The Fed’s Poison in a Medicine Bottle

I’d like to show, by way a few graphs, why the current all time highs of US stock prices are in direct conflict with the underlying economy.  This topic can get very complex, however, if we ignore the noise and look at the basic fundamentals with common sense it becomes very simple.  We all hear from time to time that the markets have diverged from the underlying economy, in fact, the Bank of International Settlements (the central banks’ central bank) recently published a report that claimed such a divergence¹.  But what does that mean?

Well stocks are driven by expected cashflows.  Whereas the economy is driven by consumption or aggregate transactions.  One must understand that in a healthy growing economy cashflows will be driven by consumption or increased consumer demand as well as productivity.  However, in an unhealthy economy, meaning flat or declining consumer demand, CEO’s are forced to drive cashflows from cost cutting rather than revenue (sales) growth.  What happens in this case is a circular problem.

Cost cutting can be done in a few ways.  Generally it starts with reduced staffing levels then moves on  to operating contraction (closing factories, etc) and increasing productivity (which leads to further reduced employee levels given no increase in demand).  These actions are effective to increase cashflows because cashflows in simplest form are sales less costs.  If costs are declining faster than sales are declining then cashflows increase.  The circularity comes in to play as employee levels decline enough on a large scale that median incomes begin to decline.  Such an impact leads to reduced consumption levels as disposable incomes decline.  Reduced consumption or demand lead to further employment cuts and thus the circularity.  To show how this works.  Let’s look at the following graphs.

You will see despite large double digit growth in earnings (a proxy for expected cashflows) that sales growth is just barely positive and median incomes are actually declining in the US.  This is exactly how the divergence takes place where markets move up on expected cashflow growth even while the economy is declining with reduced incomes and flat consumption.   (The charts are courtesy of²

S&P 500 Earnings Growth Rate

S&P 500 Earnings Growth Rate Chart

S&P 500 Real Sales Growth

S&P 500 Real Sales Growth Chart

US Real Median Income

US Median Real Income Chart

US Real Median Income Growth

US Median Real Income Growth Chart

So despite the talking heads and the Fed claiming that the economy will follow the markets’ rise to glory, the reality is the divergence will continue because of the circularity of the problem.  Unless you fix the demand or sales side of the equation, CEO’s will be further forced to grow cashflows from cutting costs and other financial engineering methods.

Facilitating this problem is the Fed targeting upward moving stock prices.  This leads CEO’s to allocate money to the stock market (directly through share buy backs and indirectly through dividend payouts) as opposed to taking risks of building new factories and/or hiring new staff.  The safe bet for higher return lower risk investment is the Fed’s back stopped stock market not in operational expansion.  So the very remedy as posed by the Fed is actually the nail in the coffin for the underlying economy.  It’s like a mother poisoning her child thinking the poison is medicine.  The child will only get worse until it finally collapses from the poison.