It has long been our underlying thesis that the huge amount of household debt accumulated during the housing boom would inhibit consumer spending and economic growth for some time to come, and this is what has been happening over the last few years. The errors recently found in the famous Rogoff-Reinhart (RR) book do not change this view.

Simply put, household debt averaged 77% of disposable personal income (DPI) over the 61-year period since 1952. It crossed over the average line in 1985 and took a sharp upward turn in 2000, eventually peaking at 130% of DPI in 2007. Since that time, consumers have reduced their debt to a level that is now 105% of DPI, still significantly higher than in the past. The result has been a significant slowdown and tepid recovery in consumer spending growth, a process that is far from finished.

The role of household savings is a key element in analyzing both debt and spending. For 41 years between 1951 and 1992 household savings rates as a percent of disposable income were consistently between 7% and 11%. However, as income growth started to slow down, consumers increasingly maintained their old spending habits by going into more debt and reducing their savings rate. This reached an extreme during the prior decade, when the savings rate stayed below 2% from 2005 through 2007, while debt soared. We all know how that ended.

No matter what you hear from the politicians, the media and “the street”, keep in mind that the combination of the household debt, low savings rates and tepid increases in income has been the reason for the deep recession and subsequent below average growth, and will continue to be the reason why economic growth will likely be slow for some time to come.

In the last two years, between the 1st quarter of 2011 and the first quarter of 2013, real consumer spending has increased by a meager 3.8%----and this was accomplished on an increase of only 1.1% in real disposable income as households reduced their saving rate from 5.1% to 2.6%. It therefore should not have been a surprise that spending looked so weak in March, and it should be no surprise when spending remains subdued in the period ahead. With consumer spending accounting for about 70% of GDP, it is easy to see why this puts a damper on the rest of the economy, particularly in a time of fiscal drag. The Fed is undoubtedly well aware of the outlook as they continue their attempt to try and offset, at least in part, the major headwinds elsewhere in the economy.

None of the above analysis depends on the Rogoff-Reinhart (RR) research, some of which was recently found to be erroneous. First, RR emphasizes mostly government rather than consumer debt. Second, they maintain that when the government debt-to-GDP ratio crosses 90%, economic growth slows down. The idea that there was some specific threshold of government debt-to-GDP that led to slower growth was probably not valid in the first place. In any event, we think that for the near-to-intermediate term, it is the still-high level of household debt that is the key drag on the economy.

As we headed into the spring there was evidence that the already lackluster economy was slowing down even further.  Although the payroll employment report for April touched off a euphoric rise in stocks, the headline belied the underlying trend. While that was a positive surprise over the expected rise of 140,000 jobs, the reported increase of 165,000 for the month was nothing to write home about. It was well below the 1st quarter average of 206,000 per month as well as the 4th quarter average of 209,000. If anything, it looks as if employment increases are decelerating, certainly not a reason for celebration.

In addition to the mediocre employment report there was a lot of other evidence that an already lackluster economy was slowing down further as we headed into the spring. The ISM manufacturing index fell for two consecutive months to its lowest level since December. The ISM non-manufacturing index also declined for two straight months and is now below its 1st quarter average. April vehicle sales slipped to under 15 million units for the first time since October. First quarter GDP grew at a disappointing 2.5% following only 0.3% in the prior quarter. Average GDP growth for the last four quarters has averaged only 1.8%. Real consumer spending has increased only 2% over the past year, and this was accomplished on an exceedingly weak 0.9% rise in real disposable income over the period. Only a sharp drop in the savings rate enabled consumers to reach even that disappointing level.

Furthermore, March core capital goods orders were up only 0.2% following a 4.8% decline in February. The year-over-year gain was 0.3%. The NAHB housing market index for May increased for the first time in four months and remains below the December/January peak. April housing starts dropped to the lowest level since November.  Although the NFIB Small Business Index rose in April, it is only five points above its lowest level for the past year and two points lower than a year earlier.  The index remains lower than at any point prior to 2008. Manufacturing production has declined for the last two months and three of the last four.  The Philadelphia Fed survey fell to minus 5.2, its lowest since February, and showed negative results for new orders, shipments and employment. All in all, despite the optimistic views of the economic pundits, the facts show otherwise.

