by John R. Goltermann, CFA, CPA, CGMA
September 7, 2018
On July 27, 2018, the US Commerce Department reported economic growth of 4.1% – the highest growth rate in well over a decade. The Russell 2000 index, composed of small cap stocks (which are big beneficiaries of US economic growth), promptly declined by 1.9% for the day. This market reaction to what was arguably good news challenged the widely accepted narrative that if the economy grows strongly, the stock market will go up.
This is not a bearish article. Rather, the intent is to bring forward a few thoughts as you consider the amount and type of risks that you own in your investments. At Highgate, we know investment markets are ultimately unpredictable; that said, the broad environment does matter when thinking about how much risk to take. Stocks are trading at high valuations, and while there are many reasons for this, almost none of them hinge on the economy. While stocks may go higher, it is important to pay attention to what is going on – and to spend time understanding your individual investments.
Why a Strong Economy Does Not Necessarily Drive Stock Prices Higher
First, not all economic booms are created equal. Why an economy might be booming matters. There are different types of booms and different factors that drive economic behavior. Some booms, such as those seen in the 1980s, were largely due to changes in demography. Other booms, such as those of the 1990s, were a function of people becoming more productive and the broad adoption of productivity-boosting technologies. Yet other booms, such as the two starting in 2001 through today, were created by the expansion of credit and increased borrowing. In a credit-fueled economy, the quality of the economic boom may not be as high. Today, the amount of debt in the economy has increased because artificially low borrowing costs have, naturally, encouraged more borrowing. Conversely (as shown by the charts below), productivity is down from the three decades prior to 2010 and debt levels are at all-time highs.
The fact that productivity is down and debt has increased calls into question how long the current economic growth period will last: is this the type of growth that predicts higher stock prices, or does it predict tighter credit conditions and an eventual headwind for stock prices? In the mid 2000s, the US had a very strong economy led by an expansion of credit. As we know, that credit cycle ended with an unaffordable and speculative housing market that rolled over, a precipitous stock market decline, and a recession. Since 2009, the US has enjoyed another sustained period of credit expansion, which has again fueled the stock market. It is possible that now, just as many feel prosperous, conditions may be set to change.
The second reason that strong economic growth doesn’t always lead to rising stock prices is that while a strong economy can spark revenue growth, it is profits and profit growth (or at least the prospects for profit growth) that matter for stocks prices. Profit is a major component of a business’ cash flow and a stock’s value is theoretically worth the present value of that business’ future cash flow (admittedly, this is not always how stocks are priced by participants). Generally, if there is widespread belief that the conditions are in place for profit expansion, stock prices can continue to rise because future cash flow is set to rise. While a strong economy drives revenue growth, it can also drive expense growth. Major expenses such as wages can increase, inventory costs can rise, and other operating expenses such as consulting fees, insurance premiums, materials, shipping costs, and rents can also increase. These all crimp profits.
Last year, however, corporate taxes were reduced, which put more money in the pockets of companies and, eventually, their shareholders. This in turn drove stock prices higher. But it is important to keep in mind that that is a one-time effect, not a sustained source of net profit growth.
The third reason that stocks may not careen higher in a strong economy is a cultural shift and the financialization of our economy. At one time, people saved in order to buy what they wanted: people saved up for college, cars, health care – all sorts of important big ticket items. No more. Now with the help of Wall Street “innovations,” there are many mechanisms, instruments, funds, and powerful organizations dedicated to providing credit. Borrowing is now as easy as ever and credit has become the lifeblood of our economy, instead of productivity.
As shown below, households carry high levels of borrowing as a result of this cultural shift, making them more sensitive to increasing interest costs. While household debt levels are not at all-time highs, interest rates – especially long-term rates – are much lower than they were in the mid-2000s. Therefore, today’s debt is still serviceable from income. But if interest rates were to rise (which a strong economy would foster), the high debt levels themselves would cause a slowing in consumption. This is why a strong economy is not necessarily good for stocks.
Since 1977, The Federal Reserve has had a mandate to simultaneously pursue “maximum employment, stable prices, and moderate long-term interest rates.” In an economy as large and diverse as in the US, this is a monumental undertaking indeed for one entity. The main tool it has is the blunt force of interest rates.
After the crash of 2008, in order to meet its mandate the Fed needed to increase economic activity, which it knew would be catalyzed by higher asset prices (stocks and real estate). As the dust settled from the crash and things stabilized, banks looked around at the wreckage and saw cheap assets and near-zero borrowing rates. Credit started to flow. It took a while, but eventually it started to flow into the economy. Rising asset prices and increased borrowing (both of which help the banks) brought on the so-called “Wealth Effect”: when people feel wealthier and more confident, they borrow more, spend more, and generally increase consumerism (over 70% of the US economy is consumption). This causes economic growth and a positive feedback loop. But if asset prices get too expensive and debt becomes more difficult to service through income, consumerism can slow and we can see a negative feedback loop of declining asset prices, less consumption, more fear, further declines in asset prices, and so on.
