Short answer: all things are possible, but change on the margin says no. With the US stock market hitting its two year anniversary this week, investors are getting skittish as fears mount about an impending bear market. Are we seeing the same signs of an imminent market top like we did in 2000 and 2007?
Economic Backdrop Continues to Improve
When it comes to the markets, they are not as concerned about absolute levels as they are about change. Yes the unemployment rate is in the high single digits, but the market has already discounted this. More importantly, which direction is the unemployment rate headed? What is the change on the margin? Since October of 2010 the unemployment rate has peaked and has been steadily falling. Moreover, the National Bureau of Independent Business (NFIB) Hiring Plans Index suggests that the unemployment rate should continue to improve into summer and even fall to 8%.
Source: Bloomberg
The Conference Board’s Employment Trends Index also suggests improvements in the labor market as it continues to head higher. Using a simple moving average (20 month) provides a great recessionary warning signal as breaks by the Employment Trends Index through its 20 month moving average have historically provided a warning flag of a coming recession several months in advance. Right now with the Employment Trends Index heading higher there is no imminent threat of a recessionary warning signal as seen below, with recessionary periods shown by the shaded red bars.
Source: Bloomberg
On a similar note, the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) continues to improve since last summer’s route, and rests above its 98-week moving average. Like the Employment Trends Index above, breaks by the ECRI through its 98-week smoothing have often preceded recessions and provide an early warning signal. As seen below, as of now there is no imminent recessionary warning signal being given by the WLI.
Source: Bloomberg
The fact that the ECRI WLI is positive and advancing is bullish for the stock market. The stock market’s best gains are typically associated with the ECRI WLI growth rate in positive territory, and thanks to Bernanke’s hinting and implementation of quantitative easing round 2 (QE 2) last year, the ECRI WLI growth rate continues to climb with last Friday’s reading coming in at 6.5%. Of note, not only is the absolute level of the WLI growth rate in positive territory but it is heading higher.
Source: Bloomberg
Perhaps summing up the above analysis, my own recessionary probability model supports the notion that a recession is not right around the corner, with only a 15.25% chance of a recession occurring in the next six months.
Source: Bloomberg
Why Anxiety Remains High
While the economy is improving on the margin this has still been an atypical recovery that feels like we are just moving along at a snail’s pace. After more than a year and a half past the recession being officially declared over by the NBER in 2009, consumer sentiment is just starting to show signs of life and the decline in consumer credit is showing some bottoming out. That said, with all the money thrown at the economy, is this as good as it gets? Are we really getting that much bang for our newly printed Fed dollars? From my standpoint, I think we really are beginning to run on fumes and unless Fed Chairman Bernanke launches QE3 this year in a “shock and awe” manner we may finally come to the end of this bull market and economic expansion.
One of the things I wanted to look at last year was to breakout the Conference Board’s Leading Economic Indicators (LEI) based on their category. The LEI in 2009 was sharply higher after plunging in 2008 and suggested investors should be bullish on the market. While the LEI was sharply positive in 2009 I wanted to see how much of its strength was attributed to the financial components (which are affected by Fed actions) and the economic components. In essence, the key question to answer was: how much of the Fed’s financial manipulation was translating into real economic improvement? Of the ten components that make up the Conference Board’s LEI roughly 50% comes from stock prices (which Bernanke cited as proof QE was working recently), interest rate spread, and, the biggest component, the M2 money supply clocking in at a hefty 36%. The other seven indicators are true economic indicators and make up roughly 70% of the LEI. A breakdown is shown below with the financial components shown in the green bracket.
Source: The Conference Board
Using the Conference Board’s methodology for constructing the LEI, I broke it out into an Economic LEI and a Monetary LEI to see how the two compared. As shown below, up until the early 1980s both the Monetary and Economic LEIs tracked each other pretty closely and so the two were not that far off from the headline LEI from the Conference Board. However, starting in the early 1980s when the huge credit cycle in the US was about to take off the Monetary and Economic LEIs began to diverge. As time progressed you can notice the two began to diverge even further. What this shows was that less and less of the money printed by the Fed was translating into real economic gains. Currently the Monetary LEI’s growth rate is near its record over the last half century but the Economic LEI is actually NEGATIVE and pulling the overall headline LEI from the Conference Board lower.
Source: Bloomberg
In the chart below I show the year-over-year (YOY) rate of change in the Monetary LEI less the YOY rate of change of the Economic LEI. In February the spread between the two reached an all-time high, showing the Fed may be running out of bullets. Part of this explanation is that we may have reached a tipping point where further Fed action produces negative results due to rising commodity prices and increased inflationary pressures eating into consumer wallets.
Source: Bloomberg
With less and less of the Fed’s printed money reaching the economy, it has to go somewhere. I argued last week in “Money Will Always Find a Home” that, right now, financial assets appear to be the monetary sinkhole.
The current period reminds me of the post Asian Currency Crisis seen in 1998-2000. Shown below is my U.S. Financial Stress Index (FSI) which measures stress within the money markets, bond market, stock market, US Treasury market, and currency markets, with negative readings showing above normal financial stress. Note the similarity between the two yellow boxes. The S&P 500 sold off sharply in 1998 as the Asian Currency Crisis and Long Term Capital Management crisis hit, but the Fed goosed the money supply and up we went. Notice that my U.S. FSI never made it materially into positive territory and yet stocks rocketed higher. The same thing is happening currently in the post Euro currency crisis from last summer in which Bernanke hit the markets with QE2. Unless stress in the various U.S. financial markets recedes this bull market is on shaky ground.
Source: Bloomberg
That said, with a Fed bent on reflating and openly commenting on stock prices as “proof” that QE is working, I would be cautious on becoming bearish too early. Trying to exit in the ninth inning can be an expensive move as you never no how many extra innings a bull market will go. This is similar to the quote from famous economist John Maynard Keynes who said that “The market can stay irrational longer than you can stay solvent.” I’d like to include below my summary comments from last week’s article and a chart highlighting the Fed’s QE programs and the S&P 500.
In short, it’s important not to remain ultra bearish when global central banks are committed to reflating their respective economies. Zimbabwe's stock market serves as a good example. In times such as this, maintaining purchasing power is of utmost importance, which can be achieved through allocating one’s assets towards commodities in general and gold in particular. While central banks are able to inflate assets with printed money, there are choking points when high inflation levels stifle economic activity and can lead to recessions. For this reason, keeping an eye out for the tipping point where commodity prices rise too far, too fast, is key. However, rather than trying to call a top in the markets at their current levels, we maintain our focus on leading economic indicators in determining when high commodity prices lead to a tipping point. Right now leading indicators continue to improve and suggest the time to be bearish is not upon us. Until they become bearish, maintaining purchasing power should be investors' number one priority.
Source: dshort.com
I do believe that we are approaching the ninth inning of this bull market, but with the Fed destroying the value of the USD I’m not turning bearish just yet. I’d rather wait until the game is over and see the evidence of this by the crowds getting out of their seats to head home than pick a market top, which, as the bears during last summer’s sell off found out, can be very dangerous. Rather, monitoring the trend of the market may be the best tool to gauge when the final out for this bull market has occurred. I’ve highlighted some trend following tools in the past such as the S&P 500 15/40 weekly exponential moving average system or the S&P 500 in relation to its one year moving average. These two tools shown below show that the trend is still bullish for the S&P 500, and the bulls and Fed should be given the bullish benefit of the doubt until the trend turns bearish as it did in 2000 and 2007.
Source: StockCharts.com
