6/30/2010

What is Driving the Stock Market

By Martin Gremm

Stocks have dished out a wild ride to investors this year. Large day-to-day swings are the norm and each economic report seems to be painting a different picture. In this note we discuss some of the main drivers behind the price swings and attempt to explain why so many economic reports seem to disagree on whether the recovery is on track or not.

Europe

The European situation has been causing a lot of anxiety lately as investors consider the possibility that the Euro or the European Union may break up. However, the major European governments are highly unlikely to back out of the Euro and the EU in the near term. Over the next decade, the EU and the Euro may very well disappear unless the structural problems are addressed, but the current mainstream political establishment in Germany and France derives much of its credibility from two decades of support for the EU. They will do almost anything to keep the core EU going rather than admit that they have been following a wrong path for 20 years. Changes in Europe that would have a real effect on world markets are very unlikely in the next few years and the recent outbreaks of fiscal responsibility should go a long way towards ensuring the long-term health of European economies. Nevertheless, the current fear that something big may happen in Europe is depressing the prices of riskier assets, including stocks.

US

The other cause of the recent market declines is the nature of the US recovery. People have become conditioned to expect US recoveries to be fueled by consumer spending in the form of retail purchases, real estate purchases, and consumption of services. Historically, these purchases have always been made on credit. That is one reason why the Fed likes to lower rates in a recession to make it easier for people to borrow and spend on credit. It is also the reason why consumer sentiment, housing, and unemployment are considered bellwethers for the strength of the recovery.

A recovery based on people making credit purchases can be very rapid because it only requires sentiment changes, not a change in industrial output, exports, or similar more tangible factors. It also tends to feed on itself, because higher employment leads to more confidence, which leads to more credit purchases.

The industries that benefit the most from consumer’s credit purchases tend to add jobs quickly as demand increases. This is possible in part because many of these jobs, e.g. wait staff, sales people, realtors, construction workers, etc., do not require specialized training.

However, these credit-driven recoveries generally contain the seed of their own destruction. When conditions change and public sentiment swings the other way or when credit tightens, all the industries that benefitted from the earlier optimism collapse, jobs disappear overnight, and we are left with a sizeable new addition to our mountain of consumer debt.

Credit-driven recoveries are a lot of fun while they last because they are quick, everybody is giddy with optimism, and the sky appears to be the limit. In the long term they are harmful because each cycle of credit expansion leaves us deeper in debt and in a worse position to achieve long-term prosperity.

So what about the current recovery of the US economy? It actually seems that is it different this time. There is little doubt that a solid recovery is underway, but it is supported by improving industrial output (see Fig. 1), increasing exports, increases in productivity, and similar real-world indicators rather than an expansion in consumer credit (Fig. 2) or a new housing bubble.

Fig. 1

Fig. 2

This type of recovery is much more sustainable. It starts from creating value by making something that people need, selling it, and reinvesting the profits. It generates wealth that ultimately leads to consumption. The big difference is that wealth is created first and consumption follows, rather than people consuming their expected future income today by taking out loans against future earnings that may never materialize.

An industrial recovery does not bring rapid job growth with it. Industries that create real value generally require skilled workers. It takes time and money to train such workers, so companies are reluctant to lay them off when things slow down and hesitant to hire new ones when demand picks up. In this scenario, job creation only really picks up once enough wealth is created for the resulting consumption to lift up the industries that in the past have benefitted from credit-driven consumer demand.

If the current trends in the US economy persist, we should expect high unemployment to continue and consumer spending to remain muted, but at the same time we should see the recovery in actual value-creating industries spur business investments and eventually personal consumption. This will be the first time in decades that the US economy is moving to a more sustainable foundation, away from consumer spending on credit and towards creating value through producing superior products that can compete in the world markets.

Outlook

For long-term investors this is a very hopeful sign. We should expect markets to remain volatile as traditional indicators of the strength of the credit-driven economic recovery (jobs, consumer sentiment, etc.) send signals that conflict with indicators of the strength of the ‘new’ recovery (industrial production, business investment, productivity, exports, etc.). However, between attractive valuations (Price–to-Book for the Russell 2000 is currently 1.7 and Price-to-Sales is 0.8) and the current shift to a less leveraged and more sustainable economy, the long-term prospects for US equities should be more attractive than they have been in many years. It is also likely that new export markets, e.g. China with its rising wages and increasingly sophisticated labor force, will open up for American companies, which should help sustain the ‘new’ recovery in the US.