Challenge For the Market Pros, CEO’s and PhD’s… Read and Answer the Last Sentence

Now we’ve all heard a lot of statistics that depict both a good and bad employment picture.  We have 5% U3 (historic lows) but we have 62% labour force participation rate (record lows for double income household era).  We hear Obama suggest he’s created 7 million new jobs but wages are stagnant.  So is the job market good or bad?

Remember job growth figures are irrelevant without the context of the working age population.  It’s all about supply and demand.  That is, if my demand for labour increases, prima facie, that seems to put upward pressure on wages.  But if my supply of labour increases by an even larger amount well that puts downward pressure on wages.  And  real wages are a good proxy for living standards, so this is important stuff.  But jobs and wages have much broader implications than just the inconsequential living standards of the working class.

So let’s use relative comparisons to understand if our probabilities of getting a job, or better yet a breadwinner job, have improved or worsened over time.

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The above chart depicts total private and government jobs as a percentage of the total working age population (demand for and supply of, labour).  What we find is that we have a 5% lower probability of getting a job than we did in 1999 (meaning supply of labour has outstripped demand for labour).  Now 5% doesn’t sound like a huge decrease but when the working age population is 204M we are talking about 10M proportionately more people who won’t get a job than in 1999.  Further think about what happens to price of labour in this scenario; exactly what we’ve seen in wages for the past 20 years.  But let’s look at breadwinner jobs specifically.

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When we narrow the scope to just breadwinner jobs (above chart), both white and blue collar, we see the same 5% differential between 1999 and today.  The reason is both a reduction of the numerator and an increase in the denominator.

Here’s a look at the numerator, which is actual 1.5 million fewer breadwinner jobs today than in 1999.

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And here’s the denominator, which is actual 28 million more working age people.

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However, when we look at part time and minimum wage jobs we see that they have almost kept up with working age population growth (.3% decline).

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What this means is that while part time and minimum wage jobs have kept up with working population growth there remains a 5% gap overall and that gap is directly within the breadwinner job sector.  Again this means there are proportionately 10M fewer breadwinner jobs for working age people in America today than in 1999.  This is an objective mathematical fact (we like these).  And so when people say “well the jobs market is just transitioning to different types of work” you can say yes, in part that’s correct, to part time and minimum wage work.

But I want to show you it is not just about transitioning from old world to new world the problem is more intricate and we must identify it if we are to first understand it and then to do something about it.  You see there are significantly more consumers in America today than in 1999 because every mouth is a consumer.  And so one would think more domestic consumption equates to more domestic production (jobs).  But here we find the opposite phenomenon.  That is, higher domestic consumption (i.e. higher revenues) but proportionately lower domestic production (lower relative demand for jobs).

Let’s have a quick look at what this looks like in practice.

Below is the 10yr moving average of Industrial Production Index growth.

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What we find is that only twice in modern history has this long term average of industrial production gone negative.  First was during the great depression and second was the recent financial crisis.  However, perhaps more concerning is that the ‘recovery’ has failed to produce any recovery in industrial production.  If we look at the above chart you’ll notice the Index growth failed to reach 1% before again rolling over.  We’ve never seen this before.

Let’s add the second derivative, or the rate of change of growth to the above growth chart to see where we’re headed.

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The above chart depicts a massive deterioration (red line) in the growth rate (black line) of industrial production.  What’s perhaps most alarming is that each of the previous two times this rate of deterioration has occurred over the past 6 decades, growth was above 3% while today it’s already less than 1% (black arrows).  Think of a 300 lb man suddenly losing 20% of his body weight.  Well he still has 240 lbs of body weight.  However, imagine a 100 lb man suddenly losing 20% of his body weight.  Well he just died.  This is exactly where the US is with Industrial Production.

This really gets at the heart of the problem.  Consumption demand, at least the staples, will be realized to prevent death.  But how is that consumption being realized if we’ve seen that domestic production has not kept up with domestic consumption?  It is realized through current account trade deficits.  Trade deficits (current acct) are what allow an imbalance between domestic consumption and domestic production and the mechanism for ‘balancing’ this imbalance is private and public debt (credit and welfare).

But do understand then, perpetual current account trade deficits simply equate to subsidized corporate revenue and profit by way of subsidized personal consumption.  Another mathematical fact.  And credit and welfare are a function of income in that there is a maximum ratio of credit and welfare to income (income has to be able to pay down the private and public debt).  This means there is a ceiling on consumption in this country and that we must be approaching it.

Now I know in this very high tech new world very few academics or market strategists care much about US production but let me show you why they might want to adjust that perspective.

