To say that 2013 was a phenomenal year for the stock markets and its two most iconic indexes, the Dow Jones Industrial Average (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC), would be a brutal understatement. With no sizable corrections, the Dow Jones and S&P 500 advanced by 27% and 30%, respectively, practically tripling their historic average annual return.
Without question, a lot of things went right for the stock market and the U.S. economy last year. The Federal Reserve maintained its accommodative low-interest-rate stance and consistently pumped $85 billion into the economy via long-term U.S. Treasury bond and mortgage-backed security purchases on a monthly basis. The jobs market improved dramatically, with initial weekly jobless claims falling well below a seasonally adjusted 400,000, and the unemployment rate dipping last week to a six-year low at 6.7%. And finally, the housing market found solid footing with home prices improving by a double-digit percentage throughout much of the country.
But all is not what it appears.
I'm certainly no doom-and-gloom forecaster, as I've witnessed significant progress in the U.S. economy since the recession in 2009, but the skeptic inside of me simply can't overlook some of the blatant ways that investors are being tricked into believing that the U.S. economy is perfectly healthy.
Here are three ways you've probably been duped into believing everything is A-OK:
A falling labor participation rate
Did you not find it even the slightest bit odd that the nonfarm payroll report from the U.S. Bureau of Labor Statistics last week showed a gain of just 74,000 jobs in December even though the ADP Employment Report and weekly initial jobless claims figure came in with significantly better-than-expected job growth earlier in the week? What's even odder is that the unemployment rate fell 0.3 percentage points to its lowest level in six years as the December jobs report missed estimates by about 125,000 jobs.
The answer to this riddle is actually quite simple: a falling labor participation rate.
"Why is a falling labor participation rate a concern?" you may be wondering. Primarily because it's not something we'd expect to see in a strengthening economy. A falling labor participation rate occurs when eligible adult workers drop out of the workforce for a number of reasons, which can include going back to college, retirement, or simply being discouraged in their attempt to find work. While going back to college and retirement will skew these results a bit and can be a positive for the economy, that group of discouraged workers who have simply dropped out of the labor force is a huge concern.
It's pretty easy to understand why unemployed workers get discouraged, given that the Bureau of Labor Statistics December figures show that the average duration of unemployment is 37.1 weeks (down just fractionally from the 38 weeks in the year-ago period), and that 53.7% of unemployed persons will spend at least 15 weeks unemployed before finding their next job, also down just fractionally from last year. The overall labor participation rate actually fell 0.2 percentage points in December to 62.8%, a 35-year low!
To put this into a totally different context, total nonfarm payroll employment (seasonally adjusted) of 136.9 million is currently at levels comparable to what the BLS reported in July 2008 at 137.1 million. However, over that span the labor participation rate has actually fallen from 66.1% in July 2008 to 62.8% in December 2013. In other words, we've seen no improvement in actual jobs creation; we've just witnessed the number of people who want jobs declining -- that's not good!
The continuation of QE3
The Federal Reserve's decision to purchase long-term U.S. Treasury bonds and mortgage-backed securities on a monthly basis has been a welcome one for both investors and consumers. While helping provide a solid foundation for the housing market, the purchase of long-term U.S. Treasuries also has the effect of pushing yields lower. Since bond yields and bond prices have an inverse relationship, the monthly purchase of bonds has been instrumental in keeping lending rates historically low.
Now don't get me wrong; I am not implying that what the Fed did by attempting to stimulate the economy was wrong. Low interest rates spur lending, home buying, and business expansion, so they can be very positive for the economy. Artificially keeping rates at historic lows for a long period of time, however, is another story.
Shortly after the Federal Open Market Committee announced last month that it would finally begin scaling back its $85 billion in monthly economic stimulus by $10 billion, long-term rates began to rise. The move isn't particularly surprising, as the purchasing of fewer long-term U.S. T-Bonds should mean lower bond prices and thus higher yields. What's really surprising, and discouraging, is how quickly mortgage loan activity has dried up in the wake of these higher rates even as lending rates still hover near historic lows. According to the weekly mortgage loan activity from the Mortgage Brokers Association, loan originations hit a nearly two-decade low in December.
For lack of a better word, the U.S. consumer has been absolutely spoiled with historically low lending rates for years. With what's essentially been a three-decade-long downtrend in lending yields, consumers are sitting on their hands until rates move even lower. With QE3 being an unsustainable long-term stimulus, it seems to me that if consumers don't wake up to the fact that rates are near all-time lows and use that to their advantage, we could be headed for a dramatic slowdown in housing growth and business expansion.
A dramatic increase in stock buybacks coupled with steep cost-cutting
Last, but certainly not least, we have the tried-and-true combination of share repurchases and cost-cutting that has helped fuel business growth since the recession.
Obviously, not all businesses are having to rely on cost cuts to drive growth. The majority of the technology sector and health-care industries have been abuzz with investor interest because of major investments in the cloud and disease research, respectively. But, for a number of other businesses, cost-cutting and share repurchases have been the only way for them to mask a genuine lack of top-line growth.
According to preliminary data from S&P Dow Jones Indices last month, over the trailing 12-month period (which ended in September 2013), S&P 500 companies increased their annual share buyback expenditures by 15% to $445.3 billion from $387.3 billion in the year-ago period. In the third quarter alone, share repurchases were up 23.6% over the corresponding 2012 period.
Share buybacks are a double-edged sword. On one hand they're a way of returning value to shareholders by reducing the number of shares outstanding in a company and helping to boost earnings per share. By boosting EPS, the company will theoretically be more attractive on the basis of valuation. On the flipside, share repurchases don't immediately put money into the pockets of shareholders like a dividend would, and they can artificially boost EPS while top-line growth remains stagnant.
The other factor here is that corporate cost-cutting has grown rampant across all industries. Based on data from S&P Capital IQ, the average sales growth of S&P 500 companies through the first half of 2013 was a meager 2.35% compared with the year-ago period, where it was 3.76%. While cost-cutting – which can include everything from wage reductions to job cuts -- can improve EPS temporarily, it's not a long-term strategy to growing a business and certainly doesn't help the top line. The really scary part is that we're seeing this combination from a variety of sectors.
Big-box retailer Best Buy (NYSE:BBY), for example, enacted a $5 billion share repurchase program in 2011 and has been closing underperforming stores to reduce its costs. Shares of Best Buy more than doubled last year, yet consensus estimates call for a 13% revenue decline in 2014 despite only a marginal drop in EPS. Are Best Buy's results really that much improved, or are they masking ongoing weakness?
The same could be said for heavy-duty construction company Caterpillar (NYSE:CAT), which announced two separate $1 billion share buybacks in 2013 as it continues to cut costs in lieu of weak commodity prices. These moves are being made to cover up the fact that Caterpillar's 2013 revenue is expected to contract 17% while regaining only 1% in 2014. Despite three earnings warnings in 2013, Caterpillar's stock actually managed to end the year higher!
Long story short: Corporate growth isn't anywhere near where it should be to support a 30% rally in the stock market.
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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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