September 8th, 2014
by Lance Roberts, StreetTalk Live
Even though it is a holiday-shortened trading week, it was extremely busy from a data standpoint. In this week's missive, I want to discuss two specific topics that peaked my attention and deserve some discussion with reference to investors both in stocks and bonds.
However, before we get into that I wanted to share my thoughts on Friday's employment data.
On Friday, the Bureau of Labor Statistics issued out the August employment estimates which were not only less than impressive, but also well below the lowest Wall Street estimate. For the month, there were 143,000 new jobs created with the birth/death adjustment accounting for over 100,000 of those jobs.
"Perhaps more striking, our research showed that the decline in new firm formation rates had occurred in every U.S. state and nearly every metropolitan area, in each broad industry group, and in all firm size classes - or the same patterns we have just reported for the share of mature firms. Figure 3 plots annual rates of firm entry and exit between 1978 and 2011.
As it shows, the rate of new firm formations fell significantly during this period-occurring because the number of new firms being formed each year (numerator) didn't keep pace with the growth in the stock of total firms in the economy (denominator). The same was not true of firm exits, which did keep pace with the growth in total firms-allowing the firm failure rate to hold mostly steady before rising in the second half of the last decade."
"In other words, what the Brookings Institute found was that there were far more "deaths" than "births" of new businesses since 2009 which would be a net subtraction to the monthly employment reports. However, the BLS has been using the same methodology to adjust employment data higher assuming that the economy of today is the same as it has been in the past. This is clearly not the case that should be evident by the roughly 92 million individuals sitting outside of the labor force currently."
While I am not disputing that there is actual employment growth in the economy, the problem is that as we enter into the sixth year of economic recovery we are still running at levels below population growth.
This is specifically why the labor force participation ratio continues to fall to the lowest levels that we have seen since the late 70's.
As I have shown previous in "Don't Blame Baby Boomers For Not Retiring" this decline in the LFPR is NOT a function of people retiring.
However, even all of that is relatively deceiving because it includes all jobs and all potential employees. However, as I discussed previously in "Jobless Claims And the Issue Of 'Full Employment':"
"Much of the effect of the decline in jobless claims is not due to substantial increases in actual employment but rather to the effect of "labor hoarding." Since "initial" jobless claims are a function of "newly" terminated individuals filing for benefits it is logical that when companies cease terminations, and "hoard" their existing labor force, claims will fall."
There is only one chart of employment that truly matters: the number of full-time employees relative to the working age population. Full-time employment is what ultimately drives economic growth, pays wages that will support household formation and fuels higher levels of government revenue from taxes. If the economy were truly beginning to recover, we should be witnessing an increasing number of full-time employees. Unfortunately, that has not been the case as this measure, as shown by the chart below, is only slightly off the lows witnessed during the financial crisis.
The point here, as I have been making repeatedly since the end of the financial crisis, is that there is a huge difference between statistically managed headline economic data and what is happening within the broader economy.
"The problem that the Fed will eventually face, with respect to their monetary policy decisions, is that effectively the economy could be running at 'full rates' of employment but with a very large pool of individuals excluded from the labor force. Of course, this also explains the continued rise in the number of individuals claiming disability and participating in the nutritional assistance programs. While the Fed could very well achieve its goal of fostering a 'full employment' rate of 6.5%, it certainly does not mean that 93.5% of working age Americans will be gainfully employed. It could well just be a victory in name only."
That statement has now come true as evidenced by Brad Delong this past week who stated:
"Meanwhile, in the US, the Federal Reserve under Janet Yellen is no longer wondering whether it is appropriate to stop purchasing long-term assets and raise interest rates until there is a significant upturn in employment. Instead, despite the absence of a significant increase in employment or a substantial increase in inflation, the Fed already is cutting its asset purchases and considering when, not whether, to raise interest rates."
It will be unlikely that the economy will be able to strengthen significantly as long as the labor force dynamics are still heavily skewed by those sitting outside the workforce. The structural shift in employment has yet to be realized by the majority of economists who continue to be confounded as to why economic growth rates remain suppressed. However, the issue is set to be compounded further as deflationary pressures continue to engulf the globe.
The End Of Bond Bull Market
Speaking of deflationary pressures on a global basis, David Tepper of Appaloosa Management stated this past week that the recent actions by the European Central Bank would be the end of the bond bull market. This has been a common theme among market pundits since the spike in rates in June of 2013 where bond king Bill Gross made a similar call. Bill Gross was wrong then, and David Tepper is likely wrong now.
