The most recent market narrative is that “green shoots” are appearing and a “recession” will be avoided. The implication is: “Put your money into the market because, without a recession, markets are safe.” Nothing is further from reality. Below, I will document some of the “green shoots.” But, realize, the economies of the world, and the U.S. continue to decelerate. With 43.6% of the top line revenues of S&P 500 companies coming from overseas sales, and with the economy of Europe rapidly sinking, it is going to be difficult for S&P 500 companies to grow their revenues.
It is a quarterly game played by Wall Street analysts. They lower top and bottom line “estimates” so that 67% of companies typically “beat.” That excites non-professional investors, and stock prices get a lift. The recent action in Morgan Stanley’s stock is a good example. With their recent “beat,” their stock price rose. Never mind that profits were down -9% from the year earlier quarter. The truth is, Q1 earnings estimates have been lowered for S&P 500 companies such that they are now -4% below their Q1/18 levels. Going back to mid-2018, the estimates for Q1/19 were +8%. Looked at from a GDP perspective, according to Wall Street economist David Rosenberg, pre-tax corporate profits peaked in Q3/18 at $2.18 trillion and have since fallen -7%. That puts pre-tax profits where they were in 2012 when the S&P 500 was trading at half the level it trades at today as today’s markets make historic new highs.
The point here is that, by any standard metric, valuations are at the high end of their historical ranges. If a recession does come along, the equity markets will likely suffer a “bear” phase, which usually sees 30% to 50% downdrafts. But, even if there is no recession, the slow growth characteristics of the economy, together with the high valuations that currently exist, are powerful arguments that some sort of “correction” is due. Corrections are usually downdrafts in the 20%-30% range. Thus, there is strong evidence that investors should take some equity money off the table.
Indeed, that appears to be exactly what is happening. February’s TIC data, prepared by the U.S. Treasury and the BEA, indicated that foreigners were net purchasers of fixed income assets to the tune of $42 billion in February, but were net sellers of equities of $11 billion (and sellers of $205 billion of those equities over the preceding 12 months). Domestic data from BAC Merrill Lynch show a net $90.7 billion exodus from equities so far in 2019 with a $120.2 billion inflow to bond funds. And market analysts can’t figure out who’s buying (machines?, corporate buybacks?). A recent WSJ article (“Trading Activity Stalls as Stocks Approach Records”, April 15, B10, A. Ramkumar) indicated that not only is YTD average trading volumes unusually low, but the most recent volumes are even below those weak averages. Rising stock prices on weak volumes have always been red flags.
Of course it is important to assess trends in the current economic environment. Let’s first look at the “green shoots.”
- China’s GDP, at +6.4% (annualized) for Q1 beat the +6.3% consensus;
- China’s exports rose +14% Y/Y in March;
- EU construction was +3.0% M/M in February (-0.8% in January), its unemployment rate is steady, retail sales in the U.K. rose 1.0% sequentially in March, and German investor confidence was at a +3.1 level in April from -3.6 in March;
- S. retail sales were up +1.6% in March – which surprised markets, and U.S. GDP for Q1 may top 2%, another unexpected “green shoot;”
- The N.Y. Fed Manufacturing Index rose +6.4 points in April;
- Some large banks, like JPM and WFC “beat” on earnings.
Unfortunately, Wall Street tailors data to fit its current narrative, and some important caveats are never mentioned. Here are some of those caveats:
- China’s “official” data is suspect. A recent Brookings paper indicates that since the recession, Chinese GDP estimates have been inflated by, on average 1.7 percentage points;
- The +14% growth in China’s exports were greatly inflated by the timing of the Lunar New Year from 2018 to 2019; quarterly data show export growth at less than 2%;
- Positive “green shoots” in the EU were offset by really ugly German production and export data, the likelihood that the U.K. retail sales spurt was Brexit related, and the fact that Italy’s economy continues to sink. When the Greek economy is the EU’s shining star, you know things have to be awful;
- The U.S. retail sales jump looks to be related to the late Easter and Passover holidays which likely played havoc with the seasonal factors. Let’s see if April confirms;
- About half of U.S. real GDP growth for Q1 is going to be influenced by inventory accumulation and by a falling trade deficit. Much of the inventory growth was unwanted, and the falling trade deficit is mostly due to weak imports (-7.9% annual rate) neither of which are good signs for future growth. Rising gasoline prices, too, are sure to impact non-energy sectors in Q2;
- In the N.Y. Fed’s Manufacturing Index, there was a very large -17.2-point decline in the future business sub-index, and there were declines in important areas like future new orders, unfilled orders, shipments, the number of employees, delivery times, prices, and capex all of which continue to point to slower business activity;
- All of the reporting large banks significantly increased their loan loss reserves; Citi guided earnings lower, and PNC guided loan loss reserves much higher. Rising loan losses are not a green shoot.
So, almost all the “green shoots” come with blemishes.
Now for the not-so pretty data:
- China’s imports fell -7.6% in March after falling -5.2% in February. How strong can that economy really be?
- Japan’s exports in March fell -2.4%, and exports to China were down -9.4%, confirming China’s flagging import data;
- Official German growth estimates for 2019 fell to +0.5% from +1.0%;
- Eurozone imports were -2.7% sequentially in February with exports down -1.4%; in addition, new auto sales were negative;
- S. Industrial Production fell -0.1% in March and has shown a negative growth trend since Q3/18;
- Citigroup’s top line revenues for Q1 were -2%; those of Goldman Sachs were -13%;
- S. housing data is indicates that housing is in recession with permits and starts falling in March and the three-month annual rates down double digits for both. New home sales were up slightly in March, likely due to homebuilder discounts and lower interest rates, but that doesn’t take this sector out of its funk;
- The Philly Fed Index lost -5.2 points in April with vendor delivery times, order backlogs, hiring plans, pricing plans, and forward expectations all falling sharply;
- S. employment via the Household Survey (a survey of the number of people working) indicates that employment in the U.S. actually fell in Q1; this seems to contradict the Establishment Survey (a survey of how many net new jobs large businesses create). When these surveys diverge, Wall Street chooses the one that fits its current narrative, all but ignoring the other survey.
There still seem to be more withering vines than green shoots. Nevertheless, improvement occurs first at the margin (specifically in the 2nd derivative), i.e., a slowing in the deceleration is the first sign of stabilization, and we should be watchful for such signs. But, regardless of whether or not there is a near-term recession, the growth rates in the U.S. and developed world economies do not appear robust enough to support the current high equity market valuations. So, if we don’t end up in a “bear” market prompted by a recession, a “correction” is still a high probability event. There are always individual stock bargains. But the typical non-professional passive investor or an investor in index-based funds, should be cautious in today’s slower growth world.