Reminder: Wall Street Does Not Equal Main Street
- As the underlying economy lags, stocks surge ahead on hopes that the Fed will save the bull market.
- There is a rift forming between Wall Street and the Main Street economy. Favorable financial conditions and buybacks bolster stocks, but the economy is stumbling.
- The lie that we investors tell ourselves will soon be exposed as false.
- What is the lie? That corporate earnings per share is a measurement of the health of the economy.
As the market keeps running joyously up and slumping anxiously down on speculation of Fed interest rate actions, I thought somebody should issue a reminder: Wall Street is not Main Street.
There may have been a day when one could simply look at the performance of the stock market to gauge the health of an economy, but those days are no more. Or, at least, the relationship between the stock market and real economy is more attenuated now than ever before. If you squint, you can see a resemblance. But it's faint.
Let me demonstrate this to you.
Interest Rate Cuts Do Not Equal Prosperity
Fed rate cuts have been driving up the stock market for months, even while many underlying economic measures have been fraying. Unemployment may be near record lows, but the downward movement of the rate has slowed from its previous trend in place since 2010. Actually, there have been two trends in the unemployment rate since 2010: one from 2010 to 2015, in which unemployment fell fastest during this cycle; and the other from 2016 to 2018, in which the trend in unemployment noticeably slowed.
Source: Trading Economics, edited by author
It appears that this year, 2019, we are witnessing another slowdown in the trend of falling unemployment.
Now, one might be tempted to think that the period of zero interest rates from 2010 to 2015 created this extended trend of falling unemployment, while rising interest rates in 2016 caused the trend to change. One need only look to the many economic indicators that had been fraying in 2015 to realize that the change in trend had nothing to do with interest rates.
In any case, despite the exuberant, upward dance of stock averages since May of this year in response to a likely rate cut, what realistically could lower rates do for unemployment, already at historic lows? Even lower unemployment would not indicate a healthy economy but rather a shortage of jobs. It certainly does not indicate that employers are competing heavily for workers and bidding wages up, as wage growth still lags below historical trends.
Real annual median household income, for instance, has been rising since 2014, but it was only about $1,300 higher in 2017 than it was in 1999.
Fed Chairman Jerome Powell has stated that he will do everything in his power to sustain the economic expansion, but it sounds a bit more like he would simply like to eliminate the business cycle completely, freezing the economy right here at the top. Despite this thinking predominating Fed officials since at least the chairmanship of Alan Greenspan in the 1980s, the business cycle has not been eliminated.
Moreover, it's important to note that most household income growth has come after the Fed began raising interest rates. There's no sign whatsoever that higher interest rates have had a negative effect on the average worker or household.
Weakness on Main Street
The point of the above is not that the economy is entirely rosy. The point is that interest rates alone do not have the power to create or erase prosperity.
Indeed, there are several troubling red flags in the real economy that bode poorly for the near future.
While most medium and heavy truck sales, an indication of retail sales, have held up well, Class 8 trucks (the heaviest kind of transportation truck) sales have been crushed recently, marking the worst sales performance for this class since July 2016.
Moreover, according to the latest ADP report, small businesses are now shedding jobs. Goods-producing sectors, especially the cyclical sectors of mining and construction, have been the hardest hit. And among services, the leisure and hospitality sectors have also been particularly weak.
As the job market pulls back, says Moody Analytics' chief economist Mark Zandi, "Small businesses are the most nervous, especially in the construction sector and at bricks-and-mortar retailers.”
All of this signifies a rolling over of consumer confidence and a turning point in the cycle. The job market weakens at small businesses and cyclical companies first, then spreads to other sectors.
Is it any wonder, then, that publicly traded small businesses are performing more poorly than their larger cap peers?
There's also a widening gap forming between the ISM Manufacturing Index and the Goldman Sachs Financial Conditions Index. The former may be considered a measurement of the real, underlying economy, while the latter is a measurement of the financial realm, including interest rates, exchange rates, and equity valuations. While the ISM has been falling and now sits at the critical 50-ish level, financial conditions remain strong and even rising.
Source: Samuel Rines of Avalon Advisors
Here is a stark visual of the difference between Main Street and Wall Street, wherein the real economy struggles while the stock market plug along as if there was no problem at all.
Meanwhile, the Treasury yield curve has become strongly inverted, meaning that longer dated Treasury bonds have experienced high demand as short term bonds have been held steady by the Fed. The 3-month T-bill (2.26%) almost yields as much as the 20-year T-bill (2.32%) at this point.
I have been recommending extended duration (10+ year) Treasuries as well as defensive stocks all year, and these two categories of investments have done remarkably well.
Not even a 50 basis point rate cut could fully un-invert the yield curve. Nor can it undo the message that the currently inverted yield curve is sending.
The Lie We Tell Ourselves
All of this leads us to the biggest and most nefarious lie that investors tell themselves. And that is, "The stock market is rising because earnings are rising!"
No, they are not! Earnings per share are rising, but total earnings (or profits) are not. In fact, the trend of corporate profits has been slightly downward since the middle of 2014. Total corporate profits currently sit around the same place they were at the beginning of 2012.
