We heard the term "green shoots" nearly ad nauseam last year as economic data was still poor, just decidedly less so as analysts cited "less bad" data as a sign of an improving economic and stock market outlook. Analysts were correct and eventually less bad turned into simply "good." However, analysts are prone to a positive bias in regard to the stock market, and very few analysts are actually looking for the S&P 500 to decline this year. Rather than basing one’s outlook on analyst projections, the leading economic indicators (LEI) have served as an unemotional and reliable gauge for future economic and stock market prospects. The LEIs correctly foretold of the 2007 market peak, the 2009 bottom, and they are currently in a topping phase and foretell market weakness ahead. Several different LEIs have begun to roll over as prior supports have begun to fall, signaling that the 2009 "green shoots" recovery may turn into the 2010 "falling fruits" growth scare.
The Organization for Economic Co-Operation & Development (OECD) calculates a Composite Leading Indicator (CLI) for various countries and its trend and level can be used to segment the business cycle into four phases: early expansion, late expansion, early contraction, and late contraction. The OECD US CLI is shown below with a two month lag. I believe the April-May levels will show the CLI has peaked and that we are entering the early contraction phase in which the CLI is still positive (>100), but is decelerating. Essentially the readings will likely become "less good" over the next few months.
Entering the Early Contraction Phase of the Business Cycle
Source: Bloomberg, OECD
I track the CLI' for 22 different countries and regions (see table below). I compare how many are rising (in expansion) versus declining (contracting economies) and then develop a diffusion index that calculates the percentage that are rising, essentially a CLI global economic breadth measure. This breadth measure is a great leading indicator for stock market peaks, whether they be bull market tops (2000, 2007) or major intermediate corrections (2004, 2006). As shown below, after hitting a peak reading of 100% in the middle of 2009, the diffusion index has steadily declined in 2010 and is foretelling at a minimum a major intermediate correction. Given the diffusion index has not turned around the current intermediate correction may continue through most of summer.
Source: Bloomberg, OECD
Source: Bloomberg, OECD
The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) growth rate has been declining ever since late 2009 and is projecting the year-over-year (YOY) growth rate in US GDP to peak this summer and then decline in the second half of 2010, which is likely currently being discounted in the markets and helps explain some of the weakness we have been witnessing.
Source: Bloomberg, ECRI
Sector Relative Performance Confirming the Business Cycle
Confirming the transition in the business cycle from late expansion to early contraction is the relative performance of the stock market. The cyclical sectors such as financials, consumer discretionary, and technology typically outperform when the LEIs are rising and the defensive sectors like consumer staples, utilities, and telecommunications typically outperform the S&P 500 when the LEIs are falling.
Just as the growth rate in LEI’s reached a positive extreme in late 2010, so too did the twelve month relative performance of the cyclical sectors. These extremes were pointed out in a March article ("Contrary Investing: Loving the Unloved") in which it was suggested that the defensive sectors would likely outperform the cyclical sectors over the next six months. As shown below, the three cyclical sectors 12-Mo relative performance trends are tracking the ECRI WLI growth rate and are likely to underperform the stock market until the WLI bottoms, which is currently dropping like a rock.
Source: Bloomberg, ECRI
Source: Bloomberg, ECRI
Source: Bloomberg, ECRI
Conversely, three defensive sectors 12-Mo relative performance displays an inverse relationship with the WLI and outperform the broad market when the WLI is falling as it is now. Shown below are the three defensive sectors of the stock market, with the WLI shown inverted for directional similarity.
Source: Bloomberg, ECRI
Source: Bloomberg, ECRI
Source: Bloomberg, ECRI
The Ultimate Business Cycle Comparison – Consumer Discretionary versus Consumer Staples
Several key markers in addition to the LEIs should be monitored to determine if we roll over into a potential recession and bear market. One relationship I am watching closely is the relative strength of the consumer discretionary sector and the consumer staples sector, basically the relative strength of the ultimate cyclical versus non-cyclical sectors. The secular bear market that began in 2000 is clearly demonstrated by the relative strength of the consumer discretionary versus the consumer staples sector shown below.
The positive trend currently in place is very similar to what transpired between 2003 and 2004, and I will be watching for a trend break in this ratio. The trend break in 2004 marked an intermediate correction and not a bear market or a recession, and a trend break in the present case does not insure a recession or a bear market, but at a minimum does point to an early contraction phase of the business cycle. That said, what makes a trend break in the current situation more troubling than in the 2004 case is that it would be occurring just after the ratio hit the upper declining trend line. Reaching the upper trend line has marked the prior bull market peaks of 2000 and 2007. I would personally look for a break below 0.85 to point to a possible bear market and recession ahead.
