Editor's Note: This is Part 1 in a 5-part series. Click here to read Part 2. Click here to read Part 3. Click here to read Part 4. Click here to read Part 5.
David Stockman was elected to U.S. House of Representatives for the 95th Congress and was reelected in two subsequent elections, serving from January 1977 until his resignation January 1981. He then became Director of the Office of Management and Budget under President Ronald Reagan, serving from 1981 until August 1985. He was the youngest cabinet member in the 20th century. After leaving government, Stockman joined Wall St. investment bank Salomon Bros. and later became a founding partner at New York-based private equity firm, The Blackstone Group. He left Blackstone in 1999 to start his own private equity fund, Heartland Industrial Partners, L.P., based in Greenwich, CT.
During its insouciant climb to1200 on the S&P
, the market’s mantra has been clear: Buy stocks! Washington saved the economy. Surely that’s the penultimate whopper -- coming right after “the checks in the mail.” In the present case, the lie is that the $78 per share of current year S&P earnings alleged to be in the pipeline deserves to be capitalized at a historically normal 15x multiple. After all, the American body economic has been heavily medicated with an unprecedented regimen of experimental drugs -- $1.7 trillion of QE, 15 straight months of ZIRP, and trillions in willy-nilly fiscal “stimulus.” Can anyone possibly know at this early juncture whether the eventual withdrawal of these treatments will lead to a relapse, a coma, or a return to the pink?
For what it’s worth, the wisdom of the ages holds that extreme promiscuity in money-printing and government-borrowing -- of the kind we’ve undisputedly indulged in -- ends in macro-economic tears, not a sustained upward march of profits. At the very least, that risk suggests attaching a cautionary PE discount to near-term earnings until there’s more evidence on the experiment’s outcome. But today’s intrepid bulls insist that neither history nor traditional financial principles are relevant – it’s all about the flow of juice from Washington and extrapolating last week’s headline numbers into the future.
Needless to say, in the fall of 2007, these same seers opined that Goldilocks would reign forever because Bubbles Ben Bernanke was already lathering up the Fed and the then-current economic numbers -- like positive jobs prints -- were still flashing green. This sunny outlook, of course, was utterly oblivious to fundamental indicators of impending peril then in the public domain -- such as the gathering fissures in the insane edifice of housing prices, the economy’s need to take on $5 of incremental debt to acquire $1 of GDP, and Wall Street balance sheets reported at an incendiary 40x leverage ratio, to cite the obvious.
But burned once… well… here they go again. Hard upon the very first month of a positive jobs print, the mantra appears to have metastasized further. Load up the truck! A “jobful” recovery is just around the corner -- or so trumpets the bullish brass horns. Thus, leaping ahead to 2011, the $97 consensus EPS estimate is apparently deemed to be a no-brainer -- clocking in, as it does, at only 12x today’s market.
In fact, the 2011 estimate also computes to a 26% gain over this year’s hoped-for $78 per share, which itself is a 37% gain on actual 2009 operating earnings. Reaching back only slightly further, the 2011 estimate also weighs in at nearly triple
the $37 per share of four-quarter operating profits recorded as recently as last June. So the current consensus outlook could be likened to leaping a tall economic building in a single bound. Then again, it might constitute yet another head-in-the-sand episode, like during the fall of 2007, when Wall Street bulls petulantly dismissed any sign of impending peril. Indeed, the possibility that they’ll experience a two-peat is strong, and is hinted at in recent key economic releases -- the March jobs report and the February income and spending survey. Lurking beneath their seemingly benign headline figures are some ominous trends suggesting that the economy may be heading for an ambush; an upset that could pulverize today’s rosy EPS estimates, as well as the naïve belief that a hot-house economy confected in Washington can be capitalized at historical rates. The first point of sobering evidence is that in February, once again, the Fed’s ZIRP generated exactly ZIG (zero income growth). But that was only the headline number. The core trend that hovers beneath -- that is, the unprecedented collapse of private sector incomes -- continued to falter. It dropped for the second straight month and is now down $22 billion from December. In the grand scheme of things, however, there’s probably no more important number than the sum of private wages and salaries + proprietors’ income + rental income + dividend and interest receipts -- which is to say, everything the public has to save or spend, apart from government transfer payments and salaries.
The seasonally adjusted annualized rate reported for core private sector income is a big number -- $8.126 trillion to be exact. The trouble is, the February figure is down more than $500 billion, or 6.2%, since the third quarter of 2008 when Wall Street allegedly had its heart attack. Importantly, the half-trillion dollars missing in action here consists of everyday (nominal) money income of the kind that shows up in actual bank statements, not the doctored-up “real income” variety as deflated by the government’s guesstimates on inflation rates. Quite simply, there’s never been a sustained drop in private sector money incomes of any magnitude -- let along 6% -- during modern economic history; that is, since we escaped the dark ages of balanced budgets and gold standard money in the 1930s.
Moreover, the green shoots which have been omnipresent since last spring have had almost no impact on this fundamental rudiment of recovery. Over the past six months, core private sector income (as here defined) bounced by the grand sum of $62 billion. At this anemic rate of gain -- slightly over $10 billion per month -- it will take 52 months, or until June 2014, to regain the private income levels extant in August 2008!
The trend in the remainder of the income equation is similarly troublesome, and points squarely to the economic ambush looming ahead. Specifically, the balance of personal income -- consisting of social transfer payments and government salaries -- was $3.39 trillion in February. But in contrast to the cliff-dive exhibited by core private sector income, this figure represents a huge $400 billion or 13% gain
compared to the third quarter of 2008. In other words, household and business spending has limped along solely because the massive $500 billion hole in private sector incomes has been largely offset by $400 billion of higher government transfers and paychecks -- a source of spending which, on the margin, was derived entirely from incremental public sector borrowings. But even the most bone-headed “borrow and spend” Keynesians don’t argue that this kind of money shuffle can be sustained indefinitely.
Stated differently, the last economic boom came to a screeching halt in late 2007 when the household sector smacked squarely into Peak Debt, thereby culminating a 30-year run in which an increasingly larger share of each year’s incremental consumer spending was borrowed, not currently earned. When the pace of new borrowing suddenly went negative, household spending growth vanished (out of mathematical necessity), even before giving effect to the incipient up-shift in its savings rate. Now, after keeping the economy on life support for the better part of two years, it appears that incremental public sector borrowing is about ready to succumb to the limits of Peak Debt, too. The cause this time will be the vigilantes -- and not merely the bond-trading kind whose footprints are becoming more visible as 10-year Treasuries approach the 4% threshold. The more pertinent vigilantes are the grass-roots kind. These tea party activists and their sympathizers appear to represent a broad, spontaneous uprising of the citizenry which is in the process of putting paid to the insanity of multi-billion bailouts for insolvent banks, rusty autos, and busted mortgages.
It needs be remembered that these fiscal rubes have been, and will remain, unmoved by the daily tutorials of Professor Krugman and his fellow traveling Wall Street pitchmen -- touts who otherwise are pleased to call themselves economists and strategists. As the latter see it, borrowing another (say) 40% of GDP (thereby raising the publicly-held Federal debt from $8 trillion to $14 trillion) would be no sweat if it’s needed to off-set the continued, massive loss of private spending. To be sure, these earlier, higher levels of private consumption rested on an essentially counterfeit economy -- people spending what they didn’t have by borrowing what they couldn’t afford. But never mind. When it comes to the GDP numbers, Washington and Wall Street are of common mind: the higher, the better -- even if it requires the essentially fraudulent conversion of un-repayable debts into current income and spending. In any event, we’re unlikely to learn how far this primitive Keynesian theory can be pushed because the unwashed tea party herd is truly something new under the political sun. The anger against America’s fiscal recklessness, and especially its egregious dispensation of taxpayer cash to Wall Street train wrecks, seems poised to shut down any new deficit-financed “stimulus” in the months ahead, and then to send the Pelosi Congress packing come November.
Accordingly, the most probable scenario is two and one-half years of bitter fiscal warfare and stalemate between the Obama White House and, if not a Republican Congress, certainly a divided, dysfunctional one. This prospective impasse will guarantee that no progress can be made in reducing the crushing long-term deficit; nor will it permit additional short-term fiscal booster shots to what’s likely to be a struggling economy. During the period ahead, the bond vigilantes will have plenty of time to fret over the $2 trillion per year of new debt financing that’s already baked into the cake under realistic budget assumptions. At the same time, the personal income accounts will cease to be flattered by any growth at all in transfer payments and government payrolls. The $400 billion income “make whole” that has been obtained since the eve of Lehman’s demise is over and done.
Having thus reached the likely political limits
of its ability to authorize incremental borrowing on the public accounts, Washington’s hothouse economy is heading for a growthless coma -- a prolonged stagnation that will sustain neither today’s giddy EPS estimates nor the capacious capitalization rates being applied to them. And that’s where the bad news in the March jobs report comes in. It cannot be gainsaid that Wall Street economists are paid princely sums merely to primp their hair before each appearance on CNBC. As it happens, they’ve been busily inventing a “jobful” rebound scenario which holds that the severe depletion of private incomes highlighted above is soon to be reversed by a robust expansion of payrolls. The 300-400K pick-up that was whispered for March turned out to be a tad premature, but the impending return of jobs is a certain as the arriving birds of spring and will accommodate a smooth hand-off from public sector juice to self-sustaining private sector growth.
The unstated predicate of this jobful rebound is that, in fact, the bullish case was never wrong! It was only blindsided by a freakish financial heart attack that overwhelmed Wall Street in September 2008 when the authorities whiffed at the hour of Lehman’s greatest need. Despite the ensuing short-lived contagion of panic that swept the financial precincts, the bulls assume implicitly -- and in some cases explicitly -- that the wider body economic suffered no lasting damage and is therefore capable of returning fully to its previous upward path.
During its brief stint in the emergency ward, however, Wall Street emitted signal errors that caused a severe overreaction on Main Street. It seems that everyday business people mistook the sweaty visage of Hank Paulson thrashing about the nation’s capital warning that the sky was falling as evidence that a real crisis was at hand. In fact, the man was just trying to safeguard the financial system with some extra insurance wrap, albeit with an unfortunate exuberance of salesmanship. Consequently, companies panicked, throwing inventories, employees, and capital-spending plans overboard with reckless abandon. Soon the macro economy entered an unnecessary but self-fueling plunge which quickly morphed into the deepest slump in modern times.
But the slump wasn’t real! It was a mistaken outburst of animal spirits -- a spasm of excessive retrenchment by millions of unnecessarily frightened producers and consumers. But now that the fevers have been quieted by Washington’s massive regime of experimental medication, confidence is returning to Main Street. Indeed, comforted by near-term economic statistics which have been jigged-up by these fiscal and monetary drugs, the public will soon realize that last year’s economic free-fall was an overreaction. In the event, Main Street will begin a compensatory round of spending for payrolls, inventories, consumables, and capital. The great whirligig of prosperity will then regain its self-propelled traction.
Call this the Phony Slump Theory and you have the current bull market case in a nutshell. There’s only one oversized fly in the ointment. A diligent review of the nonfarm payroll reports for March -- along with those for the entire first quarter this year and the two-year recession that preceded it -- reveals no plausible evidence of a “firing spree.” The staggering loss of 8.36 million jobs between December 2007 and December 2009 was actually less than proportionate
to the decline of sales and output in virtually every category of the BLS series. For example, the job loss in residential construction was 30% compared to a 40% decline in new construction spending. Likewise, employment in retail dropped by 8% versus a 111% sales decline; the 30% decline in auto-plant jobs compared to a 44% drop in unit volume; and the 6% reduction in real estate employment was dwarfed by the 35% reduction in housing turnover. What really happened was possibly something of an altogether different nature. During America’s fabulous financial bubble era, payrolls ballooned by millions in response to surging demand for building tradesman, retail clerks, mortgage brokers, hospitality workers, architects, car salesmen, management consultants, gardeners, decorators, personal shoppers, and much more. But on the margin these were bubble jobs funded by the household sectors’ ATM account, not its far lower, sustainable level of spendable earnings. Consequently, the peak nonfarm payroll of 138 million jobs in December 2007 has been severely winnowed over the past two years -- not in response to a temporary spat of bad psychology on Main Street, as the bulls would have it, but on account of a permanent liquidation of final demand commensurate with the ongoing shrinkage of household debt and discretionary spending.
Indeed, the more pertinent theory would be one focusing on the opposite idea -- that of the Phony Boom which occurred in the years before December 2007, not on the crash years that inevitably followed it. And the more apt prism for viewing Wall Street’s recent trauma would be the possibility that Lehman wasn’t a random accident that should have been prevented, but that it (and almost any one of its competitors) was an accident destined to happen, the straw on the camel’s back that finally brought down a 30-year super-cycle of reckless and unsustainable debt expansion.
There’s a graph currently making the rounds that’s dramatically on point. It shows the US economy’s long-term leverage trend, measured as the ratio of combined public and private debt to GDP. You can draw a bright-lined box -- bounded on the vertical axis by the years 1870 and 1980 and on the horizontal by a lower and upper debt-to-GDP ratio of 140% and 190%, respectively. Save for an aberration around 1933 when the ratio soared due to the fact that Depression-era money GDP plummeted from $100 billion to $50 billion in four years, the actual US leverage ratio stayed within the box for more than a century -- notwithstanding numerous cycles of war and peace, boom and bust.
Then, beginning in the early 1980s, the economy’s leverage ratio staged a breakout, with the graph going parabolic right through the events of September 2008. Under the weight of Promethean Federal debt issuance since then, the ratio has continued to climb, even as some $1 trillion in private debt has been liquidated. Now perched at 370%, the economy’s total leverage ratio is extended far above all previous history.
During its century in the historical leverage box, of course, America’s economy performed tolerably well, expanding by several orders of magnitude. But it apparently left untold riches on the table because on average it only carried 1.7 turns of debt compared with today’s 3.7 turns. Yet if the bulls are right and nothing is broken, the two extra turns of debt that our forefathers forswore on account of prudence needs be chalked off to economic superstition, instead. Indeed, had yesteryear’s policy makers known that the financial gods bore no animus against excessive debt, they could have piled it high decades sooner, pulling undreamed-of future wealth into their own present. Bye and bye, economic miracles such as the Internet would have logically come along far earlier, perhaps by the 1950s, thereby facilitating its invention not by Al Gore, but, if fate had willed it, by Senator Albert Gore Sr. instead.
There remains the off-chance, however, that the ancient superstitions had merit, and that the last 30 years’ debt binge did a great deal of harm. This would be manifest in massive “malinvestment” in shopping malls, office buildings, and household closets and garages, for example, and in a tendency for the prodigious debts that funded this excess to weigh heavily on the American economy for years to come. Furthermore, there would be no reason to expect that jobs liquidated in the aftermath of the boom will ever return -- whether Main Street’s allegedly frayed nerves have been repaired or not.
So far, the evidence from the government’s own statistical mills -- including the March jobs report -- is overwhelmingly more consistent with the Phony Boom Theory than its bullish opposite. Not only is there no evidence of the purported business “overreaction” during the recent recession as previously explained, but the longer-term trends are also fully consistent with the notion that there’s been a massive permanent loss of jobs in the US, and that growth going forward will be anemic, at best.
The starting point for penetrating the non-farm payroll report is to recognize that it’s anchored by what might be termed the HES Complex (the vast array of both public and private sector jobs in the BLS health, education and social categories). The HES Complex posted nearly 30 million jobs in the March report, including just under 20 million reported in the BLS’s officially designated “health and education” category, as well as another 10.5 million education jobs reported under state and local government. During the most recent 10-year span, from January 2000 to December 2009, the average monthly job growth in the complex was 52,000 -- with very little variation and virtually no correlation to the macro cycle. The astonishing fact is that right on cue, the pickup in March was 48,000, meaning that a third of the report’s headline gain (162,000) was a pure evergreen
, not a portent of any cyclical rebound.
Likewise, another 20-30,000 of the March headline number likely consisted of weather-related aberrations in the month-to-month statistics. For instance, output is still falling rapidly in non-residential construction, and while this category lost a sizable 66,000 jobs in the first quarter as a whole, the March print actually showed up as an 18,000 gain -- undoubtedly reflecting the shift from stormy skies in February to sunny ones in March. Similarly, it can be questioned as to whether home and garden stores -- still fighting the headwinds of the on-going housing collapse -- actually gained 14,000 permanent jobs during March. By the same token, it’s very evident where all of the remaining 90,000 new jobs in the headline print originated. The census bureau enrolled 48,000 temporary employees in March while the volatile BLS category for “temporary help” had a monthly census gain of 40,000. Some of these “temps” may be just that and others may migrate into full-time status, but, as will be seen below, this category has almost no bearing on the longer-term trend of job creation. The more immediate point, however, is that the ballyhooed gain in the March headline, setting aside the HES Complex evergreen, occurred within a narrow 5% slice of the nonfarm job market. The vast remaining expanse of the job market was still dead in the water. And the corollary conclusion from the March report is that any single month’s print most likely contains as much noise as signal. The notion of a jobful rebound, therefore, requires a deeper and more extended look at the data.
One way to accomplish that is to analyze the recent monthly and recession period data for the various segments of the jobs market in the context of the longer term boom and bust cycles of the past decade. Thus, the long period from January 2000 to December 2007 measures the peak-to-peak result of the last business cycle and may fairly be considered an indicator of Boom Period trends for each job category. Next, the 24-month period from December 2007 to December 2009 can be considered the Slump Phase of the cycle, since it begins with the officially designated start of the recession and ends at the point when material job losses ceased. Finally, the first three months of 2010 have been labeled the Bounce Phase in deference to the general perception that the jobs recovery began this winter and that a full quarter’s observation is less susceptible to noise and revision than the preliminary print for the latest month.
When viewed in this framework, the first high-level conclusion is nearly fatal in its implication for the jobful-recovery thesis. Specifically, even during the seven-year Boom, the American economy was only a tepid generator of jobs, with growth totaling about 7.2 million or 86,000 per month over the period. Running at its boom time average rate, then, the job market would require a decade to recover the Slump period losses -- to say nothing of absorbing the 170,000 per month growth rate of the labor force. But even these figure overstate the case because notwithstanding the consumption binge evident in the shopping malls, housing market, and car dealerships during the bubble era, two-thirds of the job growth during the Boom period occurred elsewhere -- namely, in the HES Complex.
Specifically, the complex generated 4.7 million new jobs or 57,000 per month. This is crucial because demand for health, education, and social services was funded not out of discretionary private incomes and bubble-era home ATM accounts, but from the Governmental Fisc (Federal, state, and local revenues and borrowings) and from open-ended payments out of the private health insurance system.
These funding sources made the HES Complex impervious to the macro-cycle -- so long, that is, as this infinitely elastic financing gig held-up. But now, as will be amplified below, the decades-long advance in the health, education, and social complex may be finally heading into a brick wall. The Governmental Fisc is exhausted, and the heretofore unimpeded flow of third-party health-insurance payments is likely to slow to a trickle as ObamaCare steadily strangles the system over the years ahead. Consequently, the cyclical jobs-rebound case depends on the outlook for the balance of the economy. But therein lies the rub. The US economy’s Boom Period jobs-growth record outside of the HES Complex was shockingly anemic, registering just 29,000 new jobs per month over the seven-year period.
As will be seen, even this scrawny figure may not be replicable in the period ahead -- at least to the extent that job growth in the balance of economy reflected bubble-era activity levels. For instance, the construction and FIRE (finance, insurance, and real estate) segments contributed about 20,000 per month of job growth during the seven-year Boom. But owing to the great housing and financial meltdown during the Slump, these segments shed in excess of 2.3 million jobs in the 24 months ending last December. True enough, some of these were temporary losses and will be recovered as the economy strengthens. But the larger point is that construction and FIRE sectors developed huge excess capacity during the Phony Boom of the past several decades -- capacity that’s now been permanently liquidated. Therefore it’s highly unlikely that construction and FIRE will generate any trend growth in jobs at all during the upcoming expansion cycle.
Likewise, during the Boom another 30,000 new jobs per month were generated in the Leisure and Hospitality and the Personal Services (repairmen, household help, trainers, etc,) segments -- nearly all of which are directly dependent on discretionary consumer spending. Again, some portion of the 750,000 jobs lost from this segment during the Slump is likely to be recovered over the course of the next business cycle. But a consumer shorn of his home ATM account and in the process of rebuilding his savings isn’t likely to have anything close to the discretionary spending power that fueled job growth in these segments during the last cycle. These examples are merely indicative of the headwinds militating against the notion of a jobful recover that’s strong enough to rapidly replenish the current $500 billion hole in private incomes -- and thereby fuel a business-cycle expansion sufficiently robust to justify Wall Street’s current giddy earnings outlook. The fact is, the kind of muscular jobs recovery expected by Wall Street’ re-born (again) bulls would take a three-fold combination of developments including: (a) vigorous compensatory hiring to make up for the alleged post-Lehman firing spree; (b) a resumption of strong trend growth in hiring across a broad swath of the jobs market; and (c) the steady recall of the purely cyclical layoffs that occurred during the two-year Slump. But as will now be further documented, there’s virtually no evidence for the Main Street overreaction theory, while the evidence with respect to a resumption of meaningful trend growth in hiring is overwhelmingly negative.
Consequently, job gains from purely cyclical recalls are likely to be modest in scale, slow in coming, and generally not at all commensurate with the jobful recovery scenario. The problem is one of pure math. With government-funded income growth now likely to slow sharply (if not cease), consumer credit still contracting (and not likely to rebound) and private income growth tepid, there’s simply little prospect of sufficient strength in final demand to trigger a rapid or extensive recall of the cyclically unemployed. It will be a slow slog.
At the end of the day, the central missing ingredient is the absence of any apparent prospect for significant secular growth in most job categories across the US economy. Moreover, that ingredient has been missing for more than a decade now, even if temporarily obscured by the past headlong expansion of the HES Complex. Here, the underlying reality is that the American consumers’ great spending spree during the Boom years didn’t fund a corresponding cornucopia of jobs on Main Street. Instead, these dollars flowed to the factories of East Asia and to windfall rents
captured by speculators in domestic land, resale properties, and financial products. Stated more graphically, the boom-time spending that didn’t end up abroad flowed in the main, not horizontally to the job market multitudes throughout the American hinterlands but vertically into the towering incomes of the Wall Street few.
Not coincidentally, the recent frantic money-printing by Bubbles Ben and his posse hasn’t changed this condition. In the present case, nearly all of the $1.7 trillion monetization of government and agency paper undertaken by the Fed over the past year has literally been sequestered within the canyons of Wall Street. The freshly minted money so beneficently bestowed either sits idle as book entry excess bank reserves at the New York Fed or has flooded the Fed-controlled repo market where it provides zero-cost funding for Wall Street’s manic trading bots and a fresh installment of the bountiful rents they extract.This is Part 1 in a 5-part series. Click here to read Part 2. Click here to read Part 3. Click here to read Part 4.Buzz & Banter: Trading ideas & insights from 30 professional traders
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