Economic Myth And Financial Reality

Includes: DIA, IWM, QQQ, SPY
by: Kevin Flynn, CFA


The myth of the 5% economy.

GDP and retail sales trends.

Near and longer-term scenarios.

If you have been following the market in recent weeks, you will have noticed by now the growing tale of the 5% economy as we end 2014. This useful "fact" is now repeated many times daily by fund managers, long-only traders, and anyone else who is long and/or bullish on the stock market and wants (needs) to justify the returns.

The 5% myth - yes, Virginia, it is a fairy tale - is an important, if not vital cog in the marketing of the "very strong" U.S. economy meme to the purveyors and holders of services that depend on rising stock prices for prosperity. For the fifth December in a row, I am reading confident, widespread predictions of the long-rumored, long-awaited, much-predicted "inflection point" in the U.S. economy that has somehow escaped detection despite the many heralds of its imminent arrival. I don't believe that 2015 will see it either.

The Bureau of Economic Analysis did indeed report that GDP grew at a 5% rate in the third quarter - 5%, that is, after annualizing and seasonally adjusting. While I have nothing against such data treatment, you need to keep in mind that the process is going to result in single data points that need to be treated more as general directions than precise co-ordinates.

The revision to 5% stems from adding about $44 billion to the second estimate of current annual GDP through September to be $17.55 trillion, or a difference of 0.25%. I don't dismiss such numbers as wrong or irrelevant, but do maintain that they are of limited precision. The four-quarter rate of nominal GDP gives a clearer picture of economic direction, and that stood at 4.3% through the end of the fourth quarter, up from 4.27% at the end of the second. Indications are that the four-quarter rate will revert to 4% by year's end, which matches up with the current, intermediate trend of 4% compound nominal growth over the last four years.

To those who want to argue that it's the most recent trend that matters, one only has to cite the (-2.1%) result of the first quarter as being no decisive figure either. However, if you want to blame the first quarter on the weather, then logical consistency demands attributing some amount of subsequent improvement to the weather too. Recall that the better, yet still subdued results for April-May economic data were somewhat of a disappointment at the time of release - indeed temperatures stayed cool in much of the country well into May. I suggested at the time that some of the rebound effect would probably come in the third quarter, and that appears to have been the case.

It wasn't only weather, of course. Recall also that the first quarter's rough weather also coincided with a drawdown pulse in the rhythm of inventory use and replenishment, a phenomenon expected at the time, and that the third quarter coincided with a period of inventory addition. Thus, the former result looked worse than the real underlying trend, but in similar fashion, the latter result also looks better than the underlying trend. The current quarter and the next are scheduled to see inventory drawdowns that could pull the four-quarter rate back below 4% (nominal), especially if heavy weather intervenes, which it often does.

That said, the 4% trend rate has remained remarkably intact and I don't see any current evidence that it has changed. The contemporaneous four-quarter rate has ebbed and flowed over the recovery, with the most recent rate of 4.31% being above average but not exceptionally so: the rate was 4.57% at the end of the fourth quarter of 2013, and has been above 4.5% several times in the last few years, with a peak of 4.7% in Q1 2012. It has also been below 3.5% several times, with the low coming not after the first quarter of 2014 (3.28%), but after the second quarter of 2013 (3.26%).

GDP measurement is not really that precise, of course, and the latter two results are virtually the same. The point is that mini-cyclical variations, particularly in inventory drawdown and rebuild, cause the four-quarter rate to oscillate in some degree around the trend rate of 4%. None of these oscillations have meant an inflection point for good or ill.

Another example of economic hyperbole was the November retail sales report (+0.7%, seasonally adjusted). The only surprise in the number was generated by Wall Street, as the number was better than the Street's own consensus. The report wasn't bad, certainly, but it wasn't great either, and the subsequent superlatives and plaudits were distortions at best, fabrications at worst.

The principal myth being printed up since that time is that (as usual) the number this time represents some kind of definitive evidence of acceleration. The central reason underlying the original thesis were that stocks had sold off in the three days prior to the report, and the consensus estimate had been a lowball number.

The reality of retail sales is that there has been no underlying change in total spending. The trailing-twelve-month (TTM) rate of growth has been just under 4% all year - about the same as nominal GDP growth. The last time TTM sales grew faster than 4% was December 2013, at 4.1%; the last three months have all rounded to 3.9%. The year-on-year change for November was 3.36%, compared to 3.39% a year ago. Again, not evidence of an inflection point.

