As I step back and view the investment landscape I can’t help but be reminded of two things. The first being John Maynard Keynes famous quote, “The market can stay irrational longer than you can stay solvent,” and the second being the dichotomy between the stock market and the consumer that eerily looks familiar with what I saw in 2007, and why I felt the market would peak and that we would enter a recession. If memory serves me correctly, the divergence between the consumer and the stock markets did not resolve in a polite fashion but rather led to one of the most dramatic bear market declines in the last 100 years with some questioning whether capitalism itself was under attack. Unless the consumer undertakes a dramatic sentimental shift that translates into higher retail sales I believe this market is standing on shaky ground. If the last two years have taught investors and money managers anything, it would be this; ignore divergences between economic reality and market exuberance to your own peril.
Fed Chairman Bernanke stopped hiking interest rates in 2006 and that sent the markets soaring into 2007, with a brief pause in February after the steep and quick correction precipitated by a selloff in the Chinese market. The markets recovered and were propelled higher as the financial talking heads ranted and raved about the private equity deals, mergers and acquisitions, and record share buybacks that were taking place at the time. The market was hitting new highs and everything seemed rosy, and I’m sure the folks at CNBC were ready to don Dow 15,000 party hats. Who at CNBC would have thought that in twelve short months they would be donning Dow 8,000 hats rather than Dow 15,000 by the fall of 2008, and nearly Dow 6,000 party hats by the time the market finally bottomed. There were clear warning signs that went unheeded and those warning signs are still present today.
Consumer Confidence Lagging Yet Again
Throughout this decade it has paid to listen to the message coming from the consumer, which makes sense as the consumer represents roughly 70% of the economy. At major turning points in the stock market the consumer confidence numbers have either given early warnings or confirmation of a coming trend change in the market. For example, the ABC/Washington Post Consumer Confidence Index peaked ahead of the stock market in 2000, warning of a market top. The index also was useful in not chasing bear market rallies as it did not experience the "V"-spike recoveries that the false bottoms in the S&P 500 did in 2001 and 2002, and at THE bottom in 2003 the consumer confidence index made a sustainable turnaround indicating the turn in the S&P 500 was on solid footing.
Source: ABC News/Washington Post Consumer Confidence Index, S&P
As the ABC confidence index proved to be an early warning indicator in 2000 of a coming market top it did so again in 2007, and was one of the main reasons I took such a bearish tone while the market was breaking out to new highs. I saw a clear divergence with a falling consumer confidence index while the S&P 500 headed higher, and the absolute collapse in late 2007 into 2008 in the confidence index gave more than a six month warning of the coming carnage that was experienced last fall. Moreover, the index failed to put in a new low in March of this year while the S&P 500 continued to decline, signaling that stabilization was occurring and showed positive divergence with the S&P 500. While the consumer confidence index has stabilized this year it has not shown the same type of “V”-spike recovery that the stock market has, making the current divergence similar to the 2001 experience where the "V"-spike rallies proved to be an illusion.
Source: ABC News/Washington Post Consumer Confidence Index, S&P
The reason why a rebound in consumer confidence is so important for the sustainability to the market is that consumer confidence directly translates into retail sales and, as mentioned above, the consumer makes up 70% of GDP. As seen below the ABC/WA Post survey shows that the percent of those polled who believe that the economy is positive remains significantly depressed and has not rebounded. This is important because of the close correlation that the survey shows to the year over year (YOY) change in personal consumption expenditures (PCE), which have yet to turnaround as drastic as the stock market.
Source: ABC News/Washington Post Consumer Confidence Index, BEA
Yet another look at the consumer and retail sales shows a similar picture. The Conference Board’s Consumer Confidence Index (CCI) has shown a decent rebound like the stock market, though its recovery still puts it below the depths of prior recessionary troughs and thus is not a call for celebration. As seen below, the CCI has displayed a close correlation with retail sales and so far the upwards spike in the CCI is not translating to improved retail sales.
Source: The Conference Board, U.S. Census Bureau
Even if consumer confidence begins to turn up I don’t expect a dramatic recovery in retail sales as we have witnessed what I believe is the third major turning point in the last half century. The first turning point came in the late 1950s to early 1960s in which a secular trend of declining consumption and rising savings dominated until the early 1980s. The falling consumption and rising savings rate dynamic dominated the secular bear market that began in the late 1960s and continued until the early 1980s, with a turnaround in this relationship marking the beginning of the secular bull market that carried into this decade. Part of the fuel that drove one of the greatest secular bull markets in history from the early 1980s to the 2000s was the U.S. consumer who slashed its savings rate from 12% to virtually 0%, and increased consumption as a percent of disposable income from 74% in the early 1980s to 84% at the market's peak in 2007. Over the last few years we have seen a declining trend in consumption levels and an increase in the savings rate, not unlike the dynamic that took hold during the last secular bear market. Obviously a trend of rising savings and falling consumption cannot be favorable to an economy 70% beholden to consumers.
Source: BEA
This trend in rising savings and falling consumption is not likely to turn around any time soon. Corroborating the trend in falling consumption and rising savings is the ABC survey that polls how consumers feel about their own financial position. As shown below the consumer is obviously not ecstatic about their balance sheets which isn’t surprising given that the economy is still shedding nearly a quarter of a million jobs a month. What should also be clear below is that the S&P 500 did not bottom until the consumer’s opinion about their balance sheets and the buying climate finally turned around. Does not the current experience scream of one massive divergence? The top panel below explains why consumers are piling into fixed income mutual funds rather than equities as they personally do not see justification to chase the stock market and prefer the safety of bonds.
