The past seven years since the financial crisis have seen the S&P 500 bounce back by 150%, even as GDP growth continues to be slow. Digging deeper, stagnant wages and extremely low productivity growth show that the real economy has not kept pace with Wall Street.
Inevitably, that gap was going to have to close, and I think we are seeing the start of that process in late 2015 and early 2016. The combination of a slowdown in China, falling energy prices, and the end of zero interest rate policy from the Fed have put markets and the global economy in an interesting state of transition.
Note that this does not mean we expect financial Armageddon. Mohamed El-Erian did a great job in laying out the challenges for the economy and charting a path forward to stability. Stocks are expensive currently, but it is not too late for policy makers to steer us out of the gutter.
We expect the increased volatility in the stock market to continue. For years, the Fed has created artificial demand, both in terms of low rates for consumer spending and excess liquidity to prop up asset prices. As markets shift from being driven by this artificial demand to the real economic fundamentals, many high-flying stocks will get left behind.
As Benjamin Graham said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
The Big Issue Is Demand
Low rates have boosted consumption in the U.S. by making it inexpensive to borrow against future earnings. Since 2011, consumer credit has grown by 6.5% compounded annually, nearly three times the GDP growth rate. This process of borrowing against future earnings cannot go on forever, and we're already starting to see signs of it letting up.
Many economists predicted heavy consumer spending in December due to savings from low gas prices. Instead, consumer savings hit a three-year high. We appear to have hit the ceiling of artificial demand, and rising interest rates will incentivize more saving and less borrowing.
More importantly, easy money has failed to stimulate heavy levels of investment. Consumer spending doesn't actually create anything of value, it just keeps the wheels of the economy going. Ultimately, high return investments that grow existing businesses and create new ones drive economic growth in the long-term.
In theory, easy money should stimulate more investment by lowering the returns an investment needs to deliver in order to earn an economic profit. Instead, we see companies holding on to trillions of dollars in cash and actually cutting back on capital spending.
What are they doing with all that money? Channeling it into buybacks and dividends that don't actually create economic growth. Stock buybacks prop up prices by creating artificial demand for shares and engineering EPS growth, while dividends attract income-seeking investors and often get reinvested, boosting prices even more.
