Everyone's Got A Plan...

Authored by Lance Roberts via RealInvestmentAdvice.com,

“There’s still room for stock markets to rise and worries of an impending recession are premature.” – Mickey Levy, Berenberg Capital Markets

This is a common view of much of the mainstream analysis as common threads still relatively low interest rates,  corporate profitability, and low unemployment rates are set to keep the bull market running well into the foreseeable future. But much of the rally since the 2009 recessionary lows has been an influence of outside factors. Interest rates are low because of the Federal Reserve’s actions, corporate profitability is high due to share repurchases, accounting rule changes following the financial crisis, and ongoing wage suppression.

But now, all of that is beginning to change. Interest rates are rising, the yield spread is flattening, and Central Banks globally are “beginning the end” of the “Quantitative Easing” experiment. As I noted recently:

“Combine a ‘trade war’ with a Federal Reserve intent on removing monetary accommodation, both through higher rates and reduction in liquidity, and the market becomes much more exposed to an unexpected exogenous event which sparks a credit-related event. (Of course, it isn’t just the Fed, but also the BOJ and ECB.)”

This is no small matter, although it is being dismissed as such. There has been a direct correlation between the“equity bull market” and the expansion of the Fed’s balance sheet. Yet, much to the Fed’s dismay, little of the asset surge translated into actual economic growth.

But now, that support is being withdrawn and as such the market, unsurprisingly, has run into trouble.

However, such shouldn’t matter if the economy, which ultimately drives earnings, is indeed firing on all cylinders as is commonly stated.

Let’s take a look at a few charts.

Employment

Employment is the lifeblood of the economy. Individuals cannot consume goods and services if they do not have a job from which they can derive income. Therefore, in order for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must be employed at a level that provides a sustainable living wage above the poverty level. This means full-time employment that provides benefits and a livable wage. The chart below shows the number of full-time employees relative to the population. I have also overlaid jobless claims (inverted scale) which shows that when claims fall to current levels, it has generally marked the end of the employment cycle and preceded the onset of a recession.

Question Does the current level of employment support current asset valuations and the assumption of a continued bull market?

Personal Consumption Expenditures (PCE)

Following through from employment; once individuals receive their paycheck they then must consume goods and services in order to live. Personal Consumption Expenditures (PCE) is a measure of that consumption and comprises roughly 70% of GDP currently.

PCE is also the direct contributor to the sales of corporations which generates their gross revenue. So goes personal consumption – so goes revenue. The lower the revenue that comes into companies the more inclined businesses are to cut costs, including employment, to maintain profit margins.

The chart below is a comparison of the annualized change in PCE to businesses fixed investment and employment.

Question: Do the current levels of PCE and Fixed Investment support current valuations or expectations of continued “strong” employment?

Revenue Growth

As we continue to “follow the money,” as stated, what consumers earn and spend drives revenue growth. As I discussed just recently in “Q1-Earnings Review,” there is evidence which suggests the economy is not a fully robust as it may appear in headline data. To wit:

“Looking back it is interesting to see that much of the rise in “profitability” since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.”

“Furthermore, while the majority of buybacks have been done with ‘repatriated’ cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders. 

Ultimately, the problem with cost-cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs.” 

Question:  Do weak rates of top-line revenue growth support the current market narrative?

Corporate Profits As % Of GDP

Following the corporate profit story, we can look directly at corporate profits. Over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, expanded share buybacks through increased leverage and continued increases in productivity. However, that profitability has come at the expense of “Main Street” as employment and wages have not risen. As shown, the annual rate of change in personal incomes has been on a decline since the turn of the century. This is a function of both the structural shift in employment (higher productivity = less employment and lower wage growth) and the drive to increase corporate profitability in the midst of weaker consumption. The chart below shows the disparity between corporate profits and employment and wages.

While corporate profitability has surged since the financial crisis, those profits have come at the expense of employees. Since 2009, wages for “non-supervisory employees,” which is roughly 83% of the current workforce, is lower today than at the turn of the century.

