The Massive Elephant In The Economic Room

 |  Includes: DIA, GLD, IWM, QQQ, SPY, UUP
by: Carlos X. Alexandre

The headlines highlighting how the American economic recovery remains elusive, continue to flow. Meanwhile, every week a ray of hope is delivered by U.S. jobless claims, and a comparison is made to historical levels and how we are certainly on the rebound. Lately we learned that U.S. GDP will be adjusted upward by 3%, although the revision will go back to 1929 and produce virtually nothing.

The US economy will officially become 3 per cent bigger in July as part of a shake-up that will see government statistics take into account 21st century components such as film royalties and spending on research and development. Billions of dollars of intangible assets will enter the gross domestic product of the world's largest economy in a revision aimed at capturing the changing nature of US output.

Let's take a step back and look at the investment forest. Despite the S&P 500 (NYSEARCA:SPY), Dow Jones Industrials (NYSEARCA:DIA) and Russell 2000 (NYSEARCA:IWM) records being broken recently, while the Nasdaq 100 (NASDAQ:QQQ) is still well below its peak, the stock market is virtually even after 12 years, considering that inflation is not taken into account. Yet we've accumulated more economic problems than we ever had in 70 years, not to mention government debt. There's a structural change that hasn't been fully acknowledged, and the ongoing adjustment is not understood.

However, and with increasing frequency, everyone mentions it in passing: Labor Force Participation Rate. It must be stated that the above mentioned jobless claims are distorted, because the fewer people work, the fewer that are eligible for benefits, rendering the jobless claims numbers somewhat useless and not a reliable labor market indicator. But every time the unemployment rate declines, the lower number has become reason enough to celebrate. The current unemployment rate of 7.5% sounds far better than the real rate of 12.0% that is calculated using the Labor Force Participation Rate average between 1990 and 2006, and that is why the economic recovery is missing in action. As the chart below demonstrates, unemployment has been virtually unchanged over the last four years.

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As an example, and as inspiring as the official unemployment number looks, if the economy was in recovery mode, the average new-car loan wouldn't have hit a record of 65 months during Q4-2012, up from 63 months only one year ago, not to mention "How the Fed fueled an explosion in subprime auto loans." We're stretching as much as we can before everything falls apart, again. In addition, and more stock market specific, some "central banks, guardians of the world's $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk-averse investors toward equities." Needless to say, central banks should not be in the equity business. Period!

Much of the analysis being conducted is misdirected and too narrowly focused, and there's a futile attempt to compare our current condition with history, while assuming that nothing has changed. Thus the frustration when answers appear certain, and then results aren't forthcoming. Let's look at a simple chart that compares the U.S. Trade Balance with the Labor Force Participation Rate over the last five decades.

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While trade deficits were minimal during the eighties, and didn't affect the Labor Force Participation Rate, the trend changed in the nineties, and trade took its toll as the domestic labor market started to feel the pinch around 1999 in response to the trade deficit acceleration after 1996. It didn't happen sooner because the mania provided temporary support. Obvious, isn't it? Understandably, the corporate world's focus is on profit, which all investors love, and it was achieved through lower labor costs abroad. But the U.S. consumer market, the largest and strongest on the planet, depends on a healthy labor market at home to feed the corporate bottom line, and, as expected, "expert" claims that emerging markets would replace the traditional U.S. consumption engine are proving to be a myth. Furthermore, the gap between civilian population and labor force/employment growth rates continues to widen.

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Although the employment growth rate has improved as compared to labor force growth, as shown below, employment is not keeping up with population, and is holding economic growth hostage. Over 20 million new jobs are needed to resume the economic normalcy of the past, translating into 600,000 new jobs every month from this point forward, for the next 3 years, non-stop, and largely unattainable. So much for 150,000 new jobs per month!

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The longer the differential endures, the worse it gets, and we'll have to adapt to a different economic engine. However, if that is the case, all the exporting countries that depend heavily on the American consumer must adjust as well, and the fixed investment that was designed to take advantage of the domestic expansion of the Labor Force Participation Rate of yesteryear, and cheaper labor sources overseas, must be deflated both domestically and overseas. Overcapacity is deflationary, as the Chinese producer price index is showing.

We're in the midst of a very different economic condition, indeed, and considering all the stimuli employed thus far, and the unusual monetary policy, total U.S. GDP is only 5.6% above where it was in Q2-2008. Many "experts" are baffled while seeing the "Fed's credibility tested as inflation drifts below target." Meanwhile, the discord among Federal Reserve members has been elevated, and while Chicago Federal Reserve Bank President Charles Evans credits QE3 for the improved labor market, if one can make such statement, Philadelphia Fed President Charles Plosser countered, calling "the effects of the bond-buying program 'dubious.'" I side with Plosser.

