When my 15-year-old daughter was younger, my favorite part of the day was tucking her in at night and reading her favorite books. Those storytelling sessions played an important role in building our phenomenal relationship. Storytelling is part of the fabric of who we are as human beings. Getting together with friends from college and reminiscing about streaking in the snow when you were 21. Telling a new friend about the time your eighth birthday sleepover had to be canceled because of a torrential snow storm, but your old man went sleigh riding with you until the wee hours of the morning so you would still have a special day. Storytelling is a critical way that we connect with others, but when it comes to financial markets, you must distinguish storytelling from data.
Economic reports get wrapped in narrative to get votes, sell ads, and make you feel warm and fuzzy. The truth is that financial market storytelling numbs you to the potential risks that lie ahead. Right now, politicians and media-types want you to believe that U.S. growth is cruising along on Class A water. Strip away the storytelling and you can clearly see that we are in Class 3 rapids, and that what lies around the corner is the equivalent of going over Niagara Falls in a barrel.
Any economic data released days ahead of a presidential election is going to have more spin than normal. The spin that media pundits and politicians put on the October nonfarm payroll report put Roger Federer’s topspin to shame.
The nonfarm payroll storytelling focused on the “solid” headline number of 161,000 jobs created during October. I recently discussed the problem with exclusively focusing on headline numbers to gauge economic progress. But when you wrap storytelling around a headline number, you get a work of fiction that could mint JK Rowling another $1B.
Yes, the number of jobs created was “solid,” but the nonfarm payroll storytelling omitted the most critical part of its report: the annual growth rate of job creation actually decelerated again, and is now at the lowest level in five years. That’s right, the U.S. is creating jobs at the same annual pace as in May 2011. I say it all the time, but it bears repeating that the most critical aspect of financial data is what occurs at the margin.
The 161K headline number is not nearly as informative as the 1.68% annual growth rate. Right there, in the monthly trend of annual growth rate, resides everything you need to know about a data series and financial markets. That’s the “margin,” and paying close attention to it will help you sidestep market risk and get you paid. Despite central bankers’ best efforts, economic data remains cyclical. Understanding where we are in that economic cycle is critical to understanding financial market price action and how to properly trade it.
The annual growth rate in nonfarm payrolls peaked 21 months ago in February 2015, and has been declining ever since. This is an important development, because every time the nonfarm payroll peaks and starts to descend, jobs growth always goes to 0% and then to outright contraction. 100% of the time! That’s a damn good track record!
After peaking, it takes approximately 30 months for nonfarm payroll growth to turn negative, and another nine months before it finally bottoms and begins to move higher. We are only 21 months removed from the nonfarm payroll peak and we are still well over 1% growth. This tells me that we should expect more downside in the labor market in the months ahead.
More importantly, understanding the nonfarm payroll cycle helps me better anticipate the trajectory of GDP growth in the coming quarters. Typically, U.S. GDP bottoms within six months of nonfarm payroll growth turning negative. This means that there is a high probability that Q3 GDP will be revised lower and that Q4 GDP growth will come in sub-1%, as we head towards a recession.
The other part of the entertaining nonfarm payroll fable being told is that wage growth “exploded” to a new cyclical high of 2.8%, confirming that Fed policies are working and higher inflation is just around the corner. There are 99 problems with this story, and economic fiction ain’t one of them.
First, wage growth hitting a cyclical high simply means the economic cycle hasn’t bottomed yet. Huh? Why would wages go up if the economy is slowing? Historically, company executives don’t pay attention to the economic cycle when they make decisions. Because they’re asleep at the wheel, they routinely increase pay at precisely the wrong time. Brilliant, right? When they eventually realize what they’ve done, they cut back work hours and eventually just start laying people off.
During the Financial Crisis, executives increased wage growth all the way until December 2008. This was six months after the U.S. entered a recession, and three months after Lehman’s bankruptcy. U.S. GDP didn’t bottom for another six months after wage growth peaked. If executives were ramping up compensation in the middle of a financial crisis, it’s not far-fetched to believe that they are repeating the same mistake now. This is evidenced by the fact that wage growth has been steadily accelerating since February 2015, while GDP growth has fallen every single quarter over that same timeframe.
The other glaring omission from Friday’s Reading Rainbow was exactly who earned that “explosive 2.8%” growth rate. Spoiler alert: it was earned by the 18% of America’s workforce at the very top of the employment food chain. Wage growth for “non-supervisory” employees, who represent 82% of the workforce or 100M Americans, fell in October, and is growing at the same snail’s pace we saw three years ago!
However, the 18% of “supervisory” folks saw their wage growth accelerate to an all-time high, at just over 4%. Apparently, it pays to be like Clark Griswold’s cousin Eddie and hold out for a management position. The only people seeing this “explosive” wage growth show up in their wallets are the top dogs.
There is a laundry list of economic indicators flashing recessionary signals, and we can now add nonfarm payrolls and wage growth as two more, indicating that the slowdown in U.S. GDP growth has further to go.
The storytellers won’t tell you that volatility and drawdown risk are set to increase dramatically based on our current position in the economic cycle. It’s not a matter of “if,” only “when.”
When the U.S. enters a recession, market volatility increases 200-600%, which means we could easily see the VIX trading at 60. When the VIX crosses 30, drawdown risks increase exponentially and spare no asset class.
During the last four U.S. recessions, the average drawdown has been: S&P 500 -43%, 30-year U.S. Treasuries -23%, gold -26% and the U.S. dollar -20%. Yes, even the tried and true “safe haven,” the U.S. dollar, gets taken out behind the woodshed at some point during a recession. Since U.S. growth peaked in Q1 2015, we’ve seen decade-lows in volatility and virtually no drawdown risk. History says the barrel over Niagara Falls is just around the corner.
Economic Story Crashers
I’d like to play for the Lakers or be a cast member for Magic Mike 7XL, but it’s not going to happen. Central bankers can try to bend economic gravity and manipulate the economic cycle, but that’s not going to happen either.
Let’s be honest, fiction pays the bills. That’s why John Grisham’s net worth rivals the GDP of a small country, while the guy who wrote “Let’s Explore Diabetes with Owls” has to borrow money for a cup of coffee.
Telling people the truth doesn’t get votes or sell advertising. The truth is that we are late in the economic cycle, and by the time it bottoms and begins to move higher, your portfolio is going to feel like it’s done a couple of turns on the Kingda Ka coaster. Prepare accordingly.
If you still rely on stories to manage your portfolio, then grow up, Count Chocula, because storytelling has no place in an investment process. Superior returns are generated by being data dependent, intently focused on developments at the margin, and remaining immune to political and media storytelling.