This was sent out by John Mauldin, by far my favorite economic analysts!
By Denis Ouellet
This is the 4th major intervention from the Fed since 2009, each one
apparently
inflating asset prices without having a definitive impact on the
economy other than, most importantly, preventing a lethal debt-deflation
spiral.
The chart above is used extensively to illustrate the close
relationship between QEs and equity prices. Hence investors' Pavlovian
reaction to last week's FOMC announcement of an open-ended and unlimited
money printing program. Virtually every asset class rose, giving
credence to Ben Bernanke's attempt to create a stimulating wealth
effect.
What if the Fed has it all wrong?
Correlation does not imply causation. Could there be another
reason for the spectacular rise in equity prices since 2009? Let's try
earnings, just in case that intuitive, time-tested, relationship might
still be working:
If there were a direct link between QEs and corporate profits,
it should be apparent in S&P 500 company revenues. Yet, Index sales
have only grown 16.5% during the last 3.5 years, nothing close to the
60% jump in Fed assets. Given that the Fed is now totally focused on
growing employment, I doubt that it would take credit for the
spectacular jump in profit margins since 2009, since most of it emanated
from cost cutting (mostly labor) and rising productivity.
Some recent facts point to weaker earnings ahead:
• Quarterly sales and earnings have peaked in the last 9-12 months.
• Corporate profit margins are at an all-time high.
It is therefore dangerous to assume that margins will expand
any further. From now on, corporations need to increase sales in order
to grow their earnings. Unfortunately, demand is waning.
American wages, currently at a 50-year low as a percentage of
GDP, are rising very slowly, so slowly that it is hampering consumer
spending and the overall economy. At the time of previous QEs, also
designed to create a wealth effect, wages were rising at a much faster
clip than today. Furthermore, real wages were rising during 2009 and
2010, partly offsetting slow employment growth.
Today, employment growth remains below 1.5% YoY, a rate
insufficient to reduce unemployment. Nominal wages are growing 1.2%
while inflation is 1.7% and threatens to accelerate, in large part due
to the impact that the Fed's actions are having on commodity prices,
particularly oil prices.
The US economy got lucky in 2011, when gasoline prices dropped
18% to $3.20/gal. just in time for the back-to-school season and
Christmas. It's luck extended into 2012, when the U.S. experienced an
extraordinarily warm winter. Unless something else extraordinary happens
soon (SPR releases?), the exact opposite will happen to oil prices.
Gasoline has jumped 16% since July, adding to the squeeze just as we
enter the most important shopping period of the year (chart below from
gasbuddy.com).
The following chart plots the Fed's printing with commodity
prices. Unlike the relationship with equity prices, it is difficult to
find anything other than excess financial liquidity to explain the
spectacular rise in commodity prices. Considering how world economies
have been doing lately, why is it that commodity prices have not
declined significantly?
The Fed's balance sheet is set to grow another $800 billion by
the end of 2013, the same amount it has increased since 2009, a period
during which commodity prices jumped 20%.
The Fed wants to grow employment faster, but jobs don't grow
out of thin air. Corporations create jobs when they have the means, they
see a need, and there is visibility to commit. Needless to say, the
last two conditions are far from being met these days. The Fed can't
offset negative US politics, the European mess, nor the Chinese
slowdown.
Bringing mortgage rates down further might help the slowly
recovering housing sector and restart construction employment, but low
wages and rising inflation remain a problem that might be perversely
aggravated by the very actions the Fed is taking.
Wages are not about to accelerate, but inflation and taxation
are problematic. If the American consumer can't spend, who will provide
the needed spark?
Higher P/E Ratios to the Rescue?
Earnings have stalled, corporations are cutting guidance, and
analysts are busy revising their estimates downward. Q3'12 estimates
have been cut 8% since March and are now below Q2 earnings, which are
themselves coming in much lower than originally expected. Q3 earnings
are now seen down YoY.
If so, trailing 12-month EPS peaked last quarter and will decline in Q3. The earnings tailwind has disappeared.
There have been eight periods since 1935 when equities have risen in the face of declining earnings (see
Banking [Betting] On Bankers?).
In all cases, inflation declined along with earnings.
The dependable
Rule of 20
says that "Fair trailing P/E = 20 minus inflation." Lower inflation
begets higher P/Es. A fair P/E is thus 18.3 at the current 1.7%
inflation level, 23% above the current 14.8x P/E, pointing to 1800 as
fair value on the S&P 500, based on trailing EPS of $98.69. If
this undervaluation is narrowed by the liquidity pumped out by the Fed,
could it create enough wealth effect to push US consumers into a
spending spree, in spite of negative real labor income growth?
The problem with Bernanke's wealth effect thesis lies with the
new reality in America. Income and assets have lately been so
significantly redistributed that only a tiny few actually feel a wealth
effect from rising equity prices. Here are some sad facts:
• Last year, the top 20% of households took in 51.1% of all
income in 2011, up from 50.2% in 2010 and the highest share since at
least 1967, according to the Census Bureau. After the top, each quintile
of income earners saw their share of income decrease, with the biggest
drop among middle-income earners. The
middle fifth of households took in 14.3% of all income last year. (
WSJ)
• In 2007, the top 20% of income earners had 53% of their
financial holdings in stocks (directly and indirectly), down from 59% in
2001. Middle-income earners had 38% of their financial assets in stocks
in 2007, down spectacularly from 47% in 2001.
