The Trouble The Market Refuses To See

May 10, 2017

The Trouble The Market Refuses To See

  • GDP growth is at three year lows, car sales have dropped 11%, and the biggest sector contributing to new employment is about to go into oversupply.
  • The FED is in a stalemate situation. It should raise interest rates and deleverage, but it’s already too late as the economy, government, and population is hooked on low interest rates.


The market’s behavior reminds me of the three wise monkeys. One doesn’t see, the other doesn’t speak, and the third doesn’t hear. The VIX index, a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices, indicates that investors expect stability and didn’t even react to the bad news coming from the automotive industry, jobs, and a very important bankruptcy.

Figure 1: The VIX index is at historical lows. Source: CBOE.

Today, we’ll first describe how the economy isn’t healthy at all as evidenced by bad news and high leverage, the we’ll analyze the FED’s reluctance to increase rates and see how an investor should behave.

The Bad

I find three pieces of information extremely important. The first is that in April 2017, passenger car sales dropped 11.1% compared to April 2016. I have been warning readers for a while now that higher interest rates would be bound to affect consumption at some point, especially of cyclical goods. Well, here it is. Lower automotive sales come on the heels of the weakest quarterly economic growth rate in the last three years.

Figure 2: GDP growth in Q1 2017 was 0.7%. Source: Bureau of Economic Analysis (BEA).

The main commentary on the weak economic data was that the first quarter is always the weakest. Statistically, it shouldn’t have an impact as the data is seasonally adjusted and the previous three occurrences where the first quarter of the year was indeed the weakest could just be coincidence. The slump in car sales will certainly weigh on economic growth in the second quarter. However, the projections for GDP growth are extremely good for the upcoming quarter, but there is still a long way to go.

The next piece of bad news comes from the jobs report. At first, everything looked great with 211,000 new jobs added and the unemployment rate at 4.4 percent. This is excellent news but as investors, we have to be more concerned about what will be than what was.

The highest number of new jobs came from the leisure and hospitality sector with 55,000 new jobs in April, and 260,000 new jobs over the year. This is very significant because there is a chance the leisure and hospitality sector may stop hiring pretty soon. I’ll explain myself through a cyclical analysis of the industry with a focus on restaurants and hotels.

Low interest rates enabled high levels of investments in new restaurants and hotels. The large increase in new businesses went along with increased demand and a shift in consumer spending as consumers have been increasing their consumption of services in relation to goods.

Figure 3: Consumer expenditure (percent of total household expenditure). Source: Deloitte.

When consumer spending slows down, as has been the case with automotive sales, many leisure and hospitality businesses will be hit hard. The latest data on consumer spending shows a meagre increase of 0.3% for 2017 but as we can see from the jobs report, companies continue to hire.

I recently listened to the Xenia Hotel & Resorts (NYSE: XHR) conference call webcast where their CFO gave an indication of potential trouble coming from the fact that in 2017, the hospitality industry will experience supply growth in excess of demand growth for the first time since 2010. Such a situation isn’t only present in the hospitality industry, but also in the automotive industry where inventories are growing, and will be the case in many other industries, especially if demand slows down due to higher interest rates. As expansion projects in the industry take a while to develop and be approved, we can expect further hiring in these sectors but as soon as companies understand that the new investments are unprofitable, further investing will be cut.

When supply grows in excess of demand, the economy is headed for trouble. However, this is something normal and a completely natural part of the economic cycle. A recession would eliminate the inefficient businesses and contribute to sustainable economic growth.

One of the main culprits of lower demand are higher interest rates.

The Ugly

Last week, the FED decided not to change the federal funds rate and keep its monetary policy accommodative. The slow pace at which the FED is rising rates means that the economy is so highly addicted to the low interest rates that any kind of higher interest rate would be extremely detrimental.

Situations like the recent Puerto Rico bankruptcy could be the norm and not the exception if interest rates increase. If you aren’t aware, Puerto Rico recently filed for the largest U.S. local government bankruptcy in history.

I accept the fact that Puerto Rico is a small island with an aging population, but what about the ballooning aggregate federal debt, one of the main reasons the FED can’t tighten as there is no sign nor intention for deleveraging coming from politicians.

Figure 4: Total public debt has doubled in the last 10 years and quadrupled in the last 20. Source: FRED.

Let’s do just a small exercise. The government’s yearly interest payment on the debt was $432 billion in 2016, implying a 2.2% interest rate. Now, if the interest rate increases by 2 percentage points, the interest payments per year would double. This would force the government to increase taxes or borrow more, the latter being more likely, and the FED to again cut interest rates. Any kind of interest rate cut could spur more inflation as the dollar would lose much of its value. Therefore, it’s important to hold assets that are inflation protective like commodities and gold.

However, inflation is already close to 2% which means you have to deduct 2% from your actual returns in order to get real returns. There goes the S&P 500 dividend.

The ugliest scenario would be one where the economy enters a recession and the FED can’t accommodate more because it has already been accommodative for the past 8 years.

The Good

The good comes from the fact that the S&P 500 has tripled in the last 8 years, and I sure hope you enjoyed the ride.

If you have to use that money in the next 10 years, a wise thing would be to sell some of your index holdings in order to sleep well at night. You might sacrifice some future returns, but you wouldn’t run the risk of losing a big chunk of your portfolio if a bear market happens.

The current situation reminds me so much of 1999 and 2006 when trouble seemed so far away. We all know what happened then.


There is no reason for the S&P 500 to increase further at this point. I’m not buying U.S. stocks, Buffett isn’t buying, but your neighbor probably is. When your neighbor stops buying and starts selling in panic, Buffet and I will wait for a price earnings ratio in the single digits and then start buying.

It’s up to you whom to follow. Buffett or the majority?