After government officials talked up the stock market following its three-month dive from October through Christmas, investors are now celebrating the resumption of the Bull market. It would certainly be interesting that one of the longest Bull markets in history would be followed by the shortest Bear market in history. While investors continue their celebration, some experts are pointing to an earnings recession, which is defined as a two-consecutive quarter decline in earnings on a year-over-year basis, and it’s about to start.
During Bull markets, analysts will raise the bar each quarter for forward-earnings guidance, which appears to be a target for a company to achieve in the coming quarters. When the Federal Reserve is maintaining a loose monetary policy, these targets are relatively easy to reach. It also helps that analysts can adjust their predictions up to the moment before a company announces their quarterly earnings.
With all the data available today, most professional analysts already know with a reasonable degree of accuracy what a company’s earnings are going to be before reporting. Short of any surprises, which occasionally happens, an analyst can adjust their prediction higher or lower before earnings are announced to make a company beat analyst expectations. Generally, but not always, when a company beats earnings expectations, their stock rallies.
By manipulating their predictions, analysts can continue to boost stock prices higher and higher. Many of these analysts work for buy-side firms, which provide buying recommendations for institutional money managers, pension funds, and other large firms who buy equities on behalf of their clients. When stock prices rise, it is easier for buy-side firms to sell their inventory of stocks.
This is also the same reason investors rarely hear an analyst recommend selling as stock since that advice would be counter to the goal of a buy-side firm, which is to sell stocks to their clients. After all, clients prefer to buy stocks in companies that are beating their earnings expectations and are expected to beat their earnings expectations, rather than companies who are not.
This trick of ever-expanding earnings also works on the retail public, who eventually buys into the notion that earnings are going to continue expanding in perpetuity. Investors often overlook one key point in their logic. If an industry is experiencing above-average earnings growth, which should translate into above-average profit growth, competition will enter the industry. It is not possible to achieve a perpetual expansion in earnings-growth without having new competitors cut into profit margins.
Predicting a drop in forward-earnings expectations isn’t too difficult, as the monetary aggregates, which measure the money supply, have already foretold that corporate earnings are going to fall. Corporate earnings lead economic growth, which follows the growth-rate of the money supply in a fiat, or unbacked-currency monetary system. While the Trump Administration is aiming for three-percent economic growth, the growth rate of the money supply is consistent with GDP growth at a sub-two percent rate.
The growth rate of the money supply can also be used to predict economic growth in other countries. China, a planned economy, predicts their economic growth will be around 6.5%. Magically, China’s economic growth seems to come within one-tenth of one percent of their target. Yet, the growth rate in their money supply suggests their actual economic growth is around 4.5%. In a debt-based economic system, as we are, money supply growth dictates future economic growth.
The growth-rate of the money supply has slowed and will continue to slow due to the Federal Reserve raising the Federal Funds rate and from the Fed’s monthly unwind of their $4+ trillion balance sheet of U.S. Treasury bonds and Mortgage-Backed Securities. The purpose of the Fed tightening monetary policy is to reduce and restrict the amount of credit in the financial system, which in turn reduces the growth-rate of the money supply.
When there is less money in the financial system, earnings growth must slow or contract. There is not a direct relationship between corporate earnings growth and the growth rate of the money supply. If the growth rate of the money supply falls by twenty percent, it does not imply that by the following quarter earnings growth will fall by twenty percent. Due to the lags in the financial system, it can take several quarters or more for earnings growth to adjust to the growth rate of the money supply.
It is impossible for corporations to continue growing earnings when the money supply is decelerating. It is also impossible for an economy to continue expanding in a debt-based system when the money supply is decelerating, because debt fuels money-supply growth, which in turn leads to economic growth.
Earnings-growth should have declined earlier last year, but the passage of the Tax Cuts and Jobs Act of 2017 fueled a bonanza of corporate share-buybacks which have been used to prop up earnings-growth. Total earnings are one aspect analysts look at but they are also interested in earnings-per-share (EPS) growth, or how much a corporation earned per outstanding share of stock.