As for foreign economies, the IMF once again reduced its 2013 global and EU growth forecasts and China reported disappointing results for 1st quarter GDP and exports. This has resulted in a significant drop in commodity prices that is having adverse effects on a number of commodity-oriented emerging and advanced economies.

Although the Fed, so far, has been able to lift stock prices, it has failed to elevate the economy to a point where growth is self-sustaining despite over four years of extremely easy monetary policy. The headwinds from fiscal policy will actually intensify in the months ahead while Washington shows few signs of alleviating the dysfunction that has plagued Congress for the last few years. 

It is also noteworthy that the market is losing the important boost it has received from rapidly rising earnings.  Over the last four quarters earnings are up only 0.4% from the four prior quarters.  Given sluggish U.S. and global economic growth, we think that current estimates of 22% second half earnings growth are highly unrealistic.   Furthermore, the S&P 500 is now selling at 20 times cyclically-smoothed trailing GAAP earnings, at the very high end of the zone that was considered normal prior to the serial bubbles of the last decade and a half.

All in all, we believe that economic growth and corporate earnings will be highly disappointing in coming quarters and that investors will drop the pretense that the Fed can fix everything that ails the economy. Although Bernanke, himself, has been virtually begging for help from fiscal policy, it does not seem likely that he will get it anytime soon.  In our view, the risk of a substantial decline in the market outweighs the limited rewards from current levels.

As we watch the market climb to new highs in the face of lackluster and deteriorating fundamentals, we have the feeling that we’ve seen this movie before in 2000 and 2007, when we were one of very few voices of caution in the wilderness.  A rise that was fueled by the perception of never-ending Fed liquidity injections has now morphed into a trend that is feeding on itself as investors are afraid of missing out on further gains.  As a result, any news, no matter how negative, is being given a positive spin in the media and on “the street”.

For instance, take last Friday’s payroll employment report for April, which touched off a euphoric rise in stocks.   While that was a positive surprise over the expected rise of 140,000 jobs, the reported increase of 165,000 for the month was nothing to write home about. It was well below the 1^st quarter average of 206,000 per month as well as the 4^th quarter average of 209,000.  If anything, it looks as if employment increases are decelerating, certainly not a reason for celebration.

Another example was the headline following the recent annual Berkshire-Hathaway gathering, stating “Buffett says stocks will go a lot higher”.  While the quote is accurate as far as it goes, it was made in the context of an interview with CNBC’s Becky Quick, in which he actually said, “stocks will go a lot higher in YOUR (caps are ours) lifetime.”  Becky Quick is 41, and, according to the life expectancy tables, can expect, on average, to live to 82, which will be in 2054.  So stocks will be a lot higher in 2054.  Well, yes, but is that worthy of a headline?

In addition to the mediocre employment report there was a lot of other evidence that an already lackluster economy was slowing down further as we headed into the spring.  The ISM manufacturing index fell for two consecutive months to its lowest level since December.  The ISM non-manufacturing index also declined for two straight months and is now below its 1^st quarter average.  April vehicle sales slipped to under 15 million units for the first time since October.  First quarter GDP grew at a disappointing 2.5% following only 0.3% in the prior quarter.  Average GDP growth for the last four quarters has averaged only 1.8%.  Real consumer spending has increased only 2% over the past year, and this was accomplished on an exceedingly weak 0.9% rise in real disposable income over the period.  Only a sharp drop in the savings rate enabled consumers to reach even that disappointing level.

In addition, March core capital goods orders were up only 0.2% following a 4.8% decline in February.  The year-over-year gain was 0.3%.  The NAHB housing market index dropped for the third straight month to its lowest level since October.  While housing starts were up 7%, more than the entire gain was accounted for by multi-family units as single family starts were down for the second time in three months.  The NFIB Small Business Index declined in March, and is only two points above its lowest level for the past year and three points lower than a year earlier.  Although March industrial production increased 0.4%, it was almost all accounted for by 5.3% rise in utility production, while the manufacturing sector fell 0.1%.

