What Happened To The Earnings Recession?

Summary: A year ago, profits for companies in the S&P had declined 15% year over year (yoy). Sales were 3% lower. Margins had fallen more than 100 basis points. The consensus believed all of this signaled the start of a recession in the US.

How has that dire prognosis worked out? In a word: terrible. Jobless claims are at more than a 40 year low and retail sales are at an all-time high. The US economy continues to expand.

In the past year, S&P profits have grown 12% yoy. Sales are 2.4% higher. By some measures, profit margins are at new highs. Why were the critics wrong? They confused a collapse in one sector - energy, where sales dropped by 60% - with a general decline in all sectors. Energy was considered the same as financials in 2007-08; events since then show that it is nothing like financials.

Where critics have a valid point is valuation: even excluding energy, the S&P is highly valued. With economic growth of 3-4% (nominal), it will likely take exuberance among investors to propel S&P price appreciation at a significantly faster annual clip.

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A year ago, profits for companies in the S&P had declined 15% year over year (yoy). Sales were 3% lower. Margins had fallen more than 100 basis points. The consensus believed all of this signaled the start of a recession in the US.

The chart below was from Barclays at the start of the 2016, who said that big drops in profitability like those last year have coincided with a recession 5 of the last 6 times since 1973 (read further here). Enlarge any chart by clicking on it.

Technology, Not Trade or Regulations, Killed Manufacturing Jobs

Summary: Manufacturing output is at an all-time high. Manufacturing employment is at a post-industrialization low. Deregulation, dollar devaluation and protectionist/isolationist policies will not resurrect manufacturing employment.

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The Economist:

In the early postwar decades, the American economy grew at a healthy clip. Millions of Americans earned a middle class wage by working in manufacturing. In recent decades, rising inequality and the stagnation of middle class earnings have generated a wave of nostalgia for the postwar economy, and for manufacturing employment in particular. If only America hadn't lost its manufacturing edge, all would be well.

You might reasonably guess that manufacturing in the US is in a secular downtrend. It's not. Real output is at an all-time high (ATH). It has nearly doubled in the past 30 years.

Forecasting The Next Recession Based On The Calendar And The Presidency

Summary: The US economy will soon be in its 8th year of expansion. The US will also have a new president next year. So, is a recession a certainty in 2017? No. Economic expansions don't die at a predetermined definition of old age, and changes in the presidency have not been a useful predictor of a coming recession. The danger in forecasting based on these things is that it makes an imminent downturn appear to be a fait accompli. It's not, and believing that it is closes your mind to other possibilities. Maintaining a mind open to changes in the data and the opportunities they present is the essence of successful investing.

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Will 2017 bring a recession? The calendar says it's likely.

The Great Recession officially ended in June 2009, 7-1/2 years ago. That is already a long time without a recession. Since 1900, the US has stayed out of a recession longer only two other times: the 1960s (9 years) and the 1990s (10 years).

There have been 23 recessions since 1900, and 21 of them have taken place within 8-1/2 years of the prior one's end. So, the historical odds based on the calendar say the next recession is likely to start in 2017 (21/23 = 91%).

Notably, the time between recessions has been expanding over time. At the turn of the 20th century, recessions took place very other year. They now take place nearly every other decade. Consider the following:

Between 1900 and 1928: a recession every 1 year and 10 months.

Between 1929 and 1949:  a recession every 3 years and 8 months.

Since 1950:  a recession every 5 years and 9 months. 

Since 1990: a recession every 8 years.  

Fund Managers' Current Asset Allocation - November

Summary: Throughout 2013, 2014 and early 2015, fund managers were heavily overweight equities and underweight cash and bonds. Those allocations entirely flipped in 2016, with investors persistently shunning equities in exchange for holding cash.

Global equities are more than 15% higher than in February. A tailwind for this rally has been the bearish positioning of investors. Cash remains in favor (although levels dropped significantly this month) and equity allocations are just slightly higher than in February. Overall, fund managers' defensive positioning supports higher equity prices in the month(s) ahead.

Bearish sentiment remains a tailwind for US equities. That is somewhat less true for European equities. Emerging markets became the consensus long last month and the region has since been pummeled. Those markets are now in the process of resetting.

Findings in the bond market are of greatest interest this month. Fund managers' inflation expectations have jumped to the highest level in 12-1/2 years. Similarly, their expectations that the yield curve will steepen are the highest in 3-1/4 years. When this has happened in the past, yields have been near a point of reversal lower, at least short-term.

The dollar is considered overvalued for the first time since April 2016. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Cash: Fund managers' cash levels dropped from 5.8% in October to 5% in November. That is a big drop for one month but recall that 5.8% was the highest cash level since November 2001. Cash has remained above 5% for all of 2016, the longest stretch of elevated cash in the survey's history. Some of the wind behind the rally has faded but cash remains supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish. Enlarge any image by clicking on it.

Small Caps Impulse Into A New All-Time High

Summary: The small cap index is at a new all-time high today, having gained more than 13% in the past 10 days. That type of price behavior has historically been very bullish. Add to that (a) positive seasonality and (b) bearish sentiment just a few weeks ago, and the odds favor further gains into year end. There's just one thing: strong gains like this usually take place during or right after a bear market low. This makes the current rally to new highs an anomaly, having the slight whiff of euphoric capitulation.

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The Russell 2000 (RUT) index of small cap stocks is at a new all-time high today. This new high is coming after the index has risen more than 13% over the past 10 days.

We think of strong gains in a short period of time as the initiation of a new uptrend. In other words, stocks fall hard into a capitulatory low and then reverse. The strong "impulse" higher from the low means that investors are switching sides and chasing price higher. That momentum most often continues into the weeks ahead. This is how new uptrends typically begin.

That's not always the case; there are exceptions, but there are exceptions to every pattern in the markets. Still, the odds overwhelming favor further upside: according to Ryan Detrick, RUT has risen more than 13% in a 10 day period 21 times before. In all but one, the index was even higher a month later. Since 1991, the median gain was 3%.

Which makes the current rise over the past 10 days an historical anomaly. The chart below looks at prior gains of 13% over 10 days since 1991. All occurred during or after a bear market. In each case, the gain of 13% either started at a significant low or was within a just few weeks one. Enlarge any image by clicking on it.

Interview With Financial Sense on US Debt

We were interviewed by Cris Sheridan of Financial Sense on November 9, the day after the US presidential election. During the interview, we discuss fiscal spending, US debt at the federal and consumer level and the impact on all these with the election of Donald Trump.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.

Fund Flows, Investor Positioning And The "Secular Low in Yields"

Summary: In July, fund managers' had their highest exposure to bonds in 3-1/2 years. In other words, they expected yields to keep falling. Instead, yields reversed higher and have since risen so sharply that several smart money managers now say that a new secular uptrend in yields is taking place. That is a big call, given that the foregoing secular downtrend has lasted more than 35 years.

Over the past 18 months, investors' money has been flowing consistently out of equity funds. Where has that money gone? Mostly to bond funds. Money usually follows performance, so it's a good guess that fund flows might soon begin to favor equities. If past is prologue, then equities should gain and bond yields should continue to rise. Whether that will constitute the start to a new secular uptrend for yields it is far too early to say.

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Perhaps the most prevalent storyline in the markets over the past several years has been the long term secular decline in interest rates. Not just in the United States, but worldwide, low economic growth and persistently weak inflation has contributed to falling sovereign yields.

Interest rates have historically moved in cycles. On a relative basis, yields were as low as they are now for most of the period between 1900 and 1960 (the 10 year is currently 2.2%). Rates rose for 20 years until 1920 and then fell for 30 years into the 1950s. Then came a long secular rise in rates until 1980. That 30 year period has been followed by one even longer, as rates have cycled down over the past 4 decades. Enlarge any image by clicking on it.

Demographics: The Boomers Have Already Been Overtaken By The Millennials

Summary: Demographics is a key driver of economic growth. Most people focus on the aging of the Boomer generation. But the working-age population in the US has been growing almost as fast as the retirement of Boomers. Millennials are now the largest living generation and will be in the working-age population until well past 2050. "By 2030 the top 11 birth cohorts will be the youngest 11 cohorts. The movement of these younger cohorts into the prime working age is a key economic story in coming years."

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Nearly 20 years ago, investors started becoming concerned about the aging demographic profile in the United States. The concern was understandable: the largest birth cohort in the nation's history was close to entering retirement. Between 1940 and 1950, the number of births per year in the US increased by a massive 45%, and that group would begin retiring in 2005. Enlarge any chart by clicking on it (data from Doug Short).

Copper Prices And The Global Economy

Summary: The rising price of copper is probably a good sign that the global economy is non-recessionary. When copper has risen, so has GDP. But the converse is not true: falling copper prices have not signaled a slump in the economy.

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Copper prices are surging. The metal's price is up over 20% in 2016. Current prices are the highest in about 18 months. Enlarge any image by clicking on it.

November Macro Update: Wage Growth Accelerates, But Some Signs of Weakness Creeping In

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

That said, there are some signs of weakness creeping into the data. Retail sales are at a new all-time high, but overall growth is decelerating and less than 2% real. Employment growth is also decelerating, from over 2% last year to 1.7% now. Housing starts and permits have flattened over the past year. There is nothing alarming in any of this but it is noteworthy that expansions weaken before they end, and these are signs of some weakening that bear monitoring closely.

Overall, the main positives from the recent data are in employment, consumption growth and housing:

• Monthly employment gains have averaged 197,000 during the past year, with annual growth of 1.7% yoy.  Full-time employment is leading.
• Recent compensation growth is the highest in more than 7 years: 2.8% yoy in October. 
• Most measures of demand show 3-4% nominal growth. Real personal consumption growth in September was 2.4%.  Retail sales reached a new all-time high in September.
• Housing sales are near a 9 year high. Starts and permits in August remain near their 8 year highs, but growth has been flattening.
• The core inflation rate has remained near 2% since November 2015.

The main negatives are concentrated in the manufacturing sector (which accounts for just 10% of employment):

• Core durable goods growth fell 2.0% yoy in September. It was weak during the winter of 2015 and it has not rebounded since. 
• Industrial production has also been weak, falling -1.0% yoy due to weakness in mining (oil and coal). The manufacturing component grew +0.1% yoy.

Prior macro posts from the past year are here.

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Our key message over the past 2 years has been that (a) growth is positive but slow, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes (enlarge any image by clicking on it).

A valuable post on using macro data to improve trend following investment strategies can be found here.

Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.


Employment and Wages

The October non-farm payroll was 161,000 new employees plus 44,000 in revisions.

In the past 12 months, the average monthly gain in employment was 197,000.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low prints of 84,000 in March 2015 and 24,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.