Is the US Economy Stagnating?
This year I have heard a lot of arguments about the stagnating US economy. GDP is not growing at 3%. Labor participation is at an all time low. Retail sales are failing expectations. PMI indexes are coming down from the 60s to the mid 50s. Monthly job gains can’t go beyond the 300,000 level. First quarter GDP was negative. Margin levels are at all time highs. There is a financial crisis just around the corner. Sometimes, the chorus is so overwhelming from a number of online pundits I highly respect, that I just feel like I should pack my bags, put all my money in cash and gold and forget about investing in the stock markets.
Yet, the financial market continue to disprove this investment thesis. Commodity bloodbath continues – gold (GLD) and silver (SLV) continue to bleed down. Oil (USO) and natural gas (UNG) just can’t engineer a recovery. The S&P 500 (SPY) is trading in a range and rarely gives you an opportunity to buy at 3% discount. Bonds (AGG) continue to hang on. Here are the Year-to-Date returns of all major asset classes with the ones mentioned highlighted in yellow:
Does this look a collapsing economy? The answer is a resounding NO. The markets just don’t think the economy is collapsing.
Economic Stagnation is a Myth
And it is not just the markets that think that the economy is doing fine. The reality is such. The US economy is doing just fine. In order to answer some the “slow growth” or “growth slowing” arguments out there, I went to TradingEconomics.com and got the US GDP and US Population data from 1990 till 2014. Put it in a spreadsheet. Drew a chart. 10 minute exercise. Here is what I discovered:
Source: Trading Economics
The US since 2010 has far outperformed the golden 90s in terms of GDP added. The US economy routinely adds north of $600 billion in new gross domestic product. Keep in mind that the GDP is already inflation adjusted (GDP is gross receipts divided by the GDP deflator – a chained CPI inflation measure). $600 billion – this is Apple’s market cap. Since 2010, the US has been adding the equivalent of one company the size of Apple per year! That is no small feat.
Ok, obviously there are more people working today than in the 90s. Let’s look at per capita GDP addition:
Source: Trading Economics
Again the picture doesn’t look bad at all. Americans work hard and continue to be very productive. Yes, some people may be out of a job, but those that do work, work hard and productively. So no, the US economy is not heading for a recession. Quite the opposite. Times have rarely been better. Here is the raw data for these charts in case you are interested:
Source: Trading Economics
The Ends Justify The Means
Ok, so let’s say that the markets and the economy are artificially goosed by FED/ECB/BOJ money printing and generally available liquidity. As an investor and a person, I generally fall in the Machiavelian “Ends Justify The Means” school of thought. It doesn’t matter how you do it, so long as you get it done.
So what if the Central Banks have unlocked the printing press? Prosperity is prosperity no matter how it is accomplished. Would we like the economy to grow without being coddled? Absolutely, yes. But what if it doesn’t grow without being coddled? What if coddling is required?
If this was your child, would you drop it on the streets on Day 1 after turning 18 and let it beg for food to teach it a lesson? Sink or swim? Yes, some tough parents would do exactly that. Yet other parents might try a different approach. They might try to slowly remove levels of support, allow for an adjustment, before they take the next iterative action leading their kids slowly to complete independence. Might take 5 years. Might take 10 years. However long it reasonably takes. Well, this is exactly what the Bernanke/Yellen FED has been doing. Maybe putting a woman at the highest leadership position in finance is not such a bad thing. Maybe the US economy can benefit from some motherly instincts.
The Central Bankers of 2015 have had a lot of lessons to learn over the past 30 years. Sharp interest rate rises have lead to financial maladjustments and panics. Financial panics and stock market drops lead to what should be completely unrelated consequences where the business community in general panics and tightens the investment purse. That in turn leads to job losses and economic recession. That script has played out so many times, I mean at some point, you’d think the Central Bankers will learn their lesson. And it seems that they have. They have to worry about 2 things – inflation and employment. If inflation is not a threat, then they should do everything at their disposal to improve employment.
Are We In a Bubble?
The end result of a policy such as this is a financial bubble. The first question is there a bubble. A very compeling argument can be made that the SPX is at bubble-like valuation levels. Price to Earnings ratio of 21 or 22 is not for the faint of heart.
