Have No Fear: Spending Keeps The Economy Going

by: Andrew Hesch

Outlining some compelling reasons to be bearish.

Notable trends in tech giants' earnings reports.

Keynes is a bull right now.

If you like charts, you're in luck.


Charts everywhere are telling everyone to sell. There are bears everywhere provoking fear in a little dip. We haven't even had five days of red. I guess if you preach the same thing day after day, eventually you'll be able to brag that you called the top...but while you're waiting for that day, make some money. I will set up the bears' cases. Then I'll look to apply Keynesian economic principles to current market conditions in order to conclude that now is the time to put your cash to work.

I should preface the remainder of the article by saying that it is only a application of theory, and not statement of belief. Theory is, by definition, unproven and founded upon specific assumptions tested in not every scenario. I decided upon Keynesian theory as it is relevant to current economic practice and helps me maintain a bullish perspective. The article does not intend to prove Keynesian theory correct. It intends to use its principles to show an alternative market outlook than what is predominantly published. My primary motivation for drafting this was to challenge myself to apply economic theory to the current state of the financial markets.

I'm sure you have heard the famous line "We are all Keynesians now." However, that is not the full quote. In proof of my disclaimer, I present you the full quote, by Milton Friedman.

In one sense we are all Keynesians now; in another, no one is a Keynesian any longer. We all use the Keynesian language and apparatus; none of us any longer accepts the initial Keynesian conclusions.

Be afraid, be very afraid.

You've likely heard this before, too.

Markets can remain irrational longer than you can remain solvent.

Facebook's (FB) management has been telling us for a long time now that ad revenue is going to start slowing. So far they've been able come up with new ways to monetize ads, but what about that ad load they always talk about. They can't just continually put more ads into their platforms. Here's a glimpse into Facebook's financials.

Facebook Revenue (YoY Change)
3Q2016 4Q2016 1Q2017 2Q2017
56% 51% 49% 45%

As you can see, they haven't been lying. Despite it's still-high, revenue growth rate, should we be scared because it's growing sloer?

Now check out this chart from July 27, 2017:

Or what about the comments from Howard Marks, that "this is a time for caution" due to lofty valuations. In February, JPM's Global Head of Macro Qualitative and Derivatives Strategy warned of a pullback: "It is safe to say that volatility has reached all-time lows, and this should give pause to equity managers." There's a blog post from an investment specialist at Schroders titled "The Calmest Markets in 20 Years - and Why That Should Make You Nervous". The Chief Market Strategist for Wunderlich Securities believes that no one is ready for the drop and we're being complacent. The director of equity trading at Wedbush Securities is quoted saying, "This momentum could reverse course real quickly, and you could see a nice dip in the S&P." Piggy-backing off of these quotes is a Northman Trader blogger who believes technicals are prime for a crash...providing this chart:

Are you scared, yet? To be clear, I am not scoffing at these guys. They have tons more experience and have gained a lot more than I have in the markets, I'm sure. They certainly know what they're doing and data doesn't lie. I am simply providing their work to outline the bears' cases. It all makes sense, and if you choose to believe historical comparisons and correlations, I can't really blame you. The Fed is tightening, and that always comes before a crash. Plus, we are surrounded by headlines that suggest we are at the top of the business cycle. What's the old journalism adage? "If it bleeds, it leads."

We're Getting Awfully Close to Full Employment - The New York Times, May 5, 2017

We May Be Closer to Full Employment than it Seemed. That's Bad News - The New York Times, June 2, 2017

Stocks just entered 'the danger zone', as this ominous flag appears - MarketWatch, July 31, 2017

Here's another professional that is worried:

"Our findings suggest that the labor market has slightly overshot full employment" - Daan Struyven, Goldman Sachs Economist, June 21, 2017.

While full employment exposes inefficiencies such as a lack of job training and education for us to fill the remaining..."Near Record 5.6 Million Job Openings" - CNN, February 9, 2016...it also means we currently have the maximum number of consumers spending money that they actually have. It also means that job competition will increase, so companies will have to pay more or offer better benefits to win over workers.

The Consumer Does Not Matter

Consumers will spend money if they have it because they either need to or have some extra left over. Spending money elevates one's standard of living and who can turn that down. As long as consumers feel safe in their jobs, consumer spending will exist. The Foundation for Economic Education explains, with the support of many respected economists, that consumers do not make the economy go 'round.

