4/10/2013 6:15 PM ET|
The bull market's last stand
Amid a slowing economy and frothy markets, policymakers are waging war on cautious savers. Investors shouldn't be euphoric -- they should be terrified.
People are feeling pretty good about the economy. All eyes are on the stock market's recent rise. The fiscal cliff and budget sequester scuffles are behind us. Cyprus didn't seem to matter. And the Japanese are attacking their long deflationary malaise by promising to double the nation's money supply over the next two years.
The global economy is a complicated thing. But if the markets are up, everything must be great. And thus, the newspapers are filling up with stories of once-apprehensive regular investors who are throwing their life savings back into the fray.
Those investors are making a mistake.
One by one, the pillars supporting this move have been knocked away. Global growth is stalling. Many of the rich nations are falling into new recessions. The U.S. job market hit a wall last month. Market breadth is narrowing, which means that fewer and fewer stocks are participating in the uptrend and that fewer and fewer shares are changing hands. The recent outperformers have been defensive names not dependent on a strong economy -- U.S.-focused stocks like drugstore CVS Caremark (CVS) and electric utility PG&E (PCG) -- while global names like Caterpillar (CAT) suffer.
All that's left now is the cheap money from central banks and the illusion of invulnerable corporate earnings growth. And both of those pillars look vulnerable. Here's why, and what it means for those just trying to protect their wealth.
The mother's milk turns sour
First, let's talk earnings. When Federal Reserve Chairman Ben Bernanke was asked, awkwardly, at his March post-meeting news conference whether the stock market was in a bubble, he replied cryptically that he didn't see anything "that's out of line with historical patterns," given that corporate profits are at record highs.
But they're not going to stay there.
The incredible rise in the corporate sector's share of total income was partially driven by exposure to the strong post-recession rebound in overseas economies like China. But more importantly, it was driven primarily by a squeeze applied to workers via layoffs, wage freezes and longer, harder hours. Labor's share of national income collapsed (as shown in the chart below), while the share accrued to capital rose.
This trend is set to change.
First-quarter earnings season started this week. Despite a bevy of negative earnings preannouncements from executives heading into the reporting season (the most since 2001, in fact), analysts' expectations about an earnings re-acceleration look overzealous (estimates are in red below). This chart shows that while year-over-year operating earnings growth has already rolled over into negative territory, equity analysts are looking for growth to rebound to nearly 30% by the end of the year:
With Europe in a deepening recession, Japan moving toward outright insolvency, China hitting the brakes as it tries to stem the inflationary tide of hot money flowing in from Japan and the United States, and a profit-crushing loss of labor productivity here at home, I don't see how this happens when revenues will be under pressure and wage costs will be drifting higher.
Where does this upward pressure on wages come from? Overall gross domestic product growth is stalling just as the pool of high-quality labor is dwindling. Companies are now faced with the choice of paying more for things like overtime or hiring lower-quality, lower-skill workers. Either way, labor productivity (output per hour worked) will suffer. In fact, we're on track for three straight quarterly declines in productivity for the first time since 1979.
And thus, profit margins and earnings growth rates will be pinched as it becomes harder to boost sales volumes in the midst of a deceleration in key measures of industrial activity.
Too much of a good thing
The final and most important market pillar to fall will be the fantasy that the abuse of the monetary system by central banks around the globe will continue unabated, that it won't create destabilizing asset bubbles, that it won't create damaging inflation and that it won't unleash a currency war as countries like China and South Korea respond to Japan's efforts to devalue the yen to bolster its exports.
Only two things will stop the central bankers: a stronger economy or higher inflation.
In the United States, the Federal Reserve says it will pull back when the unemployment rate falls to 6.5% or inflation rises above 2.5%. This, according to skeptics, shows a dangerous flirtation with what’s known as the "Philips Curve," a theory that presupposes a tradeoff between higher employment and lower inflation. This idea was abandoned by former Fed Chairman Paul Volker after the early 1980s experience of 15% consumer price inflation in concert with unemployment near 11%.
Gluskin Sheff economist David Rosenberg finds "no evidence where trying to produce higher inflation produces positive economic results." Yet that is exactly what the Fed and its cohorts are trying to do.
And this is exactly the mistake the Fed made in the 1970s under Arthur Burns and George Miller, unleashing waves of inflationary pressures that damaged the economy and resulted in the "stagflation" of the early 1980s. The catalysts then, as now, were a combination of high energy prices, a fall in labor productivity and a drop in capital formation (due to inadequate investment by nervous CEOs). That resulted in "cost-push" inflation as businesses tried to pass on the higher costs of production to consumers to protect the high levels of profitability investors had grown accustomed to.
It's about to happen again.
Only this time, Bernanke's Fed is being far more aggressive in its effort to boost the prices of assets like homes and cars as it increases the volume of credit flowing into the economy. This has largely been ineffective. Since the Fed launched its new quantitative easing efforts in September, GDP growth has collapsed to 0.4%, job gains have stalled, the pace at which a dollar travels through the economy (a measure of credit growth) has collapsed, factory activity has slowed and the savings rate has plummeted to 2.4%. The problem? Most U.S, households are affected more by stagnant wages, less hiring and a rising cost of living than by an ebullient stock market.
(This was a terrible idea to begin with. One of the economy's structural problems has been a rise in wealth inequality. The Fed's efforts to boost wealth by lifting stock and bond prices exacerbate that inequality by catering to the ultra-wealthy with huge financial asset holdings. Another is excess indebtedness maintained by households and the government. The Fed's policies only encourage more borrowing by these groups.)
In the 1970s, the Fed held inflation-adjusted interest rates in negative territory for too long after the 1975 downturn. A similar, but shorter-lived, flirtation with negative rates helped fuel the housing bubble of the last decade. The chart above, which displays real, inflation-adjusted short-term interest rates, shows they're making the same mistake again. This is potent stuff.
When investors are essentially paying banks for the right to keep money in them, as they are now, the normal mechanisms of the financial system start to malfunction. Risk appetites swell. Capital gets misallocated. Downside risks aren't hedged. Credit risks are ignored.
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If stock prices had to depend on money earned from actual work, instead of printed money that banks get for free, the dow stock market would now be below 4000.
Anthony, I like your "War on savers" heading since this is exactly what us retirees are up against. You make it seem like buying solid dividend stocks is a bad thing, but it's the only way we can get a reliable ROI these days. We won't care how much the stock prices of T, VZ, etc. fluctuate as long as they don't cut the dividends.
Buying treasuries, bank CDs is pretty much like flushing money down the toilet since you are going in the hole due to inflation.the day you buy them.
Sooner or later there will be a selloff or correction. Anthony will take credit & say he told us so. Never mind that anyone following his advice months ago would have missed out on some nice appreciation on their investments. He obviously missed it, made the wrong call. What else can he do now? Admit he was wrong? Better to say everyone's been in a delusion and this market makes no sense. Talk it down. But then, there's rarely been a bull market where no one thinks that. Those are probably the ones to be most concerned about. That's far from being the case these days. Whenever the inevitable selloff or correction does come, that really shouldn't vindicate him, although he'll probably act like it did. My advice is to invest in companies with good earnings and bright prospects and sit tight until those things change, and in the meantime give up trying to play the market like a casino.
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