Yet a dividend yield of nearly 2% is not far from 2.18% yield for 10 year Treasury Bonds. Earnings yield (the inverse of P/E) is at 4.6% (1/21.5) – far higher than the 2.18% level. According to the FED Earnings Yield Model first revealed by Alan Greenspan a few years ago, the S&P 500 P/E ratio could double from here to 45 and once Earnings Yield hits long-term treasury bond yield at 2.5%, stocks will have a achieved valuation parity.
May be. At the end of the day, investors invest for the hard cash they receive not for the ability of some corporate honcho to produce outstanding profits so that he can then turn those into a mind-boggling year-end bonus. I mean nobody really wants other people to use their money, leverage them and make a ton of money without sharing, right? So dividend yield which measures the hard cash investors receive is probably a better marker to use in our comparison with the 10-year bond. And those are roughly the same. Stocks are actually slightly overvalued based on this marker. But companies have the ability to increase dividends. And the FED does not want to increase interest rates and thereby bring bond yields up higher. As it stands at present, stocks are fairly valued so longs as this interest rate regime persists and earnings and dividends don’t decline precipitously.
Financial Regulation Works
In addition, Central Banks will not use the crude tool of rising interest rates to contain a financial bubble. They will use other tools – macroprudential tools as they call it – to contain a financial bubble. They will raise cash requirements at banks, they will make it harder to go public, they will bury the compliance departments of companies in paperwork, they will send black Chevy vans with FED agents over to look over books and do penetration tests. Once they see the black vans, the last thing on a corporate honcho mind is how to lever up to keep his bonus big. At that point, he is in a battle for his own job. The question is, is he going to have a job tomorrow? Centralized regulation works and the Central Banks have finally abandoned the Alan Greenspan counter-party check system in favor of centralized financial regulation. So long as regulation doesn’t escalate into dictatorship, the outcome will be good.
The Most You Can Lose is 100%
The financial bubble in venture capital can also be contained very quickly. But the powers that be have deliberately decided that a venture capital is good for the country. The experience of the 90s taught them that young people need young companies. Startups may not make money, but startups are a perfect training ground for young people. Young people learn practical job skills which they can later translate into real jobs at real companies that make profits. So the FED will let the entrepreneurial spirit of America thrive even if some inconsequential app maker gets a ridiculous valuation. And private equity and venture capital investors are more than willing to play along. Recently, I heard these words of wisdom from somebody who was in early on Facebook and Twitter and countless other companies that went public the past couple years at his six figure annual membership country club:
“After all, if you invest, the most you can lose is 100%. If you don’t invest, you may give up 10000% gain. “
So venture capital groups together, individually they put small bets, but taken together big bets and they let the startups of America help improve the job outlook for our young graduates. That is not going to change any time soon.
BEST INVESTMENT THEME of 2015
Low volatility continues to be the best investment theme of 2015. On this list of 60 major ETFs, the Short Volatility ETF (XIV) continues to be a resounding winner over any other ETF this year beating by 40% the next closest runner up the Japan Currency Hedged ETF (DXJ) :
July proved to be a very treacherous month for the SPX, featuring surprise rips and dips that didn’t align well with historical averages. The XIV was also rather volatile, but still ended up with a 18%+ gain on the month. On the charts below the light blue bars are the daily average for that trading day within the month since 1990 (that being the year the SPY and VIX were introduced and modern financial markets started). The purple bar is the actual daily return for July. The red line is the average month-to-date return through that trading day for the month. The purple line is the actual month-to-date return for July:
Data Source: vixcontango.com
August tends to be the worst month for the SPX. On average, the month starts with a 3% drawdown which then it slowly recovers from to post a slight average loss of -0.5%. That in turn leads to a rise in volatility and XIV consequently suffers. XIV drops 7% in the first 2 trading weeks of August and continues to drop until it posts an average 12% loss for the month.
Data Source: vixcontango.com
Given that July was very choppy on a day to day basis and daily moves didn’t conform to historical averages, I think August will be more of the same. In fact, I kind of expect August to be a positive month given that it has been so negative in the past. This year, Market Makers have been very adept at moving averages against historical performance and given the low volume of August, I expect more of the same. Given the historical risk, I would tighten stops in XIV and SPX, but if the month starts on a positive note, you should continue to ride the low volatility train.
This year looks very similar to 2012 and 2013 when the XIV posted bigger than 50% YTD return through the end of July. In both of those years, the XIV continued to gain an additional 38% and 27% to close the year with 154% and 107% gains respectively.
So to summarize, continue to be short volatility.