As for foreign economies, the IMF once again reduced its 2013 global and EU growth forecasts and China reported disappointing results for 1^st quarter GDP and exports.  This has resulted in a significant drop in commodity prices that is having adverse effects on a number of commodity-oriented emerging and advanced economies.

Although the Fed, so far, has been able to lift stock prices, it has failed to elevate the economy to a point where growth is self-sustaining despite over four years of extremely easy monetary policy.  The headwinds from fiscal policy will actually intensify in the months ahead while Washington shows few signs of alleviating the dysfunction that has plagued Congress for the last few years.  Furthermore, the S&P 500 is now selling at 20 times cyclically-smoothed trailing GAAP earnings, at the very high end of the zone that was considered normal prior to the serial bubbles of the last decade and a half.

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It has long been our underlying thesis that the huge amount of household debt accumulated during the housing boom would inhibit consumer spending and economic growth for some time to come, and this is what has been happening over the last few years.  The errors recently found in the famous Rogoff-Reinhart (RR) book do not change this view.

Simply put, household debt averaged 77% of disposable personal income (DPI) over the 61-year period since 1952.  It crossed over the average line in 1985 and took a sharp upward turn in 2000, eventually peaking at 130% of DPI in 2007.  Since that time, consumers have reduced their debt to a level that is now 105% of DPI, still significantly higher than in the past.  The result has been a significant slowdown and tepid recovery in consumer spending growth, a process that is far from finished.

The role of household savings is a key element in analyzing both debt and spending.  For 41 years between 1951 and 1992 household savings rates as a percent of disposable income were consistently between 7% and 11%.  However, as income growth started to slow down, consumers increasingly maintained their old spending habits by going into more debt and reducing their savings rate.  This reached an extreme during the prior decade, when the savings rate stayed below 2% from 2005 through 2007, while debt soared.  We all know how that ended.

No matter what you hear from the politicians, the media and “the street”, keep in mind that the combination of the household debt, low savings rates and tepid increases in income has been the reason for the deep recession and subsequent below average growth, and will continue to be the reason why economic growth will likely be slow for some time to come.

In the last two years, between the 1^st quarter of 2011 and the first quarter of 2013, real consumer spending has increased by a meager 3.8%----and this was accomplished on an increase of only 1.1% in real disposable income as households reduced their saving rate from 5.1% to 2.6%.  It therefore should not have been a surprise that spending looked so weak in March, and it should be no surprise when spending remains subdued in the period ahead.  With consumer spending accounting for about 70% of GDP, it is easy to see why this puts a damper on the rest of the economy, particularly in a time of fiscal drag.  The Fed is undoubtedly well aware of the outlook as they continue their attempt to try and offset, at least in part, the major headwinds elsewhere in the economy.

As the evidence of an economic slowdown continues to mount, corporate revenues are feeling the pressure and the effects of the sequester are beginning to seep into the economy.

Last week we enumerated the overwhelming majority of economic reports that declined or fell short of expectations.  These included payroll employment, the ISM manufacturing and non-manufacturing indices, retail sales, the University of Michigan consumer confidence survey, the NAHB housing market index, single-family housing starts, the NFIB small business index, the Empire State index and manufacturing production.  Since then, additional releases have shown a meager 0.2% increase in March core capex orders following a drop of 8% in February.  The Philadelphia Fed Index dropped in April, while the Richmond Fed index was down in both March and April.  Overall, the ISM weighted composition was the lowest since November.  Existing home sales have been about flat since November.  The Chicago Fed National Activity Index was also down in March.

At the same time corporate earnings are flattening while revenues and guidance are disappointing.  With 47% of the S&P 500 companies having now reported 1^st quarter results, it appears that 69% have beaten their recently downward revised estimates, which are significantly under the projections made just a few months ago. Overall, first quarter earnings are tending toward an increase of about 3% over a year-earlier after being down in the prior two quarters.  Importantly, however, only 35% of the companies beat their revenue estimates, compared to an average of 62% since 2002, and 52% over the last four quarters.  Equally or even more troubling is the fact that negative guidance for 2013 exceeded positive guidance by a ratio of 14:1, compared to the historical average of 2:1.  This indicates the probability of a lot of earnings problems in coming quarters.

