A lot is being made of the new high that was recorded by the Dow Jones Industrial Average yesterday. However, in the context of still weak income growth and lacklustre economic growth, the new Dow highs are not as widely celebrated as the stock market highs of 1999 or 2000. I have some thoughts on this. But I also wanted to use this as an opportunity to look back at the cycle lows and what the predictions from that time 4 years ago might tell us about what to expect today.
First, what is interesting is that the Dow has hit a new high and the S&P500 is really close despite the fact that S&P500 earnings peaked in Q1 2012. Now, we only have numbers through Q3 2012 but it seems likely that the Q4 2012 will still be below the Q1 2012 peak. What that says is that something other than earnings growth is driving the market higher. An optimistic reading of this dichotomy would be that the market is correctly forecasting continued economic growth that will translate into earnings growth. Another interpretation, that I support, says that the decrease in yields accounts for much of the increase. Low yields drive prices higher by decreasing discount rates and by increasing the desire to hold risky assets, so called private portfolio preferences. This says nothing about the aggregate market as a forecaster of earnings.
Yves Smith and Matt Phillips both point out that household income has failed to keep pace with the rise in share prices in the US. As Matt puts it, “real median US household income — that’s “real,” as in “adjusted for inflation” — was $50,054 in 2011, the most recent data available from the US Census Bureau. That’s 8% lower than the 2007 peak of $54,489.” And Matt points out that labor’s share of the economy is at a half-century low. My takeaway from this in the context of new Dow highs is that the increase in share prices is only sustainable to the degree that wage growth starts to accelerate, consumers take on debt, companies grow earnings overseas or profit margins continue to increase.
Consumers are taking on more debt – at least cyclically – particularly to buy cars and to finance education fees (NY Fed pdf here). But it reasonable to ask whether this is a mean-reverting data point. We know that Europe is in the midst of a recession, and renewed crisis there is causing the euro to depreciate against the US dollar. In this case, overseas earnings are more likely to be pressured than to accelerate. Profit margins were cyclically high early in 2012 when earnings peaked and are now reverting to the mean. Margins certainly could expand again but we should view any expansion as cyclical since this data point is mean-reverting. So this leaves wage growth as the most likely sustainable way for equities to continue their rise in the absence of multiple expansion. And while I am hopeful we are going to see this, there are no indications whether above trend real wage growth in the US will happen or not.
The reality though is that despite earnings peaking and wage growth stagnating, equities have gone from strength to strength. Moreover, I would have thought lower-beta, higher quality stocks would have outperformed as the earnings peak past. In fact, the opposite has been true. More speculative stocks have outperformed in equities. Just as high yield has outperformed in bonds. Bank stocks (and accounting gains) have done well too as the credit cycle has been lengthened, with all of the earnings growth coming from non-interest income and a reduction in loan loss reserves.
The bottom line for me here is that interest rates are low. And the Fed is telling us they will stay low and that the Fed will continue to buy financial assets and expand its balance sheet. That is like a green light signal for risk-on positions and leverage and makes multiple expansion possible. Clearly a recession would change this picture, however.
That brings me to 2009 predictions. Last year I put together a compilation of posts that highlighted the bullish prognostications of various pundits. These people stand out – apparently along with a few others – like Jack Bogle – because a lot of people like Louise Yamada were talking doom and gloom at this time. (David Rosenberg was bearish but managed to hit the 666 low on the S&P500 right on the head.)
What does all that tell us, if anything?
I think it says a lot about extreme contrarian indicators. You won’t necessarily be able to call the top exactly; but if you look at extreme pessimism and huge rates of economic contraction and job losses, chances are those events presage recovery. I wouldn’t say I got the bottom 100% right either despite linking so much to the increasingly bullish voices. But I did begin to call the turn soon afterwards – so much so that by May 2009 I had to defend myself against all the snarky negative comments.
If you think of cyclical tops as being the polar opposite environment to March and April 2009, right now is nothing like that. I would defend Janet Yellen’s interpretation of things actually. She said the following just this week:
Of course, risk-taking can go too far, thereby threatening future economic performance, and a low interest rate environment has the potential to induce investors to take on too much leverage and reach too aggressively for yield. At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.
My interpretation here is that she is saying there is a lot of froth out there – in part because the Fed is leaning heavily toward the employment side of its mandate since inflation is low and the labor market is weak. But none of this is pervasive in a 1999 kind of way. I think that’s accurate if discomforting. We are a long way from 1999. The problem of course is that we don’t want to get there or anywhere close to there. So what is the Fed to do in the context of a dual mandate and increasingly tight fiscal policy which is now officially austerity in the US? I don’t have the answer, though I wouldn’t have lowered rates or relied heavily on QE to begin with. At any rate, I certainly don’t envy Fed policy makers.
Overall though, I think the data suggest that low rates are going to support continued risk-taking and leverage until the economy and earnings are dire enough to cause a pullback. While I do see a pullback of 15% as a good bet, it’s not clear at all yet that the economy is headed for another downturn that will crash the market. Let’s see how sequestration and the government shutdown threat proceed. In the meantime, the credit cycle in the US continues unabated. Consequences will come when the credit cycle turns down demonstrably.
Thoughts on the Dow high and a look back at the market bottom in 2009
A lot is being made of the new high that was recorded by the Dow Jones Industrial Average yesterday. However, in the context of still weak income growth and lacklustre economic growth, the new Dow highs are not as widely celebrated as the stock market highs of 1999 or 2000. I have some thoughts on this. But I also wanted to use this as an opportunity to look back at the cycle lows and what the predictions from that time 4 years ago might tell us about what to expect today.
First, what is interesting is that the Dow has hit a new high and the S&P500 is really close despite the fact that S&P500 earnings peaked in Q1 2012. Now, we only have numbers through Q3 2012 but it seems likely that the Q4 2012 will still be below the Q1 2012 peak. What that says is that something other than earnings growth is driving the market higher. An optimistic reading of this dichotomy would be that the market is correctly forecasting continued economic growth that will translate into earnings growth. Another interpretation, that I support, says that the decrease in yields accounts for much of the increase. Low yields drive prices higher by decreasing discount rates and by increasing the desire to hold risky assets, so called private portfolio preferences. This says nothing about the aggregate market as a forecaster of earnings.
Yves Smith and Matt Phillips both point out that household income has failed to keep pace with the rise in share prices in the US. As Matt puts it, “real median US household income — that’s “real,” as in “adjusted for inflation” — was $50,054 in 2011, the most recent data available from the US Census Bureau. That’s 8% lower than the 2007 peak of $54,489.” And Matt points out that labor’s share of the economy is at a half-century low. My takeaway from this in the context of new Dow highs is that the increase in share prices is only sustainable to the degree that wage growth starts to accelerate, consumers take on debt, companies grow earnings overseas or profit margins continue to increase.
Consumers are taking on more debt – at least cyclically – particularly to buy cars and to finance education fees (NY Fed pdf here). But it reasonable to ask whether this is a mean-reverting data point. We know that Europe is in the midst of a recession, and renewed crisis there is causing the euro to depreciate against the US dollar. In this case, overseas earnings are more likely to be pressured than to accelerate. Profit margins were cyclically high early in 2012 when earnings peaked and are now reverting to the mean. Margins certainly could expand again but we should view any expansion as cyclical since this data point is mean-reverting. So this leaves wage growth as the most likely sustainable way for equities to continue their rise in the absence of multiple expansion. And while I am hopeful we are going to see this, there are no indications whether above trend real wage growth in the US will happen or not.
The reality though is that despite earnings peaking and wage growth stagnating, equities have gone from strength to strength. Moreover, I would have thought lower-beta, higher quality stocks would have outperformed as the earnings peak past. In fact, the opposite has been true. More speculative stocks have outperformed in equities. Just as high yield has outperformed in bonds. Bank stocks (and accounting gains) have done well too as the credit cycle has been lengthened, with all of the earnings growth coming from non-interest income and a reduction in loan loss reserves.
The bottom line for me here is that interest rates are low. And the Fed is telling us they will stay low and that the Fed will continue to buy financial assets and expand its balance sheet. That is like a green light signal for risk-on positions and leverage and makes multiple expansion possible. Clearly a recession would change this picture, however.
That brings me to 2009 predictions. Last year I put together a compilation of posts that highlighted the bullish prognostications of various pundits. These people stand out – apparently along with a few others – like Jack Bogle – because a lot of people like Louise Yamada were talking doom and gloom at this time. (David Rosenberg was bearish but managed to hit the 666 low on the S&P500 right on the head.)
What does all that tell us, if anything?
I think it says a lot about extreme contrarian indicators. You won’t necessarily be able to call the top exactly; but if you look at extreme pessimism and huge rates of economic contraction and job losses, chances are those events presage recovery. I wouldn’t say I got the bottom 100% right either despite linking so much to the increasingly bullish voices. But I did begin to call the turn soon afterwards – so much so that by May 2009 I had to defend myself against all the snarky negative comments.
If you think of cyclical tops as being the polar opposite environment to March and April 2009, right now is nothing like that. I would defend Janet Yellen’s interpretation of things actually. She said the following just this week:
My interpretation here is that she is saying there is a lot of froth out there – in part because the Fed is leaning heavily toward the employment side of its mandate since inflation is low and the labor market is weak. But none of this is pervasive in a 1999 kind of way. I think that’s accurate if discomforting. We are a long way from 1999. The problem of course is that we don’t want to get there or anywhere close to there. So what is the Fed to do in the context of a dual mandate and increasingly tight fiscal policy which is now officially austerity in the US? I don’t have the answer, though I wouldn’t have lowered rates or relied heavily on QE to begin with. At any rate, I certainly don’t envy Fed policy makers.
Overall though, I think the data suggest that low rates are going to support continued risk-taking and leverage until the economy and earnings are dire enough to cause a pullback. While I do see a pullback of 15% as a good bet, it’s not clear at all yet that the economy is headed for another downturn that will crash the market. Let’s see how sequestration and the government shutdown threat proceed. In the meantime, the credit cycle in the US continues unabated. Consequences will come when the credit cycle turns down demonstrably.