Recently, I wrote an article detailing the divergence between the strong performance of economically sensitive indexes such as the transports and small caps and manufacturing data which has remained unimpressive, failing to confirm the strength in the markets. Puzzled by this disparity, I concluded that manufacturing data needs to come in stronger to justify the recent market strength.
I received some interesting feedback from readers pointing out that recent data may be skewed due to Hurricane Sandy and the effects of the fiscal cliff which temporarily stifled new spending and orders. Additionally, one reader asked me to look at the consumer spending data and it was eye opening. In this article, I want to point out the strength of the US consumer and their contribution to the market's current strength.
October 2011 - Today
Many pure technicians are dismissive of economic data as it tends to be backwards looking while they state that markets are forward looking. This statement is certainly true, however at some point we have to check the data to see if the market's anticipation of better conditions was correct. Although this rally feels like it is just getting started due to the drama and gyrations of the fiscal cliff, the stock market has been climbing higher since October 2011.
Since October 2011 with the markets in free fall due to fears about the EU's survival, the market has been on a steady pattern of higher highs and higher lows. Basically anyone with the temerity to ignore the headlines whether Europe, fiscal cliff, debt ceiling, and a long enough holding period has done well over this time period with regards to the indexes.
Using the ratio chart of the iShares Russell 2000 Index (NYSEARCA:IWM) to the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) as a rough proxy of the market's anticipating of future conditions, we see that the ratio bottomed in August along with Draghi and the ECB's aggressive pledge and actions to ensure that the euro would survive. No doubt, systemic risk being taken off the table is bullish.
The election and the fiscal cliff resulted in a bout of profit taking, however there were strong divergences between price and market internals as detailed in this article. Since then, the market correctly anticipated a resolution and it has not looked back with the S&P 500 climbing 160 points higher in 11 weeks.
The point of this discussion was to show that the market is almost 40% higher since the October 2011 bottom and even at the climax of the brutal fiscal cliff correction in November, it was about 25% higher than the October 2011 nadir. Therefore, there should be some data to justify this move higher that is reflecting a stronger economy. There is, and it points to a strong and resilient consumer that has been carrying this market.
One quick way to show the health of the consumer is by showing a 7 year chart of the Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY).
The performance is remarkable. The consumer discretionary stocks took out their all time highs back in early 2011 and have managed to climb another 25% from then. Was the market correct in anticipating a stronger consumer?
Clearly, the answer is yes. The consumer, those with jobs, is doing well. Of course, this strength is only evident by looking the actual data or the market performance of stocks within the sector. During the period of July 2011 to August 2012 which began with the downgrade of the US credit rating and ended with the ECB's pledge of unlimited bond buying due to the rapidly, rising interest rates of Italy and Spain which threatened the viability of the Euro and possibly the EU, the S&P 500 ended flat although in a range from 1075 to 1375.
Masked in this was the free fall of cyclical stocks such as steel, basic materials, and emerging market stocks. Many of these stocks plunged back to 2009 levels. However, the market remained resilient due to consumer stocks, thanks to the US consumer who continued to keep spending despite the palpable fear in the markets.
Now with traders' perception of future conditions improving (based on outperformance of small caps, transports, and cyclical stocks), strength in these stocks would add more fuel to the fire, given that the consumer keeps spending. This seems a reasonable assumption since the stock market is almost back at all time highs and housing seems to be coming back - the wealth effect in action.
My optimism about this market's ability to take out all time highs in 2013 stems from the strong internals of the market. The strong consumer spending numbers provides a compelling reason for the market resilience despite the staggering weakness in cyclical stocks and macro headwinds.
Currently, economically sensitive stocks continue to strongly outperform. Breadth is impressive and already well past all time highs. Apple, the market's darling for so long, has been cut down by 40%, yet the market has barely blinked. The money coming out of Apple has not been finding its way into investors' pockets but rather being rotated back into new stocks. This is another positive sign for bulls - correlations are dropping - a key ingredient in a sustaining, trending market.
Further, although manufacturing growth remains limp and not entirely consistent with new highs. The consumer is doing well, or at least spending like he is doing well. Its hard to believe that the consumer has bounced back so strongly after the wealth destruction of 2007-2009 but its a testament to the resilience of our economy.
In the short term with the market so overbought and sentiment sky high, a correction at some point seems likely. As long as market internals remain strong, I think it will be an opportunity to "buy the dip". For the long term sustainability of this rally, I think its important that manufacturing join the rally and for consumer spending to keep growing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.