Last week, the markets hit new “all-time” highs as Greece caved into the demands of the Eurozone, at least for now, in order to secure funding for another four months. The relief that the latest Eurozone crisis has been resolved sent money flowing into equity markets as investors remain “afraid to miss out” on rising asset prices. The general consensus of analysts and economists is that the rise in capital markets is clearly a sign of economic strength which makes equities the “only game in town” as long as Central Banks stand at the fore.
However, I have a few points which are a bit more pragmatic.
First, while it is true that the markets have risen to “all-time highs,” on an inflation adjusted basis, this is not the case for most investors. As I have written previously in “Why You Can Never Beat The Index“ I stated that:
“The sad commentary is that investors continually do the wrong things emotionally by watching benchmark indexes. However, what they fail to understand is that there are many factors that affect a ‘market capitalization weighted index’ far differently than a ‘dollar invested portfolio.’”
These misunderstandings lead to emotional decisions to buy and sell at the wrong times; jump from one investment strategy to another as well one advisor to the next. While these actions are great for Wall Street, as money in motion creates fees and commissions, it does little to solve the bulk of the problem with investor’s portfolios which is simply emotional mistakes based on unrealistic expectations.
The single biggest mistake that investors make is the fallacy of chasing a benchmark index (i.e. the S&P 500) thinking that it is something they must beat. But why wouldn’t they? This is what they are told day in and out by the media. It is the mantra that has been drilled into all of us by Wall Street over the last 30 years. However, what we fail to understand is that this is for Wall Street’s benefit and not our own.”
As I explain to my kids with respect to baseball – it is not getting hits that win baseball games but rather having fewer errors than your opponents. It is the same with investing – the winner is the person with the fewest errors.
It is also worth noting that throughout history it is relatively unimportant that the markets are making new highs. The reality is that new highs represent about 5% of the markets action while the other 95% of the advance was making up previous losses. “Getting back to even” is not a long-term investing strategy.
However, let’s set aside the impact of all the other factors and look solely at the markets as an indication of economic strength. It is here that we find a very large disconnect.
Since Jan 1st of 2009, through the end of 2014, the stock market has risen by an astounding 148.8% (based on Fed Reserve quarterly data.) With such a large gain in the financial markets we should see a commensurate indication of economic growth – right?
The reality is that after three massive Q.E. programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total to more than $33 Trillion and counting, the economy has grown by a whopping $1.9 trillion since the beginning of 2009. This equates to just 13.5% growth in real GDP during the same period that the market surged by more than 100%.
However, as shown in the chart above the Fed’s monetary programs have inflated the reserve balances of member banks by roughly 403% during the same period. The increases in reserve balances, 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 increase in the Fed’s balance sheet and the return of the stock market over that period.
Unfortunately, while Wall Street benefits greatly from repeated Federal Reserve interventions – Main Street has not. Over the past few years, while asset prices surged higher, personal consumption expenditures have remained mired at levels typically associated with very weak economic expansions. This is reflective of continued weak income growth which has been a function of a large amount of slack in the labor force.
As an example – the last two reports on economic growth have shown that more than large portion of the increase came from surges in healthcare-related spending. The problem is that higher “healthcare costs” reduce the discretionary spending capabilities of individuals and is one reason why “retail sales” has remained stagnant despite the drop in gasoline prices.
Of course, weak economic growth has led to employment growth that is primarily a function of population growth. Sustained levels of unemployment have reduced the standard of living for many Americans forcing them to turn to social support programs. Food stamp usage and disability claims have risen sharply since 2009 and currently remain near record levels. The chart below shows the percentage of real disposable incomes that are comprised by social benefits.
It is extremely hard to create stronger, organic, economic growth when the dependency on recycled tax-dollars to meet living requirements remains so high.
Corporate profits have surged since the end of the last recession which has been touted as a definitive reason for higher stock prices. While I cannot argue the logic behind this case, as earnings per share are an important driver of markets over time, it is important to understand that the increase in profitability has not come due to strong increases in actual revenue. As the chart below shows while earnings per share has risen by over 250% since the beginning of 2009 – revenues have grown by less than 33%.
As expected, since the economy is 70% driven by personal consumption, and the companies that make up the stock market are a reflection of actual economic activity, it is not surprising that both GDP growth and revenues remained sluggish. Therefore, the question as to where corporate profitability came from must be answered? That answer can be clearly seen in the chart below of corporate profits per worker which is at the highest level in history (data through Q3 of 2014.)
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.
So, while the markets have surged to “all-time highs,” the majority of Americans who have little, or no, vested interest in the financial markets have a markedly different view. Currently, mainstream analysts and economists keep hoping with each passing year that this will be the year the economy comes roaring back but each passing year has only led to disappointment. Like Humpty Dumpty, all the Fed stimulus and government support has failed to put the broken financial transmission system back together again.
Eventually, the current disconnect between the economy and the markets will merge. My bet is that such a convergence is not likely to be a pleasant one.