While no one can predict what security markets will do in the future, we can glean some useful information from economic statistics. Consumer spending represents approximately 70 percent of total gross-domestic product, so it’s instructive to track and evaluate the trends in consumer spending and consumer sentiment to help gauge the possible impact consumer spending could have on corporate profits and the economy overall.
Year-to-date the stock market (Standard & Poor’s 500) has returned 12.6 percent in what has been the best first half of the year stock performance since 1998. During the second quarter, the Dow rose 2.27 percent, the S&P 500 climbed 2.36 percent and the Nasdaq gained 4.15 percent. However, for the month of June, the Dow lost 1.36 percent, the S&P 500 fell 1.5 percent and Nasdaq lost 1.52 percent. In the nearby table, I provide performance data for the S&P 500. We can see that the index had an exceptionally strong first quarter, gaining 10.61 percent, with performance slowing dramatically during the second quarter. With stocks ending the quarter with declines in June, it is clear that bull market momentum has faded.
After reaching an all-time high of 1,687 on May 22, the S&P 500 experienced a sizable decline, falling about 7.5 percent to a recent low of 1,560 on June 24, only one month hence. Since then, stocks rebounded somewhat, ending the quarter at 1,606, bouncing by about 3 percent from that recent low, but ending the quarter almost 5 percent below the all-time high.
We find that in May, at the same time the stock market was setting its all-time high, consumer spending actually fell 0.3 percent. Although spending rebounded in June, it was only up 0.3 percent for the month, representing basically a break-even over the final two months of the quarter. The triple threat of the payroll tax holiday that ended at the end of 2012, effectively raising taxes on everyone earning W2 income by 2 percent (the payroll tax holiday had lowered payroll taxes to 4.2 percent from 6.2 percent), the implementation of the sequester spending cuts, which began to go into effect March 1, and the threat of the Fed’s tapering of its bond-purchasing program, QE3, combined to curtail spending.
Despite the $85 billion per month that the Fed has been pumping into the economy for the past nine months, with the intention of driving economic activity through making more cash available, banks have not responded by providing additional credit. The United States has a credit-based economy — spending is determined in large part by the availability of credit. Since the implosion of the real estate market in 2008-2009, banks have tightened their lending policies, and have significantly reduced available credit to consumers through cutting credit limits on credit cards and raising lending requirements for new loans. Add on top of this the dramatic contraction in real estate values, which resulted in the evaporation of home equity, and consumers simply do not have access to credit. Without credit, and with unemployment still running at elevated levels (7.6 percent), consumers do not have either the ability or the will to spend.
The recent final reading on first quarter GDP, which was revised down to 1.8 percent from 2.4 percent, experienced this revision, in large part, because consumer spending, which had been reported at a 2.5 percent annualized rate for the first quarter, was cut to just 0.7 percent as a component of GDP.
Earnings season will begin shortly, and because consumer spending is such a large component of the U.S. economy, and spending has been basically flat recently, we should not expect second-quarter earnings to be strong. We should also not expect second-quarter GDP to be impressive either. Most economists have been predicting that 2013 GDP will run at about 2 percent to 2.5 percent. However, given the expected impact of the sequester spending cuts, the payroll tax increase mentioned above, and the Fed’s tapering, which is expected to commence by September, it is unlikely that second-half GDP will be sufficient to result in overall growth of 2 percent or better for the year.
Consumer sentiment, which hit a six-year high in May at 84.6 (University of Michigan), fell only slightly in June to 84.1. Sentiment measures consumers’ attitudes about the prospects for the economy going forward. It’s hard to square sentiment with consumer spending, since spending certainly does not reflect the strong sentiment figures. One possible explanation for strong sentiment could be the wealth effect — the recent rise in stocks and real estate prices that has improved consumer balance sheets. Despite this improvement, without available credit, and perhaps because many consumers still worry about the stability of their jobs, consumers have not rushed out to make purchases.
We should continue to watch consumer spending carefully as this economic indicator provides one of the best predictors of economic activity. We should also carefully analyze corporate earnings for the second quarter, as these reports will reflect whether consumers spend money to purchase goods and services during the second quarter, and also how companies managed their businesses during this challenging economic environment.
Given the recent pullback in stocks, we could be in the beginning stages of a significant correction phase, which could produce declines of 15 percent to 20 percent or greater from the recent all-time high. (A 20 percent decline would bring the S&P 500 down to about 1,350 from its recent all-time high of 1,687.) With the weakness in consumer spending, a potentially disappointing second-quarter earnings season, and the threat of looming Fed tapering, caution seems to be a good strategy.
Although I expect to see a sizable correction in the short term, I believe we are still in a bull market, which should continue well into 2014. After the correction phase runs its course, stocks should represent the most attractive asset class, relative to bonds, commodities and real estate, all of which should underperform given the rising interest rate environment that should result from the Fed’s tapering. Investment strategies should take this into account, and should include a plan for reinvesting cash balances after the correction phase has concluded.