David Stockman: The Bottom Is Definitely Not In

By David Stockman as originally published on Contra Corner and reprinted here with permission

Flush. Rinse. Repeat. BTFD!

Well, you could also give a good whack to the weak hands, burn the over-boughts, call in the sideline cash and get giddy about the fundur…mentals!

After all, the man on bubblevision said nothing has changed since the January 25 high at 2873 on the S&P 500. So there’s that: Another easy peasy 6% gain by just getting back to the trajectory of still another blowout year.

Moreover, having posted nine consecutive such years, one more doesn’t seem that hard to imagine, nor does another successful episode of buying the dip. The chart below documents dozens of that very thing since the March 2009 bottom.

Unfortunately, it also charts an alternate financial universe that is treading hard upon its sell-by date. That is, this is not the work of a capitalist free market in equity securities; it’s the consequence of a $14 trillion bond-buying spree by the Fed and other central banks since the financial crisis.

This tsunami of false liquidity and the accompanying price-keeping operations did drastically suppress interest rates and fuel rampant free-money carry trades. It also fostered the TINA (there is no alternative) trade in stocks and the investor scramble for yield into corporates and junk bonds, which, in turn, triggered massive corporate financial engineering maneuvers.

The latter flushed trillions of buying power into the Wall Street casino, even as it shrunk the supply of equities. Deeper in the casino, short sellers were executed, portfolio hedging became dirt cheap and various exotic forms of structured finance in options and volatility trades ramped the stock indices still higher.

At length, the financial markets and the main street economy became completely decoupled, and that is the true “fundamental” that has not changed in the last two weeks. It’s also the fundamental which guarantees that the Friday-Monday swoon was just a minor warm-up for the main event.

That’s because the economy is getting progressively weaker and longer in the tooth—-even as the central banks pivot away from the massive liquidity injections which inflated and sustained the financial bubble.

Indeed, whatever dip buying that remains will likely be shallow and short-lived. The peak level of central bank liquidity injection at a $2.1 trillion annual rate is already fast sinking toward the flat line, pulled down by the Fed ramping its bond dump-a-thon toward $600 billion per annum and the fast fading ECB’s bond-buying campaign as it glides toward the zero bound by October.

So the time is at hand to say good-bye to the chart below. Rather than climbing much further to the upper right, we think it is only a matter of time before involuntary cliff-diving becomes the order of the day.

The perma-bulls, of course, implicitly argue that someone or nother (they don’t say who or what) has abolished the business cycle, and that a never before midnight hour romp is about to hit the current aging recovery. When it comes to business cycle repeal, we’ll take the unders. But even then, it does seem pretty evident that the US economy is not about to get a shot of monetary Viagra from the Fed.

It’s still run by Keynesians, and Jerome Powell is just Janet Yellen in trousers and tie. The whole posse encamped in the Eccles Building is increasingly desperate to normalize rates and re-load their dry powder—least they get bushwhacked by the next recession and are left sucking their thumbs for wont of stimulus tools.

Apparently, the thought in the casino is that even if the Fed repairs to the sidelines, the GOP’s big bad tax cut is going to kick-start our greying economy now entering its 104th month of expansion. But the punters forgot to factor in what happens when you have an honest financing (i.e. not monetized by the central bank) of an erupting deficit.

That’s understandable enough. Since the Fed and other central banks have been sequestering (monetizing) Washington’s prodigious debt emissions for decades, the muscle memories in the bond pits have apparently atrophied or undergone elective surgery.

But this time the old-fashioned ill of “crowding out” is roaring down the tracks toward the fiscal year incepting in October (FY 2019) wherein the Treasury is set to borrow about $1.2 trillion which will crowd into a bond market that will be also absorbing $600 billion from the Fed’s QT dump-a-thon.

We think what happens is a “yield shock” not a kickstart, and the new data presented below on the spending melee underway in Washingtion only adds to conflagration ahead. Still, it is worth asking what happened last time we were at month #104 of an economic recovery.

In point of fact, it has only happened twice in modern US history. The longest expansion on record was 119 months between 1991 and 2001.  Accordingly, the #104 mark occurred in early 2000, and here’s what happened to real GDP and corporate profits thereafter.

That obviously didn’t justify the sky-high PE multiples then extant because it turns out that that time wasn’t different, either. Even then, the global and domestic headwinds that loom ahead today are far more forbidding then they were back then.

Nevertheless, real GDP succumbed to the flat line during the next several quarters and corporate profits growth went down for the count.

End of the Cycle: Month #104 to #128 of the 1990s Expansion

Nor is the above some kind of fluke outlier. Here is what happened after month #104 of the second longest expansion in modern history (108 months) during the 1960s. It goes without saying that pricing in 40% profits growth over the next two years, as is embedded in the current Wall Street hockey sticks, would have been a considerable mistake.

End of the Cycle: Month # 104 to month # 128 of the 1960s Expansion

The truth is, there is no historical, logical or empirical basis for pricing the S&P 500 at 26X end-of-the cycle earnings—to saying nothing of the Russell 2000, which stood at 150X before last week’s break. Honest price discovery has been so completely ruined that there is no analysis left on Wall Street; it’s now operating purely on fairy tales, hopium and residual momentum.

