The rally off the March lows has been something to behold with the S&P 500 up more than 45%. The market has climbed a wall of worry as many financial pundits were repeatedly looking for a market top for the bear trend to continue or a significant pullback to at least offer them a chance to reenter the market. However, after the brief correction in June the market vaulted northwards again with the S&P 500 breaching the 1,000 mark for the first time since October of 2008. Many are wondering what has fueled this rally and if it is sustainable. Can the short term supports for the market offset the longer term headwinds facing the economy? The struggle between the two is leading to quite the balancing act between risk and reward, and this balancing act is likely to be with us for the foreseeable future.
Follow the Money
Over the course of the last two years Federal Reserve Chairman Bernanke has slashed interest rates virtually to zero to help stimulate the economy. For the most part, the low interest rate environment has not had the intended result of spurring bank lending as bank credit and commercial paper outstanding are contracting at a 1.5% year-over-year (YOY) rate of change.
Source: Federal Reserve
While the low interest rate environment created by the Fed has not led to a significant turnaround in bank credit, what it appears to have done is force households and investors out from their bunkers as they seek higher returns and yields. Two ingredients appear to have led households and investors to put money back in the stock market, which are reduced fears of economic and financial Armageddon and a low interest rate environment. There is simply no way that Boomers can hope to retire on investment portfolios that are invested in short to intermediate-term US Treasuries (UST) given current interest rates, particularly so if their capital base was cut in half in the carnage from the recent bear market.
To illustrate this point is the table below that shows the required portfolio size invested in various maturities of USTs to produce annual before tax income of ,233, which was the median household income in the US in 2007 (U.S. Census Bureau). Depending on the maturity of the UST, a household would need between .1 million to .5 million dollars just to produce the median annual household income from 2007.
Knowing that the vast majority of households do not have over one million dollar portfolios, it is not surprising to see an exodus out of safe assets and into riskier assets. You can see this exodus from safety to risk below where the bottom panel shows the amount of money coming out of money market funds (shown inverted below) and the increase in NYSE margin debt balances. The 2003 bottom in the stock market was characterized by rising NYSE margin balances and a peak in the net asset value of money market funds (trough below since inverted for directional similarity) as investors risk appetites increased. Conversely, the 2007 market top was characterized by a peak in NYSE margin debt and an accelerating trend in the increase in money market fund assets. The tide appears to have changed this year as NYSE margin debt has been slowly increasing, accompanied by what appears to be a peak in money market fund assets, a similar occurrence to the 2003 market bottom.
Money market fund assets peaked on January 14th of this year at .922 trillion and have declined by 6 billion, while NYSE margin debt has increase by roughly billion over the same time frame. Granted, the decline in money market funds and increase in NYSE margin debt does not account for the entire increase in US stock market capitalization, but it does indicate that the trend has shifted from panic stricken investors to those seeking increased risk. What is also prevalent when looking at the chart above is that the trend in NYSE margin debt and money market fund assets is like an oil tanker, the momentum shift is gradual and continues for months to years before another shift is seen. The increase in money market funds that began in late 2004 occurred after the Fed began raising interest rates and with the Fed announcing a prolonged period of low interest rates, it isn’t likely that the trend in money moving out of money market funds is going to change any time soon.
Where’s The Beef?
While animal spirits are likely to propel the market further in the months ahead given current momentum and lack of divergences in terms of breadth, one must begin to ask the question of how far this rally can continue and will it be sustainable into next year. As David Rosenberg of Gluskin Sheff has pointed out over the last few months, sustainable stock market rallies are characterized by sustained economic growth. Perhaps the best illustration of this is what occurred earlier in the decade. The four key elements that the National Bureau of Economic Research (NBER), the official arbiters of recession dating, use when determining the peaks and troughs of economic cycles are employment, personal income less transfer payments, industrial production, and manufacturing and retail sales.
The NBER committee called an end to the last recession in November 2001 as two of the four key elements they monitor (industrial production, manufacturing & retail sales) were rising or had bottomed, while personal income less transfer payments was already stable and only employment was declining. While NBER declared that the recession was over, it wasn’t until all four indicators were either rising or about to rise that the market began a sustained advance, with the stock market rally only fading once the fundamental underpinnings of the economy (the 4 key NBER indicators) began to roll over one by one in 2007-2008.
