According to former Fed Chair Ben Bernanke in an excerpt from a Nov. 3, 2009 Bloomberg article, the Fed strategy is that “..large-scale asset purchases should boost economic growth through lower borrowing costs and higher stock prices…”. Now as depicted in the following chart (by Gallup) we see that the top 5% own almost 75% of financial wealth (i.e. stocks) while the bottom 80% own less than 5% (these are 2010 figures and certainly things have gotten significantly worse over the past 4 years).
Rather than boosting economic growth through incentivizing capital expenditures as has been the way of monetary policies gone by, this new Fed strategy, to explicitly target higher stock prices, is meant to create enough excess wealth to those on top by way of stocks such that some of that wealth would then trickle down to the rest of America. The Fed has made this clear both verbally and by way of action, that is, by ensuring (manipulating) higher stock prices. The result is that low cost debt is being used to invest into a risk free stock market. To get an idea of how this works look at the following table which I pulled from a December 2014 report from Factset.com,
So during 2014, these 10 companies spent roughly $150B on share buybacks and paid out $55B in dividends, leading to an average market cap increase of around 25% across the 10 firms. It appears then that firms have been taking advantage of the low cost debt to borrow and buy back shares to increase market capital and pay out dividends which are typically reinvested directly back into the market.
For instance, IBM has borrowed $33B since 2012 and has repurchased $37B worth of stock. Apple spent circa 9x the amount on share buybacks as they did on capital expenditures in 2014. The point here is that the Fed’s policy strategy, as expressed by Bernanke above, of lowering borrowing costs and targeting higher stock prices to create wealth at the top was extremely successful. In fact, I doubt Bernanke ever dreamed how effective his wealth creation strategy would be.
However, the second part of the Fed’s policy strategy was to have some of that extraordinary wealth trickle down to the 90%ers. Unfortunately this part of the strategy has failed miserably. Now as we’ve discussed many time here on First Rebuttal, the second part of the strategy was inherently flawed in such a way so as to actually necessitate its failure. That is, by targeting (guaranteeing) higher stock prices you force CEO’s and all other investors to push available capital that would otherwise have been reinvested back into the company and other economic investments to simply allocate directly into the market. Meaning no need or money left for hiring, and in fact, the layoffs continue along with the share buybacks.
Just how many layoffs are continuing is becoming difficult to ascertain. Ironically I found the following notice from the BLS in its last Layoff Report…
But suffice it to say looking at the U6 figure we know hiring for real breadwinner jobs has been sparse at best (we’ll take a detailed look shortly). So the result of not only targeting but guaranteeing an upward moving market, which the Fed has been very explicit about doing, has literally prevented the trickle down part of the trickle down strategy meaning all we’ve attained is extreme wealth creation to those on top. And this seems to be recognized by essentially everyone.
What becomes obvious in researching the topic of ‘trickle down economics’ is that this is one subject that appears to have almost unanimous agreement amongst everyone outside of the political class. Left, Right, Gay, Straight, Religious, Atheist, you name it they agree on the subject unless they hold a political office. In fact, the resounding agreement is that this latest experiment has been a tremendous failure. That said, here we are in year 6 of the now completely failed experiment with no signs of changing course. Rather than allocating efforts to reshaping our economic growth strategy, all efforts seem to be focused on selling a false story of success to the American people.
So this brings us to the debate around whether the parabolic move in equity valuations is the same as last time, meaning the asset bubble the eventually burst in 2008. The ‘secular bulls’ are screaming “It is different this time!”. And well I agree, things are very different this time around. But is that a good thing or a bad thing? Well let’s take a stroll past all of the bullshit nonsense from both sides of the bull bear coin and just look at the very parameters that are time tested indications of growth and valuation.
So just on pure price level we see about a 25% increase between 2007 and today on the S&P 500. That would suggest we have had material improvement today relative to 2007. Now let’s have a look at some multiples to see how we feel about our growth prospects relative to 2007.
The chart depicts price to sales of S&P 500 companies and the Adjusted Buffet Indicator. We are using price to sales because it is a much better long term gauge than price to earnings as earnings, especially given all of the share buybacks and reallocation of funds from capex to income, is easily manipulated in the short term. What we find in price to sales is that today’s multiple is 30% higher than in 2007 (according to multpl.com). This suggests the market is pricing in some pretty heavy growth relative to the expected growth in 2007.
