Starting off this year I had a pretty good feeling that it would be a good year for the economy and a mediocre year for the stock market. Part of this stemmed from the observation that the M2 money supply growth rate was decelerating and the leading economic indicators were stalling, similar to what occurred late in 2003, which preceded the 2004 correction and consolidation. Now that 2010 is nearing its final innings an update of my beginning of year article, “2010: A Good year for the Economy and a Mediocre Year for Stocks?” appears in order.
As mentioned in that article, the peak in the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) and the M2 growth rate did correctly predict a difficult year for the markets as they did in 2003/2004. From the start of the year to the low point in July, the S&P 500 was down roughly 10% but has since recovered to close today up 5.54% year-to-date. Just as the ECRI WLI predicted a tough start for the stock market this year, it’s bottoming action also likely signifies another turning point, this time a bullish one. Additionally, the M2 growth rate has also bottomed and is perking up, such that monetary liquidity and leading economic indicators are pointing towards higher stock prices, a complete 180 from the start of the year.
Source: Bloomberg
Source: Bloomberg
And it isn’t just in the U.S. that things are starting to pick up. Every day we're hearing about currency wars and a race to devalue one’s currency to combat a slowdown in global economic growth, which is likely to accelerate economic growth heading into 2011. Currently we appear to be in stage 3 of the business cycle globally, which is the early contraction phase in which global growth slows but remains positive. The bulk of countries that the OECD compiles data are in stage 3 while a few remain in the late expansion phase.
Source: Bloomberg
We are pretty bombed out in terms of global economic sentiment using my OECD CLI Diffusion Index and a turnaround would signal a return to the late expansion phase of the business cycle rather than a continuation into phase 4, the late contraction phase. The turn may come from a global round of quantitative easing by central banks all over the world.
Source: Bloomberg
An early sign that global economic growth may begin to accelerate is the price action in the Chinese market. The stocks related to housing in China (Shanghai Property Index) lead the price action in housing prices by several months and the index appears to be bottoming, which would suggest a soft landing in Chinese real estate in the first half of 2011 and not an implosion as some fear.
Source: Bloomberg
The Shanghai Property Index has been in a bear market since peaking last summer but it has put in a solid base of support near 3000 and just recently broke out. A move back above the 200 day moving average (green line) would provide further bullish confirmation that the Chinese economy is likely to have averted a recession with growth reaccelerating in 2011.
Source: Bloomberg
The ECRI WLI has improved for six straight weeks and the M2 money supply growth rate has risen for six straight months. As of now it does appear that the leading economic indicators and monetary stimulus are pointing towards a reacceleration in growth early 2011, which the stock market may be just now discounting in addition to QE 2. So far, things are looking up to close out 2010 on a positive note. One final confirmation I'm looking for is a breakout in the PIIGS (Portugal, Ireland, Italy, Greece, Spain) equity markets coupled with a breakdown in their credit default swaps (CDS). I’ve created an equally-weighted composite for the PIIGS equity indexes and CDS, which is shown below. Both the equity and CDS composites are at key critical junctures. The intermediate trend is bearish for the equity composite (red lines) while the short term trend has been bullish since June. The two trends are converging and resolution should be right around the corner. Looking at the CDS composite shows a similar condition with the rising trend of higher lows currently being tested. If the equity composite breaks out in addition to the CDS breaking down, that would indicate an easing of the fears over the PIIGS which could be another catalyst to spark global bullish sentiment.
So to recap, two very large concerns on the global economic front are a Chinese real estate bubble and a sovereign debt crisis with the PIIGS. Given that we've already seen a breakout in the Chinese Shanghai Property Index, a final breakout in the PIIGS would be another bullish support for the markets. Until these occur I’d recommend watching and waiting for confirmation since the PIIGS can still be the Achilles heel to a global financial-market recovery.
