So what is driving the market higher and higher?
If it was pure business fundamentals, like I mentioned in my last blog post, then companies should be doing extraordinarily well. Retailers should be announcing increasing same store sales and foot traffic. Manufacturing should be high with companies like Caterpillar building machinery like crazy to satisfy demand. Employment should be high, with the majority being in higher paying industries rather than retail or fast food. Essentially, the economy should be strong, GDP should be growing at a healthy pace, and major foreign markets should be equally positive, being that we’re part of a larger global economy. So what is reality? Unfortunately, very little of what I just described is actually happening. The economy doesn’t appear to be as strong as market prices would indicate.
Earnings Are Decreasing.
In general, company earnings have been decreasing for over a year. If we look at the S&P 500 Index as a whole, 12-month earnings peaked in Sept. 2014 at $106, and subsequently dropped almost 19% to $86 by Mar. 2016. Meanwhile, the market price increased by over 10% from Sept. 2014 to Aug. 2016.
In each case, the earnings dive accelerated past -20% to as high as -90% (during the Financial Crisis) before bottoming out. You can see that we’re in the early stages of the current earnings decrease. Only time will tell if they’ll manage to recover, or continue trending downward. What’s weird is that the market has continued going up during this time frame.
Breaking it up by sector, it’s obvious that the energy sector has been decimated by the collapse in crude oil prices. In one year, from 2015 Q1 to 2016 Q1, the trailing 12-month earnings per share in the energy sector decreased by 214%. Obviously this has been catastrophic to oil companies’ revenues, and is a key reason why they’ve been cutting costs like crazy, which includes extensive layoffs. The Materials and Utilities sectors haven’t fared so well either.
So…what has caused such an enormous increase in the stock market over the last 7 years, and more importantly, why does it continue even when it appears that corporate earnings have topped out and are now decreasing?
In my opinion, stock market behavior over the last 7 years is strictly due to Central Bank manipulation through Quantitative Easing (QE) and interest rate policy. If you don’t know what QE is, the short answer is that it’s when the central banks trade cash for financial assets on the open market. Essentially to prop up the economy and the stock market as a whole. Look at the effect of QE on the stock market since the recession.
At the end of QE1 the S&P started an immediate pullback. Similarly, in 2011 QE2 ended and once again, the market pullback. At this point the US FED went all out, first with Operation Twist (link it), then with QE3, which cont’d until the end of 2014. The market has been significantly more volatile and mostly flat since Q3 ended. The last couple of months have seen a final push to break towards a continued uptrend, however the momentum doesn’t seem to be there.
Something equally important to note is that when the US FED enacted the QE programs, they simultaneously lowered interest rates. In the past, the FED could use a strict lowering of the interest rate to stimulate spending and the economy as a whole. However, following the recession, the FED was only able to stimulate spending through both lowering the interest rates, and conducting multiple rounds and huge amounts of Quantitative Easing.
First of all, the larger problem has more than likely been brewing for many more years than just the last 8. If you look at it from a total economic credit cycle perspective. Our economy has had enormous credit expansion over the decades. However, with all that credit expansion, credit contraction has to eventually occur. This is the normal boom and bust cycle. I believe the US FED is essentially trying to remove the bust portion of the long term economic credit cycles. However, they’re now out of bullets, so to speak. They’ve already lowered interest rates to near zero. If the economy continues to slow, they have no way to try and stop it other than more rounds of QE, which I believe are coming.
Additionally, by having low interest rates, it forces savers to spur savings accounts or even bonds and put their money into the stock market because it’s the only place they can get earnings returns. Once again, when and if the fed decides to raise interest rates, it’ll make bonds and alternative investments more appealing, adding another stock correction catalyst. If you can get 3% yield in the stock market, and 2% yield in a no risk gov’t treasury, it’s pretty obvious that most investors will go for the treasury. The risk for an extra 1% just isn’t worth it.
What have we gotten for all those years of Quantitative Easing and low interest rate policy?
So here we are 8 years later. The Federal Reserve ended QE, but they’re still too scared to raise rates. More than likely, they waited too long and have potentially created another bubble.
For all this fed intervention, we’ve had very little GDP growth. In fact, the U.S. economy has grown by just under 2% annually in the past seven years, the slowest pace since the 1940’s. Keep in mind, this was during a time of unprecedented fed stimulus measures.
Raising rates now would further depress the economy and potentially push an already very low GDP into negative territory. Raising interest rates makes borrowing (mortgages, cars, business investment, etc) more expensive. It incentivizes saving because of the higher interest gained. It discourages large businesses investment because of increased cost and risk uncertainty. All of these are a roadblock to GDP growth and economic stability.
