At the end of February, the market as measured by the S&P 500 moved slightly above the year-end levels. Subsequently, a brief calming of the tensions surrounding the events in the Ukraine (time will tell) generated a relief rally that extended a bit further resulting in new record highs exactly 5 years after the financial crisis lows of March 2009.
Recently the S&P 500 dipped below its closing level on Dec 31. The combination of unrest in the Ukraine economic setbacks in China has not yet proved to be the catalyst for a serious market decline. Ultimately market participants will have to address the stock market bubble that has inflated since last summer. When this happens we will get our opportunity to invest at reasonable (and hopefully even cheaper) prices.
As it stands, the bulls and bears agree on two things; stock prices this year will be driven by growth in the economy, and inflation is unlikely to rise in 2014. We are convinced that both of those premises are wrong. The bullish majority believes stock prices will rise in response faster US growth, while the bearish minority expects disappointing growth to drag stocks lower. With both camps expecting stock prices to track the economy synchronously, the market is moving up or down with each new economic data point. Don’t plan on this continuing.
Over very long periods of time (say a decade or more) stock prices usually mirror economic growth. During shorter periods (say any given year), history shows no such correlation. For instance, the divergence between the stock market growth and real economic growth last year was over 27%. Although some wild card event (like Ukraine or China) may be the catalyst for the correction, rising inflation will be the true Achilles’ Heel of the markets. Over the past few years stagnant wages have kept inflation dormant and bolstered corporate profits. Recently, despite a weather-depressed economy, hourly wages (a primary driver of inflation) have started to rise sharply.
This should come as good news. Firstly, most Americans pay bills with our wages; wages that are rising. Secondly, we believe even the bulls are grossly underestimating US economic growth in 2014. Faster growth means that wages, inflation and (to a lesser degree) interest rates are likely to rise more rapidly than the bulls anticipate. Stock prices are not necessarily correlated with the economy in the current year. Stock prices are however a decent predictor of next year’s economy (as is the slope of the yield curve). The outsized stock gains of past 18 months, as well as a steep yield curve (long-term rates higher than short-term rates) support our expectation of rapid growth and higher inflation in 2014.
Fueling these trends is the recent growth in bank loans. Bank-created credit is already expanding at a rapid pace, despite the drag of an unusually severe winter. The banks are sitting on $2.5 trillion dollars in excess reserves. Even under the somewhat restrictive banking rules, these reserves provide an abundance of rocket fuel for new credit. Banks are desperate to expand lending now that their other profit centers have dried up, while consumers are more willing to borrow. Combine this with household net worth at record highs and better hiring conditions and faster growth looks inevitable.
I won’t bore you with a treatise on money and banking (I’ll save that for a discussion with my grandson Elijah in a couple of weeks). But briefly let us remember, our fractional reserve banking system has typically created credit about 10 fold relative to reserves. That process went into reverse during the financial crisis when the Fed expanded bank reserves exponentially but bank lending flat-lined. If the “money multiplier” rises back to a more normal 8 times reserves, US nominal GDP will DOUBLE. In a best case scenario it would take 15 to 20 years of record growth for real economic output to rise that much, leaving inflation to take up the slack; unless the Fed aggressively contracts bank reserves.
Faster growth and rising inflation will force the Fed to accelerate the tapering process currently underway (withdrawing the support that has fueled the meteoric rise in stock and bond prices over the last few years). In Janet Yellen’s first congressional testimony as Fed Chairman she acknowledged that this may occur sooner (as we have been forecasting) than either the Fed or the markets have anticipated. Rising interest rates are not necessarily bad for stock prices. However, a shift from Fed-created credit pumping up asset prices to bank-created credit pumping up the economy is.
Accelerated economic growth will amplify the recent reacceleration of wages. Rising wages will not only drag inflation and rates higher, but will also cut into profit growth.
Since the financial crisis, economic fears have focused on unemployment and potential deflation. Going forward the big risks to the economy risks will be a shortage of skilled workers and rising inflation (and interest rates). During the past few years, QE and a banking system paralyzed by increased regulation combined to pump up the value of financial assets rather than the real economy (see The TINA Hypothesis). Today banks are overcapitalized. They are restricted from trading securities and inundated with Fed-created excess reserves (but have reduced reserves for loan losses to the lowest level in half a decade1). Meanwhile the market for refinancing mortgages has dried up. With no other option for profit growth, banks are beginning to lend aggressively. Please forgive, but don’t forget my redundancy; the spring thaw will bring positive economic surprises that drive both wages and prices higher.
