Part Three: Malignant Growth

I.C. Angles Investment Post

The stock market is enjoying one of the strongest bull markets in its history, but the story is the opposite for the economy, where this recovery represents one of the weakest in U.S. history. And that spells bad news for investors. High-flying stock market valuations and corporate profits reverting back to more normal ranges, as covered in Part One and Part Two of “This Isn’t Going to End Well” aren’t the only reason for investors to fear an especially painful stock market decline. The particularly malignant and unsustainable nature of much of this cycle’s growth is another powerful reason to prepare for a big decline in stocks.

Still Structurally Unsound

Some are hoping that the stock market can permanently stay at high valuations and enter a new paradigm, where record corporate profits will not revert back to their historical mean and take stock prices down with them. But taking a hard look at economic data gives more reason for concern than optimism. Structural changes needed around the world in the wake of the so-called “Great Recession” have not been made. Those same problems have only gotten worse. Too big to fail financial institutions have only gotten bigger. Global finances remain opaque, as leveraged debt in the system scales new heights and shadow banking skirts regulations. Needed structural reforms in Europe, Japan, China and America have simply not been made.

Instead, problems have been papered over by printing money—lot’s of it. And the easy credit has funded malinvestments. But those policies in the form of historically unprecedented monetary expansion from the world’s central banks are running out of gas and at best producing weak growth. Central bank balance sheets have immense amounts of leverage, the governments of major economies (including China when considering local governments) are sitting on huge amounts of debts and unfunded liabilities, and corporations, as well as consumers are heavily leveraged. And all of this has only bought weak economic growth, while leaving tools for driving future growth depleted. When this recovery, which is already long in the tooth finally comes to an end, the next recession is likely to make the Great Recession look mild by comparison, and there will be no easy ways out, like for instance inflating a property bubble and an orgy of commodity-buying construction in China.

Malinvestments on the Rise

China has been the world’s engine of growth, while in the developed world the U.S. economy has demonstrated “relative” strength. As I’ve written previously, much of China’s growth in the current cycle has revolved around a real estate bubble. Immense malinvestments have been made in constructing entire ghost cities, where few live. It’s hard to think of a better example of malignant growth than in some cases paving over productive farmland, displacing workers from their homes and building high rises that no one lives in, while temporarily creating a “wealth effect” for a new, vulnerable middle class looking for places to invest their savings, until the reality of owning an unproductive asset sets in.

Malignant economic growth in the United States, during this recovery has to a significant degree taken the form of unproductive malinvestments in fracking for oil and natural gas, as well as another Silicon Valley startup boom reminding some of the dotcom era.  Easy access to debt, has meant a surge in economic activity around drilling wells that are going dry more quickly than hoped and not recouping their investment cost. Such empty wells are a bit like those empty cities in China. They generate debt and growth in jobs, while they are being constructed, but because they don’t generate sustainable revenues, eventually the jobs fade, but the debt remains. That’s also a lesson the rest of the world is learning, particularly the Japanese who now have plenty of bridges and highways few use, along with a mountain of debt and faltering growth. And while some hope the United States can decouple from the world, it has only become more vulnerable to weakening global growth, partly due to the very real weakness of its own recovery.

A Weak and Narrow Recovery

In the U.S., this jobs recovery has been the slowest in the past half century. Unemployment has only shown meaningful improvement, when excluding people who have given up looking for jobs and taken part time work when they need full time. The long term unemployed remain at record high levels. On a similar note inflation has remained low, as long as you don’t use gas for your car, pay rent or buy healthcare. For those who do and have managed to stay employed, many are having to either borrow or cut back, because net income growth in this recovery has been abysmal, with many segments actually experiencing declines. The New York Times also recently reported the median inflation adjusted household networth declined over 36 percent for the last decade. For those who can’t find work, they have plenty of company. Food stamp issuance is at record levels, at 20 percent of American households. If people had to wait in line for food, instead of getting their stamps, the bread lines would easily rival those seen in the Great Depression. Only debt-fueled government assistance programs have kept this recovery from feeling more like a depression.

The current economy has been characterized by high unemployment, disappointing net income trends, deteriorating finances and non-productive investments. The theory of central banks was that quantitative easing would increase credit in the system that would be used for not just rebuilding bank balance sheets, but also productive investments that would drive strong employment and income growth, resulting in broad-based, sustainable economic growth. The reality has been access to cheap credit for wealthy individuals and institutions has resulted in debt-fueled speculation, with the stock market making new highs, as well as high-end real estate and fine art markets. But little money has found its way to productive investments that drive the healthy employment and income experienced in a board based economic recovery. And little money has found its way to the average household, which eventually corporations need to sell more goods to, in order to justify even higher stock prices, when they hit the wall of using debt to buyback their own stock to drive earnings per share higher.

Too Much Debt, Too Little to Show for It

The bottom line is the world’s economic policy has failed. At the price of immense amounts of debt, asset prices, like stocks, have risen higher. But history and the absence of broad-based, productive growth underpinning those asset rises mean they are not sustainable. The malignant nature of current economic growth also means the next downturn will be particularly negative. Governments, corporations and consumers will be constrained by all that debt. Central banks will also be constrained from stimulating growth by their already heavily leveraged balance sheets. And it’s not just the amount of debt and limitations on borrowing more. That debt has bought too much in the way of unproductive assets—empty cities and wells, as well as overpriced paintings and penthouses. The stock market doesn’t reflect that reality yet, but it will probably around the same time record amounts of margin debt aren’t being used to buy overpriced stocks.

This Isn’t Going to End Well–Part One: Stocks are too Expensive

This Isn’t Going to End Well-Part Two: Problems with Profits