Headwinds & Market Messages
By Chris Puplava, June 23, 2010
Co-Manager of PFS Group's Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account
The stock market for the past year has been supported by numerous economic and financial tailwinds that have helped propel it to retrace a significant portion of the 2007-2009 decline, roughly a 61.8% Fibonacci retracement for the S&P 500. That said many of the prior tailwinds have become headwinds leading to a deceleration in stock prices. Looking at various indicators suggests that these headwinds are likely to continue through the bulk of 2010 and implies a potential economic growth scare. Moreover, with a slew of potential market wild cards (BP oil spill, Euro debt crisis, China economic deceleration, US state fiscal nightmares) filling the investment landscape it would not take much for a growth scare to turn into a double-dip recession. Clearly the time to be bullish was in 2009, while at the present time capital preservation is likely to be the order of the day.
Heading into 2009 the markets had two very powerful financial supports that provided a potent financial tailwind, which were a strong growth in the money supply (M2) and a sharp decrease in interest rates. These 2009 tailwinds have turned into 2010 head winds as the M2 money supply year-over-year (YOY) growth rate is on the verge of going negative (deflation) as it sits at a 1.70% growth rate, and global interest rates have began to increase. Global interest rates play a key role in economic activity, and given the interconnectedness in economic growth among countries it is not surprising to see that the trend in global interest rate changes correlates strongly with the Conference Board’s Leading Economic Index (LEI) for the U.S. As seen below, the sharp increase in the YOY change in global short rates suggests that the US LEI is likely to continue to decline sharply throughout the rest of 2011.
The general volatility in the markets also suggests the likelihood that leading economic indicators are in the process of rolling over. The volatility index (VIX) has had a strong correlation to the ISM manufacturing and non-manufacturing indexes and its recent upward trend (shown inverted below) suggests the ISM indexes are likely to decline over the next few months.
Source: Moody’s Economy
The decline in the LEIs over the remainder of the year suggest at a minimum that we can expect a growth relapse in economic activity, and given that the stock market discounts economic activity we can expect a declining economic growth rate to lead to subpar stock returns. While a growth scare can be expected with reasonable certainty, at the current time there is not enough evidence to suggest that an economic growth scare will turn into a double-dip recession. A double-dip recession is a clear possibility, and as mentioned in the beginning of this article there are clear wildcards that could lead to a double-dip recession; it’s just that there isn’t enough evidence to suggest one is on the immenient horizon, which is basically the view of ECRI’s co-founder Lakshman Achuthan in a recent video (Click for link).
Below is a recession probability model I have developed based on general economic activity from the 50 US states. The recession model generally provides several months warning before a recession begins as the recession probability level begins an upwards decline well before the onset of a recession, with readings above 20% representing a key threshold as levels above 20% have led to recessions in every case since 1980. So far we are still seeing the probability of a recession fall which isn’t surprising as the coincident economic indicators are still improving. Supporting my recession probability model is the model developed by University of Oregon professor Jeremy Pigler, whose model has been quite accurate over the last four decades. Like the PFS Group model his recession probability model is still declining and suggests a recession is not on the near term horizon.
Monitoring recession models will be important through the remainder of 2010 as well as 2011, and all the tax increases set to hit the economy loom large. As stated above the LEIs are in the process of peaking and suggest that we are entering the early contraction phase of the business cycle. During this phase investors should be shunning risk assets and cyclical sectors like financials, technology, and consumer discretion, while beginning to overweight defensive sectors like health care, telecommunication services, utilities, and consumer staples. Fixed income assets also typically receive a bid during this phase as well, though their peak relative performance comes in the late contraction phase.
I’ve created a relative trend scoring system for sectors and asset classes that incorporates short-term, intermediate-term, and long-term technical trends into a simple score. The trend scoring system incorporates the MACD and key moving averages of an asset classes relative to the S&P 500. Tracking the trend scores helps to visually identify sector rotation and asset class shifts and how those scores correlate to the business cycle using the ECRI WLI Growth Rate as a proxy.
Shown below are five general investment classes of sectors and fixed income. The financials, technology, and consumer discretion sectors are grouped to give an average score for early cyclicals while the industrial sector is used as a mid-cyclical sector proxy. The non-cyclical group is an average score made up of the defensive health care, telecommunication services, utilities, and consumer staples sectors. The energy and basic materials sectors comprise the commodity group and the iShares long bond exchange traded fund (TLT) is used as a fixed income proxy.
As seen below, it appears that early cyclicals (red) have likely seen their best days and have been in a topping process since late 2009 on a relative performance basis. The peaking of the cyclical trend score correlates with the peak in the ECRI WLI, and given the WLI continues to decline the cylical sectors of the S&P 500 are likely to deteriorate further going forward. We can also see that the mid-stage cyclicals (industrials) came into strength in the middle of 2009 and also appear to be in the topping process. In mirror image fashion, the non-cyclical sectors and fixed income trend scores bottomed as the WLI and cyclical sectors were peaking. The general message of the trend scores below supports the notion that we are in the early contraction phase of the business cycle and argues for a defensive market posture.
In last week’s article, "All Along the Watchtower," I suggested watching various indicators to tell when the current recovery rally is likely to end and a renewed decline begin. An update of the indicators mentioned in last week’s article are provided below with a general mixed message. While USD and Euro currency swamps have fallen throughout June, the Ted spread and LIBOR-OIS spread have remained sticky and have not fallen in concert with a stock market rally suggesting there still remains a heightened level of credit risk.
Supporting the LIBOR-OIS and Ted spread pattern are corporate bond spreads which have virtually remained near their highs, in stark contrast to what was seen after the February bottom, which suggests credit markets remain uneasy.
One likely cause of credit market uneasiness is that 5-year Greek credit default swaps (CDS) are on the verge of reaching breaching the 1000 mark and breaking out to a new high despite the European Union and ECB’s best efforts. On the domestic front, the CDS for what I call the CINN states continue to rise as the fiscal health of some states remains precarious.
5-Yr CDS on Greek USD-Denominated Debt
Before investors try to catch a bottom in the stock market or invest in risky assets, it is probably best to wait for a turn in the LEIs as well as a clear and discernable trend reversion in credit spreads and CDS for various financial entities. As of yet those events have not occurred and the decline in LEIs is expected to continue heading into 2011. If that is to be the case then it does appear like 2010 will go down as a "A Good Year for the Economy and a Mediocre Year for Stocks."
© 2010 Chris Puplava