Tag Archives: bear markets

NFIB Survey Trips Economic Alarms

Last week, I wrote an article discussing the August employment report, which clearly showed a slowdown in employment activity and an overall deterioration the trend of the data. To wit:

“While the recent employment report was slightly below expectations, the annual rate of growth is slowing at a faster pace. Therefore, by applying a 3-month average of the seasonally-adjusted employment report, we see the slowdown more clearly.”

I want to follow that report up with analysis from the latest National Federation of Independent Businesses monthly Small Business Survey. While the mainstream media overlooks this data, it really shouldn’t be.

There are 28.8 million small businesses in the United States, according to the U.S. Small Business Administration, and they have 56.8 million employees. Small businesses (defined as businesses with fewer than 500 employees) account for 99.7% of all business in the U.S. The chart below shows the breakdown of firms and employment from the 2016 Census Bureau Data.

Simply, it is small businesses that drive the economy, employment, and wages. Therefore, what the NFIB says is extremely relevant to what is happening in the actual economy versus the headline economic data from Government sources.

In August, the survey declined 1.6 points to 103.1. While that may not sound like much, it is where the deterioration occurred that is most important.

As I discussed previously, when the index hit its record high:

Record levels of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle.” 

That point of “exuberance” was the peak.

It is also important to note that small business confidence is highly correlated to changes in, not surprisingly, small-capitalization stocks.

The stock market, and the NFIB report, confirm risk is rising. As noted by the NFIB:

“The Uncertainty Index rose four points in August, suggesting that small business owners are reluctant to make major spending commitments.”

Before we dig into the details, let me remind you this is a “sentiment” based survey. This is a crucial concept to understand.

“Planning” to do something is a far different factor than actually “doing” it.

For example, the survey stated that 28% of business owners are “planning” capital outlays in the next few months. That’s sounds very positive until you look at the trend which has been negative. In other words, “plans” can change very quickly.

This is especially the case when you compare their “plans” to the outlook for economic growth.

The “Trump” boom appears to have run its course.

This has significant implications to the economy since “business investment” is an important component of the GDP calculation. Small business “plans” to make capital expenditures, which drives economic growth, has a high correlation with Real Gross Private Investment.

As I stated above, “expectations” are very fragile. The “uncertainty” arising from the ongoing trade war is weighing heavily on that previous exuberance.

If small businesses were convinced that the economy was “actually” improving over the longer term, they would be increasing capital expenditure plans rather than contracting their plans. The linkage between the economic outlook and CapEx plans is confirmation that business owners are concerned about committing capital in an uncertain environment.

In other words, they may “say” they are hopeful about the “economy,” they are just unwilling to ‘bet’ their capital on it.

This is easy to see when you compare business owner’s economic outlook as compared to economic growth. Not surprisingly, there is a high correlation between the two given the fact that business owners are the “boots on the ground” for the economy. Importantly, their current outlook does not support the ideas of stronger economic growth into the end of the year.

Of course, the Federal Reserve has been NO help in instilling confidence in small business owners to deploy capital into the economy. As NFIB’s Chief Economist Bill Dunkleberg stated:

“They are also quite unsure that cutting interest rates now will help the Federal Reserve to get more inflation or spur spending. On Main Street, inflation pressures are very low. Spending and hiring are strong, but a quarter-point reduction will not spur more borrowing and spending, especially when expectations for business conditions and sales are falling because of all the news about the coming recession. Cheap money is nice but not if there are fewer opportunities to invest it profitably.”

Fantasy Vs. Reality

The gap between those employers expecting to increase employment versus those that did has been widening. Currently, hiring has fallen back to the lower end of the range and contrasts the stats produced by the BLS showing large month gains every month in employment data. While those “expectations” should be “leading” actions, this has not been the case.

The divergence between expectations and reality can also be seen in actual sales versus expectations of increased sales. Employers do not hire just for the sake of hiring. Employees are one of the highest costs associated with any enterprise. Therefore, hiring takes place when there is an expectation of an increase in demand for a company’s product or services. 

This is also one of the great dichotomies the economic commentary which suggests retail consumption is “strong.” While business remain optimistic at the moment, actual weakness in retail sales is continuing to erode that exuberance.

Lastly, despite hopes of continued debt-driven consumption, business owners are still faced with actual sales that are at levels more normally associated with the onset of a recession.

With small business optimism waning currently, combined with many broader economic measures, it suggests the risk of a recession has risen in recent months.

Customers Are Cash Constrained

As I discussed previously, the gap between incomes and the cost of living is once again being filled by debt.

Record levels of consumer debt is a problem. There is simply a limit to how much “debt” each household can carry even at historically low interest rates. In turn, business owners remain on the defensive, reacting to increases in demand caused by population growth rather than building in anticipation of stronger economic activity. 

