Today’s forecast for the US economy & stock market: cooling, perhaps with storms.

Summary: Today we have another briefing on the US economy and stock market. The situation grows darker, cliffs might lie ahead, but it’s still too soon to say more than that. Read on to learn the details.  {1st of 2 posts today.}

This is a new economic regime, profoundly different than the post-WWII era. Many of the relationships we used to navigate by have changed, as things considered extraordinary have become normal (e.g., long periods of zero interest rates and even negative rates). Yet there are warning signs with a long history of accuracy.

Don’t be comforted by economists’ optimism; many studies have shown their unreliability (especially their inability to foresee recessions). Listen instead to the 30 central banks that have cut interest rates this year, showing their true view of the situation.

For clear advice I recommend reading Albert Edwards of Société Générale, among the most insightful of investment strategists. In this from his 12 February report he gives the essential facts about our situation:

The market seems pretty convinced that the Fed will tighten in the middle of this year and maybe it will. Certainly the labour market is tighter and the Fed tells us that the recovery is well established. But, the Fed always spins a bullish yarn. Their track record of over-optimism is only surpassed by the appalling record of private sector forecasters – most especially in forecasting recessions. A rate hike this year when deflation pressures are intensifying could go down as big a policy cock-up as the BoJ raising VAT {valued-added taxes} in 1997, triggering recession, or the ECB tightening rates in July 2008 when the global recession was already well underway!

His report on 26 February updates that with the missing part of the equation: bad news. US economic data has grown worse since he wrote this.

 

Investors are transfixed instead by the Fed and when it will tighten rates and can’t see the wood for the trees. The Fed’s focus on payrolls, a lagging indicator, is most perplexing but not unusual at this stage in the cycle. The reality is that the vast bulk of economic, as well as earnings, data (even outside the energy sector), has been simply dreadful.

Corporate Earnings

The slowdown in job growth (a lagging indicator) reported on Friday should not have surprised anyone given the long series of poor news about the economy. Next we should expect feedbacks that further slow the economy (i.e., second and third order effects). Such as falling corporate earnings, reversing the trend that has so enriched the 1% since the crash — as little of the recovery’s gains have gone to the rest of us.

Analysts are usually too optimistic, coming only slowly down to reality — but Q1 was an unusually severe crash, a break in the long years of rising earnings. Much of this results from falling prices for oil and other commodities. Much but not all. This graph shows the evolution of forecasts for each quarter, from the initial euphoria to a markdown-to-reality to the slight bounce from the actual results — CFO’s manipulate analysts so the estimates are too low prior to announcing earnings, allowing a small “beat” each month (nothing shows the cynical corruption of this game like the applause from the artificial earnings “beats” each month).

Security analysts are optimists (pessimism doesn’t sell), so they mark down the current quarter but remain hopeful for the rest of the year. So they still expect 2015 earnings to continue their growth since the recession ended. I suspect they’ll be disappointed.

The next shoe to drop: corporate investments

What do CFO’s do when earnings drop? They cut capital expenditures (and jobs). That’s how recessions often begin. That’s what we should be watching for next, as Albert Edwards explains:

The chart above shows that US GDP growth is currently 2½% and business investment is contributing around ½% of that 2½%, i.e. contributing about one-fifth of GDP growth. Normally in a recovery, business investment is not a huge contributor to the recovery (see chart above). But in a recession (i.e. when the dotted line goes negative), the red line totally overlays the dotted line. This means that business investment, only 15% of GDP, fully “causes” recessions.

The stock market

Valuations are high, investors are optimistic, and markets have disconnected from economic fundamentals. Andrew Lapthorne puts this bull market in perspective (Société Générale, 11 March 2015), explaining that:

• This bull move began March 2009 (the recession ended in the 2nd quarter). At 70 months it’s the longest since WWII — slightly longer than the bull move that ended in 2000, and longer than the 60 months of the move that ended in 2007.
• This S&P has risen over 200%, the 3rd largest after the 300% move ended in 1929 and the 225% that ended in 1999.
• The S&P has gone over 800 days without a 10% correction, far behind the 1200 days ending in 2007 and the 1800 days ending in 2000.

The common element to the great bull markets ending in 1929, 2000, and 2007: they all were driven by speculation and ended badly. Unregulated free markets require sacrifices. They reoccur because we FAIL to learn.

Conclusions

We can see details, but the big picture remains lost in the fog. That’s still often true despite our vast economic and financial reporting systems — so superior to what past generations worked with. We can see that the slow growth since the 2008 crash (the equivalent of flying close to the ground) means that slowdowns put us at risk of recession, and that the economy is clearly slowing. Caution is warranted. Saying more than that would be guessing.

My prediction is that the next recession — almost certain during the next few years — will mark a decisive break with the post-WWII era, taking us into a new economic regime. What might that look like?

For More Information

If you liked this post, like us on Facebook and follow us on Twitter. See all posts about economics, about markets, and especially these about financial bubbles:

• Let’s ignore another warning from the BIS. Do we enjoy paying for burst bubbles?
• How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.
• We see a stock market bubble but prefer to close our eyes.
• About the disturbing disconnect between markets and the real economy.
• Economics gets interesting as the economy darkens while stocks bubble.
• Don’t ask if there’s a biotech bubble. Ask why we have another bubble.

I recommend these books for those who would like to learn more about this things:

• Charles P. Kindleberger’s Manias, Panics and Crashes: A History of Financial Crises (1978).
• Michael Lewis’ The Big Short: Inside the Doomsday Machine (2010).
• Essential reading: Charles Mackay’s Extraordinary Popular Delusions and The Madness of Crowds (1841).