So, when looking at the chart above the phrase that comes to mind is, “where’s the beef?” We have just witnessed an incredibly dramatic “V”-spike rally that has not been associated so far with any improvement in the four key NBER indicators. Notice that the “W” bottom in 2002-2003 characterized a gradual stabilization in the economy followed by a significant expansion that followed in 2003. When the stock market finally bottomed there was clear stabilization in all four indicators, and in the present situation all four are currently falling at a rapid pace. Returning to the oil tanker analogy, the does not turn on a dime, yet this is exactly what the market is pricing in, a “V”-spike economic recovery. Given the current dramatic decline in all four indicators the market appears to be overly exuberant and lacks fundamental supports. Where are the so-called “green shoots” in the NBER indicators? Answer, there are none!
It is likely that the stock market has discounted a far rosier economic recovery than will probably be seen given massive headwinds facing the economy. As such, the further the market advances and the richer valuations become the greater the eventual disappointment and sell off that will likely occur. However, the eventual disappointment is not likely to be seen until the end of the year or into early 2010 given the money flow trends in margin debt and money market funds coupled with underinvested portfolio managers, and the real possibility of a positive print for Q3 GDP, which will likely be hailed the mother of all green shoots so far.
While the market may be fixated on the here and now, my focus is on what the landscape will be on the horizon. While it may be true that we are in the midst of a valley after a steep decline, what is before us in terms of economic recovery? We know the decline was steep and much longer than the typical recession, but the question I am asking is, how long is the valley? Is the economic valley ahead one characterized by a long flat path before a rising economic expansionary hill, think “L”-shaped recovery, or is the valley brief or gradual as in a “V”-shaped or “U”-shaped recovery respectively?
Since the start of the year my contention has been for an “L”-shaped recovery, and the indicator I use for monitoring the type of recovery we are having is the Philadelphia Fed State Coincident Index, which is a monthly coincident index for the 50 states. Similar to the four key variables NBER tracks, the Philly Fed index monitors four state-level indicators for each state. The four state-level variables in each coincident index are nonfarm payroll employment, average hours worked in manufacturing, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average). The trend for each state’s index is set to the trend of its gross domestic product (GDP), so long-term growth in the state’s index matches long-term growth in its GDP. The diffusion index is bound by +100 (all 50 states showing increasing economic activity) and -100 (all 50 states showing decreasing activity).
As seen below, the Philly Fed Index reached a low of -100 in February as every state was contracting, but has since improved to -86 in June, though it has yet to confirm the “V”-spike rally in the stock market as economic breadth in terms of state activity remains extremely weak.
"Less Good" - The Second Derivative in Reverse?
Perhaps my greatest reservation about the sustainability of the stock market’s rally has to do with employment. An economic expansion cannot be sustained unless there is an improvement in employment as rising employment leads to rising incomes which leads to rising retail sales and rising corporate profits. Perhaps the biggest glaring exception to this would be the 2001-2007 expansion which was fueled by a bubble in household debt that is inconceivable of being repeated for decades to come. There has been a major shift in household perceptions of debt and savings as the word “frugality” has returned to the U.S. consumer’s lexicon once more.
It is unlikely for the U.S. consumer to go on another debt binge as the Fed and Obama administration would like with the Fed’s low interest rate environment and Obama’s “Cash for Clunkers” program that encourages consumers to take on more auto debt. If this is the case then employment is likely to be the key factor in determining the future economic landscape, and the stock market's sustainability for that matter. To illustrate how key employment is to a sustainable economic expansion and stock market the 2001-2003 experience serves as a great model.
The ISM Purchasing Manager’s Index (PMI) staged a dramatic recovery from the low seen in October 2001 of 40.80 to a high of 53.60 in June of 2002. The stock market rallied late in 2001 as it discounted an improvement in manufacturing, but later rolled over as the results from the PMI would become “Less Good” as the PMI weakened into 2002. The weakness in the PMI that transpired in 2002 was amidst a declining job market, so “Less Good” results from the PMI coupled with continued job declines were not the supports the 2001 market rally was looking for. While the recession was over according to NBER in November of 2001, it didn’t “feel” like it as jobs losses continued into 2003 and unemployment was still rising. The stock market’s first sustainable advance came in 2003 as the stock market not only anticipated a recovery in manufacturing as seen by a sharply rising PMI, but also a final bottom in employment.
Source: ISM, BLS, Standard & Poor’s
The reason why employment is probably the key element to any economic expansion is the link that employment levels have on retail sales and the relative importance of personal consumption to GDP, which currently stands north of 70%. The relationship between employment and retail sales could not be any clearer than the chart below, and with no rebound in employment it’s hard to conceive of actual positive growth in retail sales any time soon.
