In the past two weeks, we have seen disappointing durable goods and regional Federal Reserve Board reports, indicating that manufacturing activity remains weak relative to the larger economy. Source: Chad Moutray, Chief Economist, National Association of Manufacturers
With each successive major economic report, it increasingly appears as if the U.S. economy is inching over a cliff. The latest of these reports includes Friday's 1st-Quarter GDP report, today's Dallas Fed Manufacturing Survey and Q1 earnings reports. If I'm right and the economy is quickly headed south, then the stock market has become significantly overvalued relative to fundamentals and could also be headed for trouble.
Q1-GDP was not as good as the headlines report indicated. The GDP growth of 2.5% reported for Q1 was less than the Wall Street economist consensus expectation of 3%. If you strip out the growth effect from Q1 inventory build, inventories grew $50.3 billion, GDP was only 1.5%. The inventory build means that inventory will have to be worked off before it's replenished, which will have a negative affect on Q2 GDP. Several economists have already revised their projected GDP growth for all of 2013 to below 2%.
Furthermore, growth in Q1 was "front-loaded" in January due to the one-time boost in income in December from special distributions of income, dividends and bonuses in order to avoid the higher taxation in 2013. Funds from this windfall were largely spent in January. February and March experienced a consumer spending slowdown as higher payroll taxes and gasoline prices hit the average consumer: Bureau of Economic Analysis.
This analysis is further reinforced by the fact that the personal savings rate fell to 2.6% in Q1, the lowest savings rate since 2007: Consumers Dip Heavily Into Savings. In other words, factors which helped to boost consumption in Q1, and therefore boost the GDP growth rate, are likely to be non-recurring going forward, which will have a negative impact on GDP.
Dallas Fed Manufacturing Report
Monday (April 29) the Dallas Fed released its monthly manufacturing survey for April. The business activity index came in at -15.6 vs 5.0 expected and 7.4 for March. This was the biggest one-month drop on record for this data series. The production index was -.05 vs the March 9.9 reading. The sub-indexes, which make up the main index showed that "conditions worsened sharply in April" (Bloomberg).
When you add this bearish economic report to the recent releases of the Empire State Manufacturing Index, the Chicago Fed National Activity Index, Durable goods (which I reviewed here) the Richmond Fed Manufacturing Index (-6 vs. 3 expected and 3 prior) and the Philly Fed Survey index (1.3 vs. 3.3 expected and 2.0 prior), it would be hard not to conclude that the U.S. economy is not only slowing down quickly but that there's a high probability that we will see possible negative growth readings in Q3 and Q4.
Corporate Earnings Don't Pass The "Eye" Test
Although several S&P 500 companies have reported net income results, which have exceeded Wall Street Consensus expectations, if you go over the results line by line, you'll find that many companies have used the standard GAAP accounting gimmicks to boost reported net income, while operating income has been flat to down. Even more revealing is the fact that many companies are reporting revenues that are below estimates: Marketwatch - revenues are falling short.
While it's not difficult for a company to use interpretative areas of GAAP accounting rules to generate non-cash net income - changing depreciation schedules, reversing deferred tax assets, releasing bad debt reserves into income, for example - it's difficult for a business to "fake" revenues. Clearly, if a lot of big companies are missing their revenue estimates, it means that the economy is not nearly as strong as stock analysts and corporate management teams have been expecting. The economic numbers presented above confirm this.
And if the economy is weaker than previously thought or expected, it means - at least to me - that there is a big disconnect developing between the fundamentals, which drive corporate stock valuations, and the level of the Dow/SPX. In other words, there is a high probability that the stock market in general is overvalued. Today, for example, the SPX nearly closed at an all-time high (although volume was the lowest of 2013). This makes no sense based on the evidence I have been presenting over the past couple of weeks about the weakening economy.
I believe the stock market has a high degree of risk that is not even remotely priced into stock valuations. With the caveat that it is likely that the Fed, at some point in the next six months, will have to once again expand its QE program, I believe that bearish bets on the stock market have a high probability of making a lot of money over the next couple of months. Certainly the seasonal effect of a stock market decline, on average, in May and through the summer adds to the possibility of a big stock market correction. The least risky way to play this view is to short the SPY or buy June/July slight out of the money puts on SPY. More aggressive speculators can buy SDS - 2x short the SPX - or SPXU, which is 3x short the SPX.
I am confident enough in my view that the stock market is going to experience a sharp correction, that I plan on loading up on SPXU after Friday's employment report. I realize the Fed will eventually re-up QE, but I don't think that will happen until the tanking economy becomes so obvious that it hits the FOMC over the head.