“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email, Twitter and/or Facebook.
The Rising Risk Of A Recession
It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.
The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:
“Bull markets are more fun than bear markets.”
Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.
Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the reality of recessionary cycles in the economy, investors are repeatedly crushed by the inevitable completion of the full economic cycle.
The table below details the impact to the financial markets throughout U.S. history during recessionary periods in the economy.
As shown, the markets tend to decline by 30% on average historically but, as witnessed since the turn of this century, some recessionary declines can be far worse. The resulting destruction of investor capital leaves many unable to reach their financial goals longer term as they repeatedly spend years trying to “get back to even.”
While much of the financial media and Wall Street analysts continue to ignore the risks of a recession, there are some important warning signs that suggest this might be a bad idea.
1) Peaks in “real” profit margins have always preceded the onset of an economic recession.
2) Earnings growth has also turned negative which has also been a leading indicator of both weaker economic growth and market returns.
3) Sharp declines in imports suggest that domestic consumption (almost 70% of GDP) is declining. Declines in exports, which comprises more the 40% of corporate profits, suggests global growth is weak as well. Historically, this combination has suggested a recessionary economic environment.
The point is that while it may not be fashionable, or polite, to discuss the rising risk of a recessionary environment, the warning signs are becoming more pronounced that such is the case.
The problem, as always, is the timing. The danger is adopting “hope” as an investment discipline.
Retail Sales Flash A Warning
Rich Duprey recently wrote:
“Total Black Friday sales fell 10% this year to $10.4 billion. Retailers who opened their doors on Thanksgiving failed to make up for that shortfall, as the $1.8 billion in sales that day were 10% lower as well…it looks like this holiday season may be shaping up to be a disappointment for the retail industry.
But maybe not. First, Black Friday has seen its influence diminished over the years as retailers begin promoting the holiday shopping frenzy earlier in the season.
But the most important change reducing Black Friday’s dominance is the switch to online shopping.”
As discussed above, the importance of consumption with respect to the overall economy cannot be overlooked. As such, retail sales, which comprises roughly 40% of personal consumption expenditures, is a good indicator of the overall health of consumer activity within the economy.
Therefore, let’s look as some of the data in this respect.
First, the annual rate of change of retail sales has been on the decline since 2012 which is supports the lackluster rate of economic growth within the economy.
Secondly, hiring of retail sales workers has also been on the decline suggesting that retail stores already had a strong suspicion that activity would be weaker than last year. As Challenger, Gray & Christmas recently reported:
“In addition to the November slowdown, retail hiring in October was adjusted downward from 214,500 to 210,400. That still represents a record high for October retail hiring, but it suggests that overall seasonal hiring may very well shrink from 2014 levels…”
Lastly, despite hopes that retail sales have simply switched from “brick and mortar” to “clicks,” credit and debit card data suggests that online sales have been weak as well. As reported by BofA:
“Retail sales ex-autos are down 0.2% yoy. However, part of this weakness owes to a decline in prices. After controlling for deflation, real retail sales ex-autos are up 1.3% yoy in November, revealing a slowing trend but not an outright decline.”
Moreover, there are disinflationary pressures elsewhere, presumably reflecting pass-through from the stronger dollar, which could continue.”
The problem is the TREND of the data more than the actual level of the data itself. While it is widely hoped that the Christmas holiday shopping season will be an economic boon, the trend of the data suggests such will likely not be the case.
Of course, with retail sales weak, imports and exports plunging, and “deflationary pressures” impacting the economy – one should probably question what data is Janet Yellen actually looking at to justify hiking interest rates now?
The Apex Of Stupdity
Just recent John Mauldin posted a fantastic article by Charles Gave entitled the “The Apex Of Market Stupidity” The entire article is worth reading but here is the important point:
“In the last week, we have reached what is surely the apex of this stupidity. A bunch of algo traders programmed their computers expecting “Derivative Draghi” to be extremely dovish, as any proper Italian central banker should be. I am not sure I understand why, but some traders obviously decided that he had not been dovish enough. European stock markets plunged by -4%, while the euro went up by roughly the same amount in the space of a few minutes. What that means is simple: value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months. So we are in a world where I can postulate the following economic and financial law: variations in the value of assets are a function of the expected changes in the quantity of money printed by the central bank. To put it in a format that today’s economists understand:
where VA is the value of assets and M is the monetary increase.
What we are seeing is in fact in one of the stupidest possible applications of the Cantillon effect, whereby those who are closest to the money-printing, i.e. the financial markets, are the biggest beneficiaries of that printing. This is exactly what happened in 1720 in France during the Mississippi Bubble inflated by John Law. The end results were not pretty.
What I find most hilarious is that some serious commentators have been pontificating at considerable length about what the market’s participants think. These days, some 70% of market orders are generated by computers, and many of the rest by indexers. And computers do not think. They simply calculate at light speed, which allows them to react to short term movements in market prices as they were programmed to do. And since they are all programmed the same way, the result is some big short term market moves. In essence, these computers act as machines that allow market participants to stop thinking. As a result, I cannot remember a time when less thinking has ever been done in the financial markets, which is why I find today’s financial markets infinitely boring.
We are swimming in an ocean of ignorance, just like France in 1720. It seems all the painful economics lessons learned over the last 300 years have been forgotten. I suppose that means we will just have to wait for another Adam Smith to appear. La vie est un éternel recommencement…”
Just something to think about.
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In