S&P 2,065: Poking Holes In The Bull Thesis

The world is back to normal. The S&P is ~1% from its high, China is stabilizing, the U.S. is adding jobs, average hourly earnings are rising, and Dennis Gartman is ever so slightly long crude.

Sound familiar? It’s what I wrote back in November in The Perfect Short and certainly is applicable to today. Coasting 2100 feet above zero has almost led to a complete devaluation of the underlying issues, in turn increasing complacency and the bull manifesto. Given that I’m quite bearish, I thought it would be beneficial to write out the other side and compare it to my work.

Bull thesis:

The U.S. economy, while not growing at a rapid clip, is growing. The low rate of unemployment is leading to higher wages and thus consumer spending, which makes up roughly 70% of GDP. This will drive earnings growth over the following years and currently supports market multiples. Additionally, consumer balance sheets remain strong; debt to disposable income is at the lowest level since 1985, which will likely lead to further credit expansion and thus demand for goods and services.

The slowdown in manufacturing is less relevant today due to the services nature of the economy, which makes up 45% of GDP. Service sector hiring remains strong and wages continue to grow.

On that note, “employment growth is close to the best since the 1990s, with an average monthly gain of 222,000 during the past year. Full-time employment is soaring.” Housing remains rock solid with starts and permits near 8 year highs. Core inflation is rising at a rapid clip as well.

Jobless claims have continued to decline, recently dropping to a 42 year low.

The Federal Reserve is very accommodative, yet at the same time has confidence in the economy.

Retail sales remain strong and are showing no sign of slowing, as the FRED chart is moving from the lower left to the upper right.

The economy is currently very strong, and any softness we are seeing is likely due to weakness overseas. The dollar has pulled back materially, which will further support earnings going forward. The market currently trades at a 17.5x multiple, fairly in line with historical averages.

There is no recession on the horizon.


It all makes sense at face value, especially if you continuously repeat it to yourself to a point where you believe it, but why does the data not correspond to the thesis?

There has been a noticeable slowdown in GDP from the second quarter of 2015 [3.9% (Q215) -> 2% (Q315) -> 1.4% (Q415) -> 0.5% (Q116)] in the face of the lowest jobless claims in four decades, above trend growth in average hourly earnings, and thousands of jobs being created.

We can point to outside factors such as global weakness, but what’s going on at home? Given that the bull thesis and 70% of GDP are contingent on consumption, it is important to look at the consumer. As previously mentioned in the outline of the bull thesis, strong job and AHE growth should lead to increased consumer spending. Looking at retail sales, we see that is not the case. The average adjusted year over year growth rate in 2015 ex auto was negative 17 BPS (20 BPS unadjusted). If the consumer is so strong and readily has access to credit via a strong balance sheet, why is consumption so low?

Admittedly, I was in the strong consumer camp as recently as October of last year. Data such as debt to disposable income was so low it suggested consumers were healthy, had deleveraged, and would be able lever up to drive growth – the common narrative today.

This is primarily false.

The deleveraging process took place in two areas of household balance sheets – credit card debt and mortgages. From the end of Q411, consumers paid down a significant portion of their credit card balances, as CC debt outstanding went from $704B to $660B in Q113. Balances remained flat throughout 2013 and 2014, before accelerating significantly in 2015. In 2011, consumers had $9,696mm in mortgage debt, and as of Q415 it totaled $9,491. The lack of mortgage growth is a function of home ownership rates that we are seeing today (rental vacancies –, rents++). Given that incomes have grown relative to the largest household balance sheet liability – mortgage debt – debt to disposable income ratios have improved. As I broke out in The Perfect Short Part II, common metrics as such are distorted due to the top 20% influence on the aggregate. That is to say that the top 20% have seen nearly all new income growth since the recovery began, and as the primary holders of mortgages, have deleveraged the largest personal balance sheet liability, bringing down total balances and improving debt to income metrics. It is important to keep an eye on this cohort going forward, as they make up 40% of total expenditures.

Referring to total consumer debt outstanding – CC, auto, student – we see that the deleveraging process really did not unfold. Since 2012, quarterly growth in consumer debt has averaged 6.24% versus personal income growth of 3.75%. Autos over this period of time have grown 9.1% on average, with student loans not far behind at 9%. As a percentage of GDP, consumer credit is at a historical high, and the same is true relative to incomes across all income deciles.

Given the above information, it seems the consumer is not as strong or healthy as the market believes, which may be the reason why they are hesitant to spend even with increasing incomes and energy tax credits.

I recently posted a chart on twitter asking if one would invest in this company.

68% of the respondents said they would not, with the remaining 32% saying yes.

This company turns out to be the US consumer ex energy as the bulls like to say. I’ve created a US consumer income statement from personal income and PCE data and will have an extended write up breaking this down in the next few weeks, but for the time being, I will leave you with the margin compression chart above, which corresponds to trends in retail sales.

In my mind, the strong consumer thesis is a very overcrowded trade. The most recent FOMC statement seemed to also put a dent in the narrative as they no longer see global economic and financial developments posing risks to the US, but at the same time “economic activity appears to have slowed.” To me, this contradicts the notion that slowing US growth is a result of international headwinds.

Day by day it seems the bulls are losing pillars to their thesis. I will commend them on the move up from Feb’s lows, as I did not see such a strong move, but I would recommend they reassess their position because it’s quite difficult to fight the truth.