The Adjusted Buffet indicator is a gauge I developed to adjust out reported economic gains that are solely a function of consumption from debt rather than income. The idea being that debt consumption is actually a net negative to economic growth and therefore is nonsensical to include in growth measures. What we see is that apples to apples the Adjusted Buffet indicator has grown by 150% since 2007, suggesting that either the economy needs to accelerate significantly or market pricing needs to come down.
And really this is the crux of the whole debate. Is the economy poised to accelerate or will the market revert back to historic norms through price collapse, as it did in 2008. So let’s have a look at our growth prospects. ‘Secular bulls’ are obviously claiming this time is very different from last time arguing that there will be no repricing as fundamentals actually do signal growth acceleration. Now that’s what they’re claiming but as we always do here at First Rebuttal, let’s have our own look to validate or discredit those claims. Specifically, we are looking for signals of economic acceleration that would support the implied expectation of relatively higher future corporate cash flows.
The above chart is the official real average GDP growth over a 5 yr period ending in the subject year. The idea is to see if generally throughout the economy we see signals of stronger growth than we had in 2007. What we find is that economic growth is 24% lower than it was is 2007. So this does not support today’s higher multiples. But let’s keep going. The market is certainly pricing higher multiples today than 2007 and so surely we should find the growth source for these higher multiples if we just keep digging.
In the above chart, sourced from the Federal Reserve, we see a 10% reduction in cash inflows for the American consumer and we see a whopping 40% decline in net worth to the bottom 90% since 2007. Historically, 70% of economic growth has come directly by way of expenditures from the American consumer. One has to ask oneself, does a consumer with less cash inflow and significantly lower wealth, as absolutely evidenced in the above chart i.e. this is not arguable, lead to sustained higher expected expenditures and thus future corporate cash flows?? The market apparently thinks so, unless we can find another source for the market’s growth expectations. So let’s carry on…
Well consumer cash flows can increase via a rise in income or reduction in costs. Above is the income side which failed to show any rational expectation for signs of consumer expenditures growth but what about the cost side? Well let’s take a look at consumers’ cost of goods and debt service relative to 2007 to see if we have freed up some cash on the consumer’s cost side.
The deflator is a better measure of the bare necessities as these are generally domestic goods and services as opposed to imported e.g. food, rent, public transport, etc. And so we see that cost of goods and services on just the staples have moved up about 2% per year despite the CPI measurement of closer to 1% per year. And so it is clear from the above chart that we had no price relief since 2007 and as such still no logical expectation for increased consumer expenditures. But what about debt service? Interest rates are lower so perhaps the American consumer has freed up some cash flow due to lower rates?
Despite the decline in prime interest rates, average consumer credit rates saw only a 6% decline (from 14.5% to 13.7%, sourced from St. Louis Fed) vs an increase in consumer credit levels of around 30%, as depicted in the above chart. The implication is that the American consumer has increased their total debt service relative to 2007 meaning expected consumer expenditures should be lower than in 2007. This means that both the income and cost side of the American consumes’ cash flows provide an expectation of lowered consumer expenditures relative to 2007. Thus current market multiples should actually be lower not higher based on the American consumer’s financial position. But the search must go on… we are nothing if not perseverant here at F.R. so let’s keep on truck’n.
Ok, so what if consumer cash flows are down and have no signals of improving relative to 2007. This doesn’t necessitate that multiples need actually be lower than in 2007. If each dollar is being used more effectively than in 2007 we could actually generate higher ultimate corporate cash flow growth than in 2007 and this could support higher market valuations. Let’s take a look…
The above chart depicts how effectively we are using both money supply and debt to generate economic growth relative to 2007. And we find that our effectiveness at using money supply has declined by about 25% while our ability to generate output growth from debt has plummeted by 75% since 2007. This actually tells us that even if cash flows were the same as in 2007 our overall growth would still be slower. Given the American consumer actually has less cash flow our reduced effectiveness will result in much lower expected growth than in 2007 and, as such, should result in lower market multiples based on the consumer and economic efficiency.
This is not looking promising for validating the higher market multiples but there could be one saving grace to all of this. Jobs are the key to every economy. The tighter the job market the greater the income distribution. The greater the income distribution the greater all of the above become. And so let’s take a look at jobs today relative to 2007 to look for signs of a tighter job market.