• Stock holdings have obviously declined since 2007:
• US house values remain 30% below their 2006 peak level and now match their 2003 level.
• Total residential mortgage debt has only declined 7.5% since
2008. Some 1.5 million homes are in foreclosure, but 10.8 million homes
remain in negative equity.
The "wealthy few" may feel wealthier if stocks advance, but
they could nevertheless have much less after-tax income to spend when
politicians finally address the looming fiscal cliff nestled within the
rapidly growing mountain of debt.
Keep in mind that it is these wealthy people who run American
corporations, keeping them lean and mean and flush with cash. They
remember how profits literally disappeared in 18 months in 2007-08. They
remember how financial markets totally froze in 2008. They see the
humongous budget deficits and the debt piling on, and the not-so-distant
day of reckoning. They realize that all the Qes in the world can't
offset inept and irresponsible politicians on either side of the
Atlantic. Yet, they are the ones targeted by the so-called wealth
effect!
Call that pushing on a golden string.
Meanwhile, the less affluent, the other 80% – some 250 million
people – are little concerned by an eventual wealth effect but highly,
directly, and immediately impacted by the side effects of all these
QEs, namely rising commodity prices and near-zero interest rates.
Consider that:
• 15% of the US population lives in poverty.
• 44% of those 46.2 million poor Americans are in "deep
poverty," which is half the level of the poverty line, defined as
$22,811 for a family of four.
• More than 45 million Americans are in the food-stamps
program, which is 15% of the population, compared with the 7.9%
participation from 1970-2000. Food-stamps enrollment has been rising at a
rate of 400,000 per month over the past four years. Just last month
(August), nearly twice as many people went on the food-stamps program
(173,000) than managed to find a new job (96,000).
• More than 11 million Americans are collecting federal disability checks.
• 11.2% of the labor force is out of work, if we include the 7
million people no longer seeking employment. This number (over 17
million workers) is unchanged since 2009.
• Full-time employment remains 1.4 million below its 2009
level. Needless to say, part-timers earn and spend considerably less.
• Most of the 43.5 million American retirees must cope with
nominal interest rates, near zero through 2015, when inflation is around
2.0%.
Call that pushing on a chafed string.
Betting on Bankers?
Now that US and European central banks have delivered the
financial heroin needed to compensate for inept and irresponsible
politicians, should we jump back in equities?
Will professional investors drive equities higher?
The risk here is that, much like businesspeople, investors may
remain cautious, given the numerous and highly complex difficulties the
US and the world are facing. They will also consider that, at the time
of previous QE program launches, equity markets were similarly
undervalued, but many economic trends were then more positive:
• Earnings were in a strong uptrend on rising margins.
• Oil prices were much lower.
• US real wages were rising (not in 2011).
• The 2011-12 winter was one of the mildest on record in the US.
• Europe was not in recession.
• China was still growing strongly.
Interestingly, the undervaluation of equities, as measured by the Rule of 20, narrowed from 40% to
0% during QE1, from 23% to
7% during QE2, and from 19% to
14% during Operation Twist (see the black line in chart below). The recent rally has narrowed the undervaluation from 27% to
19%.
It would be very surprising if we got near fair value anytime soon. If
10% undervaluation (average of QE2 and OT) is the best we can hope for,
the resulting 16.5 P/E (90% of 20 minus 1.7% inflation) brings the
S&P 500 to 1625, just about 10% above current levels.
That assumes that inflation stays constant at 1.7% YoY.
However, gasoline prices are +7% YoY in September, after rising 1.8% in
August.. If they remain unchanged until year-end, gas prices will be
+18% YoY. Not only would that considerably disrupt Christmas sales, it
would also help raise inflation (gasoline is 5.5% of the CPI, energy is
9.7%). If inflation rises to 2.0%, a 10% undervaluation would get the
S&P 500 Index to 1565, a mere 6% above current levels.
If the Fed has it all wrong, simply pushing on golden or chafed
strings, and the only effect of QE3 is to boost inflation, only God(ot)
knows what will happen.
While the Fed waits for the wealth effect to take effect, the
European Central Bank is also waiting for its own Godot, following
Draghi's magic with the ECB rules and regulations. Super Mario's
"whatever it takes" promise is powerful but not without pitfalls:
• When, if ever, will the eurozone achieve the necessary banking and fiscal unions?
• Will Spain and Italy surrender before it is too late?
• Will ever more austerity finally work?
• When will the debt spiral stop?
• How much longer will the Germans put up with the situation,
accepting that the ECB ruins its balance sheet by taking on unlimited
risk on behalf of the German taxpayers, risking their fiscal sovereignty
to save the "reckless Southerners"?
• How much longer will the hordes of unemployed young Europeans put up with the situation?
Central bankers have indeed delivered. In truth however, they
are merely experimenting with totally unproven ways and means, hoping to
gain enough time until more responsible politicians emerge. Given the
significant risks still facing us until Godot shows up, investors should
await more evidence that either earnings will resume their uptrend or
some kind of miracle will happen.
Equity holdings should be trimmed to conservative levels.
Sustainable income should be favored. Cash earns essentially nothing but
is safe for now. Gold remains attractive for many, many obvious
reasons.
