This Recovery Is A Ruse

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Includes: DIA, IWM, QQQ, SPY
by: Lawrence Fuller

Summary

This is a weekly series focused on analyzing the previous week's economic data releases.

Our objective is to identify what are leading indicators of economic activity in hopes of gaining insight as to whether the economy is strengthening or weakening.

This week we take a look at Q2 GDP and durable goods orders.

The economic forecasts continue to fall short of consensus estimates in the same manner that corporate earnings are revenues are falling short, but markets don't seem to care.

When we started this weekly series at the beginning of the year, the hope was to help investors accurately interpret the flow of economic data in order to identify the underlying trend in the rate of economic growth. Historically, this has been paramount when it comes to long-term investment decision making. Stock prices are a function of corporate profits over the long term, and profit growth is dependent on the rate of economic growth. More than halfway through 2016, we believe we have done a good job so far of separating the spin from the reality on the ground. The ultimate scorecard for the US economy is the quarterly GDP report. Our forecast for US economic growth in 2016 remains unchanged from what it was at the beginning of the year-1%.

Q2 GDP

The Commerce Department reported that the US economy expanded at a rate of 1.2% in the second quarter, and it revised its previous estimate for the first quarter to just 0.8%. The most significant drags on economic growth were business spending and a decline in inventories, which respectively detracted 0.28% and 1.16% from the overall rate of growth. The most significant contributing factor was consumer spending, which added 2.83% to the overall figure.

The initial estimate for the second quarter was well below the consensus forecast of 2.5%, but not ours. Economic growth is now on pace for a 1% rate in 2016, which is the weakest start to a year since 2011. We arrived at our estimate based on analyzing the year-over-year trends in the economic data that we monitor each week in this series. We do not see this data as improving to support a reacceleration in the rate of growth.

The labor market continues to weaken, as we initially began to see signs of at the beginning of this year. The rate of real income growth, as measured by average hourly earnings, continues to decline on a year-over-year basis. Capital spending continues to fall in lieu of stock repurchases and other forms of financial engineering. We are very suspicious of the estimate that the rate of consumer spending growth rose to 4.2% in the second quarter from what was just 1.6% in the first quarter, and we expect this figure will be downwardly revised in the next estimate.

Despite these discouraging trends, the consensus of economists continues to believe that growth will reaccelerate, as it believed at the beginning of the previous quarter. As we pointed out last quarter, the Wall Street consensus arrives at its estimate by conjuring a number that will support the corporate revenue and earnings recovery that it is forecasting, which is required to support its upside price target for the S&P 500 index.

The research staff at the New York Fed has developed its own real-time forecasting model called the "nowcasting report," which isn't much better. This group was expecting a 2.1% rate of growth in the second quarter. Despite missing the mark by a substantial amount for the second quarter, it is still predicting a 2.5% rate of growth for the current quarter. This isn't research. It seems more like a marketing effort of the Federal Reserve intended to lift moral and keep the investing public believing that its policies will eventually work.

What you see below is the underlying trend in the rate of economic growth. It is not good. It shows five consecutive quarters of deceleration, which falls in line with the corporate revenue and earnings recession that began 18 months ago. This looks like we are headed for a quarter of economic contraction rather than economic reacceleration.

The consensus is pointing to the sharp decline in inventories, which slowed the rate of growth, as a potential source of future growth. We suppose that leaner inventories could indicate future build up, which would increase production and employment. The problem with this assumption is that the inventories-to-sales ratio remains extremely high. This implies a continued reduction in inventories.

Durable Goods

The durable goods report shows the strength in new orders from an approximate 4,000 manufacturers in more than 85 industries of high-priced goods that have a useful life of three years or more. These are items purchased by both consumers and businesses. When consumers and businesses lose confidence in the economy, they typically hold off on purchases of higher-priced items first, which is what makes this report a valuable leading indicator.

The Commerce Department reported that orders for durable goods plunged 4.0% in June and 6.4% on a year-over-year basis. The 2.2% decline for May was downwardly revised to a decline of 2.8%. Orders declined in nearly every category with the exception of motor vehicles and parts, which rose 2.6%. This is odd given the elevated level of inventories-to-sales in this category and the forecast for a decline in auto sales from the record level in 2015.

In a variation of this report that focuses on business spending, orders for non-defense capital goods excluding aircraft was up a modest 0.2% for the month, but down 3.8% on a year-over-year basis. The second-quarter GDP report shows that capital spending has now contracted for three consecutive quarters, which is the first time this has happened since the Great Recession.

Conclusion

In a rational world the deteriorating trend in economic growth, combined with the negative implications this has for corporate revenue and earnings growth, would foretell a decline in stock prices. This is not the case today in an era defined by central bank manipulation of market prices. This manipulation is intended to achieve a desired economic outcome. The Fed has put the cart in front of the horse.

The Federal Reserve, along with its foreign central bank co-conspirators, hope they can levitate financial asset prices long enough that the fundamentals necessary to validate them eventually catch up. The problem is that they are moving in completely opposite directions. The recovery that the stock market is portraying is a ruse.

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.