Economy: The Glass is Half Full…And Filling Up by Todd Sullivan, ValuePlays

“Davidson” submits:

1)      If one studies markets using the historical record, the most striking feature revealed is that fundamental economic trends correlate with the long term trends in equity prices.

2)      If one examines multiple measures of economic activity, they correlate with each other and let one make good guesses as to future changes in security prices. There exist ‘forecastable’ patterns!!

3)      But, security prices are not directly determined by the level of economic activity…If only it were so simple!!

4)      Security prices are determined by what investors think fundamentals are worth-Here is where simple interpretations become very, very messy and why so many specific price predictions fail.

5)      Most investors believe that markets and market psychology control the economy, but in reality it is economic supply/demand which impacts investor psychology and thus market prices.

6)      Nonetheless, economics are very helpful in predicting market direction even if not precisely!!

Below are 5 economic charts which together show the economic correlations to which I refer and a chart of the SP500w/earnings & Selected P/E Levels Dec 1939. (The economic charts come from the St Louis Fed FRED site http://research.stlouisfed.org/fred2/ and the SP500 data comes from Standard&Poors site http://us.spindices.com/ .

Economy

Economy

Economy

Economy

Economy

The story these tell us are that we and markets always recover from severe corrections. Reading human history should convince anyone who is willing to take the time, that economic cycles have been with us as long as there have been groups of humans living together. We always recover from corrections, but then we also continue into another period of excess, but net/net we progress ever ahead in our standard of living even though it is a bumpy ride historically. Many have called this behavior ‘Bipolar’, the swing from wide-spread pessimism to wide-spread optimism. It is the swing from the belief that ‘nothing is going right’ to the belief that ‘nothing can go wrong’ which drives market psychology and this is intimately connected to economic fundamentals. Market prices are pure psychology while economic fundamentals are supply/demand. Market psychology is generally correlated to fundamentals over the long term, but often shows little specific correlation short term. The history is clear if one looks longer term, economics are the larger influence on security prices even though most investors believe that is market psychology which controls everything.

Why most investors do not see the longer term relationships is based on the desire for quick riches in my opinion. Once someone sees that markets react to some news worthy event, the perception that psychology and markets are strongly connected becomes imbedded quickly into investor thinking. Most do not move beyond these short term perceptions because they are investing for quick shifts in market prices and as a consequence spend considerable time, money and effort trying to predict them. ‘Short-termism’ is what causes most investors to miss the broader economic connections to security prices.*

*(I taught investments at one of the nations recognized universities. The accepted mathematical approach in the globally accredited syllabus, which is deemed ‘scientific’, completely ignores economic fundamentals.)

The 6 economic charts below are highly correlated and reflect where we are today. I think they are simple to see even with the separate data sets representing differing periods. The first chart is that of Retail Sales. Sales are strongly representative of economic activity. But, Sales do not come with out increases in Employment, which in turn does not come without Job Openings or demand for Temporary Help. Certainly, none of this activity comes without some increase in Real Disposable Personal Income. What is missing from our current recovery is Privately Owned Housing: 1-Unit Structures which remain at about half the levels we have seen historically.

Housing need in any economy is a huge investment during periods of economic expansion. Our housing has been stifled by tight credit conditions and regulations due to responses to the Sub-Prime Crash. This is why in my opinion “The glass is only half full and filling up…”.Housing peaked in early 2006 or 8 ½ years ago. During this time we have added roughly 22mil individuals to the US population  . Unless something unusual occurs, we should expect the level of Privately Owned Housing: 1-Unit Structures(Single Family Homes) to normalize back to ~1.2mil start rate as the economy continues to expand to accommodate our expanded population.

A hidden element in this recovery is partially shown in the ($SPY)  SP500w/earnings & Selected P/E Levels chart. Without the impact of housing and banking profits, you can see that SP500 earnings are bumping just below the historical earnings channel. Banking and Construction make historical sizable earnings contributions during expansion yet without much contribution from these sectors we are only a little below peak economic performance. What I see happening is revealed by the very bottom chart of Industrial Production vs. Corporate Profits. We have heard no end of complaints that companies have reported much higher profits vs. their revenue(IndProd stands in for this) and many have complained that this is on the backs of employees not receiving wage gains. One has to study business history to understand what is actually occurring but here is my opinion.

Economy

Economy

Beginning in ~1985 the “Leaning of US Industry” began when Toyota began to manufacture in the US. Danaher(NYSE DHR). Art Byrne, the developer of the US version of ‘lean mfg.’ wrote “The Lean Turnaround: How Business Leaders Use Lean Principles to Create Value and Transform Their Company”, Aug 28, 2012 about how this impacted profits and employee engagement.  The methods from the Toyota Business System and as developed at Danaher spread into many corners. United Technology, Johnson Controls, Boeing were early entrants. More recently Ford, Caterpillar and General Electric implemented similar approaches. A key feature of employee engagement are bonuses tied to corporate productivity. In the process, wages act as minimal compensation levels which are supplemented by bonuses based on corporate profitability. The corporate goal is to retain employees with the base wage during economic corrections and add compensation during boom periods through bonuses. Interestingly, the Bureau of Labor Statistics does not record bonuses just wages. In my opinion, this is the basis for those who complain about wages not rising while corporate profits soar. Bonus payments are also the reason why Real Disposable Income has risen to record levels thus far in the current cycle. Yet, we continue hear that wages are stagnant as are Retail Sales, neither of which are supported in the economic data. The history of this quiet revolution is in the Industrial Production vs. Corporate Profits chart.

The Industrial Production vs. Corporate Profits chart shows a period in which the pace (slope) of profits slowed vs. IndPro from 1978 to 1986. Once ‘lean mfg.’ began to take hold in the US the slope of profits turned higher and has continued to out pace IndProd ever since.

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