The market rise since the 2009 bottom has been supported by two major factors—-massively easy monetary policy and a 95% jump in S&P 500 earnings. Now, a tapering and eventual ending of Quantitative Easing (QE) is in sight and corporate earnings growth has greatly diminished. Nevertheless, investors remain highly bullish as they look forward to what they believe will be a sustainable economic recovery and a pickup in earnings growth. In our view this is a highly dubious assumption. The economy has maintained a tepid 2% growth pattern since early 2010 and shows few signs of accelerating anytime soon. If anything, the economy seems to be slowing down even further, indicating a decline in earnings rather than the robust increase that most seem to be forecasting.
The major problem facing the economy is a lack of demand, and we see no catalyst that is going to change this in the period ahead. As we pointed out last week, 1st quarter GDP grew by only 1.8% while the 2nd quarter so far looks as if it will come in at about 1% or even less as a result of lackluster consumer spending, barely increasing disposable income, sub-par employment, minimal wage gains and a savings rate that is already historically low.
Non-farm payroll employment in June was still 2.1 million less than the number employed at the peak in early 2008, and a higher proportion of this total was in part-time and low paying jobs. As a result, consumer disposable income in May was still 1.4% less than it was five years earlier. Consumer spending since that time has increased only 4.7%, and we emphasise that this is a 5-year total, not an annualized rate. And even to support that totally inadequate rate of spending, consumers had to reduce their savings rate from 8.3% to 3.2%.
Since consumer spending accounts for about 70% of GDP, we see little chance that other sectors can make up for the shortfall created by the lack of demand. In fact, the economy is likely to face additional headwinds as a result of the coming showdown in Washington over the fiscal 2014 Federal budget and another fight over the debt ceiling. The result could be either a White House concession on spending leading to additional fiscal restraint or the debilitating threat of a government shutdown. Although this has not yet gotten a lot of attention in the media, it will probably hit the headlines and dominate cable news after the congressional summer recess.
In addition the market can no longer look forward to the soaring earnings increases that occurred from 2009 through 2012. First quarter S&P 500 earnings were up 6.3% from a year earlier, and, with over half of the companies reporting, seems to be zeroing in on a second quarter rise of about 5%. Revenues, however, seem to be showing a decrease of about 0.4% as profit margins have been stretched to an all-time high. We note that, historically, profit margins are cyclical and that they are mean-reverting. Over the last 60 years profit margins have swung between 2.4% and 8.1%, and therefore have much more downside than upside.
In sum, we see the market losing its two main pillars of support—-earnings and QE. The only way that QE gets extended further than the consensus predicts is for the economy and earnings to tank, an event we doubt investors will like.
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