The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below shows corporate profits as a percentage of GDP relative to the annual change in GDP. As you will see the last time that corporate profits diverged from GDP it was unable to sustain that divergence for long and economic growth subsequently declined with profits.

QuestionHow long can corporate profit growth remain detached from slower rates of economic growth?

Margin Debt Vs. Junk Bond Yields

As stated above, global Central Banks have lulled investors into an expanded sense of complacency. The problem is it has led to a willful blindness and disregard of the underlying fundamentals as asset prices have risen with seemingly reckless abandon. The complete lack of “fear” in the markets combined with a “chase for yield” has driven “risk” assets to record levels. The rise in leverage also supports this idea.

The chart below shows the relationship between margin debt (leverage), stocks and junk bond yields. This didn’t end well last time as the reversion in the assets triggered repeated margin calls leading to a cycle of forced liquidations.

Question:  What is the possibility of this divergence being maintained indefinitely?

Being bullish on the market in the short term is fine – you should be. Central Banks have rushed in every burning building with a “fire hose” of liquidity each time a crisis has presented itself. So far it has worked.

However, the problem is that a crisis, which will be unexpected, inevitably will trigger a reversion back to the fundamentals. What will that catalyst be? I don’t have a clue and neither does anyone else. But disregarding reality in a quest to chase market-based returns has always ended badly when the “herd” inevitability turns.

It has never been, and will not be, a slow and methodical process but rather a stampede with little regard to valuation or fundamental measures. As prices decline it will trigger margin calls which will induce more indiscriminate selling. The vicious cycle will repeat until margin levels are cleared and selling is exhausted.

The reality is that the stock market is extremely vulnerable to a sharp correction. Currently, complacency is near record levels and no one sees a severe market retracement as a possibility. The common belief is that there is “no bubble” in assets and the Federal Reserve has everything under control. The question you have to answer, is whether or not such is actually the case? 

“Wall Street is a street with a river at one end and a graveyard at the other.” – Fred Schwed, Jr. 

Comments

hedgeless_horseman Looney Thu, 06/28/2018 - 10:28 Permalink

 

“Combine a ‘trade war’ with a Federal Reserve intent on removing monetary accommodation, both through higher rates and reduction in liquidity, and the market becomes much more exposed to an unexpected exogenous event which sparks a credit-related event.

Unless The Trade War is really just cover for The Tightening.  

Not many people on Wall Street, or anywhere, truly grok the mathematical relationships between Trade, ForEx, and the Treasury market.

Simon Potter may be evil, but he isn't stupid, and he definitely has a plan for the unwind.  

Is China his bag man for all the dog shit on The Fed's balance sheet? 

Who else could it be?

In reply to by Looney

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In reply to by hedgeless_horseman

Endgame Napoleon Looney Thu, 06/28/2018 - 11:01 Permalink

Maybe, Trump is trying to counterpunch from different directions, keeping his boxing opponents on edge until he has time to think it out, have others think it out for him (probably mostly Establishment types) or act on instinct, using the educated-guess approach that is the only “Plan” of even brilliant, in-the-know people in the end.

In reply to by Looney

Scipio Africanuz Looney Thu, 06/28/2018 - 13:41 Permalink

I'm reminded of the dot com bubble at the end of the last century. Nobody wanted to face the truth of its unsustainability until it was too late. The stock market is a reflection of the health of the underlying economy, but where the economy is hurting, and the stock market is booming, you have magical illusions, rather than concrete reality.

There's the debt, unfundable liabilities, anaemic productivity, political chaos, rampant corruption, and delusional beliefs. What could go wrong?

Plenty! As we'll observe soon. There's a tsunami on the horizon, seek higher ground!...

In reply to by Looney

Endgame Napoleon Deep Snorkeler Thu, 06/28/2018 - 11:40 Permalink

From those graphs, it is pretty apparent that all of the Millennials—a bigger generation than the Boomers—are not in the workforce.