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We can pretend fundamentals don’t matter and sure in the day to day profit taking of Citadel and the like they really don’t matter.  But for investors i.e. savers, the last bastion for returns is equities but now even here we see the long term average returns failing to achieve more than 5% and with a large risk cherry on top.  So while the PhDs may talk big about this new world economy where a move to universal welfare means jobs and wages don’t matter (this means you Bill Gross, Paul Krugman, Kevin Murphy, etc. etc.), well that is nonsense.   Jobs and wages matter and they will always matter.

For those of you that still don’t believe me let me have one more shot at convincing you.  We are all aware of the elephant in the room we simply never mention, namely, almost ubiquitous declining top lines throughout the market.  And why??  Well this ain’t rocket science folks…..

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What we find is that long term growth in PCE (red line) has been deteriorating since the early 80’s and currently at a pace (black line) rarely seen before.  So Mr. Market Pro, CEO and PhD, as we quickly and undeniably approach the proverbial ceiling on consumption, where do you set the following parametres, Valuation = Price level/Fundamentals 10 years from now?


Record P/E’s & A Too Big To Fail Market Explained

In a recent Yahoo Finance article (h/t Nick Webb), Richard Bernstein attempts the latest rationalization of rising P/E multiples.

“There is an old investment rule-of-thumb called the Rule of 20 that uses combinations of headline inflation and the S&P 500 P/E to determine fair value,” Bernstein said. “Our valuation models are, of course, more elaborate than the simple Rule of 20, but based on a more rigorous analysis of inflation and P/E ratios, the current equity market appears, at worse, to be fairly valued. Investors forget that inflation was increasing leading up to the 2008 bear market. In fact, the CPI, which is a lagging indicator, peaked at 5.6% in July 2008. Today’s headline inflation is 1.0%.”

Bernstein’s suggestion is that the market “appears, at worst, to be fairly valued” when one does a “more rigorous analysis of inflation and P/E ratios”.   So I’ve gone ahead and done a more rigorous analysis of inflation and P/E ratios.

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What we find is that Bernstein is telling, well, a half truth, which is better than most market analysts these days.  Specifically we find a strong inverse correlation between inflation (blue line) and P/E (red line) and this supports Bernstein’s proposition that periods of low inflation support higher P/E multiples.  However, in 2000 we see P/E break through a 120 year ceiling on the long term P/E trend despite having far lower historic inflation values over that period than we find today.

This suggests that while inflation is playing some part of today’s near record valuations the P/E is still approximately 28% above where it should be after taking inflation into account.  And so then we need to be a bit more rigorous than was Mr. Bernstein if really understanding today’s multiples is truly the goal.

In order to fully understand the rising P/E multiple phenomenon let’s first review some basics.  What does P/E imply to the investor?  Well in a very basic way, that if earnings growth  = 0% then the P/E multiple is the number of years to breakeven on the investment.  As growth increases the breakeven becomes something less than the P/E multiple.  And so an investor, given some growth expectation, can decide what multiple he/she is willing to pay based on how quickly they need to breakeven and begin generating some positive return.

What Bernstein is suggesting is that P/E valuations are not just a function of growth but are also a function of cost, namely from his perspective, inflation.  When costs are low, everything else equal, returns will be better is the thesis.  And this is where his hypothesis falls short.  First, everything else is not equal.  Second, he leaves out a few costs.

He rightly incorporates a cost function to P/E but he mistakenly limits costs to inflation.  In order to understand the excess 28% P/E premium beyond what can be explained by inflation we need to look to interest and opportunity costs.  What we find is that these two costs too are historically low.  And so one might assume that because the overall cost structure of investments has moved to record lows, we can pay a P/E premium for assets given the low costs should produce higher returns.

But, and this is a big ‘but’, we cannot leave the analysis there.  Remember risk is a cost.  So let’s look at risk.  Currently we have record debt levels throughout both the public and private (enterprise and households) sectors and that equates to record leverage risk (don’t forget market cap is very fluid while debt obligation is very rigid – meaning those debt obligation to equity multiples may not be what they appear to be…).  So we have elevated leverage risk throughout the system.

Risk is also a function of growth.  Today we have historically low growth on both the macro and micro levels.  We rarely think of growth this way but growth has an inverse relationship to risk.  That is, when growth is robust risk is subdued as robust growth can offset bumps in the road.  Low growth economic environments generally mean payout ratios are high (and thus excess cash is low) and so even small hiccups can have a material negative impact.  In a sense we are walking very close to the edge.

