We look to be heading into 2010 with one of the most dramatic rallies after a bear market in over 100 years as the S&P 500 is up more than 65% off the March lows and is up roughly 23% year-to-date. With such a dramatic rally in the stock market one would expect to see a vibrant economic recovery ahead given that the stock market acts as a discounting mechanism. While the economy has certainly recovered from the depths of the “Great Recession” over the course of the last six to nine months, can we expect the economy to deliver what the stock market has already priced in? The big question for 2010 seems to be whether there will be follow-through in terms of economic activity and will the improvement be sustainable.
There is no doubt that the economy has improved and that the worst of the recession is behind us. At the apex of the economic decline all 50 states were showing negative economic growth according to the Philadelphia Fed. This was a new record as the previous record was seen during the 1982 recession with a reading of 40 states. No recession in the last quarter century saw the entire US contracting simultaneously with the “Great Recession” being the first example. Over the course of the year more and more states are expanding so that only 27 states (54%) are contracting while 23 states (46%) are expanding. Along with the improved state readings is a decline in initial jobless claims as employment layoffs moderate from the highs seen earlier in the year. Congruent with the state economic activity improvement seen in the Philly Fed survey is the US recovery status map from Moody’s Analytics that shows 11 states expanding and only one state (Nevada) still in recession.
Source: Bloomberg
Source: Moody’s Analytics
While the economy has certainly enjoyed a nice economic snapback, one has to wonder if the current economic momentum will continue into 2010. Given the major headwinds still facing the economy, a high level of skepticism is in order. For example, while the Philly Fed State Coincident Index has rebounded dramatically from a record low of -100 in February, it still resides in negative territory with a reading of -24. This is in stark contrast to the last recovery where by the time the stock market had bottomed in 2002 the State Coincident Index was already well into positive territory with a reading of 34.00 and had reached the upper limit of 100 by the close of 2003. The reading of 100 by 2003 occurred after the stock market had advanced by 65%, and yet we are still in negative territory after the 65% run up in the S&P 500 off the March lows. Either the market has advanced too far too soon or the State Coincident Index is set to stage a dramatic recovery ahead.
Source: Bloomberg
There are some other reasons to have a healthy level of skepticism heading into 2010, with one principal reason being the lack of follow-though in terms of the Conference Board’s Coincident Economic Index (CEI) which typically lags the Leading Economic Index (LEI) by six months. As shown in the figure below, while the LEI has staged a nice snapback in terms of year-over-year (YOY) growth, the CEI has had a tepid recovery and actually appears to be either stalling or rolling over, clearly not a good sign.
Source: Bloomberg
A lack of follow-through in terms of growth seen in the LEI later translating into growth in the CEI has been a nagging fear of me this year. My suspicion was that the dramatic recovery in the LEI was predominantly due to the monetary components and not the economic components, which would then cast a misleading picture for true future economic growth. I commented on this in an article in September (“Fool Me Once, Shame on You. Fool Me Twice, Shame on Me”), and in the article I highlighted the weightings of the 10 components of the LEI, with the three monetary components comprising roughly 50% while the 7 economic components made up the other 50%, with the emphasis clearly skewed to the financial components.
Source: The Conference Board
Using the Conference Board’s methodology I broke out the monetary and economic components into separate LEIs and graphed their growth rates along side the overall Conference Board’s LEI. As you can see below, all of the growth in the LEI comes from the financial components as the economic LEI is still contracting! The lack of growth in my economic LEI helps to explain why in the chart above that the CEI is failing to follow with a six month lag the path of the LEI, as the monetary stimulus is failing to translate into real economic growth. What is also troubling is that the six month growth rate in my economic LEI is rolling over even while the YOY rate is still negative. The economic LEI rolled over in 2002 which led to a dramatic decline in the markets, while the roll over in 2003 into 2004 only led to a consolidation in the market. Will the current loss in momentum play out like 2002 or 2004? We’ll find out soon enough.
Source: Bloomberg
Source: Bloomberg
Both the bulls and the bears can make their case for the stock market to either hold up or sell off respectively, but it appears the consumer has already made it’s case with the consumer presently still in the caves with the bears. Given the dramatic recovery in the stock market this year you would think that consumer confidence levels would be much improved. However, this is far from the case as confidence levels are still below even the lows of the depth of the last recession, no doubt affected by the horrid jobs market. Like the consumer confidence levels the employment diffusion index has recovered but remains below the lows of the last recession as only 31% of industries are hiring while 69% are still shedding jobs.
