reports
we've been reading about problems in their shadow banking system. China has about $1.8 trillion invested in
so-called “trusts”, and a large portion is apparently in danger of default. Over 40% of these trusts mature this
year. A few have already defaulted. We don’t know any more than that, but any
continuation of the trend could have exceedingly ominous consequences for the Chinese
All in all, it seems
to us that investors are viewing both the U.S. and global economies through
rose-colored glasses, and that the risks to the market are unusually high.
The Economy Was Sluggish Prior To The Abnormal Weather
2/13/14 7:00 PM
Let's not get carried away with blaming all of the economic weakness on
the weather. While weather was
undoubtedly a factor, the economy was still stuck in a rut prior to the drop in
temperatures and heavy snowfalls. The
minor bump in economic growth from mid-to-late 2013 was within the confines of
the approximate 2% rate evident for the last three years. There have been times when growth was
somewhat above that level and other times when it was below, but has never
broken into the clear on the upside. The
Fed’s tapering policy was started not because growth was suddenly accelerating,
but because Quantitative Easing (QE) was losing its effectiveness at the same
time that unintended and unwanted negative consequences began to look more
likely. A return to more normal weather
will probably give us another minor bump that is highly unlikely to signify a
renewed economic acceleration.
January retail sales, reported today, were down 0.4%
month-to-month, partially reflecting bad weather. But December sales were downwardly revised to
minus 0.1%, reflecting poor holiday sales that left retailors with higher than
desired inventories that will have to be worked off. It is important to recognize, however, that
retail sales growth has been trending down for some time. On a year-over-year basis, they peaked in
July 2011 at 8.5%, and gradually dropped to 3.2% in March 2013. After jumping back to 6% in June, it
subsequently declined to 3.1% in December.
Payroll employment followed a similar pattern, peaking at
1.9% year-to-year in March 2012 and declining to 1.5% by March 2013. In December it was 1.7%. The key takeaway though, is that job growth has
never broken out into new high territory during the entire recovery. It is notable that in prior economic
expansions year-over-year job growth has reached between 3.5% and 5% in
numerous months, a mark that has not even been closely approached in the
current tepid recovery.
While weather has undoubtedly been a factor, it seems
clear that the economy has been stuck in an approximate 2% growth trend,
sometimes slightly more and sometimes slightly less. Although we could see another minor growth bump
as the weather clears, the economy is unlikely to accelerate. The latest savings rate is down to 3.9%, the
second lowest monthly rate in six years, and real disposable income is barely
rising. The Fed’s tapering policy is not
based on renewed economic growth, but on the widespread belief that it is losing
its effectiveness at the same time that the risks of unwanted consequences are
In sum, we believe that economic growth will continue to
be disappointing at a time when QE can no longer be relied upon to provide a
floor under the stock market. It seems
to us that the risks are high in the period ahead.
A Cyclical Market Downtrend Is Underway
2/06/14 6:30 PM
According to the Fed’s long-term plan, quantitative
easing (QE) was to remain in effect until the economy was strong enough to grow
on its own. This was the so-called
anticipated “handoff” whereby a strengthening economy would take over from QE
as the catalyst for growth. The problem
is that it is not quite happening that way.
With QE encountering diminishing results along with increasing unwanted
side effects, it is gradually being withdrawn at a time when it appears that
the economy has still not broken out of its approximate 2% growth trend. In addition, the stock market is facing
numerous other headwinds including high valuations, excessively bullish
sentiment, stagnant economies in Europe, a slowdown in China, and currency
problems in many emerging markets. All
in all, this does not bode well for the stock market in the year ahead. A brief summary of the various headwinds are
All in all, the
market looks a lot like it did in early 2000 and late 2007 when the consensus
was also uniformly optimistic and valuations were stretched on the high side. In our view the risk of a substantial market
decline is high
perceived strength of the economy in the 2nd half of 2013 was not
soundly based and is unsustainable. A large part of the growth was a result of
unwanted inventory increases and foreign trade.
In addition the rise in consumer spending was mostly financed by a
decreased saving rate while disposable income continued to languish. In seems likely that growth, at best, remains
in the 2% range, and even that is subject to disappointment without QE, and
with all of the other problems throughout the world.
to the consensus view, we believe that the market is significantly overvalued. The majority are looking for 2014 S&P 500
operating earnings of $120, resulting in a P/E of 14.8, supposedly in line with
past norms. However, the long-term P/E
average of about 15 is based on reported (GAAP) trailing earnings rather than
forward-looking operating earnings.
Profit margins are about 70% above the long-term average, and are likely to return to the mean. As calculated by Ned Davis Research,
cyclically smoothed earnings for 2014 are about $81, resulting in a P/E of
21.9, a full 46% higher than the long-term average. We note, too, that the forward-looking P/E in
late 2007 was about the same as it is now, and did not preclude a 50% drop in
the market. Furthermore, the ratio of
total market value to GDP is the highest of any time in the post-war period
with the exception of the late 1990s internet bubble.
sentiment is historically high. The Investor’s
Intelligence Survey shows the highest percentage of bulls in 25 years, while
margin debt as a percentage of GDP is the highest ever. Anecdotally, market opinion going into this
year was almost unanimously bullish.
withdrawal of QE is negative for stocks. The market soared on the implementation
of QE1, and declined when it ended. The
same happened with QE2. The market again
rose at the start of QE3. The ending of
QE is tantamount to tightening, and that is not good for stocks.
economy is slowing down at a time when it also has severe credit problems that
restricts its options. The slowdown puts
downward pressure on global commodities that are the major exports of emerging
nations, which are also undergoing significant currency problems caused by an
outflow of funds. A worldwide economic
slowdown or recession is likely to create headwinds for the U.S. as well.
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