Economists and market strategists are raising estimates for real economic growth in lockstep with the new highs achieved for the stock market indices. Last week Bill Gross abruptly doubled his estimate for GDP growth in 2013 to 3%. One impetus for this optimism, which I have seen referenced in numerous sell-side research reports, is the fact that U.S. consumer financial obligations as a percentage of disposable personal income have fallen to levels not seen since 1981 and 1994. A chart depicting this decline can be seen below. Both years presaged time periods of strong economic expansion and stock market performance. The logical conclusion is that today's lower debt burden, when combined with the wealth effect of rising home and stock prices, will lead to a similar increase in the rate of consumer spending. Consumer spending accounts for 70% of economic growth.
Perhaps in anticipation of these developments, the consumer discretionary sector was the second-best performer in the S&P 500 last year, returning 23.9%. The sector continues to lead the broad market in 2013 with the two largest ETFs in terms of assets, the Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY) and SPDR S&P Retail (NYSEARCA:XRT), handily outperforming the S&P 500 (NYSEARCA:SPY). Continued outperformance is not supported by the macroeconomic fundamentals, and I believe we will see a period of underperformance relative to the broad market through the remainder of this year.
While debt levels have clearly declined, this has largely been the result of write-downs and write-offs, rather than a healthy reduction in debt through loan repayments that would be reflected in a rising savings rate. The savings rate remains near multi-decade lows. Low debt levels do not portend increases in the rate of spending on their own. Increases in real consumer spending are derived from a combination of increases in real income with what consumers can and are willing to borrow. Confidence is the most significant factor in consumers' willingness to borrow.
Comparing today to the early 1980s and 1990s is nonsensical. In the early 1980s there was a tax-cut anomaly that led to a real-estate investment boom, which is not likely to be repeated today. The Tax Reform Act of 1981 allowed consumers to purchase residential homes to rent so that they could deduct the losses generated by accelerated depreciation against earned income. That was largely responsible for the rise in financial obligations during that period. In 1994 there was a steady rise in real average hourly earnings, which can be seen in the chart below, that fueled consumer spending growth. Today consumers face both tax increases and declining real wages.
The Bureau of Labor Statistics (BLS) reported last week that real average weekly earnings for all employees declined .2% for the month of February on a year-over-year basis. I think the weekly earnings figure is more relevant than hourly earnings because it accounts for any additional hours worked. There has been virtually no increase in real disposable income over the past three years, as seen in the chart below, with the exception of the spike at the end of last year caused by the accelerated dividend and income payments intended to avoid higher tax rates. The bottom line is that consumers simply can't spend what they don't earn unless they have the confidence and credit available to borrow.
Confidence appears to be waning. Despite the surge in stock and home prices in recent months, the University of Michigan's consumer sentiment index fell in March to its lowest level since December 2011. Their preliminary index, which measures expectations six months from now and serves as a better indicator of consumer spending, fell to its lowest level since November 2011. Without confidence, we are unlikely to see the increase in borrowing needed to offset the decline in real wages that is required to realize an increase in the rate of consumer spending. I think waning confidence also undermines the reported strength in the most recent employment report, which I discussed in an article last week.
I realize that these are details that fall well beneath the headlines that are used by the computer algorithms to trade, but eventually these details will be the headlines. Until then, we will see more spin, as was evidenced in last week's retail sales report. The Wall Street Journal reported that "retail sales rose 1.1% to a seasonally adjusted $421.4 billion, the Commerce Department said Wednesday. January's increase was revised up to 0.2% from a 0.1% earlier estimate. The report shows consumers absorbing the combined strains of stagnant incomes, rising gasoline prices and a two-percentage-point increase in the payroll tax that went into effect at the start of the year." Bloomberg jumped on the investigative reporting bandwagon, commenting that "sales at U.S. retailers climbed twice as much as forecast in February, showing improving job prospects are helping consumers and the economy overcome higher taxes and gasoline prices." Extrapolating the reported increase in retail sales, Joe LaVorgna, the lead economist at Deutsche Bank Securities, raised his forecast for first-quarter GDP to a 3 percent pace from a 1.5 percent prior estimate.
Once again, the devil is in the details. When we pull out the seasonal adjustment in the Census report that led to the $4.4 billion sequential gain in retail sales, or a 1.1% increase, we find that sales actually declined $1.3 billion for the month of February. This is depicted in the chart supplied by ZeroHedge below. This was the first sequential decline in sales for the month of February since 2010. That might be useful information for investors to have since the corporate earnings that rely on these sales are not seasonally adjusted.
Based on my research, the increase in consensus estimates for economic growth by the Wall Street punditry doesn't make much sense. The pundits are lost in the minutia of high-frequency economic reports, losing sight of the macroeconomic themes that dictate long-term trends. They are anticipating stock market wealth magically trickling down to the consuming masses, but it isn't happening. The last I checked, your 401k doesn't come with an ATM card. Nor can a homeowner spend the equity gained over the past 18 months as home values have recovered, unless that homeowner is an investor flipping a property purchased in a depressed market within the past two years. This is why the rate of consumer spending growth, otherwise known as Personal Consumption Expenditures (PCE), continues to decline on a year-over-year basis, as seen in the chart below.
It is also important to remember that the consumer-related sectors have been significant beneficiaries of the federal government policies focused on consumption-inducing stimulus during this recovery. We had cash-for-clunkers, -appliances and -homes, followed by the payroll tax cut that lasted two years. Each of these policies simply stole forward demand in hopes of creating a better economic backdrop at the time the stimulus was implemented. Fiscal stimulus efforts have come to an end. Now stock prices, which normally act like discounting mechanisms, are in a tug-of-war between the Fed's monetary policies and weakening fundamentals. At the moment, quantitative easing (QE) is winning the tug-of-war, but its continued success is dependent upon improvement in the economic fundamentals. I see these fundamentals deteriorating, which is why I think it is very important for investors to focus on the devilish details that are routinely glossed over to support the current uptrend in markets. I would be wary of investing in the U.S. consumer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.