Source: Bloomberg
Source: Bloomberg
The U3 unemployment rate was 10.2% in October and the broader U6 figure that incorporates part-time unemployment and marginally-attached workers stands at a much higher 17.5% rate, with the spread between the two coming in at 7.5%, the largest spread since U6 rate was introduced in the early 1990s. What the spread captures is the slack in the labor force that will be worked off first before the U3 number declines significantly as it is easier for a company to increase worker’s hours back to full-time employment than go out and higher new workers. For this reason we can expect the unemployment rate to remain stubbornly high for the next several years, which is likely captured by the low consumer confidence levels. Presently the US has more than 18 million people who are working part-time though they would like full-time employment that simply isn’t there.
Source: BLS
Source: BLS
While economic growth in the US is questionable and likely to be tepid at best going into 2010, that cannot be said of the developing countries in Asia, Latin American, and Africa. According to the IMF, most of South East Asia and Africa will have GDP growth in 2010 ranging from 3-10% while most of the developed world including North America and Europe will have GDP growth in the 0-3% range. Even looking further out to 2014 the IMF still sees tepid GDP growth in North America with the U.S. significantly lagging the rest of the world.
Source: International Monetary Fund, IMF Data Mapper
Source: International Monetary Fund, IMF Data Mapper
The disparity in future economic growth between the US and the rest of the world is likely the reason that there is such a dichotomy in the recovery of small businesses versus US companies that have international business exposure. This is perhaps best seen when comparing the ISM manufacturing Purchasing Managers Index (PMI) that captures US business whose manufacturing base has a major international focus to US small businesses. In the past the ISM PMI has tracked fairly closely with the National Federation of Independent Business’s (NFIB) Small Business Optimism Index. This was the case when the US was the world’s economic juggernaut in the 1990s but it appears the economic growth baton is being passed to China and the developing world. The improved growth rates in the developing world are being translated into a higher PMI while the NFIB Small Business Optimism Index is significantly lagging at a rate never seen before.
Source: Bloomberg
The US consumer remains depressed given the horrid jobs market and thus is reining in its debt accumulation and consumption levels, which then translates into weak consumer demand that supports the small businesses throughout the nation These small business then do not have a reason to hire new workers given the slack consumer demand and the vicious cycle continues. However, the same can not be said for the manufacturing base as the ISM employment composite has staged a sizable recovery while overall national employment remains incredibly weak as small businesses make up the lion’s share of US employment.
Source: ISM, BLS
Given the above analysis, it seems that a healthy degree of skepticism in regards to follow-through for US economic growth for 2010 is justified, while at the same time global economic growth is likely to vastly outperform the US, thereby making regional investment plays a key them for 2010. Heading into 2010 will likely not only be about regional selection but also sector selection. The initial thrust out of a stock market recovery is seen where virtually all boats are rising with the tide as the sector correlations to the stock market (S&P 500 as a proxy) remains elevated. However, as the stock market recovery progresses the market leaders begin to pull ahead of the pack and dance to their own tune, while market laggards also begin to emerge. As the rally matures the average sector correlation to the stock market declines and it appears we are currently in this later stage as the average sector correlation has contract from roughly 90% to 85%. This can be seen in the figure below that charts the average sector correlation inverted for directional purposes alongside the S&P 500. A rising correlation is often associated just after market peaks and so a falling correlation can be interpreted as bullish at this point and highlights the importance of sector bets as opposed to a simple market strategy of buying the indexes like the S&P 500.
Source: Bloomberg
Since the March lows the clear winning sector has been the financial sector which has outperformed the S&P 500 by 52.45%, with the materials, consumer discretionary, and industrial sectors also significantly outperforming. However, since the July lows the materials and industrial sectors have been the market leaders which are typically seen near the early to middle of a stock market cycle. Sectors to look for going into 2010 according to S&P’s guide to Sector Rotation highlighted graphically by StockCharts.com would appear to be a continued emphasis on industrials, basic materials, and energy, all of which have a global emphasis (commodities and developing country growth) that should be a benefit to them as highlighted previously.
Relative Sector Performance: 03/10/09-12/02/09
Source: StockCharts.com
Relative Sector Performance: 07/08/09-12/02/09
Source: StockCharts.com
Sector Rotation Model
Source: StockCharts.com
In summary, while there are open questions to sustainable US economic growth ahead, it appears that the developing nation economies are staging strong rebounds due to expansionary monetary and fiscal policies across the globe. While the US has an expansionary fiscal and monetary policy it is not translating into as much economic growth as is being witnessed across the globe, likely due to major long-term headwinds facing the US like a deleveraging consumer and struggling housing market. For this reason sector and geographic investing will likely play a key role in terms of 2010 investment implications, with globally focused sectors like the industrials, basic materials, and energy sectors likely to perform well in addition to overall emerging market exposure.
