Resilient Consumer? Not During The Manufacturing Retreat And Corporate Revenue Recession
Is the 70% consumer so resilient that he/she can overcome a global slowdown, a stagnant domestic manufacturing segment and a domestic revenue recession. Six of the regional Fed surveys – New York (Empire), Philadelphia, Kansas City, Dallas, Chicago and Philly – show economic contraction in manufacturing. The expected revenue for the S&P 500 for the third quarter is headed for a third straight quarterly decline at 3.3%; the 4th quarter should show a 1.4% decline to make it four in a row. Concerned investors started punishing foreign stocks and emerging market equities in May. The primary reason? Many feared the adverse effects of declining economic growth around the globe as well as the related declines in world trade. By June, risk-averse investors began selling U.S. high yield bonds as well as U.S. small cap assets. A significant shift away from lower quality debt issuers troubled yield seekers, particularly in the energy arena. Meanwhile, the overvaluation of smaller companies in the iShares Russell 2000 ETF (NYSEARCA: IWM ) prompted tactical asset allocators to lower their risk exposure. All four of the canaries (i.e., commodities, high yield bonds, small cap U.S. stocks, foreign equities) in the investment mines had stopped singing by the time the financial markets reached July and early August. I discussed the risk-off phenomenon in August 13th’s ” The Four Canaries Have Stopped Serenading.” What had largely gone unnoticed by market watchers, however? The declines were accelerating. And in some cases, such as commodities in the PowerShares DB Commodity Index Tracking ETF (NYSEARCA: DBC ), investors were witnessing an across-the-board collapse. The cut vocal chords for the canaries notwithstanding, there have been scores of warning signs for the present downtrend in popular U.S benchmarks like the S&P 500 and Dow Jones Industrials. Key credit spreads were widening, such as those between intermediate-term treasury bonds and riskier corporate bonds in funds like the iShares Baa-Ba Rated Corporate Bond ETF (BATS: QLTB ) or the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ). Stock market internals were weakening considerably. In fact, the percentage of S&P 500 stocks in a technical uptrend had fallen below 50% and the NYSE Advance-Decline Line (A/D) had dropped below a 200-day moving average for the first time since the euro-zone’s July 2011 crisis. (See Remember July 2011? The Stock Market’s Advance-Decline Line (A/D) Remembers. ) Equally compelling, any reasonable consideration of fundamental valuation pointed to an eventual reversion to the mean; that is, when earnings or sales at corporations are rising, one might be willing to pay an extraordinary premium for growth. On the other hand, when revenue is drying up and profits per share fall flat – or when a global economy is stagnating or trending toward contraction – investors should anticipate prices to fall back toward historical norms. Indeed, this is why 10-year projections for total returns on benchmarks like the S&P 500 have been noticeably grim. Anticipating the August-September volatility – initial freefall, “dead feline bounce” and present retest of the correction lows – has been the easy part. When fundamental valuations are hitting extremes, technicals are deteriorating, sales are contracting and economic hardships are mounting, sensible risk managers reduce some of their vulnerability to loss. It is the reason for my compilation of warning indicators (prior to the downturn) in Market Top? 15 Warning Signs . Anticipating what the Federal Reserve will do next is a different story entirely. The remarkably low cost of capital as provided by central banks worldwide is what caused the investing community to dismiss ridiculous valuations and dismal market internals up until the recent correction. Now Fed chairwoman Yellen has explicitly acknowledged that the U.S. is not an island unto itself. The fact that half of the developed world in Europe, Asia, Canada, Australia are staring down recessions – the reality that many important emerging market nations are already there – has not slipped by members of the Federal Reserve Open Market Committee (FOMC). Unfortunately, the Fed’s problem with respect to raising or not raising borrowing costs does not end with economic weakness abroad. With 0.3% year-over-year inflation in July, the Fed’s 2% inflation target has been pushed off until 2018. With 0.2% year over year wage growth (or lack thereof), the Fed’s hope that consumer spending can save the day looks like wishful thinking. For that matter, as I demonstrated in 13 Economic Charts That