The political controversy over the air controller furloughs and related airline delays are the canary in the coal mine indicating that the effects of the sequester are starting to be felt in the economy.  The protests over the cuts are an indicator of what will happen as the pain and inconvenience spread through the economy.  But, after all, this is just what the sequester was supposed to do----make the cuts so onerous that the authorities couldn’t let it happen.  Unfortunately they did let it happen and unless something is changed, the economy will feel the dire effects.

All in all, we believe that economic growth and corporate earnings will be highly disappointing in coming quarters and that investors will drop the pretense that the Fed can fix everything that ails the economy.  Although Bernanke, himself, has been virtually begging for help from fiscal policy, it does not seem likely that he will get it anytime soon.     

To gauge the current state of the stock market, look no further than the economy.  As far as the market is concerned, everything else is random noise. Recent data releases make it quite clear that the economy lost momentum in March and is continuing into April as the overwhelming majority of reports come in below expectations.  We cite the following evidence:

1)     March payroll employment dropped to a disappointing 88,000.

2)     The ISM manufacturing index dropped to its lowest level since December.

3)    The ISM non-manufacturing index declined to its lowest level since September.

4)    Retail sales fell in March and the prior two months were revised down.  The weakness was widespread through various categories.

5)    The University of Michigan consumer confidence index declined to its lowest point since July.

6)    The NAHB housing market index dropped for the third consecutive month to its lowest level since October.

7)    While housing starts were up 7%, more than the entire gain was accounted for by multi-family units as single family starts were down for the second time in the last three months.  New building permits were similarly down the second time in three months.

8)    The NFIB small business index declined in March and is only two points above the lowest level of the past year and three points lower than a year earlier.  Moreover, the majority reported weaker sales over the last three months and expect a drop in sales over the next six months.  This does not bode well for new hiring or capital expenditures from an important sector of the economy that is often not well represented in other key indicators of the economy.

9)    The Empire State Index fell to 3.1 from 9.2 and 10.3 in the prior two months.

10)  Although March industrial production increased 0.4%, it was almost all accounted for by a 5.3% rise in utility production while the manufacturing sector fell 0.1%.

11)  The IMF cut its 2013 forecast for global growth to 3.3% from 3.5% and the Eurozone to -0.3% from +0.1%.  Eurozone GDP has declined for five consecutive quarters and the first quarter will probably be the sixth.  The Eurozone periphery nations are already in recession and getting worse, and now France and Germany are slowing down as well.  This will be felt in the U.S. as well since American exports to the EU fell to a two-year low in February

12)  China recently reported disappointing results for first quarter GDP at a time when their real estate sector is in the midst of an inflationary bubble.

All of the above indicates that the economy is once again entering a soft spot as it did in the prior three years.  The big difference is that in 2010, 2011 and 2012 the soft spot more or less coincided with the end of QEs 1, 2 and 3.  In each instance QE was re-instated and the economy bounced back to its previously mediocre growth rate.  In the current instance, however, growth is slowing down even while QE is in full force.  In addition, unlike the prior slowdowns, the economy is facing the additional headwinds of the January tax increases and the sequester, which have not yet been felt in a major way.  In our view it would be extremely difficult for the Fed to provide any more support to the economy than it already has.  

Already, the economic slowdown is being reflected in the price of gold, which has virtually collapsed and in long-term government bond yields that have dropped sharply in recent weeks.  In fact, the prospect of deflation that we have constantly discussed in our comments is suddenly being widely discussed in the media.

Most observers are taking the recent market weakness in stride as they say a correction was overdue anyway, and that they are actually looking forward to buying the dips.  We take the contrary view that the market is in the midst of making a major top as a result of an economy that will surprise on the downside, taking current optimistic earnings forecasts down with it.