Past 8 Years - GDP Up 31%, Real Wages Flat, Yet... The S&P Up 200%+; What Gives?

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by: Long/Short Investments

Summary

Over the past eight years, US economic growth and real wages have underperformed expectations, yet the stock market has tripled in value.

Main influences include an initially oversold market in 2009, central bank policies, and heavy credit expansion at the corporate and government level.

The market’s current price point suggests an overbought market with risk skewed to the downside.

However, a continuation of negative real rates and additional credit expansion may continue to provide for a bullish short-/medium-term outlook.

Argument: The past eight years have provided one of the best bull markets in history despite one of the weakest expansions out of a recession in history. It's my belief that the US equities market, taken as a whole, should be avoided from a value perspective, although I recognize that a continuation of low rates, further credit expansion, and earnings growth from upcoming fiscal measures could continue to support higher valuations.

Overview

Since Q1 2009, nominal GDP has been up 31% (17% in real terms), real wages have picked up less than 1%, yet the S&P 500 (NYSEARCA:SPY) has tripled. If this article were to be delayed until the second week in March, and the S&P 500 stays at its current valuation, the rise over the past eight years will come to a factor of 3.4x - 240%, or 16.5% annualized. This compares to 3.4% annualized in nominal GDP appreciation, or a spread of about 13%.

This is a massive discrepancy that shows that the rise in the US equity markets has been a product of far more than basic economic growth. Some contributing factors:

1. The S&P was oversold when running below 700 in March 2009

Markets tend to oversell in times of panic. Fear is a stronger emotion than greed, and losses tend to hurt far more than gains from a psychological perspective. Investors pulled their money out of funds in record quantities and were far undercapitalized when there was a grand opportunity to snap up many highly underpriced assets. Even though the crisis was mostly cleaned up by the end of 2008, the market continued to sell off for another 10-11 weeks after before starting to reverse course.

The same type of lagging phenomenon is seen with unemployment, where companies don't begin rehiring until they're absolutely certain the economy is continuing on an upward trajectory. Consequently, unemployment always spikes after a recession rather than during. This explains why U-3 unemployment peaked in October 2009 at 10%, and didn't fall below 8% until September 2012, a full four years after the worst of the recession, when unemployment in the fall of 2008 was only 6.1%.

(Source: US Bureau of Labor Statistics; modeled by fred.stlouisfed.org)

2. Low interest rates

This is a no-brainer with its effect in calculating the value of a business, which is the amount of cash that can be taken from it over its life discounted back to the present. The cost of capital is used as the discount rate. The cost of debt (a portion of the cost of capital) is lower with lower rates, and is tax deductible assuming the business is profitable and pays taxes. This compresses discount rates and boosts corporate valuations even if the numerator term - cash flows, of which a large portion is earnings - stays constant.

Each 100-bp reduction in the cost of debt projects to increase corporate valuations by 5%-6%, based on the current financial and capital profile of the overall US equities market. If cheaper debt also creates the incentive to take on more debt as a portion of the overall capital structure, the valuation increase could be even higher assuming the accretive effects of the relative cheapness of the capital source offset the additional insolvency risk.

3. Quantitative easing ("QE")

Another no-brainer, but fundamentally important. Quantitative easing works through a mechanism by which cash is printed and a central bank uses that cash to buy a bond or other form of security. This bids down yields in those assets by reducing their supply in the market and forces market participants out over the risk curve into riskier assets, such as stocks and real estate, in order to chase the higher returns of these assets. This bids up their prices and expects to create a windfall of wealth that will in turn be spent in the economy in order to drive growth.

The US Federal Reserve expanded its balance sheet from $910 billion as of August 2008 (before the fall of Lehman) to $4.5 trillion as of December 2014, a factor of 5x, where it's mostly stayed since.

(Source: Board of Governors of the Federal Reserve System; modeled by fred.stlouisfed.org)

A lot of this QE money fed itself into the stock market. The S&P 500 alone recently zoomed past the $20 trillion market capitalization threshold.

One could argue that central bank policies are socially non-optimal in that they reward those who are well off (people who have the ability to buy stocks and/or real estate) at the expense of those who are savers (retirees, conservative investors) - who now make little to nothing off interest - and those unable to invest in risky assets due to a lack of disposable income. Widening income disparity can breed social conflict and could be at least be partially attributed to the surprising electoral outcomes of Brexit, Trump, and possibly additional unanticipated results in the upcoming European presidential elections in France, Germany, the Netherlands, and potentially Italy.

