We are in an interesting time for equity investing because productivity is stuck in a rut, yet stocks are levitating higher. Since productivity growth drives economic growth, there’s no way stocks can rally in the long-term without it. I think both will correct as productivity growth will likely revert to the mean, possibly due to Trump’s deregulatory efforts; stocks will fall back down to earth reaching median multiples once again. In this article, I will review the latest charts which show how weak productivity is and how high the stock market has risen.
First, I will look at what I consider to be the most important chart in the markets. The chart below is the 10-year bond yield which has risen above, what Bill Gross has called the critical 2.60% level. It is about 2 basis points away from the high that was reached in December. Yields rising is a part of the Trump trade which also has included stocks rising, inflation expectations rising, and the dollar rising. The 10-year has risen about 30 basis points since February 24th. I remember asking others in finance why the 10-year was falling considering the Fed was about to raise interest rates and the stock market was hitting all-time highs. One possible justification was the bond market didn’t believe in increasing inflation expectations.
In analyzing the declining 10-year bond yield I felt it wasn’t ‘telling the truth’ and would follow the other assets classes soon. The caveat to my near-term expectation was that inflation expectations could fall if oil prices fell. This makes the current movement confusing because oil prices have fallen, yet the 10-year yield has risen. Inflation will come down if oil prices fall to the high $30s. The two-day sell off hasn’t yet influenced anything; the trend would need to be more sustainable. The strength of the summer driving season will start to effect oil prices in the medium-term. It will be interesting to see how oil prices effect inflation in the EU and the U.S. The E.U. has seen inflation surprises increase as you can see from the chart below. Looking at the low core inflation shows energy has had an undue influence on E.U. inflation.
The Trump trade can only continue for a limited period because yields can’t keep rising without crimping stock market multiples. I may be overestimating the potential for the two-day move in oil prices to be the start of a trend, but it would be amazing to see it cause U.S. inflation to fall just as the Fed starts raising rates. I have previously mentioned that the Fed would claim victory for inflation falling which is actually caused by shale oil producers sending oil lower. This would the best-case scenario. It would be much worse if the Fed ignores lowering inflation and continues down its path to raise rates three times anyway.
The 10-year bond yield is not near a price which will cause stock multiples to fall, but its technical breakout could signal the start of a broader sell off. That is why it is significant. As I mentioned, I will be reviewing a couple of charts which show the stock market rally could be near its end. The chart below shows what has historically happened to stocks after an 8-year rally of greater than 200%. The signal, which strikes after 12 months of the rally, being above 200% has, on average, led to the SPX falling 4.75% in the next year. I acknowledge that the number of years and percentage of the rally is somewhat arbitrary. My takeaway from this chart is the current environment of high multiples and high profit margins won’t continue much longer based on historical precedent.
I’m not a huge follower of technical analysis, but the chart below looks ominous even if you don’t either. The chart with the monthly Bollinger Bands shows the market reaching an overbought level which has previously preceded corrections. 98% of observations fall within the 2.326 standard deviation width of the bands. This market just hit above the upper band for the third time in the past 10 years. As you can see, when the SPX went below lower bound of the Bollinger Bands in October of 2008, it was a good time buy stocks if you had a long-term time horizon.
As I said, productivity growth has been putrid which lowers long-term growth potential and eventually hurts stock performance. The Labor Department reported Q4 productivity grew at a 1.3% annual rate which was down from the 3.3% annual rate seen in Q3. In 2016, productivity grew an at anemic 0.2% which was the slowest growth rate since the 0.1% growth in 2011. My hypothesis is productivity has been hurt by government regulations and quantitative easing. QE has created a phony economy which never corrected along the normal business cycle. When businesses see demand declining because the core economy is weak, but also see interest rates low and the stock market roaring, they borrow money to buy back stock instead of invest in the business which hurts productivity.
The chart below shows productivity growth in the U.K. which has missed expectations much like in the U.S. It looks just like the estimates for future S&P 500 earnings. Economists keep expecting productivity to grow faster than it does. If their estimates are always wrong, it’s no surprise policies that grow productivity aren’t enacted.
Conclusion
Productivity growth in the U.S. and the U.K. along with other developed nations has been worse than expected which is why developed economies have had low GDP growth as you can see in the chart below. What do these economies all have in common? They all have central banks buying up assets, creating a phony economy. Eventually low productivity growth will cause stocks to have weaker performance. On the bright-side Trump’s deregulation efforts may improve U.S. productivity growth. Even though oil price declines will hurt S&P 500 earnings, it can also lead to lower inflation which may stop the increase in the 10-year bond yield. As long as the 10-year bond yield doesn’t rally above the 5-year high of 3.00%, I think stock multiples will be able to remain elevated.
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