July 1st, 2014:
This column keeps getting harder to write. For the 6th consecutive quarter, and 7th of the last 8, the market rose to new highs. How many different ways can this story be told? We have been fortunate enough to experience an historic bull market that the average investor doesn’t trust. And the fact that this market remains somewhat distrusted is actually good news.
Let’s start with the facts. GDP for the 1st quarter was –2.9%. This is a terrible number. A contracting economy is not typically an optimistic indicator. Yet the stock market shrugged this number off and continued its advance. Job growth has been steadily improving and other economic indicators point to a frozen winter causing a one-time blip in economic growth as opposed to a lasting trend. Many expect that the economy rebounded in the 2nd quarter (2nd quarter GDP will be announced July 30th) and that it will grow strongly in the 2nd half of the year, when corporate earnings are forecasted to grow around 10%. As the stock market is typically a forward looking indicator, one could argue that given these expectations the market should indeed rise.
As for this bull market being distrusted by the average investor, we view this as another positive for the market’s health. Most readers will recall the enthusiasm for stocks during the late 1990’s and the period from 2005 – 2008. The euphoria present then is generally lacking now. When everyone is on board, markets usually peak.
With so many still doubting the rationale for the present bull run, we have yet to reach the point of overcrowding. Or have we?
Overcrowding doesn’t necessarily come from the likely suspects. And in the case of this market, it can be argued that any present overcrowding is the direct result of the Federal Reserve’s policies. As we have discussed many times before, the Fed remains on a bond buying binge. Because the Fed is shrinking the supply of bonds available for the public to buy, many are forced into alternative investments. For every dollar the Fed spends to purchase bonds, it forces someone else’s dollar into something other than bonds. Much of that money has ended up in the stock market.
The money flowing into the stock market is not coming from individuals in the same amount as in previous bull markets. Rather, it seems largely to be coming from “smart” money – institutions, pension funds, foreign buyers and the like. This class of investor, unlike the average individual, seems to be overwhelmingly bullish. Many believe that this “smart” money is less likely to panic and exit en masse at the first sign of trouble the way individuals have behaved in the past.
To be sure, Fed policy has had a remarkable impact on the stock market. The top of this page is dominated by a chart illustrating this relationship. The dark blue line represents the size of the Fed’s balance sheet (presently over $4 Trillion, up from $800 Billion six years ago). For every month
that the Fed buys more bonds, the balance sheet grows.
And as the balance sheet grows, the stock market (represented by the S&P 500) has moved in lock step. The few times the Fed stopped, the market went lower. As soon as bond buying resumed, the market returned to its upward ascent. At its peak, the Fed was buying $85 Billion/month. They have begun to taper this amount by $10 Billion/month and are on course to cease new buying later this year(assuming they stay on course). It remains to be seen if the market will be able to stand on its own without the Fed’s spending or if it will head lower for lack of support.
And this brings us back to why the market rose after a lousy GDP number. The market may or may not believe that the Fed will finally cease its spending spree. However, it does seem to believe that the economy is getting strong enough fast enough to stand without the Fed’s direct support. And thus, the bad 1st quarter GDP will be replaced by a better 2nd quarter number followed by a robust 2nd half of the year.
Please forgive us our skepticism. As we discussed in the last issue, we have witnessed for awhile now rosy expectations for corporate earnings having to be lowered and pushed further out. Expectations of 10% corporate earnings growth
seem to us to be more of the same. We believe that for there to be real and sustainable economic growth, individuals need to be economically stronger than they presently are. One way to measure individual economic strength is by earnings. If we make more we spend more. If we make the same or less we worry more and spend less. Perfectly logical.
While it is true that unemployment has come down steadily, it is also true that at least part of this decline is due to a smaller percentage of the population participating. Baby boomers are retiring from the work force in large numbers
and this accounts for some of the decline in the participation rate. It is also true that many have given up and “retired” unemployed. Many retirements are turning out to be not what retirees envisioned and their resources are strained.
Over 2/3 of GDP is driven by the consumer. During the snow and ice of the winter just past, consumers couldn’t get out of their houses to spend money. As a result, GDP was bad. Now that winter has past, normalcy has likely returned. But normalcy doesn’t mean improvement, and the market seems to be anticipating improvement. We see little sign of true improvement at present. June employment data was released July 3rd. The headline number said that the economy added 276,000 jobs in June, marking the 5th consecutive month with job gains exceeding 200,000. As a headline, this is certainly impressive strength. Yet we actually
lost 523,000 full time jobs in June and gained 799,000 part time jobs. Of all the jobs added thus far in 2014, approximately 40% of them were part time.
While this economy is indeed adding jobs, it doesn’t seem to be adding high paying jobs. The tables at the right of this page illustrate this point clearly. Real wages adjusted for inflation, both hourly and weekly, have actually decreased by 0.1% over the last year This is not a positive trend and not indicative of meaningful job creation. Earnings gains are not keeping pace with inflation and hours worked is stagnant. If hours worked is not increasing, what is the incentive for employers to add new full-time workers?
Apparently any increased demand for labor by employers can simply be accommodated with part time workers. All of this would seem to place the typical consumer in a precarious spot. If GDP, the measure of economic growth, depends so heavily on the consumer, how can we forecast robust growth when real wage growth is nonexistent? It would seem to us that stagnant real wages simply spell
more of the same. By no means are we economic forecasters so take what we say with that in mind. Yet as the Fed nears the end of its bond buying spree and below-the-surface employment data remains stuck in neutral, we fail to see the signs of optimism that appear to be driving the stock market ever upward.
That said, we see little reason to fear some other outcome for the stock market. There is an old adage on Wall Street don’t fight the Fed. And with more than a $4 Trillion balance sheet, picking a fight with the Fed is folly. Fundamental data may suggest another outcome, but as long as the Fed wishes to keep interest rates low, there are few alternatives to the stock market. And herein lies the conundrum. The fundamentals that we value as investors suggest to us the market could use a correction. Nothing serious mind you. Simply a break in price gains to allow corporate earnings time to catch up. However, with few alternatives
and the individual participating to a lesser extent than in previous bull markets, this market would seem to have more room to run. Particularly if fundamentals are given a chance to catch up with a price correction. Neither extreme optimism nor pessimism are warranted. Stay the course, keep some powder dry, wait for opportunities and enjoy the run. It is historic.