In a conversation with one of my partners - who happens to be my father - over the weekend, a common question emerged, “what percentage
of recent market gains are due to broad market euphoria vs. actual company
performance?” While my next task is to
compare the individual company gains against the S&P to determine aggregate
lead or lag, it brought up another interesting point: How excited should an
investor get about market exuberance?
Judging from financial publication cartoons, the dislocation between
economic recovery and stock market recovery is rather evident. So, how should we look at the differing information. Further, is the information differing? We'll have a look at current U.S. economic data, S&P fundamentals as a bellwether for the broader market, and fund fundamentals with the goal to analyze the trends over the next 6 months, 1 year and 2 years.
Part 1 begins with the economy...
Last Friday we got a strong jobs
report. Since one report a
recovery does not make, the initial positive reaction was likely tempered by
the poor unemployment number. IHS Global
Insight states:
Strong jobs growth combined with a
declining labor force is not ideal because it brings closer the day on which
the unemployment rate hits 6.5% and the Federal Reserve will start to think of
raising interest rates.
Employment
Diving deeper into the numbers we
see a 14,000 rise in manufacturing jobs (the same rise from the preceding 2
months), along with a 0.5% rise in overall manufacturing production-worker
hours. Construction employment rose
48,000 for the fifth consecutive double-digit monthly increase, indicating a
recovery in the housing market (of course tempered by last week’s Bloomberg
article citing underlying dangers if housing resumes its old ways). Services employment also increased by
179,000, up from 99,000 in January.
On the negative side, government
sector jobs fell by 10,000, all coming from state and local loss as federal
jobs remained steady. However, this
number could increase in future months as the sequestration will apply
mandatory cuts across all government agencies, which will kick in at the end of
March unless Congress acts. I see the
continuation of the sequester at a 60% probability as more and more people in Washington,
D.C. seem to agree with the cut to government spending though they fear their
own job security. IHS Global Insight
expects sequestration to end in June (optimistic), but if it does last the
whole year they predict a 400,000 net job loss. Looking at the larger picture, discretionary spending
will do little to help the U.S. fiscal situation so long as healthcare costs
remain elevated.
Smart pundits point to the labor-force participation rate (LFPR) [more on that below], which had the
effect of reducing the unemployment rate to 7.7% from 7.9% in February. The employment-population ratio held at 56.8%
while the LFPR fell to 63.5% matching cyclical lows. The most comprehensive
unemployment measure, U-6, fell to 14.3% from 14.4%.
A worse case scenario would be if current the current trend continues AND
there is a 400,000 loss in federal jobs. In this case, the unemployment rate will not increase due to private sector momentum offsetting the government job losses. Unemployment will likely stagnate around 7.5%
and keep the Fed away from the inflation lever.
The down-side risk comes in the form of stable labor-force participation. If this number falls, then unemployment could
move below 7.0% for the "wrong" reasons prior to 2015 and we could see the Fed consider action. This would put pressure on consumers and
borrowers at the same time providing investors with increased
returns.
Production
and Confidence
Durable goods, shipments, unfilled
orders and capital goods all fell after multi-month gains. These production numbers fail to demonstrate
a trend and continue to hint at sideways economic activity. At the same time inventories continued to
rise for the sixteenth month to $374.8 billion showing continued upward
momentum. Net-net this leads me to forecast slow recovery.
CPI is still growing at a monthly
annualized rate of 0.32%, far below the long term average annualized growth
rate of 3.61% indicating that inflation is not currently an issue. The PPI growth rate for
January, 2.45%, is closer to its historical growth rate of 3.10%. Growth as reflected in the PPI seems to be
recovering more quickly than the cost of living is rising in the current
environment. The CPI will be one measure
affected by change in Fed interest rate policy.
Consumer sentiment is currently in the middle of its one year range
which supports other sideways economic data.
Labor Force Participation Rate
I see the economy in a slow state of recovery with an important caveat. Investors should pay close attention to the LFPR. The rate is touching levels not seen since the early 1980s and has failed to recover from its peak after the dot com bubble and the Great Recession. From the
Bureau of Labor Statistics:
When taken to its maximum time period, we can see a substantial run up in LFPR starting in the late 1960s.
What gives?
Willem Van Zandweghe, a senior economist at the Federal Reserve Bank of Kansas City, indicates half of the downward effect since 2007 is due to long-term factors while the other half is cyclical. Long-term forces including labor population size and gender participation largely explain the period between 1966 and 2000. Specifically, the increase in LFPR is attributable (1) to the baby boomers entering the labor force and (2) to the increase in women in the labor force (which peaked and leveled off at 60% in 1999). Both trends leveled off in the early part of the 21st century and correlate with the start of the decline in the participation rate. Van Zandweghe notes the decline in LFPR correlates to another two demographic events. First, the boomers began reaching retirement age and began cutting back on work hours or retiring. Second, there has been a steady decline in participation among youg people, in large part due to school enrollment (he sites Daniel Aaronson and others).
These demographic trends seem intuitive, but what of the cycle? According to Van Zandweghe, the LFPR cycle has an increasingly negative correlation with the unemployment rate since the beginning of the last three recessions, reaching negative correlation levels not seen since 1982. This indicates a very tentative hiring situation. To what extent this is due to productivity or efficiency is a topic for another time. What is clear is that corporate earnings have turned positive well ahead of LFPR recovery, which is logical. What is unknown is the effect of policies, such as the extension of unemployment benefits, the general willingness of Americans to accept jobs they see as below their skill level, or the size of the shift from a manufacturing economy to knowledge economy (assuming the latter is less labor intensive). Whatever the case, it is clear that the "jobless recovery" is an indicator that the U.S. economy is in uncharted waters.
Economic Conclusion and Forecast
The above LFPR review indicates why the economy will take longer to recover from the 2008 recession than at any time in modern history. There are changes in labor demographics, employment cycles and business trends never dealt with in modern American economy. For these reasons, expect policy makers to stumble through the complexities (getting wrong more then they get it right) and expect businesses to continue to seek efficiencies which will stall large scale hiring for the next two years. The LFPR will adjust to new norms around 63-64%. Assuming the current situation (and no drastic policy changes), I anticipate unemployment to re-calibrate around a norm of 5-5.5% and GDP to grow at 2.5-2.9% by mid 2015, at which point the Fed will begin to raise rates priming the investment motor.
Part 2 on S&P Fundamentals to Come...
