Economy Is Much Weaker Than Believed While The Stock Market Ignores Fundamentals

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Includes: DIA, IVV, QQQ, SDS, SH, SPY, SSO, VOO
by: Power Hedge

Summary

The common narrative in the financial media today is that the US economy is quite strong but this is far from reality.

Factory orders have declined over the past 16 months on a YOY basis - this has never happened outside of a recession.

The jobs market is much weaker than advertised - currently 23.2% of citizens in their prime working years do not have jobs.

A significant portion of the jobs created since the end of the recession are low-paying jobs, not jobs that will support a middle-class lifestyle.

The stock market ignores these fundamentals and has increased in price even as corporate earnings decline.

There has been a significant amount of discussion by both politicians and the financial media about the strength of the United States' economy and about how much it has improved since the end of the Great Recession. However, a much closer look reveals that the true conditions are nowhere near as bright as we are being led to believe and in fact many indications show that the United States is on the verge of a recession if it is not already in one. As a result, the stock market as a whole may be considerably overvalued currently and may be on the verge of a decline.

One of the most accurate, if widely ignored, measures of economic strength is factory orders. This makes sense. After all, in a strong economy, businesses will seek to expand their operations in order to increase their profits. In many cases, they will require the use of manufactured goods in order to do that. However, they have not been doing that. In fact, factory orders have declined for the past 16 months when measured on a year-over-year basis.

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Source: Zero Hedge

It is worth noting that this has not happened in the past 60 years unless the United States has been in a recession.

Admittedly, at least one reason why factory orders are down is the decrease in the price of energy. This is due to the highly capital-intensive nature of the energy industry. The extraction of oil and gas from the ground, especially unconventional oil and gas, requires highly sophisticated machinery along with the manufactured infrastructure to transport that oil and gas. In addition, the broader decline in commodity prices has weakened the mining sector, another capital-intensive industry. As a significant proportion of the equipment used by these industries is manufactured domestically, the weakness in these industries has adversely affected the manufacturing sector as companies in the energy and mining sectors have reduced their demand for equipment.

Numerous commentators have been stating that the strength of the jobs market is a sign that the economy is quite strong. However, there are numerous signs that the jobs market is nowhere near as strong as we are being led to believe. As of the time of writing, the official unemployment rate is 5.0%. However, the method used to calculate this rate is flawed. This is because the official unemployment rate excludes "discouraged workers," or those individuals who want to work but are not actively seeking employment for whatever reason. There are, in fact, a very large number of these people. There are officially 8.1 million people currently unemployed. However, there are an additional 93.9 million Americans of working age that do not have a job and are considered to be "not in the labor force." That means 102 million Americans of working age do not have a job. It is true that some of the people included in this figure are retired and the number of Americans that are retired has been increasing since the end of the most recent recession. However, even if these individuals are excluded then the employment situation is still not as good as we are being led to believe. There are approximately 124.5 million Americans aged 25-54, an age range which should exclude both students and retirees. Of these, 28.9 million, or 23.3%, do not currently have a job. This is well above the official 5% unemployment rate.

Source: Bureau of Labor Statistics

Furthermore, there is evidence that the country never had an employment recovery as we keep being told. Evidence of this can be found by looking at a little followed metric known as the inactivity rate. Loosely defined, the inactivity rate is that percentage of people who do not have a job and are not looking for a job. These two charts, from the Federal Reserve Bank of St. Louis, show the inactivity rates for both men and women aged 25-34. As you can see the rate for both has been steadily rising since the last recession.

Source: Federal Reserve Bank of St. Louis

If the jobs market as a whole were truly strong, this is most certainly not what we would expect to see. Instead, the inactivity rate should be declining.

Another problem with the official unemployment rate is that it ignores differences between jobs. For example, a part-time minimum wage job is considered to be equivalent to a full-time professional job, but the two are hardly equivalent. Unfortunately, the former accounts for a significant portion of all job creation over the past several years. As Zero Hedge reports, over the February 2015 to February 2016 period, the nation's businesses added a total of 360,000 low-paying waiter or bartending jobs. Over the same time period, only 12,000 high-paying manufacturing jobs were created.

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Source: Bureau of Labor Statistics, Zero Hedge

This is not a one-time occurrence or statistical anomaly. In fact, this has been the case throughout the economic recovery. Over the December 2007 to February 2016 period, the nation's businesses added 1.6 million jobs waiting tables or tending bar. Over the same time period, 1.4 million manufacturing jobs were lost.

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Source: Bureau of Labor Statistics, Zero Hedge

In short, the prevailing trend over the past few years has been the steady migration of workers from high-paying jobs into low-paying ones. This is likely one reason why 51% of all American workers make less than $30,000 per year, according to the Social Security Administration. This is also far from being indicative of a labor market recovery. Unfortunately, that income level does not provide for much discretionary spending in many areas of the country so it is difficult to see how the economy can be described as strong in that situation.

Further evidence of economic weakness can be found by looking at corporate earnings. One thing that was impressive about the post-recession recovery was the growth in corporate earnings. However, that has now begun to change. Back in the third quarter of 2014, S&P 500 earnings hit an all-time high of $106 per share. Since that time, earnings have fallen 18.5% and came in at $86.44 per share during the fourth quarter 2015. Furthermore, analysts expect earnings to decline further in the first quarter of 2016. There are some analysts out there who will place the blame for this earnings decline on the fact that the U.S. dollar has been strengthening relative to other currencies and indeed this is one cause. After all, when the U.S. dollar appreciates, our exports become more expensive to foreigners, who will naturally purchase less American exports. This in turn negatively affects the top- and bottom-lines of domestic corporations. However, an investor should not ignore the weakness in the domestic economy as a cause either. Regardless, it does not truly matter why corporate earnings are declining, only that they are, and ultimately that is a negative sign for the stock market and for the economy as a whole.

Interestingly, the stock market has shrugged off this decline in corporate earnings. At the end of the third quarter 2014, the S&P 500 index stood at 1950, a lofty valuation of 18.4x after a period of record earnings. As of the time of writing, the index trades at 2102, despite the fact that corporate earnings are now significantly lower and are expected to decline further. In other words, the market appears to be completely ignoring economic fundamentals and will correct, but it is uncertain when that will be as the Federal Reserve continues to support the stock market bulls.

Another way to compare the relative value of the stock market over time is through the use of a metric known as the Shiller P/E ratio. This ratio, developed by Yale economist and Nobel laureate Robert Shiller, is calculated by averaging the earnings of the S&P 500 over the preceding 10 years and comparing that to the current index price. By using the preceding ten years of earnings, it is less likely that the ratio will be affected by either swings in the business cycle or swings in the stock market and it can help us more accurately compare valuation levels over time. This chart shows how this ratio has varied over time:

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Source: Multpl.com

As this chart shows, the Shiller P/E ratio currently stands at 26.35. This is significantly above its historical mean of 16.67 and historical median of 16.03. When we consider the broader weakness in the real economy, this could be a strong indication that the overall market is substantially overvalued. While this does not necessarily predict a coming decline, it does point to the presence of considerable risk in the market today.

Disclosure: I/we 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.