Excesses that build up in the system need to be purged, which is why booms lead to recessions. This process is inevitable. And the stock market usually rolls over before the economy does because slowing credit flows lead to flattening asset prices and waning confidence, catalyzing a negative feedback loop. Declining asset prices further impair the flow of credit, which our financialized economy needs in order to function. This is what happened in 2008: debt levels got out of control and rising interest rates impaired the flow of credit, thereby causing a vicious cycle of negativity and killing economic growth.
The fourth and final reason is behavioral. When people become accustomed to a long period of prosperity, complacency sets in and their focus becomes more about where to make money and less about risk. But by definition, when asset prices climb, risk increases. Investing is really about mean reversion, and for investors the goal is to try to be well-positioned for when things inevitably revert to the mean. When people assume that interest rates will stay low forever, they become complacent about the risk in asset prices. But if history teaches us anything, it is that the conditions of financial markets do not stay the same forever. Mean reversion happens.
The Watch Outs
While the economy itself is in great shape in many respects, it is not without some issues:
1. The Federal Reserve likes to consider PCE (Personal Consumption Expenditures) as a proxy for consumer spending when it crafts interest rate policy. While people have indeed increased their spending (PCE) as a percentage of GDP, PCE is not a perfect measurement. If one looks deeper into the data and backs out expenditures on healthcare, which is rapidly taking up an ever-greater share of people’s income, consumption has been relatively flat since the mid-1960s (see chart below). Education costs and education-related borrowing are also huge and rising components of spending but are not accounted for here. So, it is possible that the Fed is considering imperfect data and raising rates into an economy that is not as strong as it thinks.
Source: Ned Davis Research
2. Government borrowing and spending have been largely responsible for all of the economic growth since 2001. In Bill Bonner’s book Hormegeddon: How Too Much Of A Good Thing Leads To Disaster (2014), he observes that, “US GDP minus government spending was $9.314 trillion in 2001. Ten years later it had risen to $9.721 trillion.” If one looks at the GDP growth numbers every year since 2001, they are matched more than dollar for dollar by an increase in US treasury borrowing.
At the end of 2000 the treasury debt balance was $5.7 trillion. At the end of the second quarter 2018, treasury debt was $21.0 trillion – a growth in the debt balance of $15.3 trillion in 18 years. Over that time, US GDP grew from $10.2 trillion per year to $19.5 trillion per year. Therefore, the amount by which the economy grew over that time was exceeded by the cumulative amount of annual government deficits. If economic growth is entirely caused by government spending, how sustainable is the growth?
These are two factors to be aware of when politicians and media pundits tout economic growth numbers as though they are news and then imply that the economy is inextricably linked to the stock market. There is always more to the story.
Why the Stock Market Will Probably Continue to Rally. Hint: Credit Markets are Everything.
Now that I’ve covered some of the reasons that economic growth doesn’t always cause stock prices to increase, let’s look at what actually does make stock prices rise.
The US is in the middle of another credit-led equity bull market that is providing massive amounts of capital to companies for shareholder enhancement activities (buybacks and M&A). If you trace the source of these funds, it begins with our public pensions needing to make above-market returns because they use above-market assumptions to project their asset returns. They invest in levered credit funds to shoot for those goals. By “credit” we’re talking about bonds, loans, structured products, mortgage-backed securities, hedge funds that loan money, ETFs that own bonds or loans, money market funds, etc. This is the proverbial shadow banking system that you may have heard about. Those credit funds’ bond purchases (which are loans to corporations) provide firms with cash to boost equity prices through share buybacks, enriching shareholders and providing the fodder for consumer spending, which finds its way into the economy, boosting confidence and triggering a virtuous cycle.
Plan sponsors of pension funds, endowments, and foundations and their investment committees continue to invest aggressively in credit (the leveraged and unleveraged pools of capital that own bonds and loans), driven by the need to achieve unrealistic investment results. That need is created by the growth of their own liabilities minus their cash flows. This “required return” then determines a plan’s risk profile: a mix of asset classes invested to produce the required rate of return, no matter how risky that leaves the portfolio.
Many people do not understand that the primary driver of a credit bull market is not fundamentals (borrowers’ ability to pay, their business models, and their income), but rather the structural need for credit investors, backed by massive amounts of institutional capital, to own credit instruments. These instruments serve as intermediaries that get cash into corporations (where boards of directors perform buybacks), and eventually the cash makes its way into the economy through rising asset prices. The economy does not lead the stock market: the economy follows it. It is credit markets that lead both the economy and the stock market.