Source: U.S. Census Bureau, BLS
Given what we are witnessing so far in terms of retail sales and the duration of the current recession, it is likely that a secular shift in consumption and savings is occurring. This can be seen when looking at retail sales normalized to 100 at the start of a recession and comparing the path taken in the current recession to those seen over the last forty years. What should stick out like a sore thumb in the figure below is that retail sales were typically either flat or expanding during prior recessions. This resulted as consumers would temporarily decrease their savings rate to make up for lost income, with the current path showing a dramatic departure from prior recessionary trends. While the consumer was a stabilizing force in prior recessions that were more of a result of a retrenchment in manufacturing, this time around we have witnessed the consumer act to weigh down economic growth rather than support it. This is a clear shift from prior recessions that tends to point to major changes under the surface, indicating a secular shift in consumer behavior.
Source: U.S. Census Bureau
What is likely to weigh on consumption patterns in the years ahead and depress GDP going forward is the deterioration seen in the employment not only over the past few years, but really over the past decade. The employment to population ratio peaked at 64.7% in April of 2000, one month after the peak in the secular bull market that began in 1982, and has been in decline since with the recent recession showing a dramatic decline in the ratio down to 59.4% presently. While the decline in the percentage of the population that was employed would tend to support weaker consumption patterns due to a decline in aggregate wages, what made up for this was a surge in household debt to make up for the lack of increase in aggregate incomes.
The employment to population ratio shows a 95% correlation to the share of personal consumption expenditures (PCE) relative to GDP when advanced by several years. As mentioned above, the share of PCE to GDP did not decline as much as the ratio of employment to population ratio was forecasting due to the increase in household debt over in the first part of the decade. As a continued debt binge by the U.S. consumer is not likely in the cards, what is likely to transpire in the years to come is a significant decline in the share of PCE to GDP. With the U.S. consumer making up more than 70% of GDP, this would be the biggest headwind for the economy in the years ahead. Interestingly enough, the employment to population ratio is forecasting the share of PCE of GDP to decline to roughly 65%, which is the historical average for PCE as a share of GDP.
Source: BEA, BLS, BOC
What is noticeable in the figure above is the dramatic increase in the employment to population ratio from the low seen in the early 1970s to the high seen in 2000 (note: the employment to population ratio is shifted roughly 5 years in the future in the figure above). What likely led to this dramatic increase in overall employment participation levels was the impact that inflation had on households in the 1970s. To make up for the declining purchasing power in the US dollar (USD) was a dramatic shift in the U.S. from single income families to two income families. This trend can be seen below where the percentage of male workers to the total workforce declined from roughly 64% in 1970 to 50% today as the number of female and male workers is roughly 1:1. While the decline in the purchasing power of the USD does not fully explain the shift to two income families, the link between the relationship is quite strong with a 98% correlation. Given an equal workforce of men and women, the secular benefit of greater participation of women in the workforce (which translates into higher aggregate incomes/retail sales) is over, and with it a major secular force that underpinned the prior secular bull market that began in the early 1980s.
Source: BLS
Given the dramatic slack in labor supply any economic recovery that develops is going to have to be driven by governmental supports, and even then is likely to be anemic with yet another “jobless recovery.” The reason for this has to do with how employers are likely to respond once they perceive the economy stabilizing. For example, it is cheaper for an employer to increase the hours of an existing employee rather than to go out and hire and train a new worker. With the percentage of full time employees to total employment resting at record lows and the number at work part time resting at nearly 18 million, there is an incredible amount of slack in the labor supply that will depress any recovery in employment ahead, and this presents a major headwind to economic growth in the years to come.
Source: BLS
Source: BLS
In summary, animal spirits are alive and well as households and professional money managers move funds out from their cash bunkers and into riskier assets. This trend is likely to stay in motion until the point where valuations become lofty and until the point where the markets begin to discount what lies ahead in 2010. Given the dramatic overhang of employment and the remote chance for consumer to increase leverage ahead, investors may be in for a rude awakening as they begin to discount 2010 economic reality rather than 2010 forecasts. If the current “green shoots” do not continue to advance then the market may be in store for the “less good” to replace the “less bad” so pervasive in the financial media much like the 2002 experience. Thus, investors will have a difficult task ahead to balance the current money flow out of cash bunkers and into riskier assets with the risk that 2010 may be a 2002 repeat. A deterioration in market breadth and a failure of risky assets to make new highs will likely be the tells for such an occurrence.
