What we saw with the latest GDP reports is something truly remarkable. A market that was explicitly told the past 4 years of economic growth had been overstated simply shrugged off the news. That is, absolutely no price recalibration took place. This really evidences beyond any doubt that there is no relationship between the economy and the market. It further evidences the Fed’s increased proficiency in directly guiding the market.
Now I know this is not shocking to many of us. But to watch the market’s blatant irreverence toward a report that, with the flip of a switch, removed 12% of the presumed economic growth from the past 4 years did strike me as remarkable. It shows that the printing of economic indicators is nothing but theater. There is absolutely no rational market explanation that the market traded flat to up on the day when current GDP missed estimates and the past 4 years of growth was adjusted downward, all in the midst of one of the worst seasons for YoY deteriorating corporate revenues/earnings.
But more realistically what it suggests is the only player left in the market is the ‘buyer of last resort’, i.e. the Fed and its minion entities. Certainly nobody wants to aggressively short the market in the face of a clear long only strategy by the Fed, but just as certainly no major money managers are longing this market. Volume has simply dried up.
I’ve been writing for almost a year now about the economic cannibalism that has been feeding earnings growth. I have discussed this concept with a dire warning that feeding earnings expansion through operational contraction is a short lived meal. And well we are now seeing the indications that the growth through contraction has now hit its inevitable end. Have a look at the following chart which is really the only chart one needs to study at this point. The chart depicts S&P 500 adjusted earnings per share (blue line), S&P Price level (green line), S&P 500 Revs per share (red line) and US Productivity of Total Industry (olive line).
I have normalized the parametres back to the early 1990’s so that we can better understand the absurdity of what’s been taking place. Now there is a tremendous amount of information we can pull out of this chart so stay with me here.
The initial observation is that the past 25 years has been a series of large bubbles and subsequent busts, at least in both the price level and adjusted eps of the S&P. Focusing on the price level we see the normalized index having two similar peaks and now into a third peak quite substantially higher than the previous two. The first two peaks top out around 400 on the index and each subsequent reset price was down around 220. Now one might expect that the sources of these two very similar bubbles were thus the same. But one would be wrong.
Notice in the first bubble that adjusted EPS topped out around 275 whereas in the second bubble they reached 450. We often hear that because of this phenomenon equities were far more overvalued in the tech bubble than in the credit bubble. While the conclusion is correct it creates a strawman analogy for this third and current bubble. Specifically, that because current price to earnings is similar to that of the credit bubble that equities are fairly priced or at least relative to the tech bubble. But this argument is a strawman fallacy.
The tech bubble was a bubble of massive direct capital allocation stupidity. The credit bubble was a bubble of massive indirect capital allocation stupidity. What I mean by that is the tech bubble was created by absurd capital injections directly into the secondary market (bypassing earnings), driving stock valuations to the moon. The credit bubble was done via flooding consumers with debt which was used to prop up personal consumption which led to growth in revenues, earnings and thus stock valuations. You can see a large increase of revenues per share between 2001 and 2007. Now revenue growth is supposed to lead earnings growth which in turn pushes up stock valuations. However, when revenue growth is driven by debt consumption it is temporary. And we all learned that cold, hard fact in 2008.
But so the argument that EPS is the figure one needs to pay attention to really misses the actual driving force which is revenue based earnings growth. The above chart depicts that while EPS has been rising significantly for the past 7 years, revenues have been absolutely flat. And so what we have is earnings growth pushing stock valuations massively higher but without the consumer onboard. Very different from the credit bubble. How does this happen?
Well again, stock valuations are being pushed higher through another temporary effect. EPS growth is coming by way of operational contraction and financial engineering – meaning dividend payouts and share buybacks. This is evident in the following chart of just this latest bubble that depicts growth in stock valuations relative to growth in revenue per share, which have (notably) declined since Aug 08 (the base period).
Now EPS growth from anything other than earned consumption, meaning consumption from income rather than debt can only be temporary. (One arguable exception would be if EPS growth came from productivity, however, we see in this first chart that productivity is flat and so not the driver of EPS growth.) And if the EPS growth is temporary it follows that the stock valuations that have grown on the back of EPS growth too is temporary. What we are about to find and already are seeing the signs of with major technical supports breaking down is that stock valuations will reset to match each firm’s operational propensity for earnings growth (i.e. each firm’s expected sustainable future free cash flow). We saw this inevitable result in each of the last two major bubbles.
Interestingly if we look at the macrocosm of the capital mix between earnings and incomes what we find since moving to a pure fiat based currency in 1971 is that while incomes are very steady as a percentage of gross domestic income (GDI), profits have been more volatile. And since the large positive inflection point of money printing in 1993, corporate profits as a percentage of GDI have gone berserk. For investors it is imperative to understand what happens to stock valuations when profits’ share of GDI collapses. In the following chart I have normalized, back to 1971, income and profits’ respective shares of GDI.
You can see income has steadily declined as a percentage of GDI while profits’ share has bounced around. But we can see that starting in the mid 1990’s profits’ share of GDI has seen massively growing bubbles and busts. This is a direct result of the temporary earnings growth scenarios discussed above. That is, rather than implementing policies that create steady long term income and earnings growth the Fed and the government have been creating policies that act as bandages. And so while we cover up the infection for short periods, eventually the infection not only reappears but spreads resulting in a continuously worsening problem for which ever more extreme bandages need to be used to cover up the problems.
Today there is an even bigger problem in that the world has been riding China’s coat tails of growth so to speak. But looking at the following chart what we find is a huge dislocation between China’s growth machine (i.e. industrial production) and the valuation of world equity markets. The dislocation really began around the time the Fed implemented Operation Twist at the end of 2011, which fed directly into QE3.
We can see a similar indicator of industrial growth decelerating by looking at collapsing materials prices which began to deteriorate around the same time that the above dislocation started in late 2011.
Despite now hearing fewer and fewer industry ‘pros’ shouting their euphoric calls for 20 year bulls we still get a constant barrage of delusional analyses. We continue to hear about a strong job market when the opposite is true. U6 (i.e. the truest official unemployment figure) remains well into the double digits. As reported today by MarketWatch, labour cost index is at its lowest growth rate since 1982 and the U.S. has gained only an average of 208,000 jobs a month this year, down from 260,000 in 2014, a 20% decline YoY. Those are the real facts and those are in the face of the lowest labour participation rate since the 1970’s and the highest number of people on government subsidy programs on record.
In short, the last 20 years has been nothing but bad policies attempting to cover up the results of previous bad policies creating a need for more extreme policies to cover up more extreme resulting fundamental problems. This is clearly depicted in the data. The end result is that global growth has deteriorated steadily now for the past 6 years to its lowest long term trend line in modern history, now below 2%.
Like the chicken and the egg, economic output and incomes are inherently intertwined.
Be prepared for the now imminent equity valuation reset. It is true the Fed now has the ability to manipulate the market well beyond anything we’ve ever seen before. However, it is also still true that when the bursting bubble achieves full momentum the Fed will be helpless to stop it. While the Fed feels increasingly omnipotent they will once again learn, that while natural laws can be bent, they cannot be broken.