Fed: Stock Market Disconnected from Real U.S. Economy
by Curmudgeon with Victor Sperandeo
In a recently published paper titled: Stock Market Provides Imperfect View of Real U.S. Economy, Julieta Yung1, Economic Researcher at the Dallas Fed, argues that the U.S. economy does not necessarily follow the movement of stock prices.
In particular, she writes:
“The stock market—through measures such as the Standard & Poor’s 500 index—is often thought to be an economic bellwether. [Curmudgeon note: Indeed, it's one of the 10 components of the Conference Board's Leading Economic Indicators]. However, market volatility compromises the reliability of such (stock market) indexes.”
In essence, the paper makes the case that the S&P 500 Index is not a discounting mechanism2 for the U.S. economy and fails as a predictor of gross domestic product.
For example, half the S&P 500 companies are manufacturers, which is much more than what's reflected in U.S. GDP. Service-providing industries have accounted for more than three-quarters of U.S. GDP over the past decade, whereas more than half the S&P 500 consists of manufacturers, Ms. Yung said. Her analysis included recalculating how much sales and profits companies in the index derive from various types of economic activity (see charts in the above referenced Dallas Fed paper).
Note 1. Yung, 29, holds a doctorate in economics from the University of Notre Dame and has authored multiple working papers on the subject of interest rates and their corresponding term structure. The research she conducts for the Dallas Fed is done independently of Fed policy makers and is intended to inform discussion among Fed officers.
Note 2. The CURMUDGEON has opined for years that the stock market was no longer a discounting mechanism for the real economy. Please see this November 2012 blog post for the reasons.)
We agree with this assessment and more importantly, that the stock market is more disconnected from the real economy than ever before.
“There’s a definite divide between the state of the economy and any decline you might see in the equity market,” Yung said in a phone interview with Bloomberg.
Dallas Fed Analysis - Differences between S&P 500 & Real Economy:
Ms. Yung first notes that short term stock price movements are essentially unpredictable, because prices rapidly adjust to reflect updates to NEW information available to investors.
Next, she convincingly argues that declines in equity prices do not directly translate into declines in real economic output. Ms. Yung cites 1st Quarter of 2016 as an example of the U.S. economy not collapsing after stock prices declined sharply during the first six weeks of the year (the worst yearly start in stock market history).
Yung provides several reasons for steep stock market declines not always causing economic weakness (e.g. Curmudgeon notes that the 1987 stock market CRASH was not followed by a recession as many expected.):
1. Unlike rapid price declines in the S&P 500 due to anticipation of negative outcomes, the economy reacts to shocks with a significant lag. “The behavior of households and businesses tends to remain unchanged in the very short term and adjusts to new developments slowly,” Yung notes.
2. An analysis of the S&P vs the real economy reveals key underlying differences in their direct exposure to declines in the price of oil. That's been a primary reason behind recent financial market volatility, she says. Further breaking down the sectors in the stock market indicates pronounced differences in the earnings profile of energy-related firms directly exposed to oil price fluctuations. Please see 5. below for additional analysis of energy vs stock prices.
3. The portion of economic output due to government activities (around 13% in 2015) are excluded when comparing the broader economy with publicly traded companies that make up the S&P 500. That's a crucial (and mostly overlooked) point.
4. Over the past 10 years (on average) non-government output of service-providing industries has accounted for more than three-quarters of total U.S. GDP. This suggests that the service sector produces the majority of output in the economy, a consistent trend that is also evident in the sectoral composition of U.S. jobs. A key reason movement in the stock market may not reflect fundamental changes in the underlying economy is that more than half of publicly traded companies in the S&P 500 mainly produce goods instead of services. That's contrary to all the hype about tech giants (like IBM, HP, Apple, etc.) shifting from goods to services companies!
5. In 1st quarter 2016, the year-over-year market capitalization of S&P 500 goods-producing companies declined more than 4%, driving most of the fall in stock market valuation. Companies classified as service producers experienced an increase of 1%, suggesting that the overall decline in the S&P 500 was not generalized but was mostly concentrated within the goods sector.
6. Energy vs stock price conundrum: In general, low oil prices directly translate into reduced energy company profitability and stock market performance, while firms in other sectors might be less affected or even benefit through lower energy costs.
Conventional economic theory suggests that low oil prices are good for oil importing economies as consumers’ disposable income rises, firms’ energy costs decrease, and redistribution occurs between oil-importing and oil-exporting states. However, the positive effects of low oil prices have been slow to materialize, not only in the U.S., but also in other oil importing countries.
Curmudgeon Note: Consumers should theoretically benefit from the so called “tax cut” of lower gas prices, but that hasn't increased retail sales or the real economy.
7. The declines in the S&P 500 in early 2016 were concentrated in the goods-producing sector, a relatively smaller fraction of the U.S. economy and overall employment as noted in 4. above.
