All Along the Watchtower
By Chris Puplava, June 16, 2010
Co-Manager of PFS Group's Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account
The markets have clearly put in a short term bottom after the April to June correction. Whether this short term bottom will turn into a more pronounced intermediate bottom that leads to a multi week to multi month rally is too soon to tell. That said, what the markets have going against them this time around that they did not have to contend with in 2009 is a decline in the leading economic indicators (LEIs) that are forecasting lower economic growth ahead, something the market is likely discounting now. Until the LEIs bottom we are likely in a subpar stock market performance environment in which risky assets and the cyclical sectors of the market are likely to underperform defensive sectors and assets.
When LEIs Are Rising "Buy the Dips," When the LEIs Are Falling "Sell the Rips"
Given that both the stock market and leading economic indicators (LEIs) discount future economic events it is not surprising to see that the relationship between the two is quite strong. For this reason, when the LEIs roll over investors should pay attention, and now is the time to listen as LEIs are peaking. The Economic Cycle Research Institutes (ECRI) Weekly Leading Index (WLI) has been falling for quite some time, and its growth rate peaked in advance of the S&P 500’s year-over-year (YOY) rate of change and is forecasting flat market returns for the S&P 500 from its year ago levels. Given that the S&P 500 was trading around 950 a year ago, the present decline that began in April may not be over. A decline from present levels to 950 on the S&P 500 would lead to a 15% decline, clearly something to avoid.
Source: Standard & Poor’s, ECRI
What is troubling is that the actual ECRI WLI has fallen to a new low signaling a potential trend change that suggests a continuing correction in the S&P 500 at a minimum. At no point in time during the 2002-2007 rally did the ECRI make a lower low, that is until late in 2007. What was also seen late in 2007 was a lower high in the WLI, though that has yet to occur in the present case, but a lower low is certainly something to take note of.
Source: Standard & Poor’s, ECRI
Source: Standard & Poor’s, ECRI
The US is not alone in witnessing its LEI peak as LEIs have been peaking all across the globe since December of last year as the table below illustrates graphically. The progressive peaking in LEIs across the globe is akin to the leaves changing color on a tree which signal a change in seasons. The progressive peaking in global LEIs is signaling a shift from late expansion to early contraction in which the second half of 2010 will likely witness a sharp decline in the rate of economic growth. We are likely to witness a moderation in the growth rate, though it’s too early to tell if we will actually see negative economic growth ahead.
A peak in the LEIs has important implications for the stock market as stocks display a strong correlation with the LEIs. For example, as seen below the S&P 500 typically advances when my OECD CLI Diffustion Index is increasing and declines when the diffusion index is falling and the turns in the diffusion index often lead turns in the stock market, and a shift in the LEIs suggests a shift in asset allocation. During times like this it is often advantageous to sell market rallies when the diffusion index is falling (sell the rips), while corrections serve as buying opportunities when the diffusion index is rising (buy the dips). Until the LEIs stabilize we are likely to continue to remain in a corrective/consolidation mode and rallies can serve as opportunities to lighten up on risky assets.
Source: Standard & Poor’s, OECD
When the LEIs move into the early contraction phase of the business cycle the cyclical sectors of the stock market often underperform while the defensive sectors begin to outperform. Confirming a peak in the LEIs is a peak in two of the most cyclical sectors of the S&P 500, financials and technology. The financials relative performance to the S&P 500 peaked in October (top panel below) and the technology sector’s relative performance to the S&P 500 peaked in December (blue middle panel). The consumer discretionary sector has yet to decisively peak on a relative performance basis, though the sector has stalled near its recent highs and may be in the process of forming a relative performance peak.
Watching various indicators will be important ahead in determining when the present rally begins to stall and possibly lead to a renewed decline. Because the LEIs are falling the market has a neutral to negative stance and so investors should have a heightened sense of caution in the current climate. If the LEIs are set to bottom soon and the stock market continues its advance to new highs, then we should see a very healthy market rally and easing in the credit markets. While it is too soon to gauge the health of the stock market's rally off the recent lows, what is a bit disconcerting is that the credit markets are not showing the same improvement as the stock markets that would tend to suggest the present rally is simply working off oversold conditions.
For example, in prior rallies after corrections since the March 2009 lows credit spreads have fallen as stocks have risen. Even as recent as the rally off the February lows credit spreads declined up until the April stock market peak. Recently the S&P 500 has rallied more than 70 points and yet corporate credit spreads remain elevated. The same is true for other spreads, though the USD 2-yr currency swap has shown some improvement.
Although not shown, credit default swaps for various regions such as North American and European corporates, emerging market sovereign debt, PIIGS sovereign debt, US states, and Baltic country sovereigns all remain near recent highs. If the market is going to put in a decent rally we should see credit spreads begin to fall. If they do not then the stock market's present rally may be short-lived as we head into the seasonally weak period of the year for the stock market. Throwing in declining LEIs makes for a potential rocky summer for the stock market and investors should remain alert for renewed market weakness.
© 2010 Chris Puplava