The good news is well understood. The U.S. stock market is at all-time highs, at least in nominal terms. If we adjust for inflation, we are still below the levels of 2007 and 2000. Regardless, the achievement of a nominal new high cannot be interpreted as anything other than good news.
Corporate earnings and profit margins are also at all-time highs, interest rates and borrowing costs are at all-time lows, and the government's measurement of inflation is negligible. Furthermore, the Federal Reserve has assured investors that short-term interest rates will remain near zero (ZIRP) well into 2014, and that it will continue to purchase $85 billion of mortgage-backed and Treasury securities indefinitely, providing freshly minted liquidity to the banks to do with as they please. This is a utopia for investors. It is like 1999, except that Ben Bernanke is your margin clerk, so you can lever up and never worry about getting a call.
This brings us to the bad news, which is largely being ignored. The real economy is horrid for the vast majority of Americans. The Fed's deluge of credit has disproportionately benefited those who didn't need assistance in the first place. As a result, the cracks in the foundation of our economy are beginning to show up in the macro-economic data. This decoupling of the stock market from the real economy has grown extremely pronounced over the past few months, as can be seen below. Markets are supposed to look forward, but this one only looks upward and over its shoulder.
Rates of growth in nearly every economic indicator outside of housing are either slowing dramatically or turning negative. Over the past two months the Purchasing Managers Index for manufacturing and services has weakened, hovering near the lows of last summer. Here is a visual of what is now a year-over-year decline in new factory orders. It is not inspiring.
Thursday morning we learned that wholesale inventories rose .4% in March, above the consensus estimate for a rise of .3%, which contributed to the bounce we saw in first-quarter economic growth. The bad news is that wholesale sales unexpectedly plunged by 1.6% in March, which was the largest decline in four years, as can be seen in the chart below. This does not bode well for future inventory or consumption figures.
Even within the strongest sector of the economy, the ancillary growth effects of the resurgence in housing are starting to wane, as can be seen in the decline in renovation spending that followed the surge resulting from Hurricane Sandy.
The headline number from the April employment report glossed over several cracks that should be of investor concern. We learned that the average workweek declined by 0.2 hours. This might not seem significant at first glance, but it was the largest decline since April 2009. Companies reduce hours at the early stages of economic contractions, prior to laying off workers. Also under the hood of the headline number was the fact that the quality of the jobs this economy continues to create is horrible. At the current rate, the majority of Americans are going to be tending bar, waiting tables or holding multiple temp jobs to make ends meet. The younger generations that have realized no net new job gains are going back to school, under the hope that things will be better after they graduate. Meanwhile, the salaried positions with benefits are a dying breed. Even the banks, which are the recipients of the Fed's largesse intended to create jobs, are laying off workers. How ironic is that? JP Morgan (JPM) announced plans to shed 17,000 positions in February.
The lack of job quality is not evident in the monthly personal income figures that appear to be muddling along, but it will be detrimental to consumer spending down the road. Hypothetically, if Jamie Dimon is awarded a $20 million cash bonus, personal income rises by $20 million, just as it would if 10,000 middle-class Americans received a $2,000 raise. When Jamie walks into a room with those 10,000 wage earners, the gross personal income figure rises for everyone in that room, along with the average earned, but the median actually declines. Wealth disparity, which has grown demonstrably over the past decade, is distorting the personal income figures that investors use to measure the health of the U.S. economy. Quantitative easing, in its current form, is exacerbating that disparity. Median household income declined 1.1% in the month of February, and it is down 5.6% since the recovery began in June 2009. Trillions of dollars created and borrowed, and these numbers are still moving in the wrong direction.
There are implications for personal consumption as well. If 10,000 middle-class Americans earn an additional $2,000, they will either pay down debt or spend that money on the goods and services that lead to growth, both of which have positive implications for the broader economy. Jamie Dimon is more likely to purchase investment securities with his bonus, which has very little impact on the broader economy. It certainly doesn't lead to job growth.
There has been an encouraging decline in household debt service costs as a percentage of disposable income, which many expect to fuel a consumption-led expansion moving forward. The bad news lies beneath the gross ratio, which is misleading. If Jamie Dimon pays off or refinances a $5 million mortgage he has on a vacation getaway in the Hamptons, then the overall ratio of debt payments to disposable income declines, even if the other 10,000 middle-class Americans who are collectively considered in the figure see no economic benefit. This is another statistic, which in aggregate, appears to be stronger than it really is. Case in point, in reviewing the most recent report on household debt service payments and financial obligations as a percentage of disposable income, I noticed that while the overall ratio has declined, it has been steadily climbing for renters. In the fourth quarter of 2012 the ratio for renters stood at its highest percentage (24.14%) since the fourth quarter of 2009. The number of renters is growing at a far faster pace than the number of homeowners today. The devil is once again in the details.
I am searching for the catalyst that will stem the current erosion in economic data, but I have yet to find it. For those who are looking for a lift in global growth from the developing world, which the current rotation into the cyclical sectors of the stock market seems to indicate is under way, don't hold your breath. It may be the right call down the road, but it is too early. The HSBC Emerging Markets Index, which tracks the Purchasing Managers Index in 16 different emerging countries, declined again in April. The weakness was not just export-oriented, as services activity also declined.
I think that what's very ugly is that the bad news today is likely to get worse tomorrow at a point when the backdrop for the stock market does not look very healthy. Unfortunately, many investors are blinded by Chairman Bernanke's artificial insemination of newly created dollars into the stock and bond markets, using the banks that are supposed to be lending as his conduit.
As a result, we have distortions of historic proportions in different sectors of the financial markets. The yield on junk bonds, as measured by the Barclays US High Yield Index, fell below 5% yesterday! This was an all-time low. I pray that the investing public, in a ravenous quest for yield, is not sucked into such a horrible risk-reward scenario at this juncture in the economic cycle.
The implication from current levels of margin debt in the equity market is also not a good sign. Perhaps quantitative easing will nullify the historic precedent, but that would require subscribing to the logic that "this time is different," which has been unsuccessful 100% of the time. NYSE margin debt now stands at $380 billion, nearly matching the July 2007 peak of $381 billion, back to all-time highs.
Finally, in a market where individual stocks rise and fall each day, but the broad indices relentlessly levitate day-in and day-out, a decline in corporate index earnings that must inevitably follow the decline in overall corporate revenues that we see today should be the final curtain call for this bull market run. There is little recognition of the fact that record profits, supported by unprecedented margins, have been a derivative of unsustainable debt-induced consumption at the government and household level. Our fiscal stimulus has been wholly focused on consumption, rather than on the investment that leads to sustainable job growth. Our monetary stimulus was originally sold with the image of helicopters dropping cash into the economy and onto the balance sheets of American households to stimulate demand for goods and services. Instead, it has been dropped into a banking system that has hoarded it as reserves for its own proprietary investment purposes. Reduced levels of savings have offset a rapid decline in investment to perpetuate the growth in profits. Reducing this debt, which combined now stands at approximately 260% of GDP, will erode current margin levels and lead to a decline in profits that share repurchases will not be able to offset.
Disclaimer: 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.