Even with recent positive comments by Federal Reserve Chair Janet Yellen, investors and Wall Street money managers have a growing fear that not all is as rosy as it appears. Yellen said that accommodative monetary policy, rising property and equity prices, and the improving global economy should lead to above average growth.  

Your correspondent has long argued that Federal Reserve stimulus only has prolonged the eventual failure of the so-called zombies – companies that have survived on the central bank’s easy money or its recapitalization of firms that would have otherwise failed.

Further, with continued tapering from $85 billion a month last year to $35 billion a month starting in July, and continued tepid growth in the economy, these trends will only accelerate the demise of these firms. Though for the most highly capitalized this could take years.

First we’ll look at the structural reasons why this is the case, and why market sentiment is reflecting the concern that a market correction of 10% to 20% could happen this year.  The reality is that many economists and market observers are beginning to face the cold hard truth that the U.S. economy – as during the Great Depression – has structurally changed. Some economists are starting to call the period we live in, “the Lesser Depression.” 

Americans pre-2007 were super consumers thanks to home equity withdrawals and loose credit standards during the mortgage finance boom. But today consumer spending is a fraction of what it was during the housing boom and it isn’t expected to rise to pre-crash levels any time soon. Household purchases unexpectedly fell 0.1 percent last month, the first decrease in a year, after a 1 percent gain the prior month that was the strongest since August 2009, according to Commerce Department figures.

The new jobs that have been created in the years after the financial crisis have been lower paying, and the labor participation rate is still at horrifying historical lows, despite some recent gains.    

Stephen Roach, former chief economist at Morgan Stanley and Yale lecturer, said in a paper that, “In the 22 quarters since early 2008, real personal-consumption expenditure, which accounts for about 70 percent of US GDP, has grown at an average annual rate of just 1.1 percent, easily the weakest period of consumer demand in the post-World War II era. That is the main reason why the post-2008 recovery in GDP and employment has been the most anemic on record.” See Chart A.

Chart A: The Weakest Period of Consumer Demand in the Post-World War II Era

Building a Better Business Model

What this all means is corporate America will have to fight harder for every dollar of consumers’ discretionary income. Whereas perhaps 5 or 6 firms in any one industry could survive during the pre-2007 mortgage bubble years, that number may be cut in half in today’s environment. Yes, corporate profitability has improved, but many observers believe it has been at the expense of growth as firms are not investing the money in new projects and people. Instead, many of these firms cut costs to the bone, and are hoarding capital or directing a large share of profits to unproductive ends.   

As many have noted, U.S. companies outside of the finance industry are holding more cash on their balance sheets than ever, with $1.64 trillion at the end of 2013. That’s up 12 percent from the prior record in 2012, according to Bloomberg. If these firms would use this capital it would have a meaningful impact on the economy, contributing substantially to increased economic growth. But that hasn’t happened yet.

Meanwhile, the corporations of the Standard & Poor’s 500-stock index spent $477 billion last year buying back their own shares, a 29 percent increase over 2012 and the most since the peak year of 2007. And while that’s good for shareholders in the short term, it could be viewed as irresponsible if it is at the cost of future growth. And the fact that 80 percent of S&P 500 companies pursued stock buybacks in the last year is a disturbing trend, not to mention that there are firms that have paid out more than 80% of their profits toward stock buybacks.  All this as profitability for many U.S. firms has stalled.

In early May we alerted readers that, according to Factset report, the blended earnings growth rate for the DJIA (which combines actual results for companies that have reported and estimated results for companies yet to report) stands at -3.3%. Said Factset: “If -3.3% is the final earning growth rate for the quarter, it will mark the third year-over-year decline in earnings in the past four quarters for the DJIA.” Earnings, the report concluded, have not been fueling the recent stock market rally.  

And while some may argue that hoarding was the right strategy given the severity of the 2008 financial crisis, history has shown that this approach only prolongs a company’s inevitable demise if the firm has no competitive advantage or successful business model. During the Great Depression, many companies hoarded capital and cut spending drastically in the hope of waiting out the worst parts of the downturn until consumer demand rebounded.

But many of these companies eventually did go bankrupt as competitors continued to invest in their businesses and hire people to develop superior products and services. By the time consumer demand improvement was obvious and the Depression-era companies that hoarded started to spend for growth, they were miles behind their competitors and lost market share. Two companies that continued to invest in new projects and people during that era: IBM (NYSE: IBM) and GE (NYSE: GE).

And while some firms may have used the Fed’s largesse to reinvent their businesses, the amount of cash on company books suggest that a good number of companies have not.

The London Banker, an anonymous blogger whose self-described career has included stints as a central banker and securities market regulator, said that at some point money spent unproductively has to be repaid or written off, and that “Without a productive foundation … those bubble assets must deflate.”

It may be years before those true bubble assets – such as zombie companies – truly deflate due to the stimulus still occurring in the U.S., Europe and Japan.

Facing the Music

We noted in early May that stocks have been more expensive relative to corporate earnings only three times over the past century than they are today, according to data from Robert Shiller, a Nobel laureate in economics. According to an April 2014 New York Times report, those other three periods are not exactly reassuring: the 1920s, the late 1990s and in the prelude to the 2007 financial crisis.

James Grant, the publisher of Grant’s Interest Rate Observer, has also been sounding the alarm. He believes this will ultimately lead to “financial turmoil,” Grant warned. And as he has maintained since last year, the turmoil could create the risk of deflation again.

And many market analysts believe the market could see a 10% or even 20% correction this year. The S&P 500 is up 185% since its trough in March 2009, and it has been almost three years since the market experienced a 10% correction. Each of the major rallies over the past 15 years ha s been followed by a significant corrections. Historically, market corrections (defined as a stock market decline of 10% or more) happen about every 2 years.

So rebalance your portfolio toward high quality company stocks of firms with clear leadership in their sectors, high margins of profitability, and modest amounts of debt on their balance sheet, and which are truly investing in their businesses.