The Daily X-Change - 3 Things - Uncomfortable Facts, 25-54 Employment, Houston RE

Uncomfortable Facts For The Bullish Bias

In a recent interview on CNBC, Steve Ricchiuto with Mizuho Securities points out the obvious to those that are paying attention.

The points that he makes are quite accurate but widely dismissed due to the current momentum push in the financial markets. However, one point in particular that I wanted to address was about valuations and profit margins. As Steve stated, companies are under pressure to maintain profitability in order to support rising asset prices. But, given the rise in employment and the squeeze on productivity, combined with global deflationary pressures and weak exports, this is becoming much more of a challenge.

The chart below shows a historical trailing valuations combined with corporate profit margins. The black dashed line represents 23x trailing earnings which has been the historical peak of bull market cycles with the exception of the late 90's "dot.com" craze.

What is important to note is that for investors bad things have tended to happen when profit margins decline at a time when valuations have been elevated. The next chart shows this a little more clearly by viewing net profit margins as compared to the S&P 500 index.

It is the risk of a mean reversion in earnings/profits that is of the biggest risk to stock market investors currently. As I have discussed previously, earnings have a very regular habit of reverting from 6% peak to peak increases which is where earnings currently reside.

Given that global deflationary pressures are on the rise, the ability for earnings to follow the expected predictions through 2020 seem overly optimistic. This is particularly the case given the strength of the US dollar which is a drag on exports which comprises about 40% of corporate profitability.

Again, the points that Steve makes are absolutely correct. However, as I stated just recently, the Fed has now likely boxed itself into a corner and will likely raise rates even though "real" economic strength would suggest caution.

"...I believe that the Fed understands that we are closer to the next economic recession than not. For the Federal Reserve, the worst case scenario is being caught with rates at the 'zero bound' when that occurs. For this reason, while raising rates will likely spark a potential recession and market correction, from the Fed’s perspective this might be the 'lesser of two evils.'"

Of course, Steve's comments about employment lead me to my next point.

Employment 25-54 Not As Robust As It Seems

The most recent jobs report sent the media spin machine into overdrive, to wit:

"Friday's monthly jobs report showed that in January nonfarm payrolls grew by 257,000 in the US. And with revisions to recent reports, the past three months were the strongest for job creation in the US in 17 years.

The main driving force behind this trend? Millennials.

Workers between the ages of 25 and 34 have been surging back into the workforce over the past several years, with this trend really taking off in 2014."

Here is the chart used to prove this point.

While this chart clearly shows that roughly 2,700,000 individuals, between the ages of 25 and 54, have entered the labor force, it is misrepresentative about the true nature of the employment level of that demographic. To clarify we must look at the employment-to-population ratio of the 25-54 age group. This is shown in the chart below.

What is missed by the first chart, which shows a massive surge of "millennials" flooding back into the workforce, is that when viewed as a percentage of the total available population of 25-54-year-olds it has only recovered back to levels last seen in the mid-1980's. At 77% currently, the workforce of millennials is well below its peak employment of nearly 82% at the turn of the century.

Furthermore, and very importantly, the current employment-to-population level is also higher given that during the post-financial crisis period (Jan. 2009 to present)the population of 25-54-year-olds has declined by 814,151.

Had the population of 25-54-year-olds followed its 2000-2009 growth rate of 592,638 annually, the employment-to-population ratio would be just 74% which would be lower today than at the lows of the financial crisis.

This decline in the population of millennials is due to declining birth rates over the last 30 years. The declining birth rate is another major headwind that will face the economy in decades ahead, but that is a post for another day.

Lastly, this chart clearly explains that an unemployment rate of 5.7% is highly misleading, as a large number of millennials are simply no longer counted as part of the workforce. Considering that this age group comprises the "household forming, tax-paying, consuming family heads of tomorrow," it certainly does not bode well for a resurgence of economic growth in years ahead.

As Myles correctly stated in his post, "This is the most important trend in the labor market right now." Unfortunately, when viewed correctly, it suggests that the real economy is likely to remain far weaker than expected in the years ahead.

Houston "We Have Another Problem" - Commerical Real Estate

As I have penned recently, Houston has a problem when it comes to tumbling oil prices.

"As oil prices rise and fall so does the number of rigs being utilized to drill for oil which ultimately also impacts employment. This is shown in the chart below of rig count versus employment in the oil and gas sector of the economy."

"Obviously, the drawdown in energy prices is going to start to weigh on the Texas economy rather sharply over the next several months. Several energy companies have already announced layoffs, rig count reductions and budgetary cuts going into 2015. It is still very early in the cycle so it is likely that things will get substantially worse before they get better."

While much of the mainstream media continues to tout that falling oil prices are good for the economy, (read here for why that is incorrect) the knock-off economic impacts are job losses through the manufacturing sector and all other related industries are quite significant.

One of those areas is commercial real estate. If you look in any direction in Houston, you see nothing but cranes. The last time I saw such an event was just prior to 2008 when I commented then that overbuilding was a sign of the maturity of the boom. The same has happened yet again, and not surprisingly, the "sirens song" has been "this time is different."

Unfortunately, not only is this time not different, the economic impacts are likely to much more substantial, not only in the Houston economy, but nationwide. To wit:

"The jagged skyline of this oil-rich city is poised to be the latest victim of falling crude prices. As the energy sector boomed in recent years, developers flocked to Houston, so much so that one-sixth of all the office space under construction in the entire U.S. is in the metropolitan area of the Texas city."

But here is the economic problem:

"And as a reminder, every high-paying oil service jobs accounts for up to 4 downstream just as well-paying jobs. Case in point:

The rush of building has created thousands of jobs—not only at building sites, but also at window manufacturers, concrete companies and restaurants that feed the workers.

But just as the wave of office-space supply approaches, energy companies, including Halliburton Co. , Baker Hughes Inc., Weatherford International and BP PLC, have collectively announced that more than 23,000 jobs would be cut, with many of them expected to be in Houston.

Fewer workers, of course, means less need for office space."

While the media and mainstream analysts discount the negative economic impact of falling energy costs, I have personally witnessed it in the mid-80's, the late 90's and just prior to 2008. In all cases, the negative outcomes were far worse than predicted which left economists scratching their heads as to what went wrong with their models. Of course, considering the BLS only saw a loss of 1900 manufacturing (oil and gas) jobs in January when there were 26,000 layoffs may explain part of the problem.