For the sake of expediency let me first direct you to my previous writings on this issue and why I have been and continue to be long-term bullish on bonds.
- 5 Reasons Why Now Is The Time To Buy Bonds
- Bonds Vs Stocks - Investors Continue To Make The Same Mistake
- Reiterating Bond "BUY" - 35 Years Of History Confirms
The reason that Tepper and the majority of economists continue to be wrong about the end of the bond bull market is that interest rates are a direct reflection of inflation, wage and salary growth and GDP. The chart below shows this historical correlation.
The problem for "bond bears" like Tepper, is that deflationary pressures are surging worldwide. Economic growth in Japan just dropped by almost 7% and the Eurozone, the largest trading partner to the U.S., is rapidly heading towards recession. The chart below shows the deflationary pressures that surging in the Eurozone.
Those deflationary pressures will likely manifest themselves in the U.S. over the next two-quarters which will slow economic growth in the U.S., as well as put downward pressure on corporate profits. Furthermore, it is likely that this winter will be as cold, or colder, than the last. It is important to remember that last year's cold spell clipped over 2% off of GDP. This becomes an issue when stocks are already running at excessive valuations.
Also Read: 12 Reasons Why Rising Interest Rates Are Bad
Stocks Are Fairly Valued
I have heard way too many people say lately "stocks are fairly valued" at present levels. First, the majority of the data used to determine valuations such as the "E" in P/E, or the "E" in EBITDA, and a variety of other measures have been heavily skewed through accounting gimmickry and share repurchases. Secondly, the majority of people claiming the stocks are fairly, or only slightly overvalued, are either a) comparing current levels to the peak valuations of 1999 which was an extreme historically anomaly; or b) are using forward operating estimates and comparing it to historical trends based on trailing reported valuations.
I recently showed two charts that demonstrate the rather extreme level of valuations currently in terms of Price to Sales and Price To Earnings Growth.
However, the guys at GaveKal Capital took this overall concept to task this past week stating:
"Let's begin by looking at the differences between average and median valuation levels. Average valuation levels are well below median valuation levels which imply that there are more companies trading at higher valuation levels at first blush. As the charts below show, this tends to be true most of the time. Currently, the median price to cash flow ratio is at levels seen from 2005-2007 and the median price to sales ratio is above 2000 and 2007 highs."
"We also like to look at valuation breadth. We analyze breadth in a few ways. We look at the percentage of stocks trading above 3-year, 5-year, 7-year averages as well as the percentage of stocks trading with 25% of their 3-year, 5-year, 7-year max valuations. We also like to look at the percentage stocks trading at important absolute levels such as 1x book value or 10x cash flow. When we analyze our breadth data points, we find that breadth is at or above levels seen in 2000 and 2007. For example, 67% of stocks are trading at their 3-year average price to book ratio. This is below highs hit in 2006 (86%) but well above the average (44%) over the past 15 years. From a price to earnings perspective, the percent of stocks trading above their 3-year average is right at the same level as it was in 2006 and 2007. When we look at 5-year and 7-year averages, we find that all valuation ratios have more stocks trading above their averages than in 2007."
"Currently, 65% of all stocks are trading with 25% of their max P/S valuation level which is higher than it was in 2007. Also higher now than it was in 2007, is the percentage of stocks trading within 25% of their 7-year max P/E ratio...64% of all stocks are trading above 10x cash flow which is slightly higher than in 2007.
Perhaps more telling is the fact that only 7% of stocks are trading below 5x cash flow compared to 45% at the bear market low. Currently, 89% of all stocks are trading above 10x earnings while only 6% are trading below 5x earnings. And lastly, just over half (53%) of stocks are trading above 2x sales while only 16% of stocks are trading below 1x sales."
The point here is that the market is by no means cheap and with bullish investor sentiment at the second highest level EVER on record there is a significant amount of risk built into stocks.
However, with that being said, buy signals are back in place, and the current bullish trend remains intact. Therefore, portfolios should remain invested at the current time either at or near target allocations. If you are closer to retirement, you may want to opt for a slightly more conservative weighting. Regardless, it will be important to pay attention to portfolios in the months ahead. The lack of volatility, extreme complacency and excessive bullishness never has in history turned out to be a good thing.
Have a great week.