Slowing GDP growth isn’t just happening in the US, China for example has watched it’s GDP growth decrease to a record low of 1.1% in the first quarter of 2016. They’re decrease in GDP growth over the years is pronounced.
Foreign markets are hurting. Let’s look at China and Japan.
I already mentioned China’s slowing GDP growth. This is inevitable due to the size of their economy. While they’ve had enormous growth in the past, similar to what happens with any business, the larger they get, the harder it is to continue growing at the same pace.
As the Chinese economy has grown, so have their levels of debt. Currently, their debt is close to 250% of GDP. The problem is that they’re more of a manufacturing driven economy, whereas ours is consumption driven. Therefore, as the rest of the world has slowed, exports from China have fallen significantly because countries around the world are no longer able to absorb all that China is producing. Which leaves China in a precarious position of trying to control debt, keep GDP stabilized, and keep its people fed and working in a slowing global economy.
China has had to resort to what look like emergency measures. They’ve been doing anything possible to keep their factories producing and people working. They’ve built bridges to no where and complete ghost cities with no one living in them. They say it's preparation for the future as their enormous population will eventually need them. But let's be real, many of these ghost cities will probably end up being shuttered. Imagine the United States Gov't building entire cities the size of Seattle with no actual demand or necessity, but they're excuse was, "people will eventually live here." Seems like an extreme case of fiscal irresponsibility, but that's exactly what China is doing. But hey, at least the satellite pictures of these ghost cities are fascinating.
This kind of monumental development has required extreme amounts of raw materials. They’re pumping out steel, concrete, and pretty much everything else that's made in a factory at unprecedented levels. While the rest of the world has slowed, China has used Credit / Debt to keep their factories going full bore.
China used more cement between 2011-2013 than the United States in the entire 20th Century!! (No Joke)
In the end, any major economic set-backs that could occur in China, will have a lasting effect on our economy as well. You better believe if they have a financial crisis similar to ours in 2008, it’ll bring our market down with it.
Similar to China in the last 15 years, Japan experienced explosive economic growth through-out the 1980’s. They had an enormous trader surplus with the rest of the world (just like China now), and with all that foreign currency flowing into Japan, and a little money printing to keep the Yen from appreciating, their economy blew into a huge bubble. Just like any bubble, it eventually popped in 1991.
Fast forward 25 years and it’s arguable if their economy has ever truly recovered. You’ll notice in the chart of the Japan NIKKEI Index that after the collapse in 1990, they’ve basically been flat with two additional drops that coincided with our Dot-com and Financial crisis busts. The ten years between 1991 and 2000 are known as Japan's Lost Decade, and the whole period through 2010 is now being coined the Lost Score (20 years). You can see why in the chart. What do you think the future will name their lost 30 years? We're not too far away and their market looks like it has no plans of recovering.
My point is that Japan has been treading water for 25 years. There is absolutely no indication that they’ll recover.
Negative real interest rates
While academics like to think this is what happens. Common sense and real life has shown the exact opposite. When people and businesses are trying to save money, and the gov't goes in and makes it harder by charging them to save, that doesn't cause them to do a 180 and say, "Well sh@t, I guess we just better spend all of our money. Screw the future." No, it makes them start saving even more because now they're seeing interest rates as another road block to their goals. Once again, the gov'ts do the wrong thing.
Economies currently with negative real interest rate policy?
Bank of Japan
European Central Bank (the Eurozone)
US? (Not yet, but in 2015 Janet Yellen (the US Fed chair) said that a change in circumstances could put negative rates “on the table”.)
Don't be fooled, the global economy isn't as stable as governments would like you to believe.
So tell me again why our stock market still sitting at all time highs?
I personally don’t feel comfortable adding any new money into my investments at this time. I have actually been slowly transitioning to cash. I’m not saying that I think the market is going to crash tomorrow. We could see a correction in the coming years, or we could see very low returns going forward. It's hard to know what the correction catalyst would be. What absolutely has to happen though, is that company earnings either have to increase significantly to justify how expensive the market is, or the market has to come down to realistic levels. I think the latter has a much higher probability mainly because I believe we're fighting against a larger credit cycle shift. I think credit contraction is on the horizon.
Anytime I invest, I am weighing the probably of an increase coupled with the amount of potential increase against the probability of decline and the amount of the potential decline. To me, the probability and amount of a potential decline far outweighs any potential gains from this point forward. Therefore, I’m taking money off the table.