The last chart below delivers a clear view of how labor force growth has virtually stalled over the last 5 years. In addition, while civilian population has grown 14% since the beginning of 2001, the labor force only expanded by 8% and job openings declined 26%, even after the rebound since 2009.

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Even though trade deficits were caused by short-sighted corporate tactics, the decline in the Labor Force Participation Rate is only a consequence, not a cause. An understanding of the product life cycle -- introduction, growth, maturity and decline -- coupled with financial behavior modification will provide the clues that everyone is seeking, while showing that all present economic theory is virtually useless because, and as well meaning as they are, most theories were formulated before the key event. How can a "What if "x"…" question be posed, when "x" didn't exist?

The sins of the past cannot be absolved through wishful thinking, and the cure lies in accepting losses through deleveraging and then moving forward through behavior modification. It will not be Armageddon, but it will not be painless either, and I will publish the root cause toward the end of this year. Meanwhile, I extend the challenge to decipher the clue to all illustrious economists, Nobel laureates included, and anyone so inclined, although economists may consider the idea to be beneath them. A teaser, without a doubt, but what fun with it be if the farm was given away on the first pass?

Suffice it to say that from a product life cycle perspective, we're only half-way through the economic decline phase, and each phase takes a generation to complete, because only generations modify behaviors, driven by experiences of the past. Just ask anyone that lived through the Great Depression, and observe their frugality. Then new generations commit the same mistakes, and the cycle starts again, while the key is always to identify the shift that will trigger the next economic disaster, way down a long winding road. And it's always about money and wants, not needs.

As an added clue, the same core principle applied when I stated that "China's 15 Minutes of Fame Are Up," although the events are different. I'm not Nostradamus, and I am not seeking "guru" status either, mostly because the widely used Sanskrit word is related to the word "grieve." I have realized over the years that answers to economic issues are always simple, mostly because human behavior is always the driver, and do not hinge on time consuming complex formulas and models that mimic true scientific research in an attempt to elevate the field of study. Otherwise the Federal Reserve's mechanical approach to monetary policy would have worked already.

What we have on the global financial and economic stage is an unusual three course meal: The debacle was the appetizer, the housing bubble was the main course, and European debt is an enormous dessert that will be shared by all the guests at the table, and there isn't a thing anyone can do to avoid taking a sweet bite. When choices are made, consequences must be accepted, although many times we cannot see all the ramifications before we embrace new ideas.

From a shorter term stock market perspective, we've been listening to the repetitive seasonal mantra to "Sell in May and Go Away," and, statistically speaking, how some months are better than others, while the authors, unknowingly and indirectly, are actually embracing a form of market timing. Yet, most of them will be the first to state that market timing doesn't work, although their understanding is lacking and strictly focused on picking specific dates, when in fact market timing is nothing of the sort. It's about identifying the subtle flow of capital and sentiment, and at times conflicting camps actually keep markets in neutral.

One important point is that while stock market performance is not immediately related to economic conditions, because the majority of investors cannot see the train coming or going, the notion that the market discounts the future is highly debatable. Reason being that if the majority of investors were cognizant of deteriorating or improving economic conditions, the market should slowly adjust. As it stands, markets burst higher on hope and then crash on reality, creating economically disruptive shock waves. Markets also crash on despair, and then rally on reality. My added observation here is that markets react and don't discount.

Looking forward it may be that the song title should be "Sell in May and Don't Come Back for A While," although the probability, as I see it, is that the other shoe will not drop before 2014 rolls around. But that is only a probability, because considering the daily barrage of official talking heads, and the ongoing ferocious attempts to steer their respective economies using a variety of conflicting tools on a global scale, somebody may push the red button unwillingly. One thing to keep in mind is the U.S. dollar (NYSEARCA:UUP), and despite normal pullbacks, the dollar has continued to strengthen since April 2011, one of the major factors affecting gold's dismal performance (NYSEARCA:GLD) over the last two years. At this juncture, and even with the information above, the U.S. is still the strongest among the weak, even though trying to establish an immediate correlation between economic data and market performance will be detrimental to one's portfolio and sanity.

One last point. Calls for the bond bull market to end are most likely true, but for all the wrong reasons. It's not inflation, but rather supply by governments against increasingly more finicky investors that will demand higher rates to compensate for risk, not to mention supply exceeding demand. While someone must fund the debt, printing money cannot continue, because the caveat is that the monetary system would no longer be trusted, and then chaos and real hyperinflation would ensue, Zimbabwe style. Remember that above all, investor sentiment is supreme, and thus far there's a belief that the central bank balance sheet expansion exercise will reverse at some point. And it will, because the Fed, and all other central banks, are not entirely disconnected from reality. The unrecognizable HYDE syndrome - High Yield in Deflationary Economy - as I like to call it, will come into play, and the fact that the acronym sounds like a revival of Edward Hyde, the evil personality of Dr. Henry Jekyll, is only a coincidence. Or not!

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.