Disappointingly we find that the job market is much looser than it was in 2007 with unemployed and underemployed 26% higher today. And so the likelihood of higher cash flows stemming from a tighter job market is essentially zero, especially given the continuing trend to trade away employees for share buybacks.
And so what we have done by way of the above analysis is provide the proof for the market’s mispricing. Thing of it is, we already knew the market is mispriced. As discussed at the beginning of the article The Fed has told us several times that their mandate for the past 6 years has been to manipulate the market higher so that it creates wealth for those at the top in hopes that this wealth will trickle down onto the rest of America. Based on that declaration of price manipulation, we know the market is mispriced. There is nothing grey or convoluted about that. None of this has been done in secret. So why is it that these TV pundits and politicians spend so much time pitching that the market is fairly valued?? And how is it that those deemed market ‘pros’ are buying into it??
Well perhaps it is not so much that these market pros are buying into it as they are trying to convince us that nothing needs to change. You see while the Fed’s manipulation has not been done covertly the fact that it has failed to create any benefit to the bottom 90% of Americans is very much being kept a secret. Those on top for which the current Fed manipulation is creating extraordinary wealth absolutely do not want a change of policies. And why would they? They are earning incredible wealth while taking no risk.
This completely perverts the basis of capitalism which results in huge misallocations of resources. It is this very misallocation of resources that not only created the economic destruction we saw in the above charts but will continue to deepen the grave we are digging ourselves. What no one can say for certain is how long the Fed manipulation will last because we’ve never been in a situation where the open mandate has been explicitly to push stock prices higher.
The hope was that the wealth would trickle down and improve the fundamentals enough to support the market valuation so that the Fed could quietly hand the market back over to fundamentals as the main pricing mechanism. Unfortunately what they’ve now realized is that the fundamentals are not going to catch up to the market valuation. And so the Fed will have to either continue to manipulate the market or allow it to reprice materially downward.
I expect the Fed has no idea what the next move will be. As I’ve mentioned in the past the Fed can theoretically continue as long as USD strength holds up. If USD devalues significantly the Fed will have to step back and the market will reprice at that point. That said, there doesn’t seem to be a near term concern for USD weakness. But you can see what an incredibly difficult conundrum the Fed has created for itself and for the nation.
By implementing the wrong policies and then refusing to acknowledge it early on, the Fed has undoubtedly created irreparable destruction for all but the very top of the food chain. The destruction is already slowly playing out and that is clear when looking at income, net worth and consumer debt levels. And at some point, as we saw in 2008, an unimaginable amount of pain is going to hit home almost overnight. What more can anyone say about this.
The market is way out of whack and that will continue until it doesn’t. In the meantime 90% of America will slowly degrade. How can any of this be considered a success as we hear so often from the market pros? The one thing that is clear in all of this mess is that our policymakers have failed miserably and so too then have our legislators for allowing this nonsense to continue. But worse is that we the people are failing as Americans. We have an obligation to those who came before us and did their job as Americans and to those who will come after deserving as many rights as were passed onto us.
But we are failing to deliver on our obligations as Americans, that is undeniable. We are allowing the political class to plunder our wealth, negate our freedoms and desecrate our Constitution. Sadly we have become the immoral populace our founding fathers warned all future generations not to become. As the ‘Founding Father of Scholarship and Education’, Noah Webster, put it in 1832,
“if the citizens neglect their duty and place unprincipled men in office, the government will soon be corrupted; laws will be made, not for the public good, so much as for selfish or local purposes; corrupt or incompetent men will be appointed to execute; the public revenues will be squandered on unworthy men; and the rights of the citizens will be violated or disregarded. If a republican government fails to secure public prosperity and happiness, it must be because the citizens neglect the Divine commands and elect bad men to make and administer the laws”
The duty and obligation is ours and so too then are the failures and successes of our society. Unfortunately ours will be the first generation to have failed at being American. Yet regrettably more unfortunate is that it will be the innocent generations yet to come that will bear the full costs of our failures. We are 15 years in to what is absolute denial regarding the competence of our nation’s policymakers. Their failures in taking us to a false war in Iraq, in making a mockery of our rights as Americans and in destroying our economic opportunities are our failures. Yet here we sit, silent and indifferent to our own demise; so completely antithetical to the character of a true American.