Business spending on capital goods, new technology, entrepreneurship, and productivity is more significant than consumer spending in sustaining the economy and a higher standard of living. In the business cycle, production and investment lead the economy into and out of a recession; retail demand is the most stable component of economic activity.

I'll concede that most economic theory lacks a variable for human reaction. However, Keynes developed this equation, savings = investments, to demonstrate how much spending was necessary for economic growth. What spending matters most? Business spending. Capital expenditures. Investment. Here's the other thing: anyone familiar with behavioral economics knows consumers respond irrationally, and they spend based on their psyche. On the other hand, businesses have teams of people and boards multiple levels of management and accountants making decisions about the future of the company and the future of their own jobs depend on. That is who I'm going to follow.

To clarify, I begin by assessing total business spending, in-line with ideas implicit in Keynes's theory - that increased spending, whether on CapEx or otherwise, is an important factor in overall market growth. I provide charts further on that outline CapEx specifically. Trends in spending may not correlate to trends in CapEx for the below companies.

Here's Facebook's earnings report, only with expenses this time.

Facebook Costs & Expenses (YoY Change)
3Q2016 4Q2016 1Q2017 2Q2017
28% 30% 40% 33%

The story is not that revenues are growing slower. It's not the story because Facebook is still growing revenue - and by a lot. The story is in the expenses. Despite revenues falling, Facebook ramped up expenditures. Clearly, it believes it has no reason to reduce costs or slow growth and that short term conditions are favorable.

Here's Alphabet (GOOG)(GOOGL):

Alphabet Revenue (YoY Change)
3Q2016 4Q2016 1Q2017 2Q2017
23% 24% 24% 23%
Alphabet Operating Expenses (YoY Change)
3Q2016 4Q2016 1Q2017 2Q2017
19% 22% 22% 41%

Woah! Alphabet shows tremendous, top-line consistency. Again, that's not the story. The story is how dramatically its expenses have grown despite this stable top line. Clearly, Alphabet agrees with Facebook that the market is in a good environment for growth.

Here's Amazon (AMZN):

Amazon Revenue (YoY Change)
3Q2016 4Q2016 1Q2017 2Q2017
29% 22% 23% 25%
Amazon Operating Expenses (YoY Change)
3Q2016 4Q2016 1Q2017 2Q2017
29% 23% 24% 28%

Everyone freaked out when Amazon showed us that whatever revenue comes in gets lit on fire. In the name of short-term profits, investors were nervous that Amazon is spending too much. This seems like a hearty overreaction and some demonstration of this market fear. Does it matter if Amazon spends every nickel it makes to grow more down the line? 15 years ago it was a bookstore, and if everyone thought they simply needed to keep all the money in the business, it'd be nothing like it is today.

So three big tech companies are spending a ton, but we ramped up CapEx spending to support tech prospects before the internet bubble, too.

Here's the difference:

Comparing the previous two charts shows only one commonality, that mining/energy CapEx spending is dropping. That shouldn't really be surprising to anyone. What's especially of note is that the rate of change for CapEx spending across most sectors is low, positive, and similar, and manufacturing to support all of this growth is growing, too. The other conclusion this chart shows is that aggregate CapEx spending is still higher than pre-recession times. Need more convincing?

The only thing keeping aggregate CapEx from constantly increasing since the recession is energy CapEx. The difference between now and the recession is that when energy CapEx dropped severely beginning 2009, so did the rest of the sectors. Now, this is not the case. Need even more convincing?

It doesn't matter what energy CapEx spending is because despite how important business investment is to GDP growth, energy investment is less than 2% of it.

The economy is in the fast lane. This metaphor does not apply to growth, but quite accurately to everything else. We're spending money faster than we ever have (velocity of money), we're improving technology faster than we ever have, and we're getting on board with that new technology faster than we ever have. We are bypassing the literal, measurable growth that we are familiar with and are spending on capital improvements, improvements that are the innovations and testing we see happening: AI, cashier-less stores, payments without physical cash or even cards.

I hope you do not have a similar regret that Keynes had, once, as his theory suggests this bull market will continue:

I should have drunk more champagne.

Disclosure: I am/we are long GOOG, AMZN, FB. 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.