Ms. Yung's Conclusions:
“Disentangling the signals in volatile equity markets is difficult. Moreover, the substantial differences between the composition of the U.S. economy and the stock market complicate such analysis.
Analyzing how different sectors are affected can shed light on the implications of equity market fluctuations for the underlying economy.”
Curmudgeon's Comment and Analysis:
Short-term fluctuations in equity prices have recently been fast and furious, especially since August 2015. IMHO, they are driven by HFT, hedge funds and other short term computerized algo traders that either want to make a quick profit or are trying to get in or out before the other big traders (AKA “front running”). Hence, the down and up stock moves don't have much of an impact on real economic output.
Michael Antonelli, an institutional trader and managing director at Robert W. Baird & Co., says big swings often just reflect human emotions. “The two can disconnect in the short-term because of the immediate effect sentiment has on stocks,” said Mr. Antonelli. “Then that nervousness wanes, and people capitulate, and that’s when you see the market come back,” he added.
Since the Great Depression ended in 1939, there have been 13 stock market declines of 20% or more. 10 of those declines preceded U.S. recessions and only four recessions occurred without a bear market warning, according to data compiled by Bloomberg. Yet that strong correlation may not be significant anymore due to the Fed’s perceived willingness to backstop the stock market during times of trouble (the never ending “FED PUT”), according to Antonelli and many others.
“The Fed has shown a willingness to assure big investors that the stock market hasn’t become shark-filled waters -- that there’s still a lifeguard on duty,” he said. “And the market has absorbed that theory due to all the extraordinary action we’ve seen over the last seven or eight years.”
Nobel laureate Paul Samuelson notably opined on the perils of relating equity markets to overall economic activity. His famous quote has become somewhat of a cliché: “The stock market has forecast nine of the last five recessions.”
Samuelson was an academic whom I assume never traded stocks in his life. Yet when looking at the surface evidence, he would appear to be totally correct. However, there is a big subtlety involved which I'll explain shortly.
First, let me state unequivocally that today there is a virtual 100% disconnect between Main Street and Wall Street, or the economy vs. the equity markets.
This “great disconnect” has evolved over time. From the late 1880's until the (Democratic) Lyndon Johnson administration, the stock markets were very connected to the economy. That was largely due to "free market capitalism,” backed by a virtual gold standard and very little regulation. Things began to change slowly and kept changing into the (Republican) Richard Nixon era. “Tricky Dick” created the EPA by executive order, went off the gold standard, instituted wage and price controls, and many other things which contributed to America's economic and political decline.
Today (and for the past several years), financial markets are 100% manipulated by the Fed. It's done in many ways, including an ultra-extreme interest rate policy, numerous rounds of QE, never ending jawboning or “talk the talk” (which confuses markets), and surreptitious buying of stock index futures and stock index ETFs by Fed surrogates (rumored to be Fed dealer banks and foreign central banks).
What Samuelson did not take into account in his quote above is the fickle finger of the Fed. Stock markets are supposed to be a discounting mechanism. So if they see the economy weakening due to the Fed raising rates like in 1966, and 1987, or for other reasons they will decline. However, if the Fed changes its mind, the market changes also, and very quickly! Perhaps, that's the cause of the last two years of rapid up and down stock price movement after numerous instances of Fed officials double-talk (as we've noted in many, many CURMUDGEON blog posts)!
Today, we have monetary and fiscal policies at odds or 180 degrees out of phase. We have tax increases (2012 and the ACA) and horrendous regulation costs that act as a tax increase on business. The Fed has been “the only game in town” in its (failed) attempt to stimulate the U.S. economy.
Curmudgeon Note: Thanks to the Fed, we have much lower interest rates, but extremely sluggish growth and decreasing corporate profits. Not only are interest rates negligible on T bills, money market funds, CDs, but the 30-year Treasury bond and long duration Municipal bonds are at or very near an all-time low (under 3%). That's quite a bit lower than at the nadir of the Great Recession! That's horrible for savers or retired folks living off interest income.
Higher interest rates are desired by financial asset holders and buyers of fixed income debt. Yet we have incredibly low RECORD INTEREST rates after 7.5 years of “economic recovery.” The collateral damage done to insurance companies and pension funds will be horrendous when the recognition comes. A former Fed official agrees.
Persistently low interest rates are doing "a lot of damage," particularly to the financial industries that underpin the U.S. economy, former Dallas Federal Reserve President Richard Fisher told CNBC this past week. The companies Fisher said he's most worried about are insurers.
The real economy is more effected by freedom, tax decreases, and far less regulation than currently exists. This toxic policy mix has not occurred since 1931.
The essence of economic growth is for tax and monetary policy to be in sync. Until that happens expect more of the same –sluggish economic growth accompanied by frustrating and difficult financial markets. It will be very difficult to make money in the markets, no matter what side (long or short) you're on.
On November 9, 2012, Milton Friedman said:
"Underlying most arguments against the free market is a lack
of belief in freedom itself."
Good luck and till next time...
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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