The Bears Are Seeing Red in a Sea of Green

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Summary:

  • Incoming leading economic indicators (LEIs) suggest widespread growth well into 2014
  • Stock market breadth confirms the message of the LEIs and suggests the bull run continues

The April release of the Philadelphia Fed’s State Leading Index report came out today and was quite bullish. Here is a summary of the report:

The Federal Reserve Bank of Philadelphia has released the leading indexes for the 50 states for April 2014. The indexes are a six-month forecast of the state coincident indexes (also released by the Bank). Forty-eight state coincident indexes are projected to grow over the next six months, while two (Alabama and Louisiana) are projected to decrease. For comparison purposes, the Philadelphia Fed has also developed a similar leading index for its U.S. coincident index, which is projected to grow 1.7 percent over the next six months. [emphasis added]

Philly Fed State LEI

There is a sea of economic green spread out across the country as 48 out of 50 states are projected to continue economic expansion over the next six months, which works out to a 92% diffusion index (percent positive less percent negative) reading. For comparison purposes, back in December 2007, the first month of the last recession, 21 states were projected to show decreasing economic activity which works out to 16% diffusions index reading and by January of 2008 the diffusion index fell to 0% and turned negative the subsequent month. April’s 92% diffusion index reading is well above the neutral zone and confirms the US economy is on solid footing.

Those bearish on the US economy believe their case was strengthened today when first quarter GDP numbers were shown to be weaker than expected, and revised lower to -1.0%. On the other hand, leading (i.e. forward-looking) economic indicators like the Philadelphia Fed’s State LEI shown above, offer a different picture and suggest growth should accelerate by the fall. Which is correct? Unless you're driving in reverse, you generally want to pay attention to what's ahead of you.

The Philly Fed State Leading Index leads real year-over-year (YOY) GDP growth by 4-6 months. In the pop out box to the right of the image below, the Philly Fed State LEI suggests real YOY GDP growth should accelerate from the current 2% growth rate to just under 3% by the fall.

Philly Fed LEI and GDP
Source: Bloomberg

The reacceleration in the Philly Fed State LEI should provide support for the bulls as equity returns are strongest when the LEI remains in positive territory and moves below 0% suggest bear markets and recessions. I use a 0.50% growth rate in the LEI to serve as an early warning of a bull market top and coming recession and at the current 1.69% rate we are comfortably above any early warning of a bull market top.

Philly Fed LEI and S and P 500
Source: Bloomberg

Support for the bears continues to erode almost daily as the market continues to firm and gather steam. When surveying the equity market I focus on the S&P 1500, which is comprised of the S&P 500 large cap, S&P 400 mid cap, and S&P 600 small cap indexes. Altogether, the S&P 1500 represents roughly 92% of the entire US market capitalization and provides a full picture of the stock market. What is a very encouraging sign for the bulls is that the cumulative advance-decline line (AD line) for the S&P 1500 is hitting new highs and confirms the S&P 1500’s move to all-time highs. Typically, we see the cumulative AD line peak well before the actual index does as fewer and fewer stocks participate in the rally and begin their own private bear markets. Eventually enough stocks are declining that their collective weight pulls down the headline index and a top is formed.

This process of forming a bull market top was described in great detail by Paul F. Desmond, President of Lowry Research in a special report in 2006 (An Exploration of the Nature of Bull Market Tops). In the report Mr. Desmond came up with a beautiful illustration of what a bull market top looks like in which, prior to the actual top, one by one individual stocks move into their own private bear market, with the image of a feather. The shaft of the feather represents the headline index (S&P 500, NASDAQ, Dow, etc.) and the individual stocks that make up the index are the barbs that branch off the shaft and peak prior to the market, i.e. headline index, peaking.

feather

We can see this in cumulative AD lines for indexes in which the AD line peaks typically well before the market does as you have more stocks declining than advancing prior to bull market peaks. This characteristic is shown below for the last two bull market tops where the peak in the AD line for the S&P 1500 is shown by the red vertical lines. For the 2000 top, the AD line peaked on April 2nd 1998, before the steep 1998 Asian Currency Crisis decline and well before the 2000 technology bubble peak. In the most recent bull market top of 2007, the AD line for the S&P 1500 peaked on June 1st 2007, more than five months earlier than the October 2007 top. What provides further support for the bulls is that the AD line hit a new all-time high recently to confirm the new high in the S&P 1500, which is shown on the right in the image below.

S and P 1500 AD Line
Source: Bloomberg

Summary

In considering the above, the bear case for a bull market peak and an end for economic expansion is still not convincing. While the revised -1% GDP number for the first quarter reflected greater weakness at the beginning of this year, this is mostly a backwards look at the economy and, as such, does not indicate future trends. On the other hand, when we look at leading economic data, there is a sea of green across the US landscape as seen by the Philly Fed’s State LEI. Confirming the health of the stock market is the new high in the cumulative AD line for the S&P 1500, which typically peaks well before the market.

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