It’s generally accepted that the US economy is recovering. And this recovery is supposed to justify the high price of the US stock market. This is despite corporate sales growing less than 2% during 2013. Some recovery. In fact there is a strong sign that the US economy could head back into recession soon. If this is the case then it has wide ranging implications for investors.
Albert Edwards is the renowned equity strategist at French bank Societe Generale. He’s consistently one of the most bearish voices around, which is rare among investment bank strategists.
Usually the job of such people is to whip investors into a frenzy of elated buying. They are permanently bullish sales people, and as such tend to produce a lot of what you’ll find at the less fragrant end of a bull.
While the bulls are stampeding through the market plains, Edwards the bear sits growling in his cave, only venturing out to take big pawed swipes at all that looks wrong in the world. He’s been doing it for years. He’s good at it. And he’s worth listening to.
In his latest weekly strategy note of 25 March he points out that US profits have started declining. He goes on to explain why this significantly increases the risk of recession in the USA.
The gist of the argument goes like this:
- US corporate profits are not growing, using the calculation method of index provider MSCI
- Changes to MSCI profits signal changes to business investment levels
- Business investment levels are a significant part of GDP and are highly volatile, therefore they drive overall economic growth rates
Looking at the graphs from his report the case seems pretty strong.
Take this first graph which compares annual changes in US MSCI profits (in red) with changes in US business fixed investment (black dotted line) since 1999.
You can clearly see that when profits collapse then business investment tends to collapse as well. And when profits climb then business investment in productive assets is strong.
This is no surprise. Most corporate management teams slash spending and investment when business conditions are weak and uncertain. And most come up with expensive new projects when profits are growing and confidence is high.
(I note however that the best management teams often do the opposite: investing in growth when conditions are weak and prices are low, to gain market share ahead of recovery, and putting aside cash during booms. But the nature of investor pressure for listed companies makes this hard in practice.)
Of course one company’s spending is another company’s income. So when investment spending is slashed it hits the sales of business-to-business providers. That in turn hits the providers’ profits.
Right now MSCI profits are not growing, according to the graph. The last two times profits moved from positive into negative growth – in late 2000 and 2008 – business fixed investment levels plummeted as well. In fact business fixed investment growth was barely positive in the third quarter, up only 2% year-on-year. It could already be on the cusp of turning negative.
Now let’s turn to the link between business fixed investment growth and GDP growth. This next graph shows how volatile business fixed investment is in relation to the rest of GDP growth.
So, as Edwards points out, although business investment is only 13% of GDP it has a big influence on the total GDP growth rate, as shown in this next graph.
You can see from this that whenever business investment has collapsed it’s coincided with a sharp fall in the growth of GDP. Most of the time it has driven an outright recession, with GDP shrinking for a time (see: 1974, 1979, 1981, 1990, 2008 – and very nearly in 2001).
So with US profit growth already on the cusp of turning negative, this could signal a fall in business investment, which in turn could pull the US economy into recession.
The US stock market already trades with a high P/E of 18.9 according to the Financial Times. Prices have been pumped up by money printing (QE) and optimistic profit growth expectations. Actual profit growth has been weak and could be on the cusp of turning negative.
If US equity strategists and stock analysts start to get wind of this then profit growth forecasts will be slashed. Reported profit growth will continue to be weak, and profits may even fall. That’s a very unsteady foundation for a stock market that rose 30% last year. A big stock market fall could be the result.
However, if that happens – with or without an actual US recession – we can most likely expect more intervention by the Federal Reserve, the USA’s central bank.
My bet is that plans to reduce the rate of money printing (QE) and allow interest rates and bond yields to rise unmanipulated market levels would suddenly be put on hold.
The result? More money printing. More market manipulation. More asset price bubbles.
In the meantime I remain sceptical that the US stock market can maintain its current elevated level for long. In the end you need profit growth for prices to rise. This is virtually absent, and may even have already left the party.
Emerging markets are out of favour, and prices are much cheaper as a result. For example, the MSCI emerging markets index has a P/E ratio around 11.8. That’s 38% below the US stock market P/E. It’s also over a quarter below the long run emerging market average of 16 since 1995. Individual country markets offer even better long term opportunities, such as Russia or China.
The lower a market P/E is then the smaller the risk of loss over, say, a three to five year time frame.
A lot of people talk about the risks of these markets. Few talk about the profit opportunities. The lower a market P/E is then the smaller the risk of loss over, say, a three to five year time frame. And the chance of large investment profits in future becomes much higher when you buy at the bargain basement.
Of course if the US stock market crashes then it’s likely that all global share prices will get dragged down in the panic.
But prices always recover to reflect true underlying value, eventually. You just never know when. Anyone who claims they can predict timing of certain price levels is unaware of their limitations…or lying.
On the other hand, maybe there will be no crash at all for years to come. That means that if you stay out of today’s bargains you could miss out.
So my recommendation, fellow OfWealthers, is to concentrate on buying today’s bargains – cheap country indices or individual company shares – stay diversified at all times, and keep cash aside to buy more shares if (when) markets crash.
Stay tuned OfWealthers,
Image credit: David Reber via Flickr