US stocks are currently up slightly on the year (despite our expectation of further declines), but gold prices have increased at a near double digit rate (gold briefly soared near our 2014 targeted high of $1400 during the Ukraine crisis but has since retreated). Our own favorite for 2014, gold-mining stocks (as measured by NYSEARCA:GDX), are up over 20%! Those extraordinary gains on our modest position in mining stocks have kept our Diversified Sector Program portfolio ahead of the market 2%-5% all year long (like gold, mining gains leading up to the Ukraine crisis were so rapid that we expected some consolidation, which is now happening). The sharp rise in gold prices to $1300-$1400 per ounce has all occurred before the miners have even released one quarter of earnings. Profits will soar over the next US stocks are currently up slightly on the year (despite our expectation of further declines), but gold prices have increased at a near double digit rate (gold briefly soared near our 2014 targeted high of $1400 during the Ukraine crisis but has since retreated). Our own favorite for 2014, gold-mining stocks (as measured by NYSEARCA:GDX), are up over 20%! Those extraordinary gains on our modest position in mining stocks have kept our Diversified Sector Program portfolio ahead of the market 2%-5% all year long (like gold, mining gains leading up to the Ukraine crisis were so rapid that we expected some consolidation, which is now happening). The sharp rise in gold prices to $1300-$1400 per ounce has all occurred before the miners have even released one quarter of earnings. Profits will soar over the next few quarters, and the stock prices will follow.
Gold prices themselves are driven by a myriad of short-term factors that mostly boil down to fear vs. complacency. Longer-term gold prices are driven primarily by “real” interest rates. When inflation expectations rise faster than interest rates, gold prices tend to rise. When rates rise faster than inflation (like 2013) gold prices tend to fall. Later this year rising inflation will push interest rates higher. At the moment, the market is focused only on the prospect of higher rates, while the risk of higher inflation is being ignored. Once recognized (later in the year) gold prices should respond dramatically. The markets haven’t fully recognized the subtle shift from financial asset price inflation to growth and inflation in the real economy currently under way. Unlike the bulls, we envision serious risks to stock prices; unlike the bears we envision serious risks to bond prices (although bonds will continue to enjoy brief rallies when stocks fall). That makes our current view contrary to nearly all other investors.
Stock prices are the mathematical product of corporate earnings and the price/earnings multiple that investors apply to those earnings. Both corporate profit margins and stock prices are at record levels. Total S&P earnings have barely grown over the past few years, despite low interest rates, clever tax planning, and depressed wages. The vast majority of growth in per share earnings has come from corporations reducing share count via buybacks. While buybacks are likely to continue, they are suddenly being offset with the largest wave of initial public offerings (IPOs) since the Internet bubble. Starting from record profit margins (70% above normal relative to GDP) a growing economy that is pushing up wages and interest rates, makes it impossible to envision corporate profits rising faster than nominal GDP. Even our ultra-optimistic scenario of 6-7% growth in nominal GDP would put the maximum upside in corporate profits below most analysts’ expectations, without any margin squeeze. Instead, earnings growth in 2014 is likely to fall short of expectations.
A quick aside, but certainly related; as we warned in our 2014 outlook letter, Chinese growth in 2014 is likely to be much slower than the market has been counting on (and certainly slower than the notoriously unreliable Chinese Government forecast).. “How much slower?” is the wild card for global growth as well as the profitability of multinational corporations doing business in China. As the US stock market stands now it is priced for across-the-board global growth. While we know very little for certain about the economic data we get from China, we do know that growth is dependent on industrial production (which in turn is heavily dependent on copper). Copper prices are plunging; down 12% this year (opposite the rise in gold). This indicates a rapid slowdown in the Chinese economy. Adding a Chinese slowdown to a wage driven squeeze on domestic margins means 2014 profit forecasts are wildly optimistic. (Almost every major bank and Wall St firm is now lowering their forecasts for both Chinese growth and 2014 US earnings).
Stock prices however reflect more than current earnings. In the very short-term price/earnings multiples are driven almost entirely by investor sentiment. Over even slightly longer periods both sentiment and the multiples themselves are driven by interest rates. Higher interest rates mean lower price/earnings multiples. Given faster growth and a less accommodative Fed, the direction for rates is clearly higher. Faced with that headwind, earnings need to rise significantly faster than interest rates to push stocks higher. If we are correct, the combination of higher US inflation and slower Chinese growth will be a big drag on earnings. Flagging earnings and rising rates are a deadly combination for a stock market that is priced for perfection.
Chief Investment Officer
1. Notes on Bank Reserves - It is easy confuse the different components of bank reserves. Free (or excess) reserves are a major determinant of a banks lending capacity. As long as a bank has adequate capital, it can make additional loans until it exhausts the free reserves on its balance sheet. Reserves for loan losses are an entirely different matter. The percentage of each loan that a bank puts aside as a loss reserve is largely determined by the bank’s recent history of losses due to defaults. During the housing bubble (as well as during the last couple of years), very few loans defaulted, therefore bank reserves for loan losses were and are a very small percentage of loans outstanding. That reduction in loss reserves resulted in a huge windfall in reported profits during the past few years. Now loan loss reserves are again approaching minimal levels so that source of profits will disappear and will need to be replaced. Additionally, small loan loss reserves increase the vulnerability of the banks future earnings although we see almost no risk of recession in 2014.
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