4. Corporate Debt Buying Spree

Non-financial corporate debt has increased 60.4% since Q1 2009, as rates have descended down to all-time lows.

(Source: Board of Governors of the Federal Reserve System; modeled by fred.stlouisfed.org)

Despite the US outperforming other developed economies since the financial crisis, US interest rates remained the most negative in real terms until January 2017, when EU inflation accelerated up to 1.8% in year-over-year terms.

This has facilitated a wave of share buybacks to prop up prices even while earnings have stagnated over the past couple years. On its own, repurchasing relatively expensive equity with historically cheap credit is a perfectly straightforward rational decision. But at the same time, it limits the use of this capital to accumulate cash, other financial assets, or be put toward capital expenditures.

The increased use of internal capital for financial engineering (rather than capital spending) became a trend leading up to the financial crisis (in response to low rates from 2002-04), tailed off as rates rose from 2004-06, and once again became highly popular as rates have stayed low over the past 8+ years.

Put in terms of growth, non-financial corporate credit relative to nominal GDP has expanded by 23.6% since Q1 2009.

(Source: Board of Governors of the Federal Reserve System; modeled by fred.stlouisfed.org)

Taking on this wave of debt fuels corporate growth, or at least pads shareholder returns by reducing the number of shares in circulation. But this credit expansion is largely unproductive given its widespread lack of use in organic growth initiatives. It works to hamper long-term growth given its future need to be repaid and pulls capital from other productive spending channels.

5. "Trump Rally"

The S&P has expanded another 7%+ since November 9 in anticipation of expansionary fiscal policy from the Trump administration. This may come in the form of lower corporate and personal income taxes, incentivizing the repatriation of cash stored abroad by US companies, deregulation, and infrastructure spending.

The market welcomed the idea of these measures, as it sent notice that there would be a shift toward fiscal policy and away from monetary policy, which hadn't produced the desired outcomes. Despite low rates and massive amounts of easing, global growth since the end of the financial crisis has lagged around 2% year-over-year in the US and EU and less than 1% in Japan where accommodative monetary policy has been taken to new dimensions. Given that low rates and easing work to incentivize growth in the present by pulling it forward from the future, this limits growth down the line and the expected efficacy of further easing.

An environment more amenable to corporate financial interests as a whole is positive. Tax breaks could pay for themselves should they stimulate enough growth to offset lost government revenue. Nonetheless, such initiatives as infrastructure spending and military expansion will add pressure onto a budget deficit that already came in at -3.2% of GDP for 2016.

This will add further onto a national debt sitting at $20 trillion, or approximately 108% of GDP. Moreover, if the Fed does begin to normalize interest rates, I estimate that each 25-bp rate hike will tack an additional $50 billion onto the annual budget at a cost of approximately $410 per taxpayer.

So while some of these measures may in effect stimulate growth and be revenue-neutral or even revenue-positive for both corporations and the federal government, infrastructure and defense spending initiatives may be partially (or fully) tabled out of concern for how these measures might require higher deficits. Naturally, this deficit spending will need to be funded through additional debt issuances. A budget deficit of 3.5% of GDP would place national debt expansion at a pace of $650 billion per year.

This could fuel additional growth in the stock market, but after a certain point, if debt grows at a pace faster than GDP - which it is if the deficit is growing faster than GDP - this is unsustainable in the long-run.

Conclusion

For now, one could probably support a bullish intermediate stance on the direction of the market. Credit expansion is still in full force while benchmark rates in developed economies continue to be negative in real terms.

Nevertheless, central banks are in a bit of a pickle. If they raise rates, they can tamp down on credit expansion that inevitably surpasses the rate of GDP. Yet, with equity markets at such lofty valuations from years of accommodative policy, a rise in rates compresses the discount rates used to value cash flows, and can raise fixed-income yields to the point where the stock market looks comparably less attractive. This is especially true considering earnings growth still lags even after all these years of easy money policies.

I estimate that forward real returns on the US equities market is somewhere around 3.9%-4.3%. These are rather poor returns expectations for an asset class that is so inherently volatile. If the 10-year Treasury (NYSEARCA:IEF) starts rising from the mid-2%'s into the high-2%'s, at some point investors are going to be reluctant to push more funds into stocks when the risk/reward fundamentals become so skewed to the downside.

A rise in organic earnings growth will help and continuing credit-fueled expansions at the government and corporate level can maintain a bullish atmosphere. But once debt costs take up too high a degree of free cash flow and bad loans start developing in a high enough quantity, the bull market will exhaust itself and come tumbling down. When this will occur is anybody's guess.

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.

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