The stats on Web traffic here at the Report on Business provide a daily reminder of how pervasive investor fear has become. Put "bubble" or "impending market apocalypse" in the headline and your story is nearly assured a trip to the top of the hits list.
What's behind investors' anxiety? Part of it is memories of the financial crisis. But among professional market watchers, the overwhelming fear has to do with corporate profits. Earnings are now at record levels relative to the size of the U.S. economy, which suggests they could collapse if profitability reverts to its long-term average.
This concern is entirely reasonable, but at the same time, people who obsess over the danger are missing some important positives.
For starters, research on past financial crises by Ken Rogoff and Carmen Reinhart of Harvard University suggests that enough time has passed since the 2007-08 debacle that investors can now expect a rebound in the overall economy.
More importantly, investors are forgetting that a decline in earnings is not the only way the profits anomaly can swing back in line with historical precedents.
If wages were to rise, and household consumption were to keep pace, gross domestic product would bounce upward – and that would bring the profit-to-GDP ratio back into line in a way that's much more friendly to your portfolio.
Recent data suggest this optimistic scenario of higher wages and spending may actually be unfolding. U.S. inflation-adjusted wage growth for non-supervisory employees has been in a strong uptrend since late 2011 and is now firmly in positive territory. Data for October showed year-over-year growth of 1.4 per cent, which matched the strongest pace since the financial crisis.
Guillermo Dominguez, a hedge fund manager with New River Investments, has provided a compelling argument that the recent strength in U.S. wage growth will continue. He notes the size of the labour force has stopped growing – an important development since it increases worker bargaining power, everything else being equal. In addition, U.S. governments have stopped firing people, removing another drag on U.S. household spending.
If wages rise and consumer confidence improves, U.S. households have considerable scope to increase spending because, in stark contrast to Canadians, they have slashed their debt levels. Americans now pay less than 10 per cent of their disposable incomes on consumer debt service payments – the lowest level since the Federal Reserve began collecting the data in 1980.
There are signs that U.S. wage growth is translating into higher consumption levels. The most recent report on personal spending saw 0.3-per-cent growth in October, which exceeded economist expectations. More encouraging, October consumer credit growth of $18.2-billion (U.S.) blew away the consensus estimate of $14.5-billion.
Higher wage costs could threaten corporate profit margins but revenue growth could offset the damage. Consider a hypothetical company that converted $100-million of revenue into $17-million in earnings, for a 17-per-cent profit margin. A 10-per-cent increase in revenue and a fall in profit margins to 15 per cent would leave this company's profits barely changed at $16.5-million.
To be sure, a recovery in U.S. wages and spending will not happen overnight. Demographic factors, especially the dwindling portion of the population in their peak earnings and spending years, suggest that pre-crisis consumption peaks will not be reached for a long time.
But there remains plenty of room for U.S. economic improvement. If markets do sink as the Fed begins to taper its bond purchases, investors should seize on the opportunity to buy stocks in U.S. market sectors sensitive to growth in the domestic economy. With U.S. consumer discretionary stocks looking too expensive for comfort, the most promising candidates include energy stocks, industrials (General Electric Co., Fluor Corp.) and financials (JPMorgan, Citigroup and Capital One Financial Corp. are highest rated by analysts).
Last week's market action provided signs of a rotation towards economically sensitive stocks. After the stronger-than-expected U.S. employment report, the best performers included industrial stocks and other market sectors that benefit from acceleration in the U.S. economy.
Social media and biotechnology stocks have done well over the past year because investors are willing to pay a premium for growth when the overall economy is sluggish. But last week, as hopes rose for more vigorous economic expansion, these shares faded as investors began to see more attractive possibilities in other sectors. This pattern would continue if the U.S. economy continues to produce stronger-than-expected results.
Scott Barlow