Adapted, with some changes and edits, from my recent Letter to Investment Clients.
In the last week, several economically important things have happened and they can be summarized together as a discrepancy between the stock market and “the economy.” First, and of primary importance, on Monday we got the 2016 first quarter GDP forecast number, which plummeted down to a 0.6% level. This was a stunningly disappointing result, as the estimates were in the range of above 2%, which itself would have been disappointing. A mere 2% growth has preceded the past 11 recessions.
Meanwhile, perhaps more onerous, corporate profits are now down 11.5% in year over year terms, according to Bloomberg. This is the worst drop since the 2008 recession. Further, durable goods orders plunged 2.8%, in a sign that businesses were reducing their purchases in preparation for slowing economic demand. These numbers, coupled with a growing number of people leaving the labor market (this means that the “labor participation rate” is shrinking), all point to a slowdown in the economy; possibly pointing to recession. In my own personal opinion, we are already in a recession, but such things are not usually officially announced until months after; we will await the pronouncement of the professional economists!
Despite the above, the stock market is reaching 2016 highs. What in the world is going on? Shouldn’t the stock market be reacting negatively to such sobering economic data?
The answer, though troubling, is fairly simple: the Federal Reserve. Here is what’s happening: since the Financial Crisis of 2007-2008, the Federal Reserve’s response has been to slash key interest rates and surge the supply of bank reserves, both of which were intended to “encourage” more borrowing, more spending, and more debt. This policy of “easy money” (the Fed calls this “accommodation) and interest rates at zero has been the norm since the previous crisis. The Fed believes that this action will spur economic growth. After nearly 8 years of this, people are beginning to ask whether this historically unprecedented activity will have to go on forever, given that growth has been just awful. So for the last couple years, all eyes were on the Fed, seeing whether they were going to “normalize” interest rates (that is, push them back up).
Of course, an economy saturated in cheap debt and addicted to a borrowing binge from newly created money can never be on a sustainable path. Thus, when in December the Fed decided to dip their toe in the water by pushing up one key interest rate (called the Fed Funds rate), the stock market threw a fit and shot downward over the course of the next month and a half. The economic fundamentals were not at all in good condition and the Fed’s move, rather than causing the economy to sink, exposed the true rot beneath the surface.
As the Fed’s February meeting approached, they decided that, rather than continuing on their path of “normalizing” interest rates, they were going to just hold still for now and not raise rates again, at least for the time being. The stock market celebrated; after all, it meant that more cheap money wasn’t going to be cut off! Mid-February then, saw 2016’s first uptick in the markets. But the fundamentals hadn’t changed one bit; no, as overviewed above, the economy is doing quite miserable.
Fast forward to late last week and early this week when we began to receive more data on the true state of the economy. As we received this data, the stock market pushed up a little more and finally, as of Tuesday when Federal Reserve chairman Janet Yellen gave a speech indicating that the economy wasn’t quite ready for more interest rate hikes, it soared.
Thus, we live in the quite backwards world where bad economic news is good for the stock market (the Fed will just print more money!) and good economic news (though such data is difficult to find) is bad for the stock market. In other words, the stock market is addicted to cheap money and economic fundamentals have been completely cast aside.
There is a major discrepancy between the true state of the economy and the story being told in the stock market. And please understand: it is tremendously dangerous. Since more debt and more cheap money can’t grow the economy (growth comes by saving and accumulating capital, the opposite of newly created credit), the only result of the current path will be a reversal on the stock market side. In other words, picture the economy headed downwards and the stock market headed upwards. As the Fed desires to throw more debt at the problem, the economy itself is increasingly burdened by the very thing that has caused its stagnation. Thus, the economy will continue to be pressured downward. But can the stock market go up in perpetuity as the economy is weighed down? Economic theory, and historical evidence, shout no. Therefore, whether in a quick move as in December/January (preferred), or in a slow, draining, and painful trend (such as happened in Japan during the 90’s-00’s), eventually the shockingly overvalued stock market will someday have to come down to reflect the actual state of the economy.
As Doug Kass commented this week:
I believe the chasm between Wall Street’s buoyant stock prices and our softening U.S. real economy is widening, while the market’s overvaluation is growing.
More debt won’t help the economy grow (move upwards). Therefore, the stock market will have to come downwards.
As the stock market becomes even more overvalued (just this week the S&P saw its stock prices move up and its earnings estimates move down to the effect that, just as they were in late December, the price is now 23X earnings), I grow more concerned about those invested in the market. In the end, though, I remain entirely convinced and convicted that free market fundamentals eventually win out. No matter how much central economic planning the government and the central bank intend to engage in, they cannot succeed against the will of the market.
I was especially encouraged by the ever-wise insight of a man I respect very much: John Hussman. He stated recently that “informed optimists reject that the market is forever doomed to rich valuations and dismal future returns. Rain is good.”
To interpret, we remain happy and optimistic at the thought of the stock market’s valuations eventually reflecting much better future returns. The idea of markets coming down to reasonable levels scares those speculating on the Federal Reserve’s easy money game; but since we are investors, not speculators, we look forward to the markets once again fulfilling their proper role in our capitalist economy.