Wall Street Doesn’t Want You To See , consumer spending has dropped on a year-over-year basis for 4 consecutive months as well as six of the last eight. Perhaps ironically, I continue to receive messages and notes from those who insist that the U.S. consumer is in fine shape. Even if he/she is stumbling around at the moment, he/she is consistently resilient, they’ve argued. I would counter that three-and-a-half decades of U.S. consumer resilience is directly related to lower and lower borrowing costs. Without the almighty 10-year yield moving lower and lower, families that have been hampered by declining median household income depend entirely on lower interest rates for their future well-being. Even with lower rates, perma-bulls and economic apologists will tell you that housing is in great shape. With homeownership rates now back to 1967? They’ll tell you that autos are in great shape. On the back of subprime auto loans with auto assemblies at a four-and-a-half year low? Wealthy people and foreign buyers have bought second properties, which have priced out first-time homebuyers. More renters than ever have seen their discretionary income slide alongside rocketing rents. And the only thing we’re going to hang our U.S. hat on is unqualified borrowers who cannot get into a house, but can get into a Jetta? (Yes, I intended the Volkswagen reference.) I am little stunned when I see people ignoring year-over-year declines in retail sales as well as the lowest consumer confidence readings in a year to proclaim that “everything is awesome.” If everything were great, the U.S. economy would not have required $3.75 trillion in QE or $7.5 trillion in deficit spending since the end of the recession. The Fed would not have needed 6-months to prepare investors for tapering of QE3 and another 10 months to end it; they would not have needed yet another year to get to the point where they’re still not comfortable with a token quarter point hike. The U.S. consumer requires ultra-low rates to get by, and that’s a sad reality with multi-faceted consequences. In my mind, it gets worse. Those who commonly fall back on the notion that 70% of the economy is driven by consumer activity seem to ignore the other 30% entirely. Manufacturing is falling apart. Year-over-year durable goods new orders? Down for seven consecutive months. Worse yet, six of the regional Fed surveys – New York (Empire), Philadelphia, Kansas City, Dallas, Chicago and Philly – show economic contraction in manufacturing. Does the 30% of our economy that represents the beleaguered manufacturing segment no longer matter? Is the 70% consumer so resilient that he/she can overcome a global slowdown, a stagnant domestic manufacturing segment and a domestic revenue recession? Investors who do not want to pay attention to the technical, fundamental or macro-economic warning signs may wish to pay attention the micro-economic, corporate sales erosion. As Peter Griffin of the Family Guy Sitcom might say, “Oh, did you not hear the word?” Simply stated, the expected revenue for the S&P 500 for the third quarter is headed for a third straight quarterly decline at 3.3%; the 4th quarter should show a 1.4% decline to make it four in a row. The Dow Industrials? They’ve experienced lower sales for even more consecutive quarters. Beware, perma-bulls would like to blame this all on the energy sector. Should we then ignore the ongoing declines in industrials, materials, utilities, info tech ex Apple? If we strip out energy, do we get to strip out the over-sized contribution of revenue gains by the health care sector? There’s an old saying that goes, “You can’t making chicken salad out of chicken caca.” Here’s the bottom line. Moderate growth/income investors who have been emulating my tactical asset allocation at Pacific Park Financial, Inc., understand why we will continue to maintain our lower risk profile of 50% equity (mostly large-cap domestic), 25% bond (mostly investment grade) and 25% cash/cash equivalents. We are leaving in place the lower-than-typical profile for moderates that we put in place during the June-July period. When market internals improve alongside fundamentals, we would look to return to the target allocation for moderate growth/income of 65%-70% stock (e.g., large, small, foreign, domestic) and 30% income (e.g., investment grade, high yield, short, long, etc.). For now, though, we are comfortable with lower risk equity holdings. Some of those holdings include the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ), the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) , the iShares Russell Mid-Cap Value ETF (NYSEARCA: IWS ) and the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ).