While the financial media is certainly going to be clamoring over the all but certain improvement in Q2 GDP numbers set to be released later in the month, should investors? Is the worst behind us and are there clear skies ahead, or is the picture far from rosy? These are the vital questions investors need to ask themselves as their answers to them will dictate how they invest going forward.
In a Bloomberg interview yesterday Martin Feldstein, a professor of economics at Harvard University and former head of the National Bureau of Economic Research (NBER, the recession arbiters), does not believe that happier times are here again. He casts a different light on the U.S. economy compared to others such as BofA Merrill Lynch that told investors that the recession is over last week (Click for BofA article). Mr. Feldstein sees the possibility of a double-dip recession, and excerpts from the article are provided below (emphasis added):
Harvard’s Feldstein Sees Risk of ‘Double-Dip’ Recession in U.S.
"There is a real danger this is going to be a double dip and that after six months or so we’ll have some more bad news," Feldstein, the former head of the National Bureau of Economic Research and Reagan administration adviser, said today in an interview on Bloomberg Television. "We could slide down again in the fourth quarter."
The economy could "flatten out" or "even be positive" in the third quarter, and then it’s likely to contract again in the last three months of the year as the effects of the federal stimulus program wear off and companies finish rebuilding inventories, he said.
"There isn’t going to be enough to sustain a really solid recovery," he said, even though recent data has provided some "good news" on the economy.
A significant improvement in Q2 GDP numbers relative to Q1 is likely as residential real estate’s drag on the economy is lessening, which is a leading economic indicator. Typically the percent contribution to GDP from residential fixed investment serves as a leading indicator while equipment and software spending serves as a coincident indicator and nonresidential real estate serves as a lagging indicator. We can say that the trough appears to be in for residential fixed investment which should be subtracting less to GDP going forward, but it will be interesting to see if equipment and software spending bottoms. If it doesn’t then the comments from BofA Merrill Lynch will likely prove premature.
Source: BEA
Another thing to keep in mind is that a positive quarter of GDP (which is quite possible in Q3) does not necessarily mean the recession is over. For example, since the 1948 recession, every recession has witnessed at least one quarter of positive real GDP, with the 1990 recession being the only exception. You can see this in the charts below that show at least one positive tick in real GDP growth during recessions (grey bars), with the average recession showing two quarters of positive real GDP growth during its duration.
Source: BEA
Source: BEA
Source: BEA
Source: BEA, NBER
Instead of focusing on the quarterly GDP numbers NBER uses monthly indicators to determine the exact months for peaks and troughs in economic activity. The four components that NBER places the most important emphasis on in their recession call decisions are the following:
- Personal income less transfer payments (in real terms)
- Employment
- Industrial production
- Volume of sales of the manufacturing and wholesale-retail sectors (adjusted for price changes.)
Looking at those four key indicators shows that none of them have bottomed and points to the recession being alive and well. The NBER called the end to the last recession back in November 2001 as retail sales picked up and industrial production was stabilizing, but note below that employment and personal income continued to decline until 2003, which also marked the end of the last bear market. This is key because sustainable bull markets are born on sustained economic activity, not "green shoots" of less bad economic activity. As all four key economic indicators are still in decline the stock market may be in for a correction unless the economy shows actual real improvement.
Source: Bloomberg
In terms of gauging the breadth of economic activity across the country, the Philly Fed State Coincident Diffusion Index serves as an excellent indicator. So far the indicator does not show any support for the rally in the markets, and its role as leading indicator to the peaks and troughs in the stock market over the last ten years should not be ignored. The index peaked prior to the 2000 stock market peak and showed dramatic improvement over 2001-2003 relative to the stock market (read “positive divergence”), and the index peaked several months prior the markets peak in October of 2007. While an improvement in the indicator in 2001 did support at least a rally in the stock markets, there is no such support currently to justify the markets sizable gains off the March lows.
Source: Bloomberg
A lack of improvement in the index in the months ahead should be sending investors a glaring red flag and should not be dismissed lightly. It’s not hard to see why the Philly Fed State Coincident Index is barely budging when we receive news of states possibly entering bankruptcy and issuing I.O.U.s. California, in an attempt to balance its budget, is releasing 27,000 inmates to cut costs; quite the dramatic measure. A reading of the article below shows how deep the recession is across the country:
- California budget deal to free 27,000 inmates
- Philadelphia Halts Payments in Crunch
- Jefferson County, Alabama, to Put One-Third of Workers on Leave
Until the four key NBER indicators begin to turn up (let alone stabilize) and the Philly Fed State Index improves, market rallies should be rented and not owned as what the markets give to investors can also be easily taken back.
Don’t Fight the Fed Back in Vogue?
While there are still economic concerns that will need to be alleviated for a sustained bull market advance, it appears that the Fed is giving the markets a boost until signs of economic growth, not just improvement, appear. Since the start of the year the size of the Fed’s balance sheet (BS) has proved a useful leading indicator to the stock market. The decline in the Fed’s BS in mid January preceded the peak in the S&P 500 that occurred two weeks later, and an expansion of the Fed’s BS in February and March preceded the markets March bottom. Also, you can see below that the peak in April in the Fed’s BS came prior to the correction that occurred in early May, while the expansion in the Fed’s BS preceded the rally into the June highs in the market. As commented in last week’s article, just as it appeared the markets were going to put in a head and shoulders (H&S) top the Fed stopped reducing its BS and reversed course with the markets then staging a dramatic recovery rally this week, invalidating the H&S top. As it appears the size of the Fed’s BS is leading market turns, then viewing the weekly Thursday release of the Fed’s BS may prove useful for investors (Click for link).
Source: Bloomberg
So far the markets remain resilient and the bulls should be given the benefit of the doubt until proven otherwise. The Euro/Yen exchange rate remains within base 2 and above its 200 day moving average (green line below), though it also remains in a declining trend since the June highs.
Source: Bloomberg
However, the currency pair did close below the rising trend line during the week and close below its 50 day moving average (red line), indicating a decline back down to the 200 day moving average is possible and would signal risk aversion is heightening and pointing towards a market correction in the short term.
Source: Bloomberg
The daily TD Combo chart for the S&P 500 also signals a possible correction lies on the horizon as we have reached count 8 of 9 for a sell setup. The last daily sell setup came back in early May and led to a multi week consolidation, and after a dramatic rally over the past week, and a TD Combo sell signal likely to occur tomorrow, caution appears to be in order for the time being.
Source: Bloomberg
