Last yeear, as we were about to enter 2010, I was optimistic about the economy but cautious on the market (2010: A Good Year for the Economy and a Mediocre Year for Stocks?), as several macro developments I was watching suggested as much. However, the converse appears to be the case this year in which it is quite possible 2011’s best returns will occur in the first part of the year while the second half may be a bit problematic.
The LEI’s Don’t Lie
In the article I penned in December 2009 I was looking at the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) which was not heading to new highs in concert with the market but in fact was rolling over. It looked eerily similar to the end of 2003 heading into 2004. While the growth deceleration in the WLI back in 2003-2004 preceded nearly a 10% correction over a five month period in the S&P 500, the decline in the WLI last year did foreshadow a rough first half for the markets in 2010. The S&P 500 declined nearly 10% in the first quarter and then witnessed a near bear market (20% + correction) in the second quarter, declining over 17% from April through July 1st. However, talk of QE2 and POMO (Permanent Open Market Operations) activity from the Fed quickly helped the markets reverse gear to finish the year in positive territory.
By that time the WLI had bottomed and turned sharply higher, and I find it disingenuous that the same bears constantly pointing to the decline in the WLI in early 2010 as evidence of a near-certain double-dip recession were mum on the fact the ECRI staged a recovery. I was also leaning towards a double-dip recession but I refused to fall to the behavioral bias of data mining (only acknowledging data that supports one’s preconceived conclusions) and followed John Maynard Keynes’example who said, “When the facts change, I change my mind. What do you do, sir?” Returning back to the late 2009 piece I wrote that compared 2003-2004 to 2009-2010, I felt a low was in and turned bullish as the WLI reversed (Investment Implications of a Bottom in Leading Economic Indicators).
Since that time it has paid handsomely to stick with the trend in the WLI which suggests buying the dips. The WLI has rallied into positive territory and is providing no warning of a significant market top as it had in 2009. Moreover, another indicator I was tracking in late 2009 that suggested rough waters ahead for the markets was a decline in the M2 money supply growth rate. Like the WLI, that too looks vastly different than it did a year ago as it is rising rather than falling sharply, signaling liquidity is bullish for equities.
Source: Bloomberg
Source: Bloomberg
Kicking the Can Down the Road
While the first half of 2011 may be a good for equities, we know that the Fed is set to end its second round of quantitative easing by June and talks of removing Fed-sponsored financial largess may lead to a correction in equities in the second half of the year as it did in Q2 2010. What may also lead to the Fed pulling in the reins a bit is the growing public mood that is turning against the Fed, with Representative Ron Paul leading the charge. As the first two articles below illustrate, sentiment is turning against the Fed which may pressure Bernanke to rein in the Fed’s balance sheet contrary to popular opinion that foresees QE3, QE4, etc. There is also the issue of raising the federal debt ceiling, which will surely be an important issue for investors to ponder this year.
•Ron Paul, Author of ‘End the Fed,’ to Lead Fed Panel
•More Than Half of U.S. Wants Fed Curbed or Abolished
•Goolsbee Says Failure to Raise U.S. Debt Ceiling Would Be `Catastrophic'
•House GOP vows unfettered vote on raising of debt ceiling
While the White House and Fed may have helped give the economy and markets a kick with the tax cuts and QE2, at some point the case for expanding the Fed’s balance sheet and/or raising the US government’s debt ceiling are going to come into question. If this occurs near the middle of the year, the implications for federal spending cuts and reduced activity from the Fed would have to be factored into investment implications which would call for slower economic growth ahead and slowing corporate earnings, both of which would likely weigh on the markets and, rather than accelerating northwards like last year, the markets may instead experience some turbulence in the second half of 2011.
Near-Term Red Flags
While the first half of the year may prove bullish for equities, I’d advise some near-term caution as red flags are starting to appear. One thing that I commented on recently (Intermediate Term Correction on the Horizon?) is how extreme sentiment is currently. Equity returns are strongest when sentiment numbers are overly bearish, and while extreme bullish sentiment may not lead to an immediate correction, at a minimum it does advise some caution here. Additionally, while the equity markets continue to march higher the percentage of stocks hitting new 52-week highs on the NYSE and NASDAQ is not, indicating fewer and fewer stocks participating in the rally, a characteristic of short-term tops.
If a short term correction does occur over the next few weeks, given that QE2 remains in full force and both the WLI and M2 growth rate are rising, a strategy of buying the dips still appears warranted at this time. That said, the WLI and M2 growth rate need to be monitored ahead as well as the political climate in regards to the Fed and federal spending. If the WLI and M2 growth rate roll over and the talks of reining in the Fed and federal spending occur, we could be in for a bumpy ride in the second half of the year, making 2011 the reverse of 2010.
