by Lance Roberts
There have been a litany of articles written recently discussing how the stock market is set for a continued bull rally. The are some primary points that are common threads among each of these articles which are that interest rates are low, corporate profitability is high and the Fed's monetary programs continue to put a floor under stocks. The problem is that while I do not disagree with any of those points - they are all artificially influenced by outside factors. Interest rates are low because of the Federal Reserve's actions, corporate profitability is high due to accounting rule changes following the financial crisis and the Fed is pumping money directly into the stock market as I discussed yesterday:
The stock market has rallied sharply in direct correlation to the expansion of the Fed's balance sheet yet economic growth has floundered much to the dismay of the Federal Reserve. As I discussed recently:
"The increases in excess reserves, which the banks can borrow for effectively zero, have been funneled directly into risky assets in order to create returns. This is why there is such a high correlation, roughly 85%, between the increases in the Fed's balance sheet and the return of the stock market."
With this in mind I do have a few questions that would like to ask in order to stimulate your thinking?
Employment
Employment is the life blood 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 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) that shows despite media headlines to the contrary - falling jobless claims does not mean improving employment.
Question: Does the current level of employment support the current rise in asset prices?
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 is a measure of that consumption and comprises more than 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 the S&P 500 index. Notice the current divergence of the index from PCE.
Question: Does the current weakness in PCE support the current rise in asset prices?
Import / Export Prices
As we continue to "follow the money" it is important to review what corporations are receiving for the goods and services that are being exported as well as what they are paying for goods and services being imported. More than 40% of corporate profits today come from the exports of goods and services. Therefore, declines in prices received from exported goods directly affect profit margins. However, declines in prices of imported goods and services are a positive for profitability. The chart below looks as the difference between export and import prices. When net prices are rising that is a positive for profitability, again at the top line of the income statement, and a negative when they are falling.
Question: Are very negative net export prices supportive of the current market?
Corporate Profits As % Of GDP
Following the corporate profit story we can look directly at corporate profits. Companies are currently at the highest level of profitability in history and is one of the key stories behind the "ongoing bull market" premise. However, that profitability has come at the expense of "Main Street" as employment and wages have not risen. I have discussed this recently stating:
"Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates - there is nowhere left to generate further sales gains from in excess of population growth."
The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below show 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.
Question: How long can corporate profits remain diverged from weakening economic growth?
Margin Debt Vs. Junk Bond Yields
As stated above the Federal Reserve's expansion of the balance sheet has investors ignoring the underlying fundamentals as asset prices rise with reckless abandon. The complete lack of "fear" in the markets combined with a "chase for yield" has driven "risk" assets to record levels with stocks at all-time highs and junk bonds sporting record low yields. This has been amplified as investors have taken on ever increasing levels of leverage. The chart below shows the relationship between margin debt (leverage) and junk bond yields. Margin on stocks is at levels last seen at the peak of the market in 2008 with yields on junk bonds at levels at levels never before witnessed. 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. The expansion of the Fed's balance sheet will continue to push stocks higher as long as no other crisis presents itself. However, the problem is that a crisis, which is ALWAYS unexpected, inevitably will trigger a reversion back to the fundamentals.
As I stated in "Clues To Watch For The End Of QE Infinity":
"...with margin debt at historically high levels when the 'herd' begins to turn it 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."
Take a moment to compare what you have heard, and read, with the questions presented here. Draw your own conclusions and invest appropriately.
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