Maybe, many of them have not yet hit the real working age or are in college. Employers prefer to hire that group temporarily for many jobs, as their parents pay their major household bills, making low wages or temp work acceptable since they lack a rent expense, just like they prefer to hire moms with “somethin’ comin’ in” from spouses, ex spouses or welfare (and the progressive tax code) for the many “voted best for moms” jobs.

The biggest fraud is the publicized “unemployment” numbers, which do not count any of us 101 million US citizens of working age who are out of the workforce. But they do count the 78 million gig workers and the 42 million employed-ish, EBT-qualified citizens and noncitizens in single-earner households who mostly work part time to stay under the income limits for multiple, monthly welfare programs, including subsidized housing in many cases, in addition to their refundable child tax credits that—in total—pay them more for womb productivity than their jobs pay them. 

Some of them work higher paying temp jobs, skipping the pay-per-birth monthly welfare for those months only, but not skipping the up to $6,431 in refundable child tax credits.

Whether or not they are citizens of this country, all of these underemployed, womb-productive, welfare-buttressed people are counted in employment statistics, while US citizens who are out of the workforce for long stretches of time—hampering their spending—are not counted as unemployed.

101 million is a massive number, especially when juxtaposed with a population of 324 million.

Most of us never get a dime of UC to cover rent between churn jobs—$0.00—and when we work, we do not consume $113 billion in yearly welfare, unlike womb-productive illegal aliens. Nor do we send $28 billion out of the US economy in remittances. That much is sent out of this country each year by the illegal aliens from Mexico alone.

We out-of-the-workforce citizens, when employed, spend every dime in US businesses, paying into the SS system and paying sales tax, rather than working under-the-table and sending money out of the country in a de-facto foreign-aid Ponzi.

This article explains what many people have noticed while trying to navigate a labor market where womb productivity pays more than hard work: Revenue boosters, like high sales-generation and high account-retention numbers, mean very little in today’s workplaces, other than boosting managers’ bonus numbers up before the hard workers who actually come to work every day, stay all day and meet the numbers every month are churned.

The way it is done, most get no UC.

Managers keep the frequently absentee (or part time) workers whose unearned income from spouses or from government makes the low pay and part-time (or temp) hours palatable.

That helps to keep their expenses down, regardless of how low the sales numbers of the retained employees often are due to above-firing crony-parent gangs.

Managers can always churn more hard workers to get their numbers up, using the hard workers and then losing them, rinsing and repeating.

Employers cannot get new American customers via this method, but they seem unconcerned about the US market, as they chase so-called emerging markets. Cost cutting is the only thing employers really care about when it comes to the US market, and consumers are, in turn, responding with their own type of self-imposed austerity, learning that they can get by when spending less.

 

In reply to by Deep Snorkeler

VWAndy Thu, 06/28/2018 - 10:46 Permalink

 Dont kid yourself folks. The fed is not going to stop picking winners and losers any time soon. They might pick more losers. But make no mistake about it. They will continue picking.

VWAndy Thu, 06/28/2018 - 11:26 Permalink

 If you managed to get yourself into a position where you control the markets would you stop if there was any way to avoid stopping? 

Ron_Mexico Thu, 06/28/2018 - 14:00 Permalink

"I think we are in rats’ alley

Where the dead men lost their bones.

“What is that noise?”

 The wind under the door.

“What is that noise now? What is the wind doing?”

Nothing again nothing.                                                       

“Do You know nothing? Do you see nothing? Do you remember “Nothing?”

rex-lacrymarum Fri, 06/29/2018 - 18:03 Permalink

No catalyst is required for the market to decline. On the contrary, most genuine bear markets begin with the market declining for no obvious "reason". The bursting of the housing bubble was really an exception to this rule, although it was quite noteworthy in that case how long it took for market participants to actually take it seriously (consider that transportation stocks reached a new all time high in May 2008, and crude oil and the Shanghai market peaked in June 2008 - half a year after the recession had begun!). 

Anyway, bear markets normally don't need catalysts to begin. No-one's going to ring a bell.