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The slow fuse

By Colin Twiggs
May 12, 2016 5:30 p.m. AEST (3:30 a.m. EDT)

Advice herein is provided for the general information of readers and does not have regard to any particular person's investment objectives, financial situation or needs. Accordingly, no reader should act on the basis of any information contained herein without first having consulted a suitably qualified financial advisor.

Hedge fund legend Stan Druckenmiller, founder of Duquesne Capital, recently warned of another financial crisis:

"The Fed has no end game. The Fed's objective seems to be getting by another 6 months without a 20% decline in the S&P and avoiding a recession over the near term. In doing so, they are enabling the opposite of needed reform and increasing, not lowering, the odds of the economic tail risk they are trying to avoid....."

Druckenmiller is not the only one to raise concerns about the level of debt being used to leverage growth through stock buybacks instead of for productive capital investment. While window-dressing may look good on company reports, it cannot conceal the fact that corporate debt is rising while earnings are falling.

Bank Loans and Leases as percentage of NGDP compared to Corporate Profits after Tax

Shrinking profit margins also warn of a down-turn.

Profit Margins

And capital investment is falling as a percentage of GDP. Normally this coincides with a decline in employee payrolls and precedes a recession but here employment is still growing at 2 percent a year. While this continues there is room for hope.

Gross Private Domestic Investment (Fixed Nonresidential) percentage share of GDP

Rather than rely on employment numbers, growth in the dollar value of weekly payrolls (total employment x average weekly hours x average hourly wage rate) offers a more accurate prediction of GDP growth. Again, there is no sign of a down-turn. So far.

Gross Private Domestic Investment (Fixed Nonresidential) percentage share of GDP

Further declines in profit margins or capital investment would be cause for concern.

Past experience has taught that it takes time for economic fundamentals to filter through to the bottom line and affect stock prices. Like a slow fuse, the problem may be evident for months before the effect is felt. In 2006 the yield curve inverted but it took more than a year for stocks to fall. As Keynes succinctly put it:

Markets can remain irrational a lot longer than you and I can remain solvent.

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