In the last 35 years, pension entitlements (the amount of money promised to pension beneficiaries) have gone from 50% of GDP to over 100%. During that same period, pension assets went from $1 trillion to $16 trillion (dwarfing the size and influence of the Fed). The twin financial crises of 2000 and 2008 significantly hurt pension funding levels (see chart below) and produced ever-larger credit booms on their heels because of the need to recoup losses and earn returns at a time when cash paid zero. It is important to understand that unfunded liabilities increase unabated as life expectancies increase, as more pensioners are added, as return assumptions shift, etc. It is now estimated that aggregate pensions are $4 trillion short of being 100% funded. 
Pensions now have to bring in more revenue, invest aggressively in credit, fire bearish managers, and shift to ETFs to try to make up for their shortfalls. This has given rise to an explosion in the business of investing in bonds and loans on behalf of pension plan sponsors (see the chart below that shows the proliferation of new credit funds since 2014).
If you refer back to the chart on the page two that shows the ratio of corporate debt-to-GDP, you can see that credit investments made by pensions have led to increased corporate borrowing. The cash companies receive from borrowing is the fuel that allows companies to buy back their own stock (see chart below).
This credit-led equity bull market (as you can see from the chart below) has been almost entirely fueled by corporations borrowing to buy back their own stock. Investors as a group have actually been net sellers of stock – most likely liquidations to fund individuals’ consumption – because of skepticism over high valuations and reallocation to investments that appear to have less risk, i.e., real estate, hedge funds, and bonds (which ironically fund buybacks anyway).
So there you have it. Forget the economy; the economy has little to do with the stock market. The economy is simply along for the ride of the Wealth Effect, created by an expansion of credit. Economic growth is the growth in spending that happens as a result of people feeling prosperous. The stock market ties back to pensions that lend money (through intermediaries) to corporations, which repurchase their own stock, fueling rising stock prices, in turn creating a Wealth Effect, and on and on in a virtuous cycle. The economy is simply a product of that dynamic, not the cause.
Where Does It End?
It is impossible to time any market move, let alone a bear market or the top of a bull market. High valuations are certainly giving individual and institutional investors pause from continuing to bid up stock prices with fresh money. But public corporations, which are buying back their own stock, care little about that. If you think about the incentives of corporate boards, they almost always believe their companies are a good investment because it is what they know, it is human nature to feel underappreciated, and they constantly hear enthusiastic reports from management about all the great possibilities for their companies. Moreover, boards have to figure out something to do with all the cash they have on their balance sheet, as excessive cash makes them targets for takeovers, they get shareholder complaints, etc. They may not think that now is the right time to invest in new projects or expansion, so they buy back their stock. And on top of that, companies buy back their own stock to offset the dilutive effect of issuing stock through share-based compensation plans (stock options) granted at prices far below the current market price.
That said, because we have seen credit-fueled rallies before, we can use history as a guide. As you can see from the chart below, bear markets have begun roughly two years after the Treasury yield curve inverts (when short-term interest rates are higher than long-term rates). The two years after the inversion have typically seen strong stock price gains due to an expansion of shadow banking…meaning a continuation of the transmission of credit through non-bank intermediaries (credit funds).
We are not making a prediction of a continuing strong rally in stocks because valuations are on the high side, and we are into a much longer period of rising stock prices than the previous two times. We are making the point that liquidity for stocks continues to be good from massive pension flow through credit intermediaries, which could continue to underpin the stock market for a little while. We are not making a judgement call on this, but rather simply recognizing the forces at work.
Forget about what you hear on television or in the financial press about economic growth and the implication that the prospects for growth are good for stocks. This is naïve reporting and does you, the individual investor, a disservice.
What matters is the yield curve and the prospect for slowing credit flow. Slowing credit can happen for all sorts of unpredictable reasons: inflation, asset prices becoming overextended (excessive speculation), the failure of a large lender (bank or non-bank), regulations, etc. And yes, if the economy overheats, it can raise the specter of increasing interest rates, which themselves can slow the transmission of credit and accelerate the timing of the cycle’s end. It is more important to pay attention to what is going on in credit markets, and not the economy, than the press would have you think. And beyond that, an even better piece of advice we can give our clients is not only to ignore the economy, but to ignore politics as a predictor of investment returns. Politics matter not at all.
Stocks, while expensive, are not insanely so. There is still a high level of bearishness in the investment community as the level of short interest as a percent of shares outstanding are near record highs. There is a degree of complacency as we have a generation of investors (Millennials) who haven’t really experienced a bear market during a time when they had money or were earning lots of money.
The best we can do is to be aware of the important factors that matter for stock prices and ignore those factors that are constantly spoken about but don’t matter. The key going forward will be to think about the amount and types of risks that we own in our portfolios and focus our energy on understanding our individual investments. We can’t control or predict what the stock market does, but we can avoid bad long-term investments and own those that we are paid to own because they have a bright future, are reasonably priced, and have the ingredients present, both fundamentally and behaviorally, to rise in price.
We invite you to discover how Highgate can help you with this. Please reach out to us for a no-obligation review of your investments, and we are happy to give you our feedback.