A Wild Ride on Wall Street: Where Do We Go From Here?

A Mid-Month Update
It’s certainly been a wild ride in the markets lately. After a virtually uninterrupted 6-month stock market rally that began in October of last year, and culminating at the beginning of April, we may now be witnessing a topping-off point. Certain sectors such as the real estate (investment) sector have made an equally steady march upwards during the last half-year. And despite the economic and fiscal monsoon unraveling in Europe, international markets have contributed their share of growth in global portfolios.

So what has apparently climaxed at the end of March, sidestepped and danced a bit in April, has now taken a decidedly negative turn in May. The question that has developed is whether this is a temporary setback or a more far-reaching trend.

All Is Not Well
In recent weeks and months, our concern for the state of the market has increased dramatically. The positive 6-month momentum notwithstanding, conditions in the market and the economy have deteriorated significantly – to the point where we may be headed back into another recession.

The Economy & Unemployment
There is a number of factors that lead to our evaluation of current conditions. First, the economy. There is a confluence of factors, which individually would not be cause for alarm, but taken in tandem creates a scenario which can only point in one direction. 

Much has been made about the slow, steady decline in the national unemployment rate. Though this is technically an accurate observation based on current measures, it is masking the larger issue beneath the surface. Political posturing leading up to the presidential election seems to be masking the fact that unemployment may be a bigger problem than it appears. Take for example the average duration of unemployment benefits (see chart here): Prior to 2009, the longest average duration of unemployment benefits (post-WWII) was in 1983 at approximately 21 weeks, with the 60-year average duration hovering around 12 weeks of benefits. Today, the average duration of benefits stands at 39 weeks, nearly double the previous all-time high. And this number is down slightly from a few months ago when the average exceeded 40 weeks.

To further complicate the unemployment picture, individuals that have become discouraged and either dropped out of the labor force, or chose to retire early (either forced or voluntary), has risen by 2.4 million people in just the last 12 months. Additionally, the number of Americans working part-time due to economic reasons (can’t find full-time work, or slow work conditions), and those that are now under-employed has not improved in any meaningful way in the last 12 months.

The final death-blow to the labor picture is that wage-growth has actually been in decline the last five years, with the rate of growth declining from nearly 4 percent five years ago to just under 2 percent today.

Corporate Earnings
Currently, many of the bright market forecasts from so-called “experts” relies almost singularly on the fact that recent corporate earnings have been nothing but spectacular since 2009. Stock prices generally rely on a measure known as the “price-to-earnings” ratio (P/E) to establish price ranges, with the numerator being the stock price, and the denominator being the earnings of corporations (or single corporation). While it may appear at first blush that P/E’s are within a reasonable range right now, what most fail to realize is that corporate earnings (as a % of GDP) fluctuate over time, and that we are now in uncharted territory. 

Let’s look at the numbers. In post-WWII history, corporate profits have generally ebbed and flowed between a low of 4 percent and a high of 8 percent, with the mean falling somewhere just shy of 6 percent (these are rough numbers). Even during the hey-days of the Technology Bubble in the 90s, corporate profits peaked at just below 7 percent of GDP.

Fast-forward to today, and we are looking at a profit margin of just under 9%, after bouncing off 10 percent briefly, which is unprecedented in history. If you look at the drivers of corporate profit margins, the concern becomes even clearer. The biggest drivers of profits are Corporate Investment, Dividends, Government Savings, Foreign Savings, and Household Savings. At times, these drivers will swing profits one way or another. When savings from those three entities (Govt, Foreign investors, and Households) are positive, it is a drag on profits. When those entities are spending (the opposite of saving), it generates profits. Traditionally, Net Investments in corporations have been the largest driver of profits (blue section in chart). However, as you can see from the following chart(Click here for chart) (provided by GMO, LLC), the Fiscal Deficit has been the single largest driver of corporate profits (shown in red). Essentially, government intervention has almost single-handedly supported the stock market since 2008. (As a side-note, “Gov’t Savings” should not be confused with direct Gov’t Spending. The Savings figure incorporates many factors such as transfer payments, taxation, investment, and of course direct spending)

So let’s ask ourselves these questions: what do we expect to happen next? If the Fed decides on another round of quantitative easing, are we simply kicking the can down the road to ruin? After all, had the first three rounds of fiscal “Red Bull” not been administered (after various other forms of stimulus, such as TARP), where would we be today? Will the Fed continue with another round? Who is going to pay for it in the end? If the Fed ultimately decides to end their stimulus programs, what happens to the drivers of Corporate Profits? Look again at the chart. What’s going to replace that thick red section if the Federal Government decides to finally tighten its belt? Note the substantial drop off in corporate investment beginning around 2008. Should we expect a dramatic increase in investment over the next few years? What would prompt that?

The worst case scenario is upon us. Millions of Americans are clamoring for the government to clamp down on excessive spending. At the same time, they are out picketing the excessive profiteering of corporations and the supposed under-taxation of the wealthy. Yes, we as Americans are eating our cake fast and furious. So while the federal deficit may remain elevated for some time to come, at some point, the government spending spree will stop, their printing presses will shut down, and corporate profits will quickly erode. When this happens, the stock market will quickly evaporate with it.

Unfortunately, there are no easy options. No simple fix. As the severity of the situation becomes more obvious, and time runs out with federal intervention, markets will begin to react. Then the drum beat of Hope and Change will quickly dissipate.

Portfolio Impact
As I shared with clients late last week, we lowered our allocation to “risk” assets in a meaningful way early last week. My expectations are mixed. As will always be the case in both bull and bear markets, short-term fluctuations will frequently occur (both positive and negative). These are unavoidable, and we would never suggest short-term timing strategies as an attempt to out-maneuver the whims of the markets. However, as our time horizon expands, we can more readily forecast potential long-term future returns. Given that current economic and market conditions are among the worst we have seen in the past 50 years, our outlook is not positive, hence our decision to reduce risk-on investment allocations. 

We have not completely eliminated equities from our portfolios. Although conditions have deteriorated, negative conditions (or over-valued conditions) can persist for quite some time before markets respond. So leaving a modest allocation to global equities across multiple asset classes (small, mid, large, etc.) seems most appropriate at this point. The bulk of the portfolios have been spread among various fixed-income asset classes (global bonds, high yield, mortgage backed, short-duration, etc.). We have also significantly reduced our exposure to longer duration U.S. Treasuries (due to depressed interest rates and the potential for those rates to rise and negatively impact prices).

Should conditions further deteriorate, we will consider further lowering our exposure to risk assets.

Click here for original article with charts.

Robert C. Henderson is the President of Lansdowne Wealth Management in Mystic, CT. His firm specializes in financial planning and investment management for individuals approaching retirement or already in retirement, with a focus on the particular needs of women that are divorced or widowed. He is an Accredited Asset Management Specialist and a Certified Divorce Financial Analyst. Mr. Henderson can be reached at 860-245-5078 or bhenderson@lwmwealth.com. You can also view his personal finance blog at http://lwmwealth.com/blog and the firm’s website athttp://www.lwmwealth.com.

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