Conclusion: The ongoing recession in domestic corporate profits just took a decided turn for the worse; this has dramatic forward-looking implications for both the S&P 500 and the labor market.
Aggregate domestic corporate profits are released commensurately with the third and final GDP report of any given quarter. With this morning’s release of the 4Q15 statistics, we learned that the ongoing recession in domestic corporate profits just took a decided turn for the worse.
The -10.5% YoY rate of contraction was slower by -540bps sequentially and represents a new low for the cycle. You have to go all the way back to the depths of the financial crisis (4Q08) to find a worse YoY growth rate. More importantly, Q4 marked the second-consecutive quarter of declining corporate profit growth; as we were keen to highlight on our 1Q16 Quarterly Macro Themes Conference Call, such occurrences have been proceeded by stock market crashes in the subsequent year for at least the past 30 years (five occurrences).
Recall that we also showed that, over the past 30 years, anytime the TTM EPS reading of the S&P 500 breaks down below its 12MMA, a recession has ensued in short order. With respect to the current business cycle, the breakdown occurred in June 2015 and we’ve been trending below the 12MMA ever since.
Recall that we also highlighted the headwind to the labor market that is declining corporate profits. Don’t for one second think that the scars of 2008-09 haven’t perpetuated a broad-based “CYA” attitude among executives of large U.S. enterprises. When it comes to protecting their “buyback babies” and their own personal (read: stock based) compensation, we believe they are most likely to eschew labor costs, at the margins. Whether or not they do it fast enough to prevent further declines in corporate profits remains to be seen.
Unfortunately for this economic cycle, we are in a fairly precarious position with respect to the domestic labor cycle. It literally doesn’t get much better than it has been trending on a trailing 6-12 month basis. That doesn’t mean the U.S. consumer is facing imminent risk of a plunge into the depths of an employment crisis. What it does mean, however, is that if you roll the clock forward by ~6 months, investor consensus could be using a decidedly more sour tone to describe the health of the domestic labor market. As the following chart highlights, once initial jobless claims roll off the lows, there’s no turning back.
There’s a credible case to be made that we hang out at the aforementioned lows for much longer than previous cycles given the depth and nature of the previous downturn (i.e. a financial crisis). That said, however, we aren’t of the view to bet on such perma-bull hopium. Anything could happen, but we’re not smart enough to side with storytelling over data; our firm has too much at risk for us to miss calling the next big draw-down in U.S. equities. Recall that being a raging bear is how Keith got fired from Carlyle in late-2007, which afforded him the opportunity to start Hedgeye in 2008.
Luck matters in this business. So does having repeatable research and risk management processes. And a core tenet of our repeatable risk management process is monitoring the relationship between volatility and price.
One way to do this over short-to-intermediate-term durations is by charting the relationship between the VIX futures curve and the SPX. As the following chart highlights, the stock market is in a fairly precarious position with respect to the steepness of the 6 month/1 month VIX curve – specifically in that we’ve yet to sustainably breach 4 points wide since we called for cross-asset volatility to start trending bullishly in mid-to-late-2014. Coincidentally, the aforementioned curve hit 4 points wide just prior to Monday’s highs in the SPX.
Source: Bloomberg L.P.
While this is one of a myriad of factors we incorporate into our risk management process, this specific factor would seem to suggest another leg down in risk assets is upon us. And given how generally bearish our client base is, I’m not so sure that’s a bad thing.
Wishing you and your family a Happy Easter,
P.S. In case you missed our latest Macro Playbook update from yesterday afternoon, we’re including the link HERE. Feel free to email with questions.