5 Reasons The U.S. Is Headed Towards Recession

| About: SPDR S&P (SPY)

Summary

Corporate Profits have peaked but corporate debt continues to rise.

Consumer balance sheets are worse off than the mainstream media leads on.

Structural unemployment is rampant in the U.S.

The market is overvalued by several measures.

Recessions are hard to predict. Wall Street economists, central bankers and academics alike have trouble predicting downturns in the economy, and by the time they sound the alarm, the market has already declined significantly. This article isn't a prediction of an imminent recession; however, the following data points are sounding the alarm even as the market marches higher.

Central bankers continue to resort to extreme measures to spur growth and inflation, which still remain illusive, so any position betting against the market is fighting a much larger force propping up the markets. Even as the economy has reached "full employment," according to the official unemployment rate, and core inflation has hit 2.1%, the Fed still hesitates to raise the Fed Funds rate by 0.25%. This fact alone is proof there remains serious soft spots in the U.S. economy. Here are several measures that prove this point further.

1) Corporate Profits have peaked but debt continues higher.

Revenue and earnings growth has hit a plateau over the last year with S&P 500 revenue per share topping in 2014 and corporate profits later topping in 2015. Companies are able to cut costs to meet EPS estimates each quarter, but the one metric you can't manipulate is revenues. Eventually, the slowing and slightly negative revenue growth hits the bottom line. The real problem with profits topping is one, it signals slowing growth in the economy, and two, negative growth makes it harder to service existing debt.

Mainly due to low rates, corporations have been on a debt binge since the GFC and this metric continues at an unhealthy pace. We have already seen the fallout of artificially low rates and subsequent debt binge in the oil and gas sector. The rest of the economy will experience a similar outcome when growth slows even more. This is exemplified by the following chart from the St. Louis Fed (FRED):

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Further evidence that over lending is starting to show signs of deterioration is evidenced in the following chart. Every recession in the past 25 years has been preceded by a large rise in delinquencies.

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2) Consumer balance sheets are deteriorating

While consumers dumped much of their mortgage debt after the housing crisis, other forms of debt have taken its place. Not to mention that a higher percentage of people are now renting than purchasing homes. Thus, a large portion of the population has missed out on a huge increase in housing prices and the dream of owning a home is well, just a dream.

This is further evidenced by home ownership rates plummeting. One sign the consumer is re-leveraging is a large rise in credit card debt. Essentially, the rise in credit card debt means two things. One, the consumer is having trouble meeting basic living expenses and is placing more of their monthly expenses on their credit cards. Two, consumption is being pulled forward and this means less consumption in the future.

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The second sign the consumer is re-leveraging is the well-covered topic of student debt. Student debt now stands at over $1.3 trillion. Considering wage growth is relatively stagnant for entry level jobs, any college grad has little ability to save for emergencies, let alone a house in the future. Millennials are the largest cohort of the population and will make up the majority of workers in the next 5 years. Essentially, their earnings and spending power are being cut by $1.3 trillion (plus interest) even before they start their first jobs.

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3) Sub-prime has moved from housing to the auto industry.

A number of factors have contributed to the rise in auto debt. Consumers' inability to shell out the full price of a new car, stagnant wage growth, low interest rates, and lack of government spending on infrastructure have all contributed to the rise in auto lending. For anyone who is wondering the Federal government spends less than 3% on mass transit and rail. It's actually pathetic we are the only advanced economy without a bullet train. In Q1 2016, leasing as a percentage of vehicle sales was the highest it has ever been at 36.1%.

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4) Structural unemployment remains

Even after almost 10 years of ZIRP and several rounds of QE, the U.S. still has structural unemployment. This is partly to blame from the GFC but there is an underlying problem in our education system. High tech skills are not being taught to the degree they need to be in an uber competitive global world. Hence, the jobs that are high-paying and available are not being filled.

To put things in perspective, the U.S. added almost 4.5 million net new jobs since peak employment in 2007. That is after losing all the jobs from the GFC, we have only added 4.5 million new jobs in the U.S. over 9 years. In that same time frame, the U.S. population has grown by over 20.5 million people. This is further exemplified by the decrease in the labor force in the U.S., which is shown in the chart below.

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One thing is for certain, a lower proportion of the U.S. population is employed versus before the GFC. This trend is also confirmed by the increasing number of U.S. citizens receiving food stamps and other transfer payments from the Federal government. The official unemployment rate looks low, but that is only because more people are being removed from the labor force each month as a statistical farce.

5) The market is overvalued.

Looking at the overall valuation of the market, it looks expensive on several measures. First is market cap to GDP ratio, which is a measure Warren Buffett has cited many times. By this measure, we are approaching Dot.com bubble levels.

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The second measure is the P/E of the S&P 500 and Robert Schiller's CAPE (cyclical adjusted P/E). Both are near decade highs and any time these measures are above 20x, forward returns are quite poor in the near term. The P/E in the following chart is based off FactSet's consensus EPS estimate of $125.

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Another report recently put out by FactSet detailed the difference between GAAP and non-GAAP EPS for the Dow Jones Industrial 30 Index. The difference between GAAP and non-GAAP measures has increased substantially and now sits at 28.9%. If you discount the S&P 500 consensus EPS of $125 by 20% (I used 20% to be conservative to get to GAAP EPS), you get about $100 per share. This puts the P/E of the S&P 500 at about 21x. Like I said, forward returns are quite poor when P/E multiples for the market are above 20x.

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I for one am very cautious in this market and have used high prices to lighten up my exposure to equities. It's hard to argue with market action even if it is driven by short covering. It is possible the market could head substantially higher from these levels, but from these levels, it is all P/E expansion without any renewed growth in revenues and earnings. If the Fed does raise rates in June or July, it will most likely be a mistake and the markets will suffer.

For the savvy investor, however, it will be a great opportunity to short the market. Some people say timing is everything and when it comes to the market and I definitely agree. Trying to short the market outright, betting on a decline is not easy but when major investors like Carl Icahn, George Soros and Stan Druckenmiller are waving the flag, it's time to listen.

As of the writing of this article, I have established short positions in SPY and QQQ with the market down roughly 1%.

Disclosure: I am/we are short SPY, QQQ.

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.

Additional disclosure: I established short positions in SPY and QQQ in the last 24 hrs. I may cover these positions in the short term and they should not be perceived as validation to short the market from current levels. Always do your own homework when trading or investing.