This as S&P 500 earnings per share have risen from about $88.50 at the beginning of 2012 to about $132.40 at the end of 2018. S&P 500 sales growth rose ~28% during that time, yet EPS rose ~50% and the index rose 125%.
How could this be, you ask? It was accomplished through what has become a primary tool of corporate executive teams: share buybacks.
The 6.6% reduction in total shares outstanding for the S&P 500 index as a whole is a bit misleading, as it mixes many companies that have reduced their share count by 20-30% or more in the last ten years with real estate investment trusts and other types of companies that are net share issuers.
This dramatic share reduction has been brought about by means of (1) a reduction in capital allocation to investment, (2) a strategic reduction in worker pay expenses, and (3) a increased corporate debt burdens.
To exhibit the first point, see the collapse and relatively tepid, partial recovery of gross fixed capital formation (a measurement of private accumulation of capital goods) as a percentage of GDP after the Great Recession:
Source: World Bank
To exhibit the second point, see the workers' share of nonfarm business sector output, which had been declining since the early 2000s but collapsed without recovery after the Great Recession:
To exhibit the third point, see the following chart from John Hussman, which shows how corporate buybacks and debt issuance became even more tightly correlated beginning in the early 2000s, when the Fed funds rate was pushed down near zero.
Source: Hussman Funds
As I've written about previously (see here), the rise in corporate share buybacks correlates strongly with the bottoming out of interest rates. If interest rates were in a more historically normal range, we would not have witnessed this surge in debt-funded buybacks and the stock market would not be nearly as high as it is today.
Why do corporate executives engage in such behavior, even at the expense of other important budget items? Well, in a market economy, executive teams are drawn to buybacks in order to hit benchmarks placed upon them by themselves as well as analysts and other outsiders. They are motivated to hit these benchmarks both in order to achieve the bonuses that are part of their compensation packages as well as in order to keep up with their competitors.
Source: Wall Street Journal
Corporate executives are responding to their environment and acting in the best interest of their respective businesses as directed by the businesses' owners, as they are supposed to do. In normal circumstances, this would result in positive allocations of capital that benefit the shareholders, employees, and broader economy alike. But with the Fed's easy monetary policy of the last few decades, circumstances have changed.
In essence, what we have witnessed since at least the early 2000s is a corporate executive-driven transfer of wealth from consumers to shareholders, facilitated and encouraged by the Federal Reserve. In order to spend more on buybacks and dividends, corporations have reduced their investment budget, held employee compensation growth at bay, and gorged on cheap debt. But none of this would have been possible if the hurdle rate (the minimum required return) for investments had not been pushed down so far to correspond with the falling risk free rate — a rate that is controlled by the Fed.
This is a zero-sum game, not one in which the economic pie is being expanded. Corporate profits, as we've seen, have been flat since 2012. And yet shareholders have been getting better off dramatically faster than everyone else. In fact, the growth of EPS (which flow to shareholders) has almost doubled the growth of sales.
Notice, however, that this buyback surge and the resulting externalities is a recent phenomenon. This problematic situation is not inherent to a market economy or capitalist system, clearly, because we experienced at least a hundred years of a functioning stock market without witnessing such an occurrence. It isn't mainly due to a change in the rules allowing corporate buybacks, either, because the rule change happened in the early 1980s and yet we didn't see this huge surge in buybacks until monetary policy became ultra-accommodative in the early 2000s.
The lie we investors have told ourselves is that EPS growth is an unqualified good. A rising tide in the stock market lifts all boats. It creates a wealth effect that trickles down to the real economy. The stock market's performance as measured by EPS is an indication of the health of the economy. Wall Street is a reflection of Main Street.
But this is false. Rising earnings per share do not equal prosperity. They do not equal a broadly healthy economy. They do not even correspond with total profits.
Wall Street does not equal Main Street, and in the coming years (perhaps even the coming months), this will be demonstrated again. For some investors, this demonstration will be quite painful. Main Street cannot continue to struggle while Wall Street parties forever. There will be a reversal, a reckoning. It's just a matter of when.
Holding a heavier allocation to defensive equity sectors (such as consumer staples, utilities, healthcare, telecom, and real estate that serves these industries) continues to make sense, although these sectors have outperformed in the last year which has driven up valuations.
Moreover, it continues to make sense to hold onto longer-dated Treasuries (e.g. the ETFs, EDV & TLT), as the United States' government bond yields sit significantly higher than those of other developed countries. The bond bull market will almost certainly last longer as the Fed has yet to bring rates on the short end back down. I would be looking to sell EDV above $135 and TLT above $136. If there is a near-term correction in long term Treasuries, however, I'd rate EDV a buy under $110 and TLT a buy under $120.
Above all, allocate cash.
This article was written by
I write about high-quality dividend growth stocks with the goal of generating the safest, largest, and fastest growing passive income stream possible. My style might be called "Quality at a Reasonable Price" (QARP) in service to the larger strategy of low-risk, low-maintenance, low-turnover dividend growth investing. Since my ideal holding period is "lifelong," my focus is on portfolio income growth rather than total returns.
My background and previous work experience is in commercial real estate, which is why I tend to heavily focus on real estate investment trusts ("REITs"). Currently, I write for the investing group, High Yield Landlord.
Analyst’s Disclosure: I am/we are long EDV. 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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