Source: ABC News/Washington Post Consumer Confidence Index, S&P
Not Your Normal Leading Economic Indicator
One of the things that many market commentators and research houses have pointed at to support their bullish outlook on the stock market are the leading economic indicators. I have had the sneaky suspicion that the aggressive and unprecedented actions on the part of the Fed have played a significant role in the LEI given a misleading signal as to an economic turnaround it is forecasting, while the economic components would likely paint a different picture. It is important to understand the makeup of the Conference Board’s Leading Economic Index (LEI) and the weights that each component makes up of the LEI. Below is the breakdown of the ten indicators that make up the LEI and their respective weights in the index. As seen below, the three financial indicators make up approximately 50% of the LEI while the seven economic components make up the other 50%, with the M2 money supply alone making up 35.8% of the total LEI. Money makes the world go round, I guess, according to the LEI.
Source: The Conference Board
Using an approximate methodology to the Conference Board’s construction of the LEI I separated the 3 monetary components out to compromise a Monetary LEI and the seven economic components to make up an Economic LEI. Since both the monetary and economic indicators make up 50% of the LEI, I simply doubled their weights in the separately constructed LEI’s. For example, while the M2 money supply has a 35.8% weight in the total LEI, I gave it a 71.6% weight in the Monetary LEI.
Shown below are the YOY rate of change growth rates in the Conference Board’s LEI and my indexes of the economic and monetary components separated out. What is a clear take away is that the monetary LEI is doing the heavy lifting as the economic LEI remains in negative territory. What you can also see is that beginning in the 1980s the growth rate between the monetary and economic LEI began to show a greater disparity in their growth rates than they did in the 1970s. What this would tend to imply is that a greater level of monetary stimulus measures were needed to translate into improved economic growth rates. This aligns with the second chart below that shows the dollar increase in debt per dollar increase in GDP, which shows higher amounts of debt were needed to produce a dollar of GDP, and we are fast approaching the "Zero Hour" in which rising debt does not translate into increased economic growth, or the “pay the piper” moment for our economy.
Source: The Conference Board
Source: Federal Reserve, BEA
Further illustrating the notion that it is taking record stimulus just to keep growth going is the YOY growth rate difference between the Monetary LEI and the Economic LEI, with the disparity between the two growth rates at the highest level in the last half century.
Source: The Conference Board
The above charts simply illustrate that our economy is fundamentally weak and instead of allowing our economy to sober up after its debt binge, our monetary and governmental authorities are trying to keep the economy drunk and chugging along, using greater amounts of monetary alcohol than ever before.
Remembering Keynes
As stated in the opening to this article, Keynes said that "the market can stay irrational longer than you can stay solvent." This was certainly the case in 2007 and I fear is the case today. At some point the markets are going to have to grapple with a consumer that is retrenching and not as optimistic about the future as the stock market is. Another famous quote is “don’t fight the trend,” and there is no telling how long the markets will stay irrational and how high price-to-earnings (P/E) multiples will reach on the S&P 500.
For this reason monitoring the credit markets, the Fed, and overall market health will be important to know when rationality will return to the market. One indicator that has proved helpful and has actually acted as either a leading or coincident indicator with the stock market has been reserve bank credit. Reserve bank credit contracted sharply into February and then had a dramatic turnaround, with the S&P 500 following a similar path with a 2-3 week lag. Additionally, the Fed slowed the expansion in its balance sheet (BS) in April and May, which translated into an intermediate market correction that did not bottom until the Fed began to expand its BS again in July. While many market participants were expecting a head-and-shoulder’s top to take place back in June that would have carried the S&P 500 below 800, it seems the Fed had other plans as it stopped contracting its BS. Last week the Fed expanded its balance sheet at the greatest rate since early August, and if the Fed’s BS continues to prove to be a reliable indicator, then the stock market is likely to continue to make a new rally high.
Source: Bloomberg
In terms of the credit markets, the corporate bond BAA to 10-Yr UST spread (inverted below) continues to be supportive of the equity market and isn’t flashing any red flags as of yet. Market breadth as well is not showing any major signs of deterioration that is characteristic of major market tops. For example, the percent of NYSE listed issues making new 52-week highs reached a new rally peak in September along with the new rally peak in the S&P 500.
Source: Bloomberg
Source: Bloomberg
While the three indicators above are not showing any warning signs the message from the consumer cannot be ignored and reward must be balanced with risk. Many market participants were fooled by the market in 2007 and ignored the signals the consumer was sending and have paid dearly for it, and ignoring the same glaring divergences now would appear foolish, to say the least. From my perch I think this market is beginning to get ahead of itself in discounting a rosy economic outlook that I feel will leave investors wanting come 2010. I may be wrong in this cautious outlook but until I see the consumer turnaround, I feel this market rally should be rented and not owned. While many are holding to former Citigroup CEO Chuck Prince’s mentality when he said in 2007, "as long as the music is playing, you’ve got to get up and dance. We’re still dancing." Woe to the investor who fails to find a chair when the music stops.
