Real Economic Weakness?

The stock market doesn't seem to be reflecting the economic weakness we are seeing. The bullish counterpoint to any negative data is that the economy will improve due to fiscal stimulus. The latest blunders in the attempt to pass healthcare reform makes fiscal stimulus seem less likely. To simplify this further, the bears say the economy is bad and the bulls say it doesn’t matter. While the economy has been weak for several quarters, the specific details of how weak it is, are important to my opinion on stocks. There is a big difference between a weak economy that is flatlining and one that is getting weaker. I think the Fed is hiking rates into a weakening economy. Normally, that doesn’t end well.

Before I delve into the latest economic reports, I want to look at an interesting graphic. The chart below shows that the stock market has done well when tax reform is in the news and poorly when Obamacare is mentioned. I acknowledge the possibility that traders may be more optimistic when tax reform is mentioned, but it is irrational to do so. As I mentioned in another post, the Ryancare proposal cut medical device taxes and reduced the deficit so the government can afford higher tax cuts. It’s overly simplistic to claim tax cuts are good for stocks and healthcare reform is bad for stocks.

The best summary of the weak economy is the chart below which shows the Atlanta Fed’s GDP Now forecast. The forecast has ticked up to 1.0% which is still a far cry from the 3%-4% GDP growth promised by the Trump administration. My point is not to rag on Trump, but to express how the market has taken these high growth estimates to heart. If the market rallies on growth acceleration expectations, shouldn’t it fall when those expectations fail to come to fruition?

We’re living through a market where the positive side is always considered even when bad news is reported. This is how we got to such expensive valuations. The reason why I focus on valuations is because they have a great track record at predicting long-term future returns. The chart below shows that track record by using the MarketCap-to-GDP ratio. This ratio is predicting negative returns for the next ten years for the second time in the past fifty years. The last time the forecast went negative, returns were negative as you can see in the chart.

One of the economic measurements which is weakening is jobless claims. They rose 15,000 from last week even though there were no special factors influencing the labor market and no states were estimated. The outstanding question remains how long the 80-week streak of under 300,000 claims will last. I have been focusing on any blip higher because the jobs market is overdue for weakness. The jobless claims data alone could bring down the market if it rose above 300,000.

The top “hard” data economic indicators that are flashing warning signs are productivity growth and core durable goods orders. Core capital spending in February fell 0.1% month over month which missed expectations for 0.5% growth. This was the first month over month decline since September. Year over year it only increased 0.2%. Orders for vehicles and auto parts fell 0.8% month over month and 3.4% year over year. The decline in auto sales is almost inevitable given the tightening credit standards and unsustainable incentives given to customers. The chart below shows the core durable goods spending in absolute dollar terms. There was a moderate increase at the end of 2016, but that appears to be stalling out. It’s still off the peak set in 2014 which was just prior to the corporate earnings/manufacturing recession of 2015.

The chart below shows the historical non-seasonally adjusted durable goods orders. It shows how weak the current recovery has been. Outside of the first two years after the recession which were bounce back years, real order growth has sagged. It shows starkly how stocks have not reflected economic reality for almost this entire cycle.

One interesting part of the rally since the election is that it wasn’t driven by buybacks like the prior few years. As you can see from the chart on the left, share buybacks as a percent of market caps is near the cycle low. It’s possible that the market could’ve corrected if the post-election optimism didn’t encourage animal spirits to drive stocks to such heights. Even though I am a bear, I remain objective. The market may be pushed higher by buybacks in the next few months because earnings are set to increase on a year over year basis at an accelerated pace and bond borrowing reached record heights in the first two months of the year. This new capital will likely be used for buybacks. The chart on the right shows that investors have started to lose interest in stocks with buybacks. This is in tune with my point that animal spirits caused stocks to rise instead of buybacks. As you can see, there was a bigger decline in 2015, but that coincided with a flat market.

Conclusion

The economy is weak, but bulls argue fiscal stimulus will take control and boost it higher. The deciding factors in determining how likely that expectation is, are the size and likelihood of the stimulus and how weak the economy is prior to the stimulus. In this article, I have categorized the current state of the economy as weak. It’s important to keep in mind the trajectory of the economy because the stimulus will come in a few quarters, if it comes at all. Starting at a 1% GDP growth in Q1 and falling doesn’t bode well for the odds of a strong economy. A tax cut can temporarily boost growth for one or two quarters but if it quickly wears off, then it’s meaningless. We saw a 0.9% GDP bump from soybean exports. That didn’t do anything for the long-term prosperity of the people. Obviously, tax cuts will provide a bigger boost than that, but it’s just an analogy to show how short term bursts don’t have much of an effect on the trajectory of the economy.

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1 Comment

  • Tim

    March 27, 2017

    Work for a semiconductor company. Just had our first Production layoff in 3 years- due to weak demand from China. Demand from China has fueled our industry for last 10 years. My colleagues in Silicon valley see similar weakness in their forecasts going out > 2 qtrs.