March 14, 2015

Since the bull market in stocks began six years ago, the Bad News Bulls have had it all their way.

Despite mostly piddling economic growth, U.S. stocks are in the midst of one of the longest and most profitable winning streaks of the last century. But with the latest favorable jobs report, the Good News Bears are poised to attempt a comeback.

Over time, stock prices are driven by the interaction of two main forces: liquidity and earnings. The best bull markets have both, the worst bear markets have neither, and meandering markets have one but not the other.

Though both forces remain operative, historically outsized gains in the U.S. job market in recent months imply that the liquidity spigot soon could be turned down.

Liquidity is a function of interest rates. When credit is cheap and investment opportunities in the real economy limited, money flows into financial markets, driving up prices. That’s been the story since December 2008, with real benchmark interest rates in negative territory even as corporate profits have doubled.

Judging from the skittish reaction of investors to the good news that nearly 300,000 jobs were created in February, the liquidity side of the equation could change sooner than expected.

Back to work

Nonfarm payrolls have increased by more than 200,000 for 12 consecutive months, the longest such stretch since 1985. The 3.2 million jobs added since March 2014 are the most over any 12-month period since the late 1990s. And the 12 million jobs created since March 2010 are the most over any five-year period in history.

Meanwhile, the U6 rate — a key measure of labor market dysfunction that also includes the unemployed, those too discouraged to look for work and those working part-time who would prefer full-time employment — also has fallen.

After peaking at 17.1% in April 2010, U6 has eased to 11%, not far above its 10.7% average over the last 20 years.

Until the February jobs report, the first Fed rate hike was projected to come in September, and possibly not until next year. But with excess capacity in the domestic labor market shrinking, sentiment among the Fed’s 12-member policy-setting committee appears to be shifting toward a quarter-point rate hike in June. The Fed could lay the groundwork for a June rate hike by removing the word patient from its statement when it meets this week.

With the onset of a new monetary tightening cycle, the surplus liquidity that has been supporting U.S. equity prices despite subpar economic growth and generous valuations will wane.

Profits recession

The earnings engine also is powering down.

The January-March quarter could result in the first decline in S&P 500 company earnings in two years, led by whopping declines in the energy sector.

While profit growth usually decelerates at this advanced stage of a business cycle, the looming drop is being helped along by the soaring dollar, which has gained 21% against a trade-weighted basket of currencies since July.

Whenever they begin, Fed rate hikes will undermine profits by restraining the domestic economy and nudging the dollar still higher.

One-third to one-half of S&P 500 sales originate overseas, and the strong greenback makes U.S. imports more expensive abroad while reducing earnings when foreign revenues are converted into dollars.

It is far from certain, however, that the first rate hike will come in June, given the mind-set of the one person whose opinion matters most: Fed Chairwoman Janet Yellen.

To the puzzlement of Yellen and most economists, wages have barely kept pace with inflation, even as labor market conditions have tightened.

Yellen has stated repeatedly that policy-makers want to see real wage gains before raising interest rates, since unit labor costs are a major source of inflationary pressure.

So it comes down to this: Will the Fed hold its fire until it figures out why wages are stagnant despite a stronger recovery, or will it stage a pre-emptive strike on the assumption that it is only a matter of time before full employment translates into higher inflation?

Not even Yellen knows the answer yet, which is why a meandering equity market looks likely until the wage question is clarified.

Tom Saler is an author and freelance financial journalist in Madison. He can be reached at www.tomsaler.com .

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