Still Within a Secular Bear Market
I still maintain that we are in a secular bear market that began in 2000 with the rally off the March 2009 lows representing a cyclical bull market, with secular markets comprised of many shorter cyclical bull/bear markets. In a secular bear market volatility often picks up both economically and in terms of the stock market. Surprises are often to the downside and so one should always remain cautious, thus while we are transitioning into the early contraction phase of the business cycle, there is a greater potential for the economy to slide into a recession, or the late contraction phase of the business cycle. However, please note in the first figure above that between 2003-2007 the economy fluctuated back and forth between early contraction (orange shaded area) and late expansion (light green shaded area), before the CLI actually turned negative in 2008.
Given I believe we are still within the confines of a secular bear market, I think it would be useful to look at prior secular bear markets as a potential road map. I’ve created a bubble composite using the Dow from the Great Depression, Gold in the 1980s after its bubble peak, and the Nikkei from the 1990s from its bubble peak. Shown blow is the NASDAQ from 1998 to the present along side my bubble composite with the peaks aligned to the 2000 NASDAQ peak. As Mark Twain famously quipped, "History does not repeat itself, but it does rhyme." The NASDAQ has been following the bubble composite with surprising closeness and the bubble composite projects a decline into the fall and then a year-end rally before a sharp and steady decline into 2013.
Source: Bloomberg
Source: Bloomberg
Comparing the S&P 500 in the current secular bear market to its last one that occurred in the late 1960s into the early 1980s shows remarkable similarity and is also calling for a peak this year. Shown below is the inflation-adjusted S&P 500 comparing the current secular bear market to the last one. The 1970s comparison suggests the potential for a rally into late 2010 followed by a slow decline until roughly 2014.
Source: Bloomberg
Bear Market or Bull Market Correction?
The always insightful folks at Bespoke Investment Group looked at the prior 10%+ corrections since 1927 and analyzed how many of them that never reached bull market territory (20%+ corrections) eventually reached new bull market peaks using the S&P 500. What they found was that there have been 58 declines of 10%+ from bull market peaks and 57% ended up not becoming bear markets and 43% did. There have been 33 corrections that did not reach the 20% threshold but only seven of those, or 21% of them declined more than the present correction and didn’t reach bear market territory. Intuitively, the greater the decline, the greater the likelihood of reaching bear market territory as a simple correction morphs into a bear market, with the average bear market decline being 35.5%.
B.I.G. Tips: Correction or New Bear? (06/08/2010)
Source: www.bespokepremium.com subscription service
If the stock market fails to hold the recent February and May lows it is quite likely that we will move from a sharp intermediate correction into bear market territory. It is essential for those lows to hold. What gives the bulls some solace is the fact that a Dow Theory Sell signal has not occurred using intermediate correction lows, with the last occurring in February. The Dow Industrial Average is toying with its February lows while the Dow Transports are well above them. A break by both the Dow Transports and Industrials (Dow Theory sell signal) and the S&P 500 as well would be sending a clear warning signal for caution and argue for a defensive market posture. Currently the markets are very oversold and showing positive divergences using many different technical indicators. If the markets are so weak they can not rally off of support and from an oversold condition, that would be sending a loud and clear signal, which should be respected.
What is encouraging is that the one year relative performance of stocks versus bonds has cooled off after hitting a major extreme. The one year relative performance for the S&P 500 versus long-term UST bonds reached its highest extreme in April since the Great Depression, and was one of the reasons I suggested last month ("Expect More Boom and Busts") that the S&P 500 may underperform bonds and defensives sectors. As seen below, the one year relative performance between the S&P 500 and long-term USTs has fallen from two standard deviations above the mean to nearly reaching the mean. There is still the potential for the performance spread to fall into negative territory before reversing, but much of the relative performance excess of stocks versus bonds has now been wrung out.
Source: Ned Davis Research
While bonds may still pose an attractive alternative to stocks over the next few months as the LEIs are rolling over the one year relative performance numbers above have not reached a negative extreme, I still believe that bonds are a horrible investment relative to stocks for the next ten years given how low interest rates are. The chart below that compares 10-year relative returns shows as much, where the S&P 500’s ten year return relative to long-term USTs is at its lowest levels in more than a half century, indicating stocks have a greater long term investment appeal than bonds for the next decade.
Source: Ned Davis Research
