Digging Into Stock’s Decline Last Week

The Dow Jones Industrial Average declined 2.60% last week while the broader Standard and Poor’s 500 fell more than 3%. 

Market analysts blamed the decline on escalating trade war threats.  This from “Market Watch” (Source:  https://www.marketwatch.com/story/stock-futures-extend-tariff-inspired-decline-ahead-of-july-jobs-report-2019-08-02):

Stocks ended at their lowest levels in a month on Friday as investors worried that President Trump’s escalation of the trade war with China would impact economic growth, despite news that the U.S. labor market remained healthy. 

The benchmark S&P 500 index fell for a fifth straight day, to record the steepest weekly loss since last December’s selloff, closing at its lowest level since June 26.

Stocks extended losses after China vowed to retaliate against President Trump’s decision on Thursday to impose 10% tariffs on the remaining $300 million of imports from China not already subject to levies. Second-quarter corporate earnings for S&P 500 companies are now also on track to record a decline for two consecutive quarters for the first time since 2016.

While the trade war is a factor in stock’s decline, it’s far from the only factor.

One cannot deny that the trade war with China has dramatically affected trade as this chart (Chart One) from Mish Shedlock’s excellent blog illustrates (Source:  https://moneymaven.io/mishtalk/economics/import-shuffle-canada-mexico-surpass-china-as-the-us-biggest-trading-partner-ZNrLnqwLaE-aZfDIp-NfRw/).

Notice on the “Share of Total Trade with the U.S. chart that Mexico and Canada are now the biggest trading partners with the United States, displacing China as the former number one trading partner.

When examining only trade with China, one can see that year over year, US exports to China are falling significantly.

While trade wars make market participants nervous, I am of the opinion that the real cause of market decline is falling profits as indicated by the “Market Watch” article excerpt above and a couple of other factors.

To some extent, declining earnings and escalating trade wars are related having an inverse or opposite relationship.  As trade tensions rise and trade wars escalate, profits decline.  That has a negative impact on stocks.

Added to that dynamic, one has to consider that the stock market has been propped up over the past decade.  The easy money policies of the Fed has created demand for stocks.  History teaches us that whenever money is printed it will have to find a home.  Typically, newly created money finds a home in stocks and real estate.  This was true prior to the Panic of 1837, the Long Depression of 1873, the Great Depression and more recently the Great Recession.  In each of these circumstances, newly created money propped up stocks causing a bubble that eventually burst.

The policy response to the Great Recession was easy money; low interest rates and then outright money creation.  Stocks and real estate responded as they have most often historically.

As expected, the Federal Reserve cut interest rates last week.  Interestingly, stocks didn’t react positively.  Looking at stock market activity last week, the Dow advanced on Monday and Tuesday but declined precipitously Wednesday through Friday.  The Fed announced the .25% rate cut on Wednesday.

Perhaps this signals a change in the sentiment of stock market investors.  Up until this point, stock market participants reacted to a Fed rate cut by buying stocks causing the stock market to rally overall.

This time market participants seemed to finally grasp the reality of the situation.

A rate cut is really not good news.

A rate cut means that the Fed senses economic weakness.  It may well be that we just got the first honest reaction to an interest rate cut since the financial crisis.

There are a couple of other factors here as well.

The first is the noteworthy positive affect that corporate stock buy backs have had on the bullish stock market over the past couple of years. 

A recent CNBC article (Source:  https://www.cnbc.com/2019/07/31/santoli-apples-gains-are-largely-the-product-of-buyback-financial-engineering.html) describes how stock buybacks have been used by Apple (emphasis added):

Stock buybacks have gotten a bad name in many precincts over the past few years, decried as unproductive “financial engineering” that detracts from corporate investment in growth.

But Apple’s aggressive use of its copious cash resources to repurchase its shares at modest valuations in recent years has shown the power of buybacks for a maturing company in a growth lull. And, for Apple, if not the typical company, long-term shareholders have benefited without compromising the company’s hiring or spending on capital investment.

The slowdown in iPhone unit sales in the past couple of years has restrained Apple’s overall growth since its fiscal year ended Sept. 30, 2015. In fact, net income this fiscal year is projected to be almost exactly equal to what Apple booked four years earlier.

Yet Apple’s resolute plan to use a healthy chunk of its $200 billion in cash — supplemented by roughly $100 billion in low-cost debt — to buy its shares and raise its dividends has paid off well.

With flat net income, the purchase of a net 1.2 billion Apple shares means that per-share earnings are slated to rise from $9.22 in fiscal 2015 to $11.51 this year. 

Apple’s net income is flat when compared to four years ago, but because the company repurchased shares using cash and by acquiring debt with low interest rates, earnings per share have increased.

Apple is just one example of many companies that have engaged in stock buy backs.

The other factor affecting both the nominal value of stocks and reported earnings is the value of the US Dollar.  Since stock values and earnings are both reported in US Dollars, as the US Dollar loses absolute purchasing power, the nominal value of stocks and earnings reported in US Dollars increase even though on a real, absolute basis they are declining.

Back in May, Advisor Perspectives published a chart that plotted the real advance in stocks after adjusting for inflation since calendar year 2000. 

The inflation adjustments were made using the Consumer Price Index which is the most commonly accepted measure of the inflation rate.  This week’s Retirement Lifestyle Advocates Radio Program and Podcast contains an interview with noted economist, John Williams.  Mr. Williams is a consulting economist who maintains the website Shadow Stats.  (www.ShadowStats.com).  He tracks and reports economic data using methodologies formerly used by government agencies prior to changes being made to make the reported data look more favorable.

Mr. Williams estimates the true, real inflation rate to be significantly higher than the reported rate.

Nevertheless, when using the Consumer Price Index to adjust the advance in stocks for inflation since calendar year 2000, one finds the Nasdaq is only 7.4% higher.  The Standard and Poor’s 500 is 29.2% higher.

That puts the average real gain annually using the CPI for the Standard and Poor’s 500 at about 1.5%.

If we want to adjust for the real, true inflation rate rather than the CPI, we might price the S&P 500 in gold, which has historically been real money.

In March of 2000, the S&P 500 was just over 2200.  Gold sold for about $290 per ounce at that time.  That means the S&P 500 priced in gold was about 7.5.  (2200 divided by 290)

Today, as noted in the data box above, gold is at about 1440 and the S&P 500 is about twice that.  That means that today the S&P 500 priced in gold is a little more than 2.

Arguably, in real terms stocks are below their 2000 peak.

What does all this mean?

One, in real terms, my forecast is for stock to continue to decline.  In nominal terms, stocks could continue to increase for a time, although they may not.

Two, since currency devaluation is now the official world monetary policy, tangible assets like gold will likely be the ultimate beneficiary and the best place to preserve purchasing power.

The Retirement Lifestyle Advocates podcast featuring John Williams has now been posted at www.RetirementLifestyleAdvocates.com.

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