Most people get it when they see a sign reading “Free beer tomorrow” hanging above a bar. The few who are naive enough to show up the next day, only to find the same sign, get it at that point. Only sophisticated investors and economists keep coming back. Again and again. Maybe on the third or fourth day, beer will indeed be free? Their elaborated mathematical models give them insights that mere experience cannot. As the saying goes, why believe your own lying eyes?
For more than four years now, the Fed, economists, the administration and the media have hung their own versions of the free beer sign: “Recovery Around the Corner”. Sometimes they changed the words. They promised “green shoots” and then a “summer of recovery”. Sometimes the recovery was going to lead to 4% growth (last year), then 2.5% was going to do it (this year). None of these predictions materialized, but investors, like the guy in the bar, kept looking forward to tomorrow. In early 2013, markets once again rallied on expectations of a sustainable recovery. Economists, who make a living predicting recoveries that never happen, are at it again: this time it is for real! The Fed needs growth to justify its reckless money printing. No wonder, then, that it continues to see the economy through rosy glasses.
Unfortunately, last Friday’s jobs number is again questioning the power of Bernanke’s crystal ball. Fewer jobs were created in the first quarter of 2013 than in the same quarter last year. In spite of all the propaganda, it is becoming increasingly obvious to non-economists that money printing is not creating growth. GDP last year did not expand by the announced 4%. It barely achieved 1.7%, decelerating to 0.4% in the last quarter. 2013 is not different. Look for more downward revisions.
The question is: how many more failed predictions will it take before the Federal Reserve Bank finally loses credibility? And what happens then? We have given the Fed so much power that one wonders how painful it will be to revert back to a free market economy.
GDP predictions based on flawed models is not the only problem for investors. Do we really believe in official CPI numbers whose largest component is the vaguely defined “owners’ equivalent rent”? Even the Bureau of Labor Statistics admits, “Clearly, the rental value of owned homes is not an easily determined dollar amount, and Housing survey analysts must spend considerable time and effort in ESTIMATING this value (my highlight). In the years before the housing bubble burst, owners’ equivalent rent failed spectacularly to send a warning signal to the Fed. This guessed element of the CPI (30% of core CPI) can easily cause an underestimation of what the real inflation number is.
Now, let’s assume that the CPI is indeed underestimated by 2% (as shadowstats.com suggests). That means that real GDP growth last year was not 1.7%, but -0.3%.
Similarly, what credibility should people give official unemployment numbers? Do we have to accept the notion that 7% of the population has vanished because they are “discouraged”? Such nonsense always allows for nice headlines. When people disappear from official statistics, the unemployment rate declines. When unemployment resumes its upward trend, bulls can then point to the fact that these zombies are rejoining the community of happy workers. Always look at the bright side.
A New Crowding Out Effect
Forecasters are overly optimistic. Economic statistic are dubious. But the biggest problem with the Fed lies elsewhere: it is the crowding out effect. Here again, what you see is not exactly what you get. One may think there is no crowding out effect today. In spite of large amounts of capital borrowed, interest rates are not going up. But look again.
First, these rates are kept below market rates through direct intervention from the central bank. The Fed has taken market forces out of the bond market. Furthermore, banks are taking advantage of free money to buy Treasuries, cashing in the 2%-or-so spread without any work or risk. Since there is so much public debt available, it becomes the only game in town. Why take the risk to lend to individuals and businesses? Shellshocked, over-regulated bankers have no incentives to lend to the real economy.
This is what happened in Japan in the last two decades. As a result, Japanese banks now lend more money to the government than to the private sector. The irony is that today the Japanese look to Bernanke for guidance. Instead, Bernanke should look to the Japanese experience. If he did, he would understand how cheap money combined with an overinflated public debt has deprived the private sector of the liquidity banks used to provide.
That is the fundamental reason why the American economy is not and will not resume its traditional growth rate. Do not believe the Fed. Don’t trust economic statistics. It is time to fight the Fed. Do not heed its call to take on more financial risk.
Stock Market Implications
Another year of sub-par growth will make it difficult for companies to grow their top line. Already profit margins are at historic highs. So, the market rally can only come from PE expansion.
US profit margins as a percentage of GDP have hovered around 10% for 3/4 years now. Before reaching this stratospheric level, profits peaked around 8% of GDP only a few times in recent history.* Through cost cutting, companies have now reached profitability levels never seen since World War II, a period when the average was somewhere around 6%. I think it prudent thus to assume that US profit margins will not go up from here.
That means earnings growth has to come from top line growth. But, as we have seen, the economy continues to disappoint in the US. At the same time, Europe is mired in a lasting recession and many emerging market economies are slowing down. Even Japan, the markets’ new darling, is only hoping to get out of its deflation through the world’s most ambitious money printing program yet.
If one has to participate in today’s equity inflation, extreme prudence is required. Companies with strong pricing power should be privileged to cyclical stocks that depend on volume growth. Apple (AAPL) comes to mind, especially after the recent correction.
Some turnaround stories also offer nice opportunities. Nokia (NOK) most prominent among them.
* Source: John Hussman