What this suggests is an inability for the current economy to gain traction as it takes increasing levels of debt just to sustain current levels of economic growth. However, that rate of growth is on the decline which we can see clearly in the RIA Economic Output Composite Index (EOCI). 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)

As shown, the slowdown in economic activity has been broad enough to turn this very complex indicator lower.

No Recession In Sight

When you compare this data with last week’s employment data report, it is clear that “recession” risks are rising. One of the best leading indicators of a recession are “labor costs,” which as discussed in the report on “Cost & Consequences Of $15/hr Wages” is the highest cost to any business.

When those costs become onerous, businesses raise prices, consumers stop buying, and a recession sets in. So, what does this chart tell you?


Don’t ignore the data.

Today, we once again see many of the early warnings. If you have been paying attention to the trend of the economic data, and the yield curve, the warnings are becoming more pronounced.

In 2007, the market warned of a recession 14-months in advance of the recognition. 

Today, you may not have as long as the economy is running at one-half the rate of growth.

However, there are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

We do know, with absolute certainty, this cycle will end.

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.” 

Being optimistic about the economy and the markets currently is far more entertaining than doom and gloom. However, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

Two Key Indicators Show the S&P 500 Becoming the New ‘Cash’

Pension plan administrators do it. Their actuaries and consultants do it. Professional endowment and foundation investors do it. Financial advisors do it. Private investors may or may not do it, but they probably should.

Do what?

All of these folks already are or should be asking themselves the following question: What’s a reasonable expectation for the long-term return on a broad-market equity investment?

Professionals usually answer the question using complex models, and there’s nothing wrong with that, but we’ll keep it simple here. Simple often beats the snot out of a long white paper, and two recent developments beg for simple.

First, on Thursday the Fed released its flow-of-funds data, which includes an estimate for the household sector’s overall asset allocation. Data show allocations to corporate equities reaching 25.1% of total household (and nonprofit) assets, a level only before seen between Q4 1998 and Q3 2000. Here’s the full history:

spy returns chart 1

Now, you may say 25% is just a number, and we would agree, but only to a point. We don’t think the household sector’s current allocations tell us anything about the market’s near-term direction. In fact, we don’t detect any of the most common precursors to major market turning points, as discussed here. But we do think household equity allocations offer clues to long-term returns. Consider the next chart, which compares the allocation data to the corresponding S&P 500 returns over subsequent periods of six, eight and ten years:

spy returns chart 2

You’ll decide for yourself, of course, how to interpret the chart, but we’ll entertain three possibilities. First, you might rely on a few instances in which S&P 500 returns reached almost 4% after the equity allocation was 25% or more. Compared to today’s minuscule bond yields, 4% looks respectable. If stocks do, indeed, return 4% over the next six to ten years, that could be higher than the return on any other major asset class, which probably explains how stocks got so expensive in the first place.

Second, you might mentally project the scatter plot’s downward trend out to the current equity allocation. Doing that, returns appear to spread evenly around today’s cash rate of about 1%. So, whereas optimistically you might expect a return of 4% or thereabouts, more realistically a negative return is almost as likely.

Third, you might look at the data and say, “So what? We should really use a traditional indicator—one that compares prices to earnings—not an asset allocation measure.” Which brings us to another recent development that might alter future returns—the S&P 500 busting through 2500. To account for that latest market milestone, the next chart updates one of our favorite S&P 500 indicators, the price–to–peak earnings multiple or P/PE. (Unlike a standard price-to-earnings multiple that places the past year’s earnings in the denominator, P/PE uses the highest four-quarter earnings to date, mitigating distortions that occur when earnings fall in recessions.)

spy returns chart 3

At a price–to–peak earnings multiple of 23.6, we’re currently at about the same valuation as in December 1997. Once again, you might find an optimistic interpretation—that is, the long bull market that finally ended in 2000 suggests there could still be room to bubble up from here. But the implications for long-term returns aren’t nearly as optimistic, as shown in our final chart:

spy returns chart 4

If you stare at the chart long enough, you might see a less bearish picture than in the first scatter plot above. (Stare even longer and you might see the King of France.) But the difference isn’t especially large. On either chart, the downward slope points to a meager long-term return. In fact, if we use only the scatter plots above to make our estimate, while also accounting for the Fed’s predicted interest rate path, the S&P 500 appears to offer a similar return to cash.

Conclusions

To be clear, we’re encouraging long-term bulls to reconsider their assumptions, but we’re not advising them to dismantle carefully diversified portfolios (meaning those that are spread sensibly among multiple asset classes). We would be more likely to recommend a major portfolio shift if the usual bear-market catalysts—sharply rising inflation, high interest rates and poor credit conditions—were present.

More to the point, it seems a good time for investors to check their expectations and risk levels. Investors should develop reasonable expectations informed by data such as those in the scatter plots above. And they shouldn’t take more risk than they’ll be able to tolerate as the next bear market plays out. As always, only a small percentage of investors will accurately time the next market cycle, and we shouldn’t bet too heavily on being among those fortunate few.