The stock market has historically acted as a discounting mechanism in which stock prices reflect future fundamental data, typically with a six month lead time. This was exactly the case this year as the stock market bottomed in March while the economy looked as though it couldn’t possibly get any worse. The stock market rightly predicted improving economic conditions in which the US economy wasn’t losing more than half a million jobs each month as it was earlier in the year. The economy went from losing 741,000 jobs in January to losing 11,000 jobs in November, quite the turnaround. Real GDP also improved in which it declined by a -6.43% annualized rate in the first quarter to showing +2.24% growth in the third quarter. Easy year-over-year comparisons for economic stats and corporate earnings all but ensures positive growth rates ahead that will show improvement in the economy as we enter 2010, but the question concerning investors is how the stock market will react. Will a positive growth picture for the economy translate into higher stock prices?
Given that the S&P 500 is up more than 60% off the March lows, the stock market has likely priced in much of the improved economic rebound and 2010 may look a lot like 2004. In 2004 the economy continued to improve and yet the stock market underwent a much needed pause as the stock market was overbought from already pricing in much of the improvement and valuations were beginning to become stretched. Earnings began to accelerate in 2004 to help drive down valuations and thus alleviate valuation concerns. After the stock market worked off its overbought condition and because the economy continued to expand the stock market also continued its advance late in 2004.
In order to determine if 2010 will be like 2002 or 2004, watching leading economic indicators as well as other key economic stats will prove crucial. They should help in determining if the stock market can advance (2004) or will resume another leg down (2002) as the overall backdrop for the stock market is a secular bear market that remains in place since beginning in 2000. The Economic Cycle Research Institute’s (ECRI) Leading Economic Index’s (LEI) growth rate began to stall in the second half of 2003 and fell back to a neutral reading by the end of 2004 and served as an early warning for the character of the stock market in 2004. The S&P 500 reflected the deceleration in the ECRI LEI in which it spent most of 2004 in a gradual decline of nearly 10% after peaking in March of 2004. Currently the LEI is off its peak as its growth rate has cooled from a high of 28% in October to 24.4% in the middle of December. If the LEI continues to stall or decelerate it could be foreshadowing a rough first half in 2010 for the stock market.
Source: Bloomberg
What also preceded the rough start to 2004 was that the money supply (M2) growth also began to decelerate, though the bottom in the stock market in the fall of 2004 coincided with a large spike in the money supply’s growth rate. The March bottom of 2009 was preceded by a large pick up in the M2 growth rate that occurred in 2008 and the significant deceleration in M2 that has occurred this year corroborates the trend in the LEI and confirms that money supply will not be as supportive to stock prices in 2010 as it was in 2009. The M2 money supply will be monitored closely as a reacceleration in the growth rate may indicate a market bottom/further advance while continued contraction will likely prove bearish for the stock market.
Source: Bloomberg
One of the key factors in 2004 that indicated the mild stock market correction in the S&P 500 was only a correction in the bullish trend was that economic fundamentals remained solid and didn’t warn of a deteriorating economy. For example, the Philadelphia Fed measures coincident economic activity for all 50 states and throughout 2004 at least 85% of the 50 states were showing increasing economic activity. It wasn’t until 2007 that the percent of states showing increasing economic activity fell below 80% and continued to decline before bottoming this year. If the state economic activity index continues to improve and shows no major sign of deterioration, then any correction in the stock market will likely prove to be just that, a correction. However, if activity falls below the 80% threshold after rising above it, there is the possibility for a double dip recession and another bear market.
Source: Bloomberg
Another recession in the not too distant future is a clear possibility as the unemployment rate stays stubbornly high. Businesses have begun to ease up on firing workers but hiring is a whole other story. According to the National Federation of Independent Business (NFIB) that measures small business activity, small businesses are in no rush to begin hiring. According to the NFIB survey, the net percent of firms planning on increasing employment is still negative as firms overall are still laying off workers. A poor employment backdrop is the culprit behind prolonged period of unemployment, with the average duration of unemployment recently setting an all-time record of nearly 25 weeks. If the recovery is going to be anything other than a pure statistical recovery small businesses need to start hiring or we will continue to see elevated unemployment insurance payments and food stamp payments eat away at state and federal coffers, likely leading to new extension packages from the White House to replenish them.
Source: BLS, NFIB
Source: Bloomberg
Source: FDA
Next year is likely to be filled with many unknowns in terms of how the markets will handle a flood of Treasury debt, whethr hiring occur in earnest, and whether businesses increase capital expenditures. What is not an unknown is that much of the economic bounce off the lows this year is likely already priced into the market and it will likely take a vibrant recovery to propel the markets significantly higher. Thus, 2010 will likely prove to be a positive year for economic data relative to 2009, though not necessarily for the stock market.
