Monday, August 25, 2014

Rickards: Stock market reality check

Listening to mainstream market commentary on television and reading the financial press leaves one with the impression that the economic recovery is gaining strength and that stock market indices, at or near all-time highs, will go higher still.

The litany of market happy talk is impressive. The unemployment rate has dropped to 6.1%, down about 4 percentage points from its peak, and is expected to go lower in the months ahead. The economy created about 230,000 jobs per month in the first half of 2014, which brings the increase in jobs to nine million since the economic recovery began in mid-2009. Interest rates remain low, which supports high asset valuations in stocks and housing. Inflation is tame and expectations about future inflation are well anchored. To hear the stock market bulls tell the story, all is right with the world.

But all is not right. In fact, the fundamentals of the U.S. economy are in awful condition and are getting worse. Almost everything about the happy talk story is superficial, and falls apart under scrutiny. There is an alternative narrative of bad news that is seldom discussed on mainstream business channels but is well known to analysts. When these adverse trends are taken into account one conclusion in inescapable. The stock market and economic fundamentals are on a collision course. One or the other will have to swerve. Either the economy will have to improve rapidly and unexpectedly and reverse its fundamental weakness, or inflated stock values are heading for a precipitous fall. The evidence suggests that the latter is more likely.

The first weak link in the happy talk chain is the nature of job creation. For example, it was reported than 288,000 jobs were created in June. But full-time jobs declined by 523,000 while part time jobs increased by about 800,000. The widely reported increase in net jobs masked a disastrous loss of full-time jobs offset by a huge increase in part-time jobs. The part-time jobs offer fewer hours, lower pay and few benefits. They may be better than no job at all, but they are not the kind of jobs that will support discretionary consumer spending on which the economy relies for growth.

This trend in part-time jobs is not new. There are 7.5 million people working part-time on an involuntary basis compared to about 4.4 million doing so in 2007. This rise in part-time jobs is expected to continue because it is driven in part by Obamacare, which does not require coverage for part-time workers. Employers are aware of this and simply cut full-time jobs and replace them with part-timers to reduce insurance costs.

Nor is there any comfort in the declining unemployment rate. Much of the decline is attributable not to job creation but rather to the decline in the number of people looking for work. Once people stop looking for a job, they are no longer technically “unemployed” and the unemployment rate drops even though no job has been found. As columnist Mort Zuckerman said, “You might as well say that the unemployment rate would be zero if everyone stopped looking for work.” Only 62.8% of Americans participate in the work force today — the lowest level since 1978.

The news gets worse. Not only is labor force participation low, and full-time employment collapsing, but the productivity of those working is now in decline. This decline in productivity is another drag on growth. The reason for it is even more disturbing. Productivity is declining because capital expenditure has slowed. Businesses are keeping up with demand by employing part-time workers instead of investing in the plant and equipment needed to make full-time workers more productive.

Not surprisingly, this triple-whammy of declining full-time jobs, declining productivity and slowing capital investment means that real wages are stagnant. If workers can’t make more, they can’t spend more without borrowing. Borrowing is more difficult because home equity has not recovered from the 2007 housing crash and lending standards are the most stringent in years. Companies won’t invest in equipment if consumers can’t spend.

The result is a death spiral of lower consumption, lower investment, declining productivity, stagnant wages, and underemployment all feeding on each other and making the overall economy weaker. This is the real reason for the shocking 2.9 percent decline in first quarter GDP. It was not the result of “cold weather,” which by the way happens every winter.

There are other signs of ill health in labor markets. In a dynamic labor market, net job gains reflect large numbers of new jobs and lost jobs as employees confidently quit their jobs in the expectation of finding new ones. But evidence reported by Goldman Sachs and James Pethokoukis of the American Enterprise Institute shows that job turnover has declined sharply as employees are extremely reluctant to quit their jobs in an uncertain environment. This tends to lock-out the unemployed who lose job entry opportunities and to weaken wage growth as employees lose leverage to demand raises.

Labor force participation is unlikely to rise significantly partly because of generous benefits that provide an adequate lifestyle for those out of the labor force. The U.S. has over 50 million on food stamps, 11 million on disability, and millions more on extended unemployment benefits. Prospective loss of these benefits creates a high hurdle to motivate a return to the workforce.

The news from abroad is no better. China is slowing precipitously and may be on the brink of a credit collapse. European growth is near zero and even the mighty German economy, the locomotive of Europe, is slowing partly because of weaker demand from Ukraine, Russia and China.

Against this backdrop, mainstream voices are beginning to call U.S. financial markets a bubble. The New York Times recently featured a front page story with the title, Welcome to the Everything Boom, or Maybe the Everything Bubble. The conservative Bank for International Settlements in Switzerland recently warned that stock markets had become “euphoric.” Even Janet Yellen of the Federal Reserve, the institution with the worst record for spotting asset bubbles, said that valuations of some securities “appear stretched.”

So, the conundrum is complete. Stock indices march to all-time highs while economic fundamentals fall apart. The two will be reconciled either with a spectacular turnaround in growth or a spectacular collapse in stock prices. The problem is that a turnaround in growth can only come from structural reform, not money printing. Structural reform is the job of the White House and Congress, not the Federal Reserve. Since the White House and Congress are barely speaking, no help should be expected from that direction. Therefore a stock market collapse is almost inevitable and is probably coming soon.

James Rickards is portfolio manager for the West Shore Real Return Income Fund and the author of “The Death of Money,” a New York Times best seller from Penguin Random House. Follow on twitter @JamesGRickards