The current level of the stock market is based on a shaky
foundation, dependent on a Fed that cannot get the economy moving and on a
business model based on not hiring labor or replacing equipment in order to
keep profit margins at an all-time peak.
This is not a sustainable growth model that justifies current market
valuations that are far above historical norms.
The economic recovery that is now five years old has
never accelerated from its ongoing tepid growth rate. Consumers, burdened by
high levels of debt and meager gains in income, are unwilling or unable to go
into further debt and have already run their savings down to historically low
rates. Real median household income
excluding capital gains and benefits, but including transfer payments, has declined
4.4% since the recession bottomed in March 2009. With consumer spending accounting for 68% of
GDP, the outlook for accelerated economic growth is bleak.
Businesses, too, have been holding a lid on
spending. According to S&P Capital
IQ, capital spending by the S&P 1500 has increased only 0.8% annually over
the last five years. Core new orders for
equipment in recent months point to continued tepid growth in capital spending
in the period ahead.
Corporations have also been reluctant to hire new employees. In the last three years the monthly
year-over-year increase in payroll employment has fluctuated between 1.59% and
1.88% and has shown no signs of a breakout to higher levels. In prior post-war economic recoveries, it was
typical to see increases of 3%-to-5% for months on end. Now, even a huge weather-related catch-up
would not lift us out of the current inadequate zone.
Keeping costs low by maintaining a lid on labor and
capital has enabled corporate earnings to soar over the last five years. In addition, corporations have used their
cash to pay more dividends and buy back stock, further helping earnings to
rise. As a result, corporate earnings
have soared to an all-time high of 11.1% of GDP, compared to 4.6% in the 3rd
quarter of 2008 and an average of about 5.4% in the 1990s. The long-term average was about 6% in the 45
years from 1955 to 2000. A reversal to
the mean is the most likely outcome.
In our view, the current trend is a house of cards. Neither consumers nor corporations are spending
enough to generate the amount of income necessary to keep the economy moving
forward at a robust pace. Traditionally,
the nation’s economy grew by building new plant, buying more equipment,
developing new products and keeping the infrastructure up to date. It seems to us that little of this is
happening now, and that the current level of earnings and profit margins are
In light of these conditions, it’s ironic that investors
would cheer Janet Yellin’s recent speech.
What the market saw was continued stimulus by the Fed. On the contrary, what we saw were the reasons
for the stimulus. Yellin stated “Since
late 2008, the Fed has taken EXTRAORIDNARY STEPS (caps are ours) to revive the
economy….I think this EXTRAORDINARY COMMITMENT is still needed and will be for
some time, and I believe that view is widely shared by my fellow policymakers
at the Fed.” To us, that is hardly a
reason for optimism. We continue to
believe that current high stock market valuations are irrational and that the
market is as close to a turning point as it was in early 2000 and late 2007.