Sales excluding autos and gasoline have improved somewhat, with a TTM growth rate of 3.7% through November, compared with a year-ago rate of 3.4%. As I constantly remind people, though, lower gasoline prices don't increase total spending. If we take $5 billion out of gasoline and spread it through other categories, those categories may benefit but the total doesn't change - we need income growth for that. The switch out of energy costs and into other categories doesn't benefit the economy as much it would have twenty years ago, either - the apparel and electronics we can buy in place of the gasoline are nearly all Asian-made, thanks to our clever outsourcing of domestic production. The gasoline we buy now has the highest US content in forty years.

Lower energy costs are definitely a boon for business and for the economy at large over time. What impact they may have on the current cycle, however, is hard to estimate and mostly guesswork. Clearly some of the fall in prices is demand-related, though the Street tends to focus almost exclusively on the supply aspect of it. Some of it is also pure momentum, and prices are quite likely to overshoot to the downside before rebounding; they may already be doing so now. When prices might rebound is something I don't dare to guess, but the business cycle will not last forever, notwithstanding $2 gasoline.

Yet so long as the stock market trends higher, one can expect the volume of noise about the "great" economy to rise during rallies and anxieties about global weakness to rise during pullbacks. The current rally is being driven almost entirely by the calendar, the Fed, and the sensation that everyone else believes it so you might as well too. It's been that way since the end of 2012, and while an abrupt ending is certainly possible - Russia in particular comes to mind, but the Shanghai stock market is also in a bubble - I don't see such an ending in the immediate future. Pullbacks yes, increased volatility likely, but we only entered the peak of the current business cycle in August. On average, they last about a year.

It's hard to make a case quite yet either for the bubble blow-off scenario that has been the subject of excited speculation in recent days. The recent CEO Roundtable in December was decidedly downbeat, and FactSet reports that earnings estimates for the fourth quarter have already been cut to 2.6%. With earnings season two to three weeks away, that number should fall more in the interim, to about 2%. Add back the cushion of about three hundred basis points that the Street builds in, and the expected growth rate is about 5% (meaning all of 2014 is at about 6%).

Some of that decline is due to pain at energy-related companies, and undoubtedly the sector will get more than its share of the blame. However, the current quarter is only tracking at about 2%-2.5% real GDP, leaving 2014 as another sub-2.5% year, and the first quarter doesn't rate to be much higher after inventory trends are taken into account. If a bubble does get going, it's going to need a better narrative than that, and may have to wait until the spring, when another inventory rebuild begins and can refire the story about "Fortress USA" (a.k.a. as Decoupling 2).

The Federal Reserve may be on the verge of acting by that time, but here I hold two contrary opinions. The first is that stocks will probably rally on the first increase, as they have usually done in the past. When increases are well-telegraphed, any self-respecting bull market will blow right past the first few rounds, using such excuses as "the Fed is on the job!" or, "It means the economy is great!" The second is that the rate increases will matter little to the real economy anyway.

Since Paul Volcker left decades ago, the Fed has tended to act after the business cycle has peaked. It isn't the modest levels of interest rates that have choked off recent expansions, but the fact that rate increases have come in the latter stages of the cycle that has led people to mistakenly attribute cyclical endings to central bank policy. I doubt very much that the Fed will have time to get short rates as high as even two percent before the current cycle ends, not without the intervention of some technological marvel on the order of aliens landing from Mars.

The downside of the Fed's obsession with creating an artificial financial stability is visible in the last two crashes of the system - the "Minsky moments" - and the impending third crash. One can see the Minsky symptoms now in private equity, where valuations have gotten truly ridiculous, the budding Shanghai stock bubble, the all-time, multi-century lows in sovereign bond yields. Having created a highly artificial stability that encourages excessive leverage and risk-taking, the Fed and the media will later wonder what got into the heads of those risk-takers. Yes indeed, whatever were they thinking.

As can be seen in the chart below (from VectorGrader), the financial economy is far, far ahead of the real economy, too far for the latter to catch up (though we are always promised that this will be the case). Despite all the learned talk about valuations, P/E expansion and the mistaken comparisons to 1999, though, it isn't valuations that make markets fall. It's the end of the business cycle, which no central bank has ever been able to prevent (cf. Japan, Inc.).

The practice of providing highly artificial environments that allow financial systems to stably and reliably grow to irrational heights, only to fall disastrously afterwards, will probably not seriously be called into question until after the third brutal crash in twenty years. I fear that the ensuing cure will be worse than the disease, but as Ibsen's Enemy of the People found out, no one wants to hear about the flaws at the bottom of the pipe dream, not while the customers are paying. So long as the real economy stays on trend, the financial economy will want to lever itself excessively higher. You don't have to believe that this time is different.

I wish all and sundry a Happy (and safe) New Year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.