And we have also created a tremendous amount of systemic risk in the overall system due to the record low opportunity costs (directly and indirectly due to Central Bank policy).  As mentioned above low costs should imply higher returns.  However, when opportunity costs are so low (meaning there are very few alternative investments generating required rates of return) that investments get further and further concentrated we begin to build a great deal of systemic risk.

Think about a large body of water that maintains a large ecosystem.  As that water dries up and the pool gets smaller and smaller more and more creatures are being supported by that shrinking pool.  Assets are the same.  As the landscape for investment opportunities begin to disappear (the existence of negative rates imply broader risk adjusted positive return opportunities do not exist) more and more investors are forced into the same pool of assets that are still providing positive returns.

And this means a very large proportion of total asset value is totally dependent on this very small and shrinking pool of assets.  In a market, such asset scarcity leads us to the record valuations (e.g. record P/E’s), via increasing equity demand but shrinking supply as corporations reduce outstanding shares through buybacks.  The result is that upside becomes very limited while the downside potential becomes very robust.

It might be useful to have a look at a recent real world example.  Mondelez (MDLZ) recently bid a 30x P/E for Hershey (HSY).  Given HSY has an earnings growth of around 2% (that’s being generous), it will take 23 years for MDLZ to break even (even if they triple growth to 6% it’s still a 17 year breakeven).  Now using the long term SP 500 average P/E of 15 and the long term earnings median growth rate of 11.5% we find the average breakeven is about 8 years.

And so we see the effect of a shrinking landscape of investment opportunities.  Specifically returns are lower (23 yr break even vs 8 year break even), not higher as the low inflation and interest costs would predict.  So while purchasing power parity (i.e. low inflation) solves some of the record valuation conundrum, 28% of the historical overvaluation appears to be a function of investment concentration and that means lower not higher expected returns.  For a money manager to suggest that doesn’t create significant risk I believe is foolish, if not negligent.

This is all a direct result of the ignorant economic policies, both monetary and fiscal, that have been implemented over the past few decades.  Deteriorating incomes, household balance sheets and breadwinner jobs and slowing population growth rates have resulted in severe demand deterioration.  Expansion of consumer credit and government transfers have peaked and with no income growth there is then very little companies can do to expand the top line.

The data is very clear that revenues are declining across the spectrum and this is a definite canary.  We’ve managed to expand EPS for several years by way of economic cannibalism (contracting operations and financial engineering) but this too is coming to an end.  There is simply less and less fat to cut and capital to reallocate and as all firms cut what’s left it becomes a death spiral for demand as consumers are forced out of good paying jobs and into min wage, temp and part time work on a macro scale.

So let’s wrap this up.  Is Bernstein correct about P/E levels and inflation?  Well he’s half right.  Sure low costs, everything else equal, will support higher valuations as they imply higher returns.  However, the structural economic problems of stalled incomes, peaked debt and welfare make operational expansion i.e. sustainable growth extremely difficult, which has led to investment concentration in secondary equity markets.   And that means the higher valuations simply represent higher risks.

The offshoot is that as such a large concentration of total asset value is dependent on the market, it becomes necessary to maintain the market at all costs.  The market has become too systemically important to allow it to fail.  And that means policymakers have changed the function of the market.  The market left to its own devices is a consequence of the underlying economy.  Today, however, the market is being used as a (false) portrayal of the underlying economy.  It is intentionally using the logical fallacy of confusing cause and effect.

That is, the thermostat is no longer meant to reflect the temperature inside the house, its only use is to convince you the house is warm.  That means policies are being targeted at manipulating the thermostat rather than keeping the furnace hot.  The consequence is a spiraling of resource misallocation, furthering the structural breakdown of economic activity making it ever more important to keep the market looking strong.  The market is no longer a market as we understand the term.


Dear Stock Market…

Dear Stock Market,

I need you to pull your head out of your ass.

You are paying record valuations.

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But in the face of the identical earnings deterioration we saw heading into the financial crisis.

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The growth you are pricing in simply cannot be realized.  Real incomes are the same level they were in 1990.

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But the real S&P price level is 3x higher today.

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What’s that?  Population growth is the key to earnings growth you say, because we know credit and welfare are beyond sustainable levels at all time record highs?  The problem with that is population growth is at 100 year lows.

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And so if Income, Population, Credit and Welfare have flatlined for the foreseeable future (which is clearly showing up in the collapsing current earnings growth rates) from whence is the record growth being priced into the market going to be realized?  Robots or Refugees?


Dead Money.