Specifically, there is absolutely no evidence that the US economy has gotten some kind of late cycle booster-shot sufficient to even remotely support the current “strong growth” narrative. The latter consists of nothing more than cherry-picked odds and sots sent out by the brokerage houses after each morning’s economic releases to keep the mullets hitting the “buy” key.

The latest factoid of this sort was the 2.9% year over year wage growth in last Friday’s jobs report. This was treated as evidence at long last of “escape velocity” and that just around the corner lies a virtuous circle of higher household incomes and spending and then more Keynesian multipliers etc. etc.

Alas, the data point was a false positive. The public relation’s departments of corporate America—especially for companies with M&A deals, tax rulings, regulatory approvals or trade restrictions pending on Washington dockets—did indeed ladle out unusually high January bonuses, thereby giving the Donald some Twitter material while helping their own cause in the process.

But it wasn’t escape velocity: The data for all US production and non-supervisory workers (80% of all employees), who generally do not get bonuses, prove that in spades. To wit, year-over-year hourly wage growth clocked in a 2.4% in January 2018 compared to 2.3% last January and 2.4% in January 2015.

The evidence that nothing is happening and that wages are barely keeping up with the CPI (2.1% Y/Y) is embodied in the chart below. When it comes to the ballyhooed wage acceleration narrative, in fact, we are of mind to start a “Where’s Waldo?” contest.

Annual hourly wage growth has been flat-lining ever since the so-called recovery incepted, and has averaged nearly 2.2% per year since January 2010, which is to say, about where we are still stuck.

To be sure, the super-perma-bulls don’t even put much stock in the economic outlook and the certainty that the current cycle will end in a down-turn like all others. Nor does it appear to dawn on them that when the cycle turns, earnings will plunge due to the double whammy of debt leverage on top of operating leverage.

At the early 2000 peak of the long 1990s cycle shown above, for example, earnings posted at $52 per S&P 500 share. As it happened, six quarters later earnings for the LTM period ending in December 2001 were down by a whopping 53% to $24.70 per share.

No matter. The Wall Street earnings narrative is always and everywhere about “growth”. When earnings decline, it’s excused as temporary or factored away via “ex items” adjustments. Likewise, short-term upticks are ballyhooed in a context-free manner and when all else fails there is the “evergreen” sell-side hockey stick.

These never fail to start high, as shown in the charts below. That is, the outlook is always rosy for the year or two years ahead, but is then forgotten about as the hockey sticks gradually get ratcheted back to earth. Only when actual results “beat” the drastically flattened hockey sticks that have quietly crept into place by the eve of earnings season, do we hear from them again.

The above chart is ex-items and eliminates most of the bad stuff. Still, with nearly 70% of companies reporting, it appears that operating earnings for 2017 will barely make $124 per share, not the $135per share projected two years ago. And that’s just 8% more than the $115 per share posted for the LTM period ending three years ago in September 2014.

In fact, however, the actual earnings “growth” story is even more tepid. According to this morning’s S&P report, GAAP earnings for 2017 are now pegged at $109.66 per share or just 3.5% higher than the $106 per share reported way back in September 2014.

The so-called  solid “growth” in this quarter’s earnings reports, therefore, reflect nothing more than a round trip rebound from the drop to $85 per share during 2015-16. That, in turn, reflected the most recent global commodity and industrial deflation cycle, which is now nearing its peak recovery, as well.

In fact, on the excellent chance that we are near the tail end of the current business expansion, the results for 2017 mean that S&P 500 earnings will have grown at just 2.4% per annum during the entire peak-to-peak business cycle since June 2007. Accordingly, even bull market euphoria can’t justify a PE multiple at 10X the 10-year growth rate.

As to the bond market collision, more on that tomorrow, but we think it will be a doozy. The Senate RINOs (Republican In Name Only) have apparently reached a “parity” deal with the Dems to add $150 billion per year to appropriated spending for the current fiscal year (FY 2018) and next year (FY 2019), and to be roughly split between defense and non-defense—plus $80 billion for disaster relief.

That will surely keep the government open—even as the US treasury speeds back into a era of permanent trillion dollar deficits sans debt monetization by the Fed.

Needless to say, that is going to generate one major “yield shock” as apparently already happened today when the 10-year UST spurted toward 2.85% on the budget busting deal’s announcement. It’s also going to generate a political shock that will rattle what remains of the GOP to the bones.

As indicated below, Chuckles Schumer and the Dems are happy as claims.

“Democrats have made our position in these negotiations very clear,” Schumer said on the Senate floor Tuesday. “We support an increase in funding for our military and our middle class. The two are not mutually exclusive. We don’t want to do just one and leave the other behind.”

The House Freedom Caucus, however, is most definitely not!

Even the rumors of a coming deal were enough to send some hard-liners reeling.

“This is a bad, bad, bad, bad – you could say ‘bad’ a hundred times – deal,” said Rep. Jim Jordan (R-Ohio), a co-founder of the House Freedom Caucus. “When you put it all together, a quarter-of-a-trillion-dollar increase in discretionary spending – not what we’re supposed to be doing.”

 

Stay tuned!