To keep EPS growth in line with analyst expectations, corporations have been buying their stock back to reduce the number of outstanding shares. By reducing the number of outstanding shares, corporations can use financial engineering to offset a decline in earnings. The reduced corporate tax rates have also helped corporations hide weaker earnings since EPS uses net income in the formula, which is an after-tax number.
Despite the best effort of corporations to mask slowing earnings-growth by buying their stock back, the recent fourth-quarter earnings announcements indicates the global economy is slowing. When earnings and profits fall, so do stock prices. The fourth-quarter, twenty-percent decline in the broad stock market, brought out the analysts who suggested this was a tremendous buying opportunity as earnings-growth is once again predicted to expand in the coming quarters. Investors believe the economy is going to resume its expansion and, instead, blame the partial government shutdown and the trade war with China for the slowdown.
While the partial government shutdown and the trade war do lead to lower growth in the money supply, the real culprit is the Federal Reserve. Due to the Federal Reserve’s tighter monetary policy, corporate earnings are going to continue to fall, even as corporations are expected to buy nearly $800 trillion in stock back in 2019. For those who believe corporate-share buybacks alone can boost the stock market, keep in mind that the Fed is expected to destroy approximately $600 billion of currency this year, assuming no further increases in the Federal Funds rate.
In 2018, corporations purchased a record $1 trillion of their own stock back, while the Fed destroyed $420 billion from their balance sheet unwind and an estimated $200 trillion from raising the Federal Funds rate. The combined efforts of the Fed completely neutralized the corporate-share buybacks, which led to the broad equity market closing in the red in 2018.
The growth-rate of the money supply isn’t the only leading indicator that is suggesting corporate earnings-growth is going to continue to slide. South Korean exports, a proxy for earnings-per-share growth, has contracted on a year-over-year basis.
When exports contract, it means companies are moving less inventory. As inventory builds, companies reduce prices to move their inventory, and in turn, earnings and profits fall. Much of the economic growth in the latter half of 2018 was due to inventory building, which corporations hoped would quickly move as the economy continued to expand.
Corporations also bought into the hype, rather than trying to understand the slowing monetary aggregates, which would have told them economic growth is expected to slow. The reason South Korean exports, along with most Asian exports, are slowing is due to the Federal Reserve and not from the trade war, even though the trade war is having a small effect on export growth.
The Federal Reserve has been reducing world-dollar liquidity by reducing their balance sheet, which in turn reduces the Monetary Base, or the total amount of currency in circulation plus the total amount of currency held at banks in excess reserves. World-dollar liquidity is expressed as the Monetary Base plus the amount of foreign-held U.S. Treasury bonds. Foreign-held U.S. Treasury securities have been falling as foreign central banks have been selling their Treasury bonds to raise cash to pay on their dollar-denominated debts.
As long as the Fed continues to unwind their balance sheet and foreign-held Treasuries decline, world-dollar liquidity will fall, along with exports. When exports fall, imports also fall, along with earnings and profits. In the meantime, corporations are trying to offset this decline by buying their shares back, but even $1 trillion was not enough to counteract slowing earnings-per-share growth.
While investors remain excited for the resumption of the Bull market as the partial government shutdown has temporarily ended, the trade war is rumored to be ending soon and the Fed is sounding dovish, world dollar liquidity along with earnings are going to continue to decline. The partial government shutdown is temporary, the trade war is far from over, and the Fed is unlikely to capitulate. Although, by this time next week the Fed will have concluded their January meeting, so investors will know if the Fed is backing down or not.
With the Fed still on track to tighten monetary policy and world-dollar liquidity falling, investors hoping for stocks to head back to their all-time highs and beyond may be in for a big surprise. Based on forward-EPS guidance given by companies who have reported their earnings, which leads stock prices, the S&P 500 should be closer to 2,100 or about -20% lower than it is